SA 240 Fraud

SA 240*
The Auditor’s Responsibilities Relating to
Fraud in an Audit of Financial Statements
(Effective for audits of financial statements for periods
beginning on or after April 1, 2009)

Contents
Paragraph(s)
Introduction
Scope of this SA .................................................................................... 1-8
Effective Date ........................................................................................... 9
Objectives .............................................................................................. 10
Definitions ............................................................................................. 11
Requirements
Professional Skepticism .................................................................... 12-14
Discussion Among the Engagement Team ........................................... 15
Risk Assessment Procedures and Related Activities ....................... 16-24
Identification and Assessment of the Risks of
Material Misstatement Due to Fraud ................................................. 25-27
Responses to the Assessed Risks of
Material Misstatement Due to Fraud ................................................. 28-33
Evaluation of Audit Evidence ............................................................ 34-37
Auditor Unable to Continue the Engagement ........................................ 38
Management Representations ................................................................ 39
Communications to Management and with
Those Charged with Governance ..................................................... 40-42
Communications to Regulatory and Enforcement Authorities ............... 43
Documentation .................................................................................. 44-47
Application and Other Explanatory Material
Characteristics of Fraud ................................................................... A1-A6
Professional Skepticism ................................................................... A7-A9

* Published in December, 2007 issue of the Journal.
Handbook of Auditing Pronouncements-I.A

Discussion Among the Engagement Team ..............................…A10-A11
Risk Assessment Procedures and Related Activities .................. A12-A27
Identification and Assessment of the Risks of
Material Misstatement Due to Fraud ............................................ A28-A32
Responses to the Assessed Risks of
Material Misstatement Due to Fraud ............................................ A33-A47
Evaluation of Audit Evidence ....................................................... A48-A52
Auditor Unable to Continue the Engagement .............................. A53-A56
Management Representations ..................................................... A57-A58
Communications to Management and
with Those Charged with Governance ......................................... A59-A63
Communications to Regulatory and Enforcement Authorities ..... A64-A66
Material Modifications to ISA 240, The Auditor’s Responsibility relating to
Fraud in an Audit of Financial Statements
Appendices:
1. Examples of Fraud Risk Factors
2. Examples of Possible Audit Procedures to Address the Assessed
Risks of Material Misstatement Due to Fraud
3. Examples of Circumstances that Indicate the Possibility of Fraud
Standard on Auditing (SA) 240, “The Auditor’s Responsibilities Relating
to Fraud in an Audit of Financial Statements” should be read in the
context of the “Preface to the Standards on Quality Control, Auditing,
Review, Other Assurance and Related Services,” which sets out the
authority of SAs and SA 200, “Overall Objectives of the Independent
Auditor and the Conduct of an Audit in Accordance with Standards on
Auditing”.

SA 240 2
Introduction
Scope of this SA
1. This Standard on Auditing (SA) deals with the auditor’s responsibilities
relating to fraud in an audit of financial statements. Specifically, it expands on
how SA 315, “Identifying and Assessing the Risks of Material Misstatement
Through Understanding the Entity and Its Environment,” and SA 330, “The
Auditor’s Responses to Assessed Risks,” are to be applied in relation to risks of
material misstatement due to fraud.
Characteristics of Fraud
2. Misstatements in the financial statements can arise from either fraud or
error. The distinguishing factor between fraud and error is whether the
underlying action that results in the misstatement of the financial statements is
intentional or unintentional.
3. Although fraud is a broad legal concept, for the purposes of the SAs, the
auditor is concerned with fraud that causes a material misstatement in the financial
statements. Two types of intentional misstatements are relevant to the auditor–
misstatements resulting from fraudulent financial reporting and misstatements
resulting from misappropriation of assets. Although the auditor may suspect or, in
rare cases, identify the occurrence of fraud, the auditor does not make legal
determinations of whether fraud has actually occurred. (Ref: Para. A1-A6)
Responsibility for the Prevention and Detection of Fraud
4. The primary responsibility for the prevention and detection of fraud rests
with both those charged with governance of the entity and management. It is
important that management, with the oversight of those charged with governance,
place a strong emphasis on fraud prevention, which may reduce opportunities for
fraud to take place, and fraud deterrence, which could persuade individuals not to
commit fraud because of the likelihood of detection and punishment. This involves
a commitment to creating a culture of honesty and ethical behavior which can be
reinforced by an active oversight by those charged with governance. In exercising
oversight responsibility, those charged with governance consider the potential for
override of controls or other inappropriate influence over the financial reporting
process, such as efforts by management to manage earnings in order to influence
the perceptions of analysts as to the entity’s performance and profitability.
Responsibilities of the Auditor
5. An auditor conducting an audit in accordance with SAs is responsible for
obtaining reasonable assurance that the financial statements taken as a whole

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are free from material misstatement, whether caused by fraud or error. Owing to
the inherent limitations of an audit, there is an unavoidable risk that some
material misstatements of the financial statements may not be detected, even
though the audit is properly planned and performed in accordance with the SAs.1
6. As described in SA 2002, the potential effects of inherent limitations are
particularly significant in the case of misstatement resulting from fraud. The risk
of not detecting a material misstatement resulting from fraud is higher than the
risk of not detecting one resulting from error. This is because fraud may involve
sophisticated and carefully organized schemes designed to conceal it, such as
forgery, deliberate failure to record transactions, or intentional
misrepresentations being made to the auditor. Such attempts at concealment
may be even more difficult to detect when accompanied by collusion. Collusion
may cause the auditor to believe that audit evidence is persuasive when it is, in
fact, false. The auditor’s ability to detect a fraud depends on factors such as the
skillfulness of the perpetrator, the frequency and extent of manipulation, the
degree of collusion involved, the relative size of individual amounts manipulated,
and the seniority of those individuals involved. While the auditor may be able to
identify potential opportunities for fraud to be perpetrated, it is difficult for the
auditor to determine whether misstatements in judgment areas such as
accounting estimates are caused by fraud or error.
7. Furthermore, the risk of the auditor not detecting a material misstatement
resulting from management fraud is greater than for employee fraud, because
management is frequently in a position to directly or indirectly manipulate
accounting records, present fraudulent financial information or override control
procedures designed to prevent similar frauds by other employees.
8. When obtaining reasonable assurance, the auditor is responsible for
maintaining professional skepticism throughout the audit, considering the
potential for management override of controls and recognizing the fact that audit
procedures that are effective for detecting error may not be effective in detecting
fraud. The requirements in this SA are designed to assist the auditor in
identifying and assessing the risks of material misstatement due to fraud and in
designing procedures to detect such misstatement.
Effective Date
9. This SA is effective for audits of financial statements for periods beginning
on or after 1st April, 2009.

1 SA 200, paragraph A51-A52.
2 SA 200, paragraph A52.

SA 240 4
Objectives
10. The objectives of the auditor are:
(a) To identify and assess the risks of material misstatement in the financial
statements due to fraud;
(b) To obtain sufficient appropriate audit evidence about the assessed risks
of material misstatement due to fraud, through designing and
implementing appropriate responses; and
(c) To respond appropriately to identified or suspected fraud.
Definitions
11. For purposes of the SAs, the following terms have the meanings attributed
below:
(a) Fraud - An intentional act by one or more individuals among
management, those charged with governance, employees, or third
parties, involving the use of deception to obtain an unjust or illegal
advantage.
(b) Fraud risk factors - Events or conditions that indicate an incentive or
pressure to commit fraud or provide an opportunity to commit fraud.
Requirements
Professional Skepticism
12. In accordance with SA 2003, the auditor shall maintain professional
skepticism throughout the audit, recognizing the possibility that a material
misstatement due to fraud could exist, notwithstanding the auditor’s past
experience of the honesty and integrity of the entity’s management and those
charged with governance. (Ref: Para. A7- A8)
13. Unless the auditor has reason to believe the contrary, the auditor may
accept records and documents as genuine. If conditions identified during the
audit cause the auditor to believe that a document may not be authentic or that
terms in a document have been modified but not disclosed to the auditor, the
auditor shall investigate further. (Ref: Para. A9)
14. Where responses to inquiries of management or those charged with
governance are inconsistent, the auditor shall investigate the inconsistencies.
Discussion Among the Engagement Team
15. SA 315 requires a discussion among the engagement team members and

3 SA 200, paragraph 15.

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a determination by the engagement partner of matters which are to be
communicated to those team members not involved in the discussion4. This
discussion shall place particular emphasis on how and where the entity’s
financial statements may be susceptible to material misstatement due to fraud,
including how fraud might occur. The discussion shall occur notwithstanding the
engagement team members’ beliefs that management and those charged with
governance are honest and have integrity. (Ref: Para. A10-A11)
Risk Assessment Procedures and Related Activities
16. When performing risk assessment procedures and related activities to
obtain an understanding of the entity and its environment, including the entity’s
internal control, required by SA 3155, the auditor shall perform the procedures in
paragraphs 17-24 to obtain information for use in identifying the risks of material
misstatement due to fraud.
Management and Others within the Entity
17. The auditor shall make inquiries of management regarding:
(a) Management’s assessment of the risk that the financial statements may
be materially misstated due to fraud, including the nature, extent and
frequency of such assessments; (Ref: Para. A12-A13)
(b) Management’s process for identifying and responding to the risks of fraud
in the entity, including any specific risks of fraud that management has
identified or that have been brought to its attention, or classes of
transactions, account balances, or disclosures for which a risk of fraud is
likely to exist; (Ref: Para. A14)
(c) Management’s communication, if any, to those charged with governance
regarding its processes for identifying and responding to the risks of fraud
in the entity; and
(d) Management’s communication, if any, to employees regarding its views
on business practices and ethical behavior.
18. The auditor shall make inquiries of management, and others within the
entity as appropriate, to determine whether they have knowledge of any actual,
suspected or alleged fraud affecting the entity. (Ref: Para. A15-A17)
19. For those entities that have an internal audit function, the auditor shall
make inquiries of internal audit to determine whether it has knowledge of any
actual, suspected or alleged fraud affecting the entity, and to obtain its views
about the risks of fraud. (Ref: Para. A18)

