## SA 240 – Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements
### Definition of Fraud
Fraud is an intentional act by one or more individuals among management, TCWG, employees, or third parties, involving deception to obtain an unjust or illegal advantage.
> Critical distinction: Fraud = intentional. Error = unintentional.
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### Two Categories of Fraud
| Category | Description |
|---|---|
| Misappropriation of Assets | Theft or misuse of company assets (mainly cash/inventory) |
| Fraudulent Financial Reporting (FFR) | Manipulation of financial statements |
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### Fraud Risk Factors
Fraud Risk Factors = events or conditions that indicate an incentive/pressure to commit fraud or provide an opportunity.
#### For Misappropriation of Assets
1. Recent/anticipated changes to employee compensation or benefits
2. Inventory items that are small, high-value, or in high demand
3. Fixed assets that are small, marketable, or lack observable ownership identification
4. Inadequate internal control over assets
5. Employee displeasure or dissatisfaction with the entity
#### For Fraudulent Financial Reporting
1. Significant portion of management's compensation tied to net profits
2. High turnover of management or board members
3. Frequent disputes with the auditor
4. Unreasonable time constraints placed on the auditor
5. Significant pressure to obtain additional capital
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### Cash Defalcation — Methods
#### By Inflating Cash Payments
1. Payments against fictitious vouchers
2. Payments against inflated vouchers
3. Dummy workers inserted into wage rolls
4. Casting larger totals for petty cash expenditure
#### By Suppressing Cash Receipts
1. Teeming and Lading — using one customer's receipt to cover another's shortfall
2. Applying fictitious/unauthorised discounts to customer accounts
3. Writing off as bad debts cash that has already been received
4. Not fully accounting for cash sales
5. Not accounting for miscellaneous receipts
6. Writing down asset values, selling them, and misappropriating proceeds
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### Ways to Manipulate Financial Statements (FFR)
1. Recording fictitious sales or omitting sales
2. Recording fictitious purchases or suppressing purchases
3. Over-valuation or under-valuation of stock
4. Recording fictitious expenses or omitting expenses
5. Taking credit for accrued income unlikely to be received
6. Reclassifying revenue expenses as capital expenses (or vice versa)
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### Auditor's Responsibility — The Key Conclusions
1. Inherent audit limitations mean auditors cannot guarantee detection of all MMS
2. Fraud is harder to detect than errors
3. Management fraud is harder to detect than employee fraud
4. The auditor must maintain professional skepticism throughout, especially regarding management override of controls
5. Bottom line: Detection of fraud is not the auditor's primary duty — but the auditor must comply with SA requirements, maintain professional skepticism, and must not be grossly negligent
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### Auditor's Responses
#### A) Overall Responses
- Increase professional skepticism
- Assign appropriate (experienced) audit personnel
- Evaluate selection and application of accounting policies
- Give special attention to complex transactions
- Incorporate unpredictability in audit procedures
#### B) Audit Procedures — Changes at Assertion Level
| Dimension | Change | Examples |
|---|---|---|
| Nature | Different type of procedure | Physical observation/inspection; use more CAATs |
| Timing | When the procedure is performed | Perform nearer to year-end |
| Extent | How much work | Larger sample size; more detailed analytical procedures |
#### C) Management Override of Controls
Management can manipulate accounting records and override internal controls — making this the highest-risk fraud scenario. Specific procedures addressing this risk are required regardless of the assessed risk level.