Chapter 3: Auditor’s Responsibility

The fair presentation of the financial statements in accordance with the applicable financial reporting
framework is the responsibility of the client’s management. The auditor’s responsibility is to design
the audit to provide reasonable assurance of detecting material misstatements in the financial statements.
These misstatements may emanate from:

1. Error
2. Fraud
3. Noncompliance with Laws and Regulations

Error

The term error refers to the unintentional misstatements in the financial statements, including the
omission of an amount or a disclosure, such as:

 Mathematical or clerical mistakes in the underlying records and accounting data

 Incorrect accounting estimates arising from oversight or misinterpretation of facts; or
 Mistakes in the application of accounting policies

Fraud

Fraud refers to the intentional act by one or more individuals among management, those charged with
governance, employees and those parties, involving the use of deception to obtain an unjust or illegal
advantage.

Types of Fraud

1. Fraudulent Financial Reporting

It involves intentional misstatements or omissions of amounts or disclosures in the financial
statement to deceive financial statement users. This type of fraud is also known as management
fraud because it usually involves members of management or TCWG.

2. Misappropriation of Assets
It involves theft of an entity's assets committed by the entity's employees. This is also called
employee fraud because it is often perpetrated by employees in relatively small and immaterial
amounts.

Fraud involves motivation to commit the act and perceived opportunity to do so.

The primary factor the distinguished fraud from error is whether the underlying cause of misstatements in
the financial statements is intentional or unintentional.

Responsibility of Management and Those Charger with Governance

The responsibility for the prevention and detection of fraud and error rests with both management and
those charged with governance of the entity. In this regard, PSA 240 requires

 Management to establish a control environment and to implement internal control policies and
procedures designed to ensure, among others, the detection and prevention of fraud and error.

 Individual charged with governance of an entity to ensure the integrity of an entity's

accounting and financial reporting systems and that appropriate controls are in place.

Auditor’s Responsibility

Although audits may act as deterrent to fraud and error, the auditor is not and cannot be held responsible
for the prevention of fraud and error.

The auditor's responsibility is to design the audit to provide reasonable assurance that the financial
statements are free from material misstatement, whether caused by fraud or error.

Planning Phase

1. When planning an audit, the auditor should make inquiries of management about the
possibility of misstatements due to fraud and error.

2. The auditor should assess the risk that fraud or error may cause the financial statements to
contain material misstatements. In this regard, PSA 240 requires the auditor to specifically
assess the risk of material misstatements due to fraud both at the financial statement level and
assertions level.

Fraud risk factors - conditions that provide an opportunity, a motive or a means to

commit fraud, or indicate that fraud may already have occurred.

Testing Phase

3. During the course of the audit, the auditor may encounter circumstances that may indicate the
possibility of fraud or error. For example, there are discrepancies found in the accounting
records, conflicting or missing documents, or lack of cooperation from management. In these
circumstances, the auditor should perform procedures necessary to determine whether
material misstatements exist.

4. When material misstatement in the FS are identified, the auditor should consider whether such a
misstatement resulted from a fraud or an error.

This is important because errors will only result to an adjustment of FS but fraud may have
other implications on an audit.

Completion Phase

5. The auditor should obtain a written representation from the management that:
  The management acknowledges its responsibility for the implementation and
operations of accounting and internal control systems that are designed to prevent and
detect fraud or error.
 It believes the effects of those uncorrected FS misstatements aggregated by the auditor
during the audit are immaterial, both individually and in the aggregate, to the FS taken
as a whole. A summary of such items should be included in or attached to the written
representation.
 It has disclosed to the auditor all significant facts relating to any frauds or suspected
frauds known to management that may have affected the entity.
 It has disclosed to the auditor the results of its assessment of the risk that the FS may be
materially misstated as a result of fraud.

Reporting Phase

6. When the auditor believes that material error or fraud exists, the auditor should request the
management to revise the FS. Otherwise, the auditor will express a qualified or adverse
opinion.

7. If the auditor is unable to evaluate the effect of fraud on the FS because of a limitation on the
scope of the auditor's examination, the auditor should either qualify or disclaim opinion on the
FS.

Because of the inherent limitations of an audit there is an unavoidable risk that material
misstatements in the FS resulting from fraud or error may not be detected.

The subsequent discovery of material misstatements in the financial statements resulting from fraud or
error does not, in and if itself, indicate that the auditor has failed to adhere to the basic principles and
essential procedures of an audit.

The risk of not detecting a material statement resulting from fraud is higher than the risk of detecting
misstatements resulting from error. This is because fraud may involve sophisticated and carefully
organized schemes designed to conceal it.

The risk of the auditor not detecting a material misstatement from management fraud is greater than
for employee fraud. This is because members of management are often in a position that assumes their
integrity and enables them to override the formally established control procedures.

Noncompliance with Laws and Regulations

Noncompliance refers to acts of omission or commission by the entity being audited, either intentional or
unintentional, which are contrary to the prevailing laws or regulations

Such acts includes transactions entered into by or in the name of the entity or on its behalf by its
management or employees (tax evasion, violation of environmental protection law, inside trading of
securities)

Noncompliance with laws and regulations may result in fines, litigations, or other consequences for the
entity that may have a material effect on the financial statements.

Responsibility of the Management

It is the responsibility of management with the oversight of those charged with governance to ensure that
the entity's operation are conducted in accordance with laws and regulations.

Prevention and detection of non-compliance rests with the entity's management.

Auditor’s Responsibility

The auditor should recognize that noncompliance by the entity with laws and regulation may materially
affect the financial statements. Nevertheless, the auditor should recognize that noncompliance by the
entity with laws and regulations may materially affect the financial statements.

Planning Phase

1. In order to plan the audit, the auditor should obtain a general understanding of the legal and
regulatory framework applicable to the entity and the industry and how the entity is
complying with that framework.

2. After obtaining a general understanding, the auditor should design procedures to help identify
instances of noncompliance with laws and regulations (such as: reading minutes of meetings,
inquiring of management as to whether the entity is in compliance with such laws and
regulations, inspecting correspondence with the relevant regulatory authorities.

3. The