4 SA 315, paragraph 10.
5 SA 315, paragraphs 5-24.

SA 240 6
Those Charged with Governance
20. Unless all of those charged with governance are involved in managing the
entity6, the auditor shall obtain an understanding of how those charged with
governance exercise oversight of management’s processes for identifying and
responding to the risks of fraud in the entity and the internal control that
management has established to mitigate these risks. (Ref: Para. A19-A21)
21. The auditor shall make inquiries of those charged with governance to
determine whether they have knowledge of any actual, suspected or alleged
fraud affecting the entity. These inquiries are made in part to corroborate the
responses to the inquiries of management.
Unusual or Unexpected Relationships Identified
22. The auditor shall evaluate whether unusual or unexpected relationships that
have been identified in performing analytical procedures, including those related to
revenue accounts, may indicate risks of material misstatement due to fraud.
Other Information
23. The auditor shall consider whether other information obtained by the auditor
indicates risks of material misstatement due to fraud. (Ref: Para. A22)
Evaluation of Fraud Risk Factors
24. The auditor shall evaluate whether the information obtained from the other
risk assessment procedures and related activities performed indicates that one
or more fraud risk factors are present. While fraud risk factors may not
necessarily indicate the existence of fraud, they have often been present in
circumstances where frauds have occurred and therefore may indicate risks of
material misstatement due to fraud. (Ref: Para. A23-A27)
Identification and Assessment of the Risks of Material Misstatement
Due to Fraud
25. In accordance with SA 315, the auditor shall identify and assess the risks
of material misstatement due to fraud at the financial statement level, and at the
assertion level for classes of transactions, account balances and disclosures7.
26. When identifying and assessing the risks of material misstatement due to
fraud, the auditor shall, based on a presumption that there are risks of fraud in
revenue recognition, evaluate which types of revenue, revenue transactions or
assertions give rise to such risks. Paragraph 47 specifies the documentation

6 SA 260(Revised), “Communication with Those Charged with Governance”, paragraph 16(c).
7 SA 315, Paragraph 25.

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required when the auditor concludes that the presumption is not applicable in the
circumstances of the engagement and, accordingly, has not identified revenue
recognition as a risk of material misstatement due to fraud. (Ref: Para. A28-A30)
27. The auditor shall treat those assessed risks of material misstatement due
to fraud as significant risks and accordingly, to the extent not already done so,
the auditor shall obtain an understanding of the entity’s related controls, including
control activities, relevant to such risks. (Ref: Para. A31-A32)
Responses to the Assessed Risks of Material Misstatement Due to
Fraud
Overall Responses
28. In accordance with SA 330, the auditor shall determine overall responses
to address the assessed risks of material misstatement due to fraud at the
financial statement level.8 (Ref: Para. A33)
29. In determining overall responses to address the assessed risks of material
misstatement due to fraud at the financial statement level, the auditor shall:
(a) Assign and supervise personnel taking account of the knowledge, skill
and ability of the individuals to be given significant engagement
responsibilities and the auditor’s assessment of the risks of material
misstatement due to fraud for the engagement; (Ref: Para. A34-A35)
(b) Evaluate whether the selection and application of accounting policies by
the entity, particularly those related to subjective measurements and
complex transactions, may be indicative of fraudulent financial reporting
resulting from management’s effort to manage earnings; and
(c) Incorporate an element of unpredictability in the selection of the nature,
timing and extent of audit procedures. (Ref: Para. A36)
Audit Procedures Responsive to Assessed Risks of Material Misstatement
Due to Fraud at the Assertion Level
30. In accordance with SA 330, the auditor shall design and perform further
audit procedures whose nature, timing and extent are responsive to the
assessed risks of material misstatement due to fraud at the assertion level. 9
(Ref: Para. A37-A40)

8 SA 330, paragraph 5.
9 SA 330, paragraph 6.

SA 240 8
Audit Procedures Responsive to Risks Related to Management Override of
Controls
31. Management is in a unique position to perpetrate fraud because of
management’s ability to manipulate accounting records and prepare fraudulent
financial statements by overriding controls that otherwise appear to be operating
effectively. Although the level of risk of management override of controls will
vary from entity to entity, the risk is nevertheless present in all entities. Due to
the unpredictable way in which such override could occur, it is a risk of material
misstatement due to fraud and thus a significant risk.
32. Irrespective of the auditor’s assessment of the risks of management
override of controls, the auditor shall design and perform audit procedures to:
(a) Test the appropriateness of journal entries recorded in the general ledger
and other adjustments made in the preparation of the financial
statements. In designing and performing audit procedures for such tests,
the auditor shall:
(i) Make inquiries of individuals involved in the financial reporting
process about inappropriate or unusual activity relating to the
processing of journal entries and other adjustments;
(ii) Select journal entries and other adjustments made at the end of a
reporting period; and
(iii) Consider the need to test journal entries and other adjustments
throughout the period. (Ref: Para. A41-A44)
(b) Review accounting estimates10 for biases and evaluate whether the
circumstances producing the bias, if any, represent a risk of material
misstatement due to fraud. In performing this review, the auditor shall:
(i) Evaluate whether the judgments and decisions made by
management in making the accounting estimates included in the
financial statements, even if they are individually reasonable,
indicate a possible bias on the part of the entity’s management
that may represent a risk of material misstatement due to fraud. If
so, the auditor shall re-evaluate the accounting estimates taken as
a whole; and
(ii) Perform a retrospective review of management judgments and
assumptions related to significant accounting estimates reflected

10 Reference may be made to SA 540, “Auditing Accounting Estimates, Including Fair Value

Accounting Estimates, and Related Disclosures”.

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in the financial statements of the prior year11. (Ref: Para. A45-
A46)
(c) For significant transactions that are outside the normal course of business
for the entity, or that otherwise appear to be unusual given the auditor’s
understanding of the entity and its environment and other information
obtained during the audit, the auditor shall evaluate whether the business
rationale (or the lack thereof) of the transactions suggests that they may
have been entered into to engage in fraudulent financial reporting or to
conceal misappropriation of assets. (Ref: Para. A47)
33. The auditor shall determine whether, in order to respond to the identified
risks of management override of controls, the auditor needs to perform other audit
procedures in addition to those specifically referred to above (i.e., when there are
specific additional risks of management override that are not covered as part of the
procedures performed to address the requirements in paragraph 32).
Evaluation of Audit Evidence (Ref: Para. A48)
34. The auditor shall evaluate whether analytical procedures12 that are
performed when forming an overall conclusion as to whether the financial
statements as a whole are consistent with the auditor’s understanding of the
entity and its environment indicate a previously unrecognized risk of material
misstatement due to fraud. (Ref: Para. A49)
35. When the auditor identifies a misstatement, the auditor shall evaluate
whether such a misstatement is indicative of fraud. If there is such an indication,
the auditor shall evaluate the implications of the misstatement in relation to other
aspects of the audit, particularly the reliability of management representations,
recognizing that an instance of fraud is unlikely to be an isolated occurrence.
(Ref: Para. A50)
36. If the auditor identifies a misstatement, whether material or not, and the
auditor has reason to believe that it is or may be the result of fraud and that
management (in particular, senior management) is involved, the auditor shall re-
evaluate the assessment of the risks of material misstatement due to fraud and
its resulting impact on the nature, timing and extent of audit procedures to
respond to the assessed risks. The auditor shall also consider whether
circumstances or conditions indicate possible collusion involving employees,
management or third parties when reconsidering the reliability of evidence
previously obtained. (Ref: Para. A51)

11 Accounting Standard (AS) 5, “Net Profit or Loss for the Period, Prior Period Items and Changes

in Accounting Policies” requires the adjustment of the prior period estimates, which may affect both
the period of change in the Accounting Estimates and subsequent periods, in subsequent years.
12 Reference may be made to SA 520, “Analytical Procedures”.

SA 240 10
37. When the auditor confirms that, or is unable to conclude whether, the
financial statements are materially misstated as a result of fraud the auditor shall
evaluate the implications for the audit. (Ref: Para. A52)
Auditor Unable to Continue the Engagement
38. If, as a result of a misstatement resulting from fraud or suspected fraud,
the auditor encounters exceptional circumstances that bring into question the
auditor’s ability to continue performing the audit, the auditor shall:
(a) Determine the professional and legal responsibilities applicable in the
circumstances, including whether there is a requirement for the auditor to
report to the person or persons who made the audit appointment or, in
some cases, to regulatory authorities;
(b) Consider whether it is appropriate to withdraw from the engagement,
where withdrawal from the engagement is legally permitted; and
(c) If the auditor withdraws:
(i) Discuss with the appropriate level of management and those
charged with governance, the auditor’s withdrawal from the
engagement and the reasons for the withdrawal; and
(ii) Determine whether there is a professional or legal requirement to
report to the person or persons who made the audit appointment
or, in some cases, to regulatory authorities, the auditor’s
withdrawal from the engagement and the reasons for the
withdrawal. (Ref: Para. A53-A56)
Management Representations
39. The auditor shall obtain written representations from management and,
where applicable, those charged with governance that:
(a) They acknowledge their responsibility for the design, implementation and
maintenance of internal control to prevent and detect fraud;
(b) They have disclosed to the auditor the results of management’s
assessment of the risk that the financial statements may be materially
misstated as a result of fraud;
(c) They have disclosed to the auditor their knowledge of fraud or suspected
fraud affecting the entity involving:
(i) Management;
(ii) Employees who have significant roles in internal control; or
(iii) Others where the fraud could have a material effect on the
financial statements; and

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(d) They have disclosed to the auditor their knowledge of any allegations of
fraud, or suspected fraud, affecting the entity’s financial statements
communicated by employees, former employees, analysts, regulators or
others. (Ref: Para. A57-A58)
Communications to Management and with Those Charged with
Governance
40. If the auditor has identified a fraud or has obtained information that
indicates that a fraud may exist, the auditor shall communicate these matters on
a timely basis to the appropriate level of management in order to inform those
with primary responsibility for the prevention and detection of fraud of matters
relevant to their responsibilities. (Ref: Para. A59)
41. Unless all of those charged with governance are involved in managing the
entity, if the auditor has identified or suspects fraud involving:
(a) Management;
(b) Employees who have significant roles in internal control; or
(c) Others where the fraud results in a material misstatement in the financial
statements.
The auditor shall communicate these matters to those charged with governance
on a timely basis. If the auditor suspects fraud involving management, the
auditor shall communicate these suspicions to those charged with governance
and discuss with them the nature, timing and extent of audit procedures
necessary to complete the audit. (Ref: Para. A60-A62)
42. In accordance with SA 260(Revised)13, the auditor shall communicate with
those charged with governance any other matters related to fraud that are, in the
auditor’s judgment, relevant to their responsibilities. (Ref: Para. A63)
Communications to Regulatory and Enforcement Authorities
43. If the auditor has identified or suspects a fraud, the auditor shall determine
whether there is a responsibility to report the occurrence or suspicion to a party
outside the entity. Although the auditor’s professional duty to maintain the
confidentiality of client information may preclude such reporting, the auditor’s
legal responsibilities may override the duty of confidentiality in some
circumstances. (Ref: Para. A64-A66)

13 Reference may be made to SA 260(Revised), “Communication with Those Charged with
Governance”.

SA 240 12
Documentation
44. The auditor’s documentation of the understanding of the entity and its
environment and the assessment of the risks of material misstatement required
by SA 31514 shall include:
(a) The significant decisions reached during the discussion among the
engagement team regarding the susceptibility of the entity’s financial
statements to material misstatement due to fraud; and
(b) The identified and assessed risks of material misstatement due to fraud at
the financial statement level and at the assertion level.
45. The auditor’s documentation of the responses to the assessed risks of
material misstatement required by SA 33015 shall include:
(a) The overall responses to the assessed risks of material misstatement due
to fraud at the financial statement level and the nature, timing and extent
of audit procedures, and the linkage of those procedures with the
assessed risks of material misstatement due to fraud at the assertion
level; and
(b) The results of the audit procedures, including those designed to address
the risk of management override of controls.
46. The auditor shall document communications about fraud made to
management, those charged with governance, regulators and others.
47. When the auditor has concluded that the presumption that there is a risk
of material misstatement due to fraud related to revenue recognition is not
applicable in the circumstances of the engagement, the auditor shall document
the reasons for that conclusion.
***
Application and Other Explanatory Material
Characteristics of Fraud (Ref: Para. 3)
A1. Fraud, whether fraudulent financial reporting or misappropriation of
assets, involves incentive or pressure to commit fraud, a perceived opportunity to
do so and some rationalization of the act. For example:
 Incentive or pressure to commit fraudulent financial reporting may exist
when management is under pressure, from sources outside or inside the
entity, to achieve an expected (and perhaps unrealistic) earnings target or

14 SA 315, paragraph 32.
15 SA 330, paragraph 28.

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financial outcome – particularly since the consequences to management for
failing to meet financial goals can be significant. Similarly, individuals may
have an incentive to misappropriate assets, for example, because the
individuals are living beyond their means.
 A perceived opportunity to commit fraud may exist when an individual
believes internal control can be overridden, for example, because the
individual is in a position of trust or has knowledge of specific deficiencies in
internal control.
 Individuals may be able to rationalize committing a fraudulent act. Some
individuals possess an attitude, character or set of ethical values that allow
them knowingly and intentionally to commit a dishonest act. However, even
otherwise honest individuals can commit fraud in an environment that
imposes sufficient pressure on them.
A2. Fraudulent financial reporting involves intentional misstatements including
omissions of amounts or disclosures in financial statements to deceive financial
statement users. It can be caused by the efforts of management to manage
earnings in order to deceive financial statement users by influencing their
perceptions as to the entity’s performance and profitability. Such earnings
management may start out with small actions or inappropriate adjustment of
assumptions and changes in judgments by management. Pressures and
incentives may lead these actions to increase to the extent that they result in
fraudulent financial reporting. Such a situation could occur when, due to
pressures to meet market expectations or a desire to maximize compensation
based on performance, management intentionally takes positions that lead to
fraudulent financial reporting by materially misstating the financial statements. In
some entities, management may be motivated to reduce earnings by a material
amount to minimize tax or to inflate earnings to secure bank financing.
A3. Fraudulent financial reporting may be accomplished by the following:
 Manipulation, falsification (including forgery), or alteration of accounting
records or supporting documentation from which the financial statements are
prepared.
 Misrepresentation in or intentional omission from, the financial statements of
events, transactions or other significant information.
 Intentional misapplication of accounting principles relating to amounts,
classification, manner of presentation, or disclosure.
A4. Fraudulent financial reporting often involves management override of
controls that otherwise may appear to be operating effectively. Fraud can be
committed by management overriding controls using such techniques as:

SA 240 14
 Recording fictitious journal entries, particularly close to the end of an
accounting period, to manipulate operating results or achieve other objectives.
 Inappropriately adjusting assumptions and changing judgments used to
estimate account balances.
 Omitting, advancing or delaying recognition in the financial statements of
events and transactions that have occurred during the reporting period.
 Concealing, or not disclosing, facts that could affect the amounts recorded in
the financial statements.
 Engaging in complex transactions that are structured to misrepresent the
financial position or financial performance of the entity.
 Altering records and terms related to significant and unusual transactions.
A5. Misappropriation of assets involves the theft of an entity’s assets and is
often perpetrated by employees in relatively small and immaterial amounts.
However, it can also involve management who are usually more able to disguise
or conceal misappropriations in ways that are difficult to detect. Misappropriation
of assets can be accomplished in a variety of ways including:
 Embezzling receipts (for example, misappropriating collections on accounts
receivable or diverting receipts in respect of written-off accounts to personal
bank accounts).
 Stealing physical assets or intellectual property (for example, stealing
inventory for personal use or for sale, stealing scrap for resale, colluding
with a competitor by disclosing technological data in return for payment).
 Causing an entity to pay for goods and services not received (for example,
payments to fictitious vendors, kickbacks paid by vendors to the entity’s
purchasing agents in return for inflating prices, payments to fictitious
employees).
 Using an entity’s assets for personal use (for example, using the entity’s
assets as collateral for a personal loan or a loan to a related party).
Misappropriation of assets is often accompanied by false or misleading records
or documents in order to conceal the fact that the assets are missing or have
been pledged without proper authorization.
A6. The auditor may, at times, be required to by a legislation or a regulation to
make a specific assertion in respect of frauds on/by the entity in his report. For
example, Clause (xxi) of Paragraph 4 of the Companies (Auditor’s Report) Order,
2003 requires the auditor to specifically report “whether any fraud on or by the
entity has been noticed or reported during the year; if yes, the nature and amount
involved is to be indicated”. Similarly, in case of audit of banks, the auditors, in
terms of the circular no. DBS.FGV.(F).No. BC/23.08.001/2001-02, is required to

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report to the Reserve Bank of India anything susceptible to fraud or fraudulent
activity or act of excess power or any foul play in any transaction. Consequently,
in such cases, the auditor’s responsibilities may not be limited to consideration of
risks of material misstatement of the financial statements, but may also include a
broader responsibility to consider risks of fraud.
Professional Skepticism (Ref: Para. 12-14)
A7. Maintaining professional skepticism requires an ongoing questioning of
whether the information and audit evidence obtained suggests that a material
misstatement due to fraud may exist. It includes considering the reliability of the
information to be used as audit evidence and the controls over its preparation
and maintenance where relevant. Due to the characteristics of fraud, the
auditor’s professional skepticism is particularly important when considering the
risks of material misstatement due to fraud.
A8. Although the auditor cannot be expected to disregard past experience of
the honesty and integrity of the entity’s management and those charged with
governance, the auditor’s professional skepticism is particularly important in
considering the risks of material misstatement due to fraud because there may
have been changes in circumstances.
A9. As explained in SA 200, an audit performed in accordance with SAs rarely
involves the authentication of documents, nor is the auditor trained as or
expected to be an expert in such authentication.16 However, when the auditor
identifies conditions that cause the auditor to believe that a document may not be
authentic or that terms in a document have been modified but not disclosed to
the auditor, possible procedures to investigate further may include:
 Confirming directly with the third party.
 Using the work of an expert to assess the document’s authenticity.
Discussion Among the Engagement Team (Ref: Para. 15)
A10. Discussing the susceptibility of the entity’s financial statements to material
misstatement due to fraud with the engagement team:
 Provides an opportunity for more experienced engagement team members
to share their insights about how and where the financial statements may be
susceptible to material misstatement due to fraud.
 Enables the auditor to consider an appropriate response to such
susceptibility and to determine which members of the engagement team will
conduct certain audit procedures.

16 SA 200, paragraph A47.

SA 240 16
 Permits the auditor to determine how the results of audit procedures will be
shared among the engagement team and how to deal with any allegations of
fraud that may come to the auditor’s attention.
A11. The discussion may include such matters as:
 An exchange of ideas among engagement team members about how and
where they believe the entity’s financial statements may be susceptible to
material misstatement due to fraud, how management could perpetrate and
conceal fraudulent financial reporting, and how assets of the entity could be
misappropriated.
 A consideration of circumstances that might be indicative of earnings
management and the practices that might be followed by management to
manage earnings that could lead to fraudulent financial reporting.
 A consideration of the known external and internal factors affecting the entity
that may create an incentive or pressure for management or others to
commit fraud, provide the opportunity for fraud to be perpetrated, and
indicate a culture or environment that enables management or others to
rationalize committing fraud.
 A consideration of management’s involvement in overseeing employees with
access to cash or other assets susceptible to misappropriation.
 A consideration of any unusual or unexplained changes in behavior or
lifestyle of management or employees which have come to the attention of
the engagement team.
 An emphasis on the importance of maintaining a proper state of mind
throughout the audit regarding the potential for material misstatement due to
fraud.
 A consideration of the types of circumstances that, if encountered, might
indicate the possibility of fraud.
 A consideration of how an element of unpredictability will be incorporated
into the nature, timing and extent of the audit procedures to be performed.
 A consideration of the audit procedures that might be selected to respond to
the susceptibility of the entity’s financial statement to material misstatement
due to fraud and whether certain types of audit procedures are more
effective than others.
 A consideration of any allegations of fraud that have come to the auditor’s
attention.
 A consideration of the risk of management override of controls.

17 SA 240
Handbook of Auditing Pronouncements-I.A

Risk Assessment Procedures and Related Activities
Inquiries of Management
Management’s Assessment of the Risk of Material Misstatement Due to Fraud
[Ref: Para. 17(a)]
A12. Management accepts responsibility for the entity’s internal control and for the
preparation of the entity’s financial statements. Accordingly, it is appropriate for the
auditor to make inquiries of management regarding management’s own
assessment of the risk of fraud and the controls in place to prevent and detect it.
The nature, extent and frequency of management’s assessment of such risk and
controls may vary from entity to entity. In some entities, management may make
detailed assessments on an annual basis or as part of continuous monitoring. In
other entities, management’s assessment may be less structured and less
frequent. The nature, extent and frequency of management’s assessment are
relevant to the auditor’s understanding of the entity’s control environment. For
example, the fact that management has not made an assessment of the risk of
fraud may in some circumstances be indicative of the lack of importance that
management places on internal control.
Considerations specific to smaller entities
A13. In some entities, particularly smaller entities, the focus of management’s
assessment may be on the risks of employee fraud or misappropriation of
assets.
Management’s Process for Identifying and Responding to the Risks of Fraud
(Ref: Para. 17(b))
A14. In the case of entities with multiple locations management’s processes may
include different levels of monitoring of operating locations, or business
segments. Management may also have identified particular operating locations
or business segments for which a risk of fraud may be more likely to exist.
Inquiry of Management and Others within the Entity (Ref: Para. 18)
A15. The auditor’s inquiries of management may provide useful information
concerning the risks of material misstatements in the financial statements
resulting from employee fraud. However, such inquiries are unlikely to provide
useful information regarding the risks of material misstatement in the financial
statements resulting from management fraud. Making inquiries of others within
the entity may provide individuals with an opportunity to convey information to
the auditor that may not otherwise be communicated.
A16. Examples of others within the entity to whom the auditor may direct
inquiries about the existence or suspicion of fraud include:

SA 240 18
 Operating personnel not directly involved in the financial reporting process.
 Employees with different levels of authority.
 Employees involved in initiating, processing or recording complex or unusual
transactions and those who supervise or monitor such employees.
 In-house legal counsel.
 Chief ethics officer or equivalent person.
 The person or persons charged with dealing with allegations of fraud.
A17. Management is often in the best position to perpetrate fraud. Accordingly,
when evaluating management’s responses to inquiries with an attitude of
professional skepticism, the auditor may judge it necessary to corroborate
responses to inquiries with other information.
Inquiry of Internal Audit (Ref: Para. 19)
A18. SA 315 and SA 610(Revised), establishes requirements and provides
guidance in audits of those entities that have an internal audit function.17 In
carrying out the requirement of those SAs in the context of fraud, the auditor may
inquire about specific internal audit activities including, for example:
 The procedures performed, if any, by the internal auditors during the year to
detect fraud.
 Whether management has satisfactorily responded to any findings resulting
from those procedures.
Obtaining an Understanding of Oversight Exercised by Those Charged
With Governance (Ref: Para. 20)
A19. Those charged with governance of an entity have oversight responsibility
for systems for monitoring risk, financial control and compliance with the law. In
many entities, corporate governance practices are well developed and those
charged with governance play an active role in oversight of the entity’s
assessment of the risks of fraud and of the relevant internal control. Since the
responsibilities of those charged with governance and management may vary by
entity, it is important that the auditor understands their respective responsibilities
to enable the auditor to obtain an understanding of the oversight exercised by the
appropriate individuals.18

17 SA 315, paragraph 23 and SA 610(Revised), “Using the Work of Internal Auditors”.
18 SA 260(Revised), “Communication with Those Charged with Governance”, paragraphs A1-A8,

discusses with whom the auditor communicates when the entity’s governance structure is not well
defined.

19 SA 240
Handbook of Auditing Pronouncements-I.A

A20. An understanding of the oversight exercised by those charged with
governance may provide insights regarding the susceptibility of the entity to
management fraud, the adequacy of internal control over risks of fraud, and the
competency and integrity of management. The auditor may obtain this
understanding in a number of ways, such as by attending meetings where such
discussions take place, reading the minutes from such meetings or making
inquiries of those charged with governance.
Considerations Specific to Smaller Entities
A21. In some cases, all of those charged with governance are involved in
managing the entity. This may be the case in a small entity where a single
owner manages the entity and no one else has a governance role. In these
cases, there is ordinarily no action on the part of the auditor because there is no
oversight separate from management.
Consideration of Other Information (Ref: Para. 23)
A22. In addition to information obtained from applying analytical procedures,
other information obtained about the entity and its environment may be helpful in
identifying the risks of material misstatement due to fraud. The discussion among
team members may provide information that is helpful in identifying such risks.
In addition, information obtained from the auditor’s client acceptance and
retention processes, and experience gained on other engagements performed
for the entity, for example engagements to review interim financial information,
may be relevant in the identification of the risks of material misstatement due to
fraud.
Evaluation of Fraud Risk Factors (Ref: Para. 24)
A23. The fact that fraud is usually concealed can make it very difficult to detect.
Nevertheless, the auditor may identify events or conditions that indicate an
incentive or pressure to commit fraud or provide an opportunity to commit fraud
(fraud risk factors). For example:
 The need to meet expectations of third parties to obtain additional equity
financing may create pressure to commit fraud;
 The granting of significant bonuses if unrealistic profit targets are met may
create an incentive to commit fraud; and
 A control environment that is not effective may create an opportunity to
commit fraud.
A24. Fraud risk factors cannot easily be ranked in order of importance. The
significance of fraud risk factors varies widely. Some of these factors will be
present in entities where the specific conditions do not present risks of material

SA 240 20
misstatement. Accordingly, the determination of whether a fraud risk factor is
present and whether it is to be considered in assessing the risks of material
misstatement of the financial statements due to fraud requires the exercise of
professional judgment.
A25. Examples of fraud risk factors related to fraudulent financial reporting and
misappropriation of assets are presented in Appendix 1. These illustrative risk
factors are classified based on the three conditions that are generally present
when fraud exists:
 An incentive or pressure to commit fraud;
 A perceived opportunity to commit fraud; and
 An ability to rationalize the fraudulent action.
Risk factors reflective of an attitude that permits rationalization of the fraudulent
action may not be susceptible to observation by the auditor. Nevertheless, the
auditor may become aware of the existence of such information. Although the
fraud risk factors described in Appendix 1 cover a broad range of situations that
may be faced by auditors, they are only examples and other risk factors may
exist.
A26. The size, complexity, and ownership characteristics of the entity have a
significant influence on the consideration of relevant fraud risk factors. For
example, in the case of a large entity, there may be factors that generally
constrain improper conduct by management, such as:
 Effective oversight by those charged with governance.
 An effective internal audit function.
 The existence and enforcement of a written code of conduct.
Furthermore, fraud risk factors considered at a business segment operating level
may provide different insights when compared with those obtained when
considered at an entity-wide level.
Considerations Specific to Smaller Entities
A27. In the case of a small entity, some or all of these considerations may be
inapplicable or less relevant. For example, a smaller entity may not have a
written code of conduct but, instead, may have developed a culture that
emphasizes the importance of integrity and ethical behavior through oral
communication and by management example. Domination of management by a
single individual in a small entity does not generally, in and of itself, indicate a
failure by management to display and communicate an appropriate attitude
regarding internal control and the financial reporting process. In some entities,

21 SA 240
Handbook of Auditing Pronouncements-I.A

the need for management authorization can compensate for otherwise deficient
controls and reduce the risk of employee fraud. However, domination of
management by a single individual can be a potential deficiency in internal
control since there is an opportunity for management override of controls.
Identification and Assessment of the Risks of Material Misstatement
Due to Fraud
Risks of Fraud in Revenue Recognition (Ref: Para. 26)
A28. Material misstatement due to fraudulent financial reporting relating to
revenue recognition often results from an overstatement of revenues through, for
example, premature revenue recognition or recording fictitious revenues. It may
result also from an understatement of revenues through, for example, improperly
shifting revenues to a later period.
A29. The risks of fraud in revenue recognition may be greater in some entities
than others. For example, there may be pressures or incentives on management
to commit fraudulent financial reporting through inappropriate revenue
recognition in the case of listed entities when, for example, performance is
measured in terms of year-over-year revenue growth or profit. Similarly, for
example, there may be greater risks of fraud in revenue recognition in the case
of entities that generate a substantial portion of revenues through cash sales.
A30. The presumption that there are risks of fraud in revenue recognition may be
rebutted. For example, the auditor may conclude that there is no risk of material
misstatement due to fraud relating to revenue recognition in the case where
there is a single type of simple revenue transaction, for example, leasehold
revenue from a single unit rental property.
Identifying and Assessing the Risks of Material Misstatement Due to Fraud
and Understanding the Entity’s Related Controls (Ref: Para. 27)
A31. As explained in SA 315 management may make judgments on the nature
and extent of the controls it chooses to implement, and the nature and extent of
the risks it chooses to assume.19 In determining which controls to implement to
prevent and detect fraud, management considers the risks that the financial
statements may be materially misstated as a result of fraud. As part of this
consideration, management may conclude that it is not cost effective to
implement and maintain a particular control in relation to the reduction in the
risks of material misstatement due to fraud to be achieved.
A32. It is therefore important for the auditor to obtain an understanding of the
controls that management has designed, implemented and maintained to prevent

19 SA 315, paragraph A54.

SA 240 22
and detect fraud. In doing so, the auditor may learn, for example, that
management has consciously chosen to accept the risks associated with a lack
of segregation of duties. Information from obtaining this understanding may also
be useful in identifying fraud risks factors that may affect the auditor’s
assessment of the risks that the financial statements may contain material
misstatement due to fraud.
Responses to the Assessed Risks of Material Misstatement Due to
Fraud
Overall Responses (Ref: Para. 28)
A33. Determining overall responses to address the assessed risks of material
misstatement due to fraud generally includes the consideration of how the overall
conduct of the audit can reflect increased professional skepticism, for example,
through:
 Increased sensitivity in the selection of the nature and extent of
documentation to be examined in support of material transactions.
 Increased recognition of the need to corroborate management explanations
or representations concerning material matters.
It also involves more general considerations apart from the specific procedures
otherwise planned; these considerations include the matters listed in paragraph
29, which are discussed below.
Assignment and Supervision of Personnel (Ref: Para. 29(a))
A34. The auditor may respond to identified risks of material misstatement due to
fraud by, for example, assigning additional individuals with specialized skill and
knowledge, such as forensic and IT experts, or by assigning more experienced
individuals to the engagement.
A35. The extent of supervision reflects the auditor’s assessment of risks of
material misstatement due to fraud and the competencies of the engagement
team members performing the work.
Unpredictability in the Selection of Audit Procedures (Ref: Para. 29(c))
A36. Incorporating an element of unpredictability in the selection of the nature,
timing and extent of audit procedures to be performed is important as individuals
within the entity who are familiar with the audit procedures normally performed
on engagements may be more able to conceal fraudulent financial reporting.
This can be achieved by, for example:
 Performing substantive procedures on selected account balances and
assertions not otherwise tested due to their materiality or risk.

23 SA 240
Handbook of Auditing Pronouncements-I.A

 Adjusting the timing of audit procedures from that otherwise expected.
 Using different sampling methods.
 Performing audit procedures at different locations or at locations on an
unannounced basis.
Audit Procedures Responsive to Assessed Risks of Material Misstatement
Due to Fraud at the Assertion Level (Ref: Para. 30)
A37. The auditor’s responses to address the assessed risks of material
misstatement due to fraud at the assertion level may include changing the
nature, timing, and extent of audit procedures in the following ways:
 The nature of audit procedures to be performed may need to be changed to
obtain audit evidence that is more reliable and relevant or to obtain
additional corroborative information. This may affect both the type of audit
procedures to be performed and their combination. For example:
o Physical observation or inspection of certain assets may become more
important or the auditor may choose to use computer-assisted audit
techniques to gather more evidence about data contained in significant
accounts or electronic transaction files.
o The auditor may design procedures to obtain additional corroborative
information. For example, if the auditor identifies that management is
under pressure to meet earnings expectations, there may be a related
risk that management is inflating sales by entering into sales
agreements that include terms that preclude revenue recognition or by
invoicing sales before delivery. In these circumstances, the auditor
may, for example, design external confirmations not only to confirm
outstanding amounts, but also to confirm the details of the sales
agreements, including date, any rights of return and delivery terms. In
addition, the auditor might find it effective to supplement such external
confirmations with inquiries of non-financial personnel in the entity
regarding any changes in sales agreements and delivery terms.
 The timing of substantive procedures may need to be modified. The auditor
may conclude that performing substantive testing at or near the period end
better addresses an assessed risk of material misstatement due to fraud.
The auditor may conclude that, given the assessed risks of intentional
misstatement or manipulation, audit procedures to extend audit conclusions
from an interim date to the period end would not be effective. In contrast,
because an intentional misstatement—for example, a misstatement
involving improper revenue recognition—may have been initiated in an
interim period, the auditor may elect to apply substantive procedures to

SA 240 24
 transactions occurring earlier in or throughout the reporting period.
 The extent of the procedures applied reflects the assessment of the risks of
material misstatement due to fraud. For example, increasing sample sizes
or performing analytical procedures at a more detailed level may be
appropriate. Also, computer-assisted audit techniques may enable more
extensive testing of electronic transactions and account files. Such
techniques can be used to select sample transactions from key electronic
files, to sort transactions with specific characteristics, or to test an entire
population instead of a sample.
A38. If the auditor identifies a risk of material misstatement due to fraud that
affects inventory quantities, examining the entity’s inventory records may help to
identify locations or items that require specific attention during or after the
physical inventory count. Such a review may lead to a decision to observe
inventory counts at certain locations on an unannounced basis or to conduct
inventory counts at all locations on the same date.
A39. The auditor may identify a risk of material misstatement due to fraud
affecting a number of accounts and assertions. These may include asset
valuation, estimates relating to specific transactions (such as acquisitions,
restructurings, or disposals of a segment of the business), and other significant
accrued liabilities (such as pension and other post-employment benefit
obligations, or environmental remediation liabilities). The risk may also relate to
significant changes in assumptions relating to recurring estimates. Information
gathered through obtaining an understanding of the entity and its environment
may assist the auditor in evaluating the reasonableness of such management
estimates and underlying judgments and assumptions. A retrospective review of
similar management judgments and assumptions applied in prior periods may
also provide insight about the reasonableness of judgments and assumptions
supporting management estimates.
A40. Examples of possible audit procedures to address the assessed risks of
material misstatement due to fraud, including those that illustrate the
incorporation of an element of unpredictability, are presented in Appendix 2. The
appendix includes examples of responses to the auditor’s assessment of the
risks of material misstatement resulting from both fraudulent financial reporting,
including fraudulent financial reporting resulting from revenue recognition, and
misappropriation of assets.
Audit Procedures Responsive to Risks Related to Management Override of
Controls
Journal Entries and Other Adjustments (Ref: Para. 32(a))
A41. Material misstatement of financial statements due to fraud often involve the
manipulation of the financial reporting process by recording inappropriate or
25 SA 240
Handbook of Auditing Pronouncements-I.A

unauthorized journal entries. This may occur throughout the year or at period
end, or by management making adjustments to amounts reported in the financial
statements that are not reflected in journal entries, such as through consolidating
adjustments and reclassifications.
A42. Further, the auditor’s consideration of the risks of material misstatement
associated with inappropriate override of controls over journal entries is
important since automated processes and controls may reduce the risk of
inadvertent error but do not overcome the risk that individuals may
inappropriately override such automated processes, for example, by changing
the amounts being automatically passed to the general ledger or to the financial
reporting system. Furthermore, when IT is used to transfer information
automatically, there may be little or no visible evidence of such intervention in the
information systems.
A43. When identifying and selecting journal entries and other adjustments for
testing and determining the appropriate method of examining the underlying
support for the items selected, the following matters are of relevance:
 The assessment of the risks of material misstatement due to fraud – the
presence of fraud risk factors and other information obtained during the
auditor’s assessment of the risks of material misstatement due to fraud may
assist the auditor to identify specific classes of journal entries and other
adjustments for testing.
 Controls that have been implemented over journal entries and other
adjustments – effective controls over the preparation and posting of journal
entries and other adjustments may reduce the extent of substantive testing
necessary, provided that the auditor has tested the operating effectiveness
of the controls.
 The entity’s financial reporting process and the nature of evidence that can
be obtained – for many entities routine processing of transactions involves a
combination of manual and automated steps and procedures. Similarly, the
processing of journal entries and other adjustments may involve both
manual and automated procedures and controls. When information
technology is used in the financial reporting process, journal entries and
other adjustments may exist only in electronic form.
 The characteristics of fraudulent journal entries or other adjustments –
inappropriate journal entries or other adjustments often have unique
identifying characteristics. Such characteristics may include entries (a) made
to unrelated, unusual, or seldom-used accounts, (b) made by individuals
who typically do not make journal entries, (c) recorded at the end of the

SA 240 26
 period or as post-closing entries that have little or no explanation or
description, (d) made either before or during the preparation of the financial
statements that do not have account numbers, or (e) containing round
numbers or consistent ending numbers.
 The nature and complexity of the accounts – inappropriate journal entries or
adjustments may be applied to accounts that (a) contain transactions that
are complex or unusual in nature, (b) contain significant estimates and
period-end adjustments, (c) have been prone to misstatements in the past,
(d) have not been reconciled on a timely basis or contain unreconciled
differences, (e) contain inter-company transactions, or (f) are otherwise
associated with an identified risk of material misstatement due to fraud. In
audits of entities that have several locations or components, consideration is
given to the need to select journal entries from multiple locations.
 Journal entries or other adjustments processed outside the normal course of
business – non standard journal entries may not be subject to the same
level of internal control as those journal entries used on a recurring basis to
record transactions such as monthly sales, purchases and cash
disbursements.
A44. The auditor uses professional judgment in determining the nature, timing and
extent of testing of journal entries and other adjustments. However, because
fraudulent journal entries and other adjustments are often made at the end of a
reporting period, paragraph 32(a)(ii) requires the auditor to select the journal
entries and other adjustments made at that time. Further, because material
misstatements in financial statements due to fraud can occur throughout the period
and may involve extensive efforts to conceal how the fraud is accomplished,
paragraph 32(a)(iii) requires the auditor to consider whether there is also a need to
test journal entries and other adjustments throughout the period.
Accounting Estimates (Ref: Para. 32(b))
A45. In preparing financial statements, management is responsible for making a
number of judgments or assumptions that affect significant accounting estimates
and for monitoring the reasonableness of such estimates on an ongoing basis.
Fraudulent financial reporting is often accomplished through intentional
misstatement of accounting estimates. This may be achieved by, for example,
understating or overstating all provisions or reserves in the same fashion so as to
be designed either to smooth earnings over two or more accounting periods, or
to achieve a designated earnings level in order to deceive financial statement
users by influencing their perceptions as to the entity’s performance and
profitability.

27 SA 240
Handbook of Auditing Pronouncements-I.A

A46. The purpose of performing a retrospective review of management
judgments and assumptions related to significant accounting estimates reflected
in the financial statements of the prior year is to determine whether there is an
indication of a possible bias on the part of management. It is not intended to call
into question the auditor’s professional judgments made in the prior year that
were based on information available at the time.
Business Rationale for Significant Transactions (Ref: Para. 32(c))
A47. Indicators that may suggest that significant transactions that are outside the
normal course of business for the entity, or that otherwise appear to be unusual,
may have been entered into to engage in fraudulent financial reporting or to
conceal misappropriation of assets include:
 The form of such transactions appears overly complex (for example, the
transaction involves multiple entities within a consolidated group or multiple
unrelated third parties).
 Management has not discussed the nature of and accounting for such
transactions with those charged with governance of the entity, and there is
inadequate documentation.
 Management is placing more emphasis on the need for a particular
accounting treatment than on the underlying economics of the transaction.
 Transactions that involve non-consolidated related parties, including special
purpose entities, have not been properly reviewed or approved by those
charged with governance of the entity.
 The transactions involve previously unidentified related parties or parties
that do not have the substance or the financial strength to support the
transaction without assistance from the entity under audit.
Evaluation of Audit Evidence (Ref: Para. 34-37)
A48. SA 330 requires the auditor, based on the audit procedures performed and
the audit evidence obtained, to evaluate whether the assessments of the risks of
material misstatement at the assertion level remain appropriate.20 This evaluation
is primarily a qualitative matter based on the auditor’s judgment. Such an
evaluation may provide further insight about the risks of material misstatement
due to fraud and whether there is a need to perform additional or different audit
procedures. Appendix 3 contains examples of circumstances that may indicate
the possibility of fraud.

20 SA 330, paragraph 25.

SA 240 28
Analytical Procedures Performed in the Overall Review of the Financial
Statements (Ref: Para. 34)
A49. Determining which particular trends and relationships may indicate a risk of
material misstatement due to fraud requires professional judgment. Unusual
relationships involving year-end revenue and income are particularly relevant.
These might include, for example: uncharacteristically large amounts of income
being reported in the last few weeks of the reporting period or unusual
transactions; or income that is inconsistent with trends in cash flow from
operations.
Consideration of Identified Misstatements (Ref: Para. 35-37)
A50. Since fraud involves incentive or pressure to commit fraud, a perceived
opportunity to do so or some rationalization of the act, an instance of fraud is
unlikely to be an isolated occurrence. Accordingly, misstatements, such as
numerous misstatements at a specific location even though the cumulative effect
is not material, may be indicative of a risk of material misstatement due to fraud.
A51. The implications of identified fraud depend on the circumstances. For
example, an otherwise insignificant fraud may be significant if it involves senior
management. In such circumstances, the reliability of evidence previously
obtained may be called into question, since there may be doubts about the
completeness and truthfulness of representations made and about the
genuineness of accounting records and documentation. There may also be a
possibility of collusion involving employees, management or third parties.
A52. SA 450, “Evaluation of Misstatements Identified during the Audit”, and SA
700(Revised), “Forming an Opinion and Reporting on Financial Statements”,
establish requirements and provide guidance on the evaluation and disposition of
misstatements and the effect on the auditor’s opinion in the auditor’s report.
Auditor Unable to Continue the Engagement (Ref: Para. 38)
A53. Examples of exceptional circumstances that may arise and that may bring
into question the auditor’s ability to continue performing the audit include:
(a) The entity does not take the appropriate action regarding fraud that the
auditor considers necessary in the circumstances, even when the fraud is
not material to the financial statements;
(b) The auditor’s consideration of the risks of material misstatement due to
fraud and the results of audit tests indicate a significant risk of material
and pervasive fraud; or
(c) The auditor has significant concern about the competence or integrity of
management or those charged with governance.

29 SA 240
Handbook of Auditing Pronouncements-I.A

A54. Because of the variety of the circumstances that may arise, it is not
possible to describe definitively when withdrawal from an engagement is
appropriate. Factors that affect the auditor’s conclusion include the implications
of the involvement of a member of management or of those charged with
governance (which may affect the reliability of management representations) and
the effects on the auditor of a continuing association with the entity.
A55. The auditor has professional and legal responsibilities in such
circumstances and these responsibilities may vary under different legislations
and regulations and, accordingly, the clients. Under some legislations/
regulations, for example, the auditor may be entitled to, or required to, make a
statement or report to the person or persons who made the audit appointment or,
in some cases, to regulatory authorities. Given the exceptional nature of the
circumstances and the need to consider the legal requirements, the auditor may
consider it appropriate to seek legal advice when deciding whether to withdraw
from an engagement and in determining an appropriate course of action,
including the possibility of reporting to shareholders, regulators or others21.
A56. In some cases, the option of withdrawing from the engagement may not be
available to the auditor due to the nature of the terms of appointment or public
interest considerations.
Management Representations (Ref: Para. 39)
A57. SA 58022, establishes requirements and provides guidance on obtaining
appropriate representations from management and, where appropriate, those
charged with governance in the audit. In addition to acknowledging that they
have fulfilled their responsibility for the preparation of the financial statements, it
is important that, irrespective of the size of the entity, management and, where
appropriate, those charged with governance acknowledge their responsibility for
internal control designed, implemented and maintained to prevent and detect
fraud.
A58. Because of the nature of fraud and the difficulties encountered by auditors
in detecting material misstatements in the financial statements resulting from
fraud, it is important that the auditor obtain a written representation from
management and, where appropriate, those charged with governance confirming
that they have disclosed to the auditor:
(a) The results of management’s assessment of the risk that the financial
statements may be materially misstated as a result of fraud; and
(b) Their knowledge of actual, suspected or alleged fraud affecting the entity.

21 The Code of Ethics issued by the Institute of Chartered Accountants of India contains guidance

on communication between the outgoing and incoming auditor.
22 SA 580, “Written Representations”.

SA 240 30
Communications to Management and with Those Charged with
Governance
Communication to Management (Ref: Para. 40)
A59. When the auditor has obtained evidence that fraud exists or may exist, it is
important that the matter be brought to the attention of the appropriate level of
management as soon as practicable. This is so even if the matter might be
considered inconsequential (for example, a minor defalcation by an employee at
a low level in the entity’s organization). The determination of which level of
management is the appropriate one is a matter of professional judgment and is
affected by such factors as the likelihood of collusion and the nature and
magnitude of the suspected fraud. Ordinarily, the appropriate level of
management is at least one level above the persons who appear to be involved
with the suspected fraud.
Communication with Those Charged with Governance (Ref: Para. 41)
A60. The auditor’s communication with those charged with governance may be
made orally or in writing. SA 260(Revised) identifies factors the auditor considers
in determining whether to communicate orally or in writing.23 Due to the nature and
sensitivity of fraud involving senior management, or fraud that results in a material
misstatement in the financial statements, the auditor reports such matters on a
timely basis and may consider it necessary to also report such matters in writing.
A61. In some cases, the auditor may consider it appropriate to communicate with
those charged with governance when the auditor becomes aware of fraud
involving employees other than management that does not result in a material
misstatement. Similarly, those charged with governance may wish to be
informed of such circumstances. The communication process is assisted if the
auditor and those charged with governance agree at an early stage in the audit
about the nature and extent of the auditor’s communications in this regard.
A62. In the exceptional circumstances where the auditor has doubts about the
integrity or honesty of management or those charged with governance, the
auditor may consider it appropriate to obtain legal advice to assist in determining
the appropriate course of action.
Other Matters Related to Fraud (Ref: Para. 42)
A63. Other matters related to fraud to be discussed with those charged with
governance of the entity may include, for example:

23 SA 260(Revised), Paragraph A47.

31 SA 240
Handbook of Auditing Pronouncements-I.A

 Concerns about the nature, extent and frequency of management’s
assessments of the controls in place to prevent and detect fraud and of the
risk that the financial statements may be misstated.
 A failure by management to appropriately address identified significant
deficiencies in internal control, or to appropriately respond to an identified
fraud.
 The auditor’s evaluation of the entity’s control environment, including
questions regarding the competence and integrity of management.
 Actions by management that may be indicative of fraudulent financial
reporting, such as management’s selection and application of accounting
policies that may be indicative of management’s effort to manage earnings in
order to deceive financial statement users by influencing their perceptions as
to the entity’s performance and profitability.
 Concerns about the adequacy and completeness of the authorization of
transactions that appear to be outside the normal course of business.
Communications to Regulatory and Enforcement Authorities (Ref:
Para. 43)
A64. The auditor’s professional duty to maintain the confidentiality of client
information may preclude reporting fraud to a party outside the client entity.
However, the auditor’s legal responsibilities vary by law & statute and, in certain
circumstances, the duty of confidentiality may be overridden by statute, the law
or courts of law. In some entities, for example, in case of audit of banks, the
auditor has a statutory duty to report the occurrence of fraud to the supervisory
authorities, i.e., the Reserve Bank of India, in terms of the latter’s circular no.
DBS.FGV.(F).No. BC/23.08.001/2001-02. Also, in some entities the auditor may
have a duty to report misstatements to authorities in those cases where
management and those charged with governance fail to take corrective action.
A65. The auditor may consider it appropriate to obtain legal advice to determine
the appropriate course of action in the circumstances, the purpose of which is to
ascertain the steps necessary in considering the public interest aspects of
identified fraud.
A66. In some clients, requirements for reporting fraud, whether or not discovered
through the audit process, may be subject to specific provisions of the audit
mandate or related legislation or regulation.

SA 240 32
Material Modifications to ISA 240, The Auditor’s
Responsibility relating to Fraud in an Audit of Financial
Statements
Addition
In paragraph A64 of SA 240, the guidance has been made more entity specific,
in the context of Indian legal requirement, by way of an example.
Deletions
1. Paragraph A6 of the Application Section of ISA 240 (A6 of SA 240) dealt
with the application of the requirements of ISA 240 to the audits of public sector
entities. Since as mentioned in the “Preface to the Standards on Quality Control,
Auditing, Review, Other Assurance and Related Services”, the Standards issued
by the Auditing and Assurance Standards Board, apply equally to all entities,
irrespective of their form, nature and size, a specific reference to applicability of
the Standard to public sector entities has been deleted.
Further, it is also possible that such a specific reporting requirement may also
exist in case of non public sector entities pursuant to a requirement under the
statute or regulation under which they operate. Accordingly, the spirit of
paragraph A6 in ISA, highlighting the fact that in some cases, the auditors may
be required by the legislature or the regulator to specifically report on the
instances of actual/suspected fraud in the client entity, has been retained and
examples of such situations have also been added.
2. Paragraph A57 of the Application Section of ISA 240 (A56 of SA 240) dealt
with the considerations specific to public sector entities. Since as mentioned in
the “Preface to the Standards on Quality Control, Auditing, Review, Other
Assurance and Related Services”, the Standards issued by the Auditing and
Assurance Standards Board, apply equally to all entities, irrespective of their
form, nature and size, a specific reference to applicability of the Standard to
public sector entities has been deleted.
Further, it is also possible that option of withdrawal may not be available in case
of non public sector entities pursuant to a requirement under the statute or terms
of appointment of the auditor. Accordingly, the spirit of Paragraph A57 in ISA,
highlighting that in some cases, the auditors may not be having an option to
withdraw from the engagement has been retained.
3. Paragraph A67 of the Application Section of ISA 240(A66 of SA 240) dealt
with the application of the requirements of ISA 240 to the audits of public sector
entities. Since as mentioned in the “Preface to the Standards on Quality Control,
Auditing, Review, Other Assurance and Related Services”, the Standards issued
33 SA 240
Handbook of Auditing Pronouncements-I.A

by the Auditing and Assurance Standards Board, apply equally to all entities,
irrespective of their form, nature and size, a specific reference to applicability of
the Standard to public sector entities has been deleted.
Further, it is also possible that such a specific reporting requirement may also
exist in case of non public sector entities pursuant to a requirement under the
statute or regulation under which they operate. Accordingly, the spirit of
Paragraph A67 as given in ISA 240, highlighting the fact that in some cases,
requirements for reporting fraud, whether or not discovered through the audit
process, may be subject to specific provisions of the audit mandate or related
legislation or regulation, has been retained.

SA 240 34
 Appendix 1
(Ref: Para. A25)
Examples of Fraud Risk Factors
The fraud risk factors identified in this Appendix are examples of such factors
that may be faced by auditors in a broad range of situations. Separately
presented are examples relating to the two types of fraud relevant to the
auditor’s consideration, i.e., fraudulent financial reporting and misappropriation of
assets. For each of these types of fraud, the risk factors are further classified
based on the three conditions generally present when material misstatements
due to fraud occur: (a) incentives/pressures, (b) opportunities, and (c)
attitudes/rationalizations. Although the risk factors cover a broad range of
situations, they are only examples and, accordingly, the auditor may identify
additional or different risk factors. Not all of these examples are relevant in all
circumstances, and some may be of greater or lesser significance in entities of
different size or with different ownership characteristics or circumstances. Also,
the order of the examples of risk factors provided is not intended to reflect their
relative importance or frequency of occurrence.
Risk Factors Relating to Misstatements Arising from Fraudulent
Financial Reporting
The following are examples of risk factors relating to misstatements arising from
fraudulent financial reporting.
Incentives/Pressures
Financial stability or profitability is threatened by economic, industry, or entity
operating conditions, such as (or as indicated by):
 High degree of competition or market saturation, accompanied by declining
margins.
 High vulnerability to rapid changes, such as changes in technology, product
obsolescence, or interest rates.
 Significant declines in customer demand and increasing business failures in
either the industry or overall economy.
 Operating losses making the threat of bankruptcy, foreclosure, or hostile
takeover imminent.
 Recurring negative cash flows from operations or an inability to generate
cash flows from operations while reporting earnings and earnings growth.
 Rapid growth or unusual profitability especially compared to that of other
companies in the same industry.

35 SA 240
Handbook of Auditing Pronouncements-I.A

 New accounting, statutory, or regulatory requirements.
Excessive pressure exists for management to meet the requirements or
expectations of third parties due to the following:
 Profitability or trend level expectations of investment analysts, institutional
investors, significant creditors, or other external parties (particularly
expectations that are unduly aggressive or unrealistic), including
expectations created by management in, for example, overly optimistic press
releases or annual report messages.
 Need to obtain additional debt or equity financing to stay competitive—
including financing of major research and development or capital
expenditures.
 Marginal ability to meet exchange listing requirements or debt repayment or
other debt covenant requirements.
 Perceived or real adverse effects of reporting poor financial results on
significant pending transactions, such as business combinations or contract
awards.
Information available indicates that the personal financial situation of
management or those charged with governance is threatened by the entity’s
financial performance arising from the following:
 Significant financial interests in the entity.
 Significant portions of their compensation (for example, bonuses, stock
options, and earn-out arrangements) being contingent upon achieving
aggressive targets for stock price, operating results, financial position, or
cash flow.24
 Personal guarantees of debts of the entity.
 There is excessive pressure on management or operating personnel to meet
financial targets established by those charged with governance, including
sales or profitability incentive goals.
Opportunities
The nature of the industry or the entity’s operations provides opportunities to
engage in fraudulent financial reporting that can arise from the following:
 Significant related-party transactions not in the ordinary course of business
or with related entities not audited or audited by another firm.
 A strong financial presence or ability to dominate a certain industry sector

24 Management incentive plans may be contingent upon achieving targets relating only to certain

accounts or selected activities of the entity, even though the related accounts or activities may not
be material to the entity as a whole.

SA 240 36
 that allows the entity to dictate terms or conditions to suppliers or customers
that may result in inappropriate or non-arm’s-length transactions.
 Assets, liabilities, revenues, or expenses based on significant estimates that
involve subjective judgments or uncertainties that are difficult to corroborate.
 Significant, unusual, or highly complex transactions, especially those close
to period end that pose difficult “substance over form” questions.
 Significant operations located or conducted across international borders in
jurisdictions where differing business environments and cultures exist.
 Use of business intermediaries for which there appears to be no clear
business justification.
 Significant bank accounts or subsidiary or branch operations in tax-haven
jurisdictions for which there appears to be no clear business justification.
The monitoring of management is not effective as a result of the following:
 Domination of management by a single person or small group (in a non
owner-managed business) without compensating controls.
 Oversight by those charged with governance over the financial reporting
process and internal control is not effective.
There is a complex or unstable organizational structure, as evidenced by the
following:
 Difficulty in determining the organization or individuals that have controlling
interest in the entity.
 Overly complex organizational structure involving unusual legal entities or
managerial lines of authority.
 High turnover of senior management, legal counsel, or those charged with
governance.
Internal control components are deficient as a result of the following:
 Inadequate monitoring of controls, including automated controls and controls
over interim financial reporting (where external reporting is required).
 High turnover rates or employment of accounting, internal audit, or
information technology staff that are not effective.
 Accounting and information systems that are not effective, including
situations involving significant deficiencies in internal control.
Attitudes/Rationalizations
 Communication, implementation, support, or enforcement of the entity’s
values or ethical standards by management, or the communication of
inappropriate values or ethical standards, that are not effective.
 Non-financial management’s excessive participation in or preoccupation with

37 SA 240
Handbook of Auditing Pronouncements-I.A

the selection of accounting policies or the determination of significant
estimates.
 Known history of violations of securities laws or other laws and regulations,
or claims against the entity, its senior management, or those charged with
governance alleging fraud or violations of laws and regulations.
 Excessive interest by management in maintaining or increasing the entity’s
stock price or earnings trend.
 The practice by management of committing to analysts, creditors, and other
third parties to achieve aggressive or unrealistic forecasts.
 Management failing to remedy known significant deficiencies in internal
control on a timely basis.
 An interest by management in employing inappropriate means to minimize
reported earnings for tax-motivated reasons.
 Low morale among senior management.
 The owner-manager makes no distinction between personal and business
transactions.
 Dispute between shareholders in a closely held entity.
 Recurring attempts by management to justify marginal or inappropriate
accounting on the basis of materiality.
 The relationship between management and the current or predecessor
auditor is strained, as exhibited by the following:
 Frequent disputes with the current or predecessor auditor on
accounting, auditing, or reporting matters.
 Unreasonable demands on the auditor, such as unrealistic time
constraints regarding the completion of the audit or the issuance of the
auditor’s report.
 Restrictions on the auditor that inappropriately limit access to people or
information or the ability to communicate effectively with those charged
with governance.
 Domineering management behavior in dealing with the auditor,
especially involving attempts to influence the scope of the auditor’s
work or the selection or continuance of personnel assigned to or
consulted on the audit engagement.
Risk Factors Arising from Misstatements Arising from
Misappropriation of Assets
Risk factors that relate to misstatements arising from misappropriation of assets
are also classified according to the three conditions generally present when fraud

SA 240 38
exists: incentives/pressures, opportunities, and attitudes/rationalization. Some of
the risk factors related to misstatements arising from fraudulent financial
reporting also may be present when misstatements arising from misappropriation
of assets occur. For example, ineffective monitoring of management and other
deficiencies in internal control may be present when misstatements due to either
fraudulent financial reporting or misappropriation of assets exist. The following
are examples of risk factors related to misstatements arising from
misappropriation of assets.
Incentives/Pressures
Personal financial obligations may create pressure on management or
employees with access to cash or other assets susceptible to theft to
misappropriate those assets.
Adverse relationships between the entity and employees with access to cash or
other assets susceptible to theft may motivate those employees to
misappropriate those assets. For example, adverse relationships may be
created by the following:
 Known or anticipated future employee layoffs.
 Recent or anticipated changes to employee compensation or benefit plans.
 Promotions, compensation, or other rewards inconsistent with expectations.
Opportunities
Certain characteristics or circumstances may increase the susceptibility of assets
to misappropriation. For example, opportunities to misappropriate assets
increase when there are the following:
 Large amounts of cash on hand or processed.
 Inventory items that are small in size, of high value, or in high demand.
 Easily convertible assets, such as bearer bonds, diamonds, or computer
chips.
 Fixed assets which are small in size, marketable, or lacking observable
identification of ownership.
Inadequate internal control over assets may increase the susceptibility of
misappropriation of those assets. For example, misappropriation of assets may
occur because there is the following:
 Inadequate segregation of duties or independent checks.
 Inadequate oversight of senior management expenditures, such as travel
and other reimbursements.

39 SA 240
Handbook of Auditing Pronouncements-I.A

 Inadequate management oversight of employees responsible for assets, for
example, inadequate supervision or monitoring of remote locations.
 Inadequate job applicant screening of employees with access to assets.
 Inadequate record keeping with respect to assets.
 Inadequate system of authorization and approval of transactions (for
example, in purchasing).
 Inadequate physical safeguards over cash, investments, inventory, or fixed
assets.
 Lack of complete and timely reconciliations of assets.
 Lack of timely and appropriate documentation of transactions, for example,
credits for merchandise returns.
 Lack of mandatory vacations for employees performing key control
functions.
 Inadequate management understanding of information technology, which
enables information technology employees to perpetrate a misappropriation.
 Inadequate access controls over automated records, including controls over
and review of computer systems event logs.
Attitudes/Rationalizations
 Disregard for the need for monitoring or reducing risks related to
misappropriations of assets.
 Disregard for internal control over misappropriation of assets by overriding
existing controls or by failing to take appropriate remedial action on known
deficiencies in internal control.
 Behavior indicating displeasure or dissatisfaction with the entity or its
treatment of the employee.
 Changes in behavior or lifestyle that may indicate assets have been
misappropriated.
 Tolerance of petty theft.

SA 240 40
 Appendix 2
(Ref: Para. A40)
Examples of Possible Audit Procedures to Address the
Assessed Risks of Material Misstatement Due to Fraud
The following are examples of possible audit procedures to address the
assessed risks of material misstatement due to fraud resulting from both
fraudulent financial reporting and misappropriation of assets. Although these
procedures cover a broad range of situations, they are only examples and,
accordingly they may not be the most appropriate nor necessary in each
circumstance. Also the order of the procedures provided is not intended to
reflect their relative importance.
Consideration at the Assertion Level
Specific responses to the auditor’s assessment of the risks of material
misstatement due to fraud will vary depending upon the types or combinations of
fraud risk factors or conditions identified, and the classes of transactions,
account balances, disclosures and assertions they may affect.
The following are specific examples of responses:
 Visiting locations or performing certain tests on a surprise or unannounced
basis. For example, observing inventory at locations where auditor
attendance has not been previously announced or counting cash at a
particular date on a surprise basis.
 Requesting that inventories be counted at the end of the reporting period or
on a date closer to period end to minimize the risk of manipulation of
balances in the period between the date of completion of the count and the
end of the reporting period.
 Altering the audit approach in the current year. For example, contacting
major customers and suppliers orally in addition to sending written
confirmation, sending confirmation requests to a specific party within an
organization, or seeking more or different information.
 Performing a detailed review of the entity’s quarter-end or year-end
adjusting entries and investigating any that appear unusual as to nature or
amount.
 For significant and unusual transactions, particularly those occurring at or
near year-end, investigating the possibility of related parties and the sources
of financial resources supporting the transactions.

41 SA 240
Handbook of Auditing Pronouncements-I.A

 Performing substantive analytical procedures using disaggregated data. For
example, comparing sales and cost of sales by location, line of business or
month to expectations developed by the auditor.
 Conducting interviews of personnel involved in areas where a risk of
material misstatement due to fraud has been identified, to obtain their
insights about the risk and whether, or how, controls address the risk.
 When other independent auditors are auditing the financial statements of
one or more subsidiaries, divisions or branches, discussing with them the
extent of work necessary to be performed to address the assessed risk of
material misstatement due to fraud resulting from transactions and activities
among these components.
 If the work of an expert becomes particularly significant with respect to a
financial statement item for which the assessed risk of misstatement due to
fraud is high, performing additional procedures relating to some or all of the
expert’s assumptions, methods or findings to determine that the findings are
not unreasonable, or engaging another expert for that purpose.
 Performing audit procedures to analyze selected opening balance sheet
accounts of previously audited financial statements to assess how certain
issues involving accounting estimates and judgments, for example, an
allowance for sales returns, were resolved with the benefit of hindsight.
 Performing procedures on account or other reconciliations prepared by the
entity, including considering reconciliations performed at interim periods.
 Performing computer-assisted techniques, such as data mining to test for
anomalies in a population.
 Testing the integrity of computer-produced records and transactions.
 Seeking additional audit evidence from sources outside of the entity being
audited.
Specific Responses—Misstatement Resulting from Fraudulent
Financial Reporting
Examples of responses to the auditor’s assessment of the risks of material
misstatement due to fraudulent financial reporting are as follows:
Revenue Recognition
 Performing substantive analytical procedures relating to revenue using
disaggregated data, for example, comparing revenue reported by month and
by product line or business segment during the current reporting period with

SA 240 42
 comparable prior periods. Computer-assisted audit techniques may be
useful in identifying unusual or unexpected revenue relationships or
transactions.
 Confirming with customers certain relevant contract terms and the absence
of side agreements, because the appropriate accounting often is influenced
by such terms or agreements and basis for rebates or the period to which
they relate are often poorly documented. For example, acceptance criteria,
delivery and payment terms, the absence of future or continuing vendor
obligations, the right to return the product, guaranteed resale amounts, and
cancellation or refund provisions often are relevant in such circumstances.
 Inquiring of the entity’s sales and marketing personnel or in-house legal
counsel regarding sales or shipments near the end of the period and their
knowledge of any unusual terms or conditions associated with these
transactions.
 Being physically present at one or more locations at period end to observe
goods being shipped or being readied for shipment (or returns awaiting
processing) and performing other appropriate sales and inventory cut-off
procedures.
 For those situations for which revenue transactions are electronically
initiated, processed, and recorded, testing controls to determine whether
they provide assurance that recorded revenue transactions occurred and are
properly recorded.
Inventory Quantities
 Examining the entity's inventory records to identify locations or items that
require specific attention during or after the physical inventory count.
 Observing inventory counts at certain locations on an unannounced basis or
conducting inventory counts at all locations on the same date.
 Conducting inventory counts at or near the end of the reporting period to
minimize the risk of inappropriate manipulation during the period between
the count and the end of the reporting period.
 Performing additional procedures during the observation of the count, for
example, more rigorously examining the contents of boxed items, the
manner in which the goods are stacked (for example, hollow squares) or
labeled, and the quality (that is, purity, grade, or concentration) of liquid
substances such as perfumes or specialty chemicals. Using the work of an
expert may be helpful in this regard.
 Comparing the quantities for the current period with prior periods by class or

43 SA 240
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category of inventory, location or other criteria, or comparison of quantities
counted with perpetual records.
 Using computer-assisted audit techniques to further test the compilation of
the physical inventory counts—for example, sorting by tag number to test
tag controls or by item serial number to test the possibility of item omission
or duplication.
Management Estimates
 Using an expert to develop an independent estimate for comparison to
management’s estimate.
 Extending inquiries to individuals outside of management and the
accounting department to corroborate management’s ability and intent to
carry out plans that are relevant to developing the estimate.
Specific Responses—Misstatements Due to Misappropriation of
Assets
Differing circumstances would necessarily dictate different responses. Ordinarily,
the audit response to an assessed risk of material misstatement due to fraud
relating to misappropriation of assets will be directed toward certain account
balances and classes of transactions. Although some of the audit responses
noted in the two categories above may apply in such circumstances, the scope of
the work is to be linked to the specific information about the misappropriation risk
that has been identified.
Examples of responses to the auditor’s assessment of the risk of material
misstatements due to misappropriation of assets are as follows:
 Counting cash or securities at or near year-end.
 Confirming directly with customers the account activity (including credit
memo and sales return activity as well as dates payments were made) for
the period under audit.
 Analyzing recoveries of written-off accounts.
 Analyzing inventory shortages by location or product type.
 Comparing key inventory ratios to industry norm.
 Reviewing supporting documentation for reductions to the perpetual
inventory records.
 Performing a computerized match of the vendor list with a list of employees
to identify matches of addresses or phone numbers.
 Performing a computerized search of payroll records to identify duplicate

SA 240 44
 addresses, employee identification or taxing authority numbers or bank
accounts.
 Reviewing personnel files for those that contain little or no evidence of
activity, for example, lack of performance evaluations.
 Analyzing sales discounts and returns for unusual patterns or trends.
 Confirming specific terms of contracts with third parties.
 Obtaining evidence that contracts are being carried out in accordance with
their terms.
 Reviewing the propriety of large and unusual expenses.
 Reviewing the authorization and carrying value of senior management and
related party loans.
 Reviewing the level and propriety of expense reports submitted by senior
management.

45 SA 240
Handbook of Auditing Pronouncements-I.A

Appendix 3
(Ref: Para. A48)
Examples of Circumstances that Indicate the Possibility
of Fraud
The following are examples of circumstances that may indicate the possibility that
the financial statements may contain a material misstatement resulting from fraud.
Discrepancies in the accounting records, including:
 Transactions that are not recorded in a complete or timely manner or are
improperly recorded as to amount, accounting period, classification, or entity
policy.
 Unsupported or unauthorized balances or transactions.
 Last-minute adjustments that significantly affect financial results.
 Evidence of employees’ access to systems and records inconsistent with
that necessary to perform their authorized duties.
 Tips or complaints to the auditor about alleged fraud.
Conflicting or missing evidence, including:
 Missing documents.
 Documents that appear to have been altered.
 Unavailability of other than photocopied or electronically transmitted
documents when documents in original form are expected to exist.
 Significant unexplained items on reconciliations.
 Unusual balance sheet changes, or changes in trends or important financial
statement ratios or relationships, for example, receivables growing faster
than revenues.
 Inconsistent, vague, or implausible responses from management or
employees arising from inquiries or analytical procedures.
 Unusual discrepancies between the entity's records and confirmation
replies.
 Large numbers of credit entries and other adjustments made to accounts
receivable records.
 Unexplained or inadequately explained differences between the accounts
receivable sub-ledger and the control account, or between the customer
statements and the accounts receivable sub-ledger.
 Missing or non-existent cancelled checks in circumstances where cancelled

SA 240 46
 checks are ordinarily returned to the entity with the bank statement.
 Missing inventory or physical assets of significant magnitude.
 Unavailable or missing electronic evidence, inconsistent with the entity’s
record retention practices or policies.
 Fewer responses to confirmations than anticipated or a greater number of
responses than anticipated.
 Inability to produce evidence of key systems development and program
change testing and implementation activities for current-year system
changes and deployments.
Problematic or unusual relationships between the auditor and management,
including:
 Denial of access to records, facilities, certain employees, customers,
vendors, or others from whom audit evidence might be sought.
 Undue time pressures imposed by management to resolve complex or
contentious issues.
 Complaints by management about the conduct of the audit or management
intimidation of engagement team members, particularly in connection with
the auditor’s critical assessment of audit evidence or in the resolution of
potential disagreements with management.
 Unusual delays by the entity in providing requested information.
 Unwillingness to facilitate auditor access to key electronic files for testing
through the use of computer-assisted audit techniques.
 Denial of access to key IT operations staff and facilities, including security,
operations, and systems development personnel.
 An unwillingness to add or revise disclosures in the financial statements to
make them more complete and understandable.
 An unwillingness to address identified deficiencies in internal control on a
timely basis.
Other
 Unwillingness by management to permit the auditor to meet privately with
those charged with governance.
 Accounting policies that appear to be at variance with industry norms.
 Frequent changes in accounting estimates that do not appear to result from
changed circumstances.
 Tolerance of violations of the entity’s Code of Conduct.

47 SA 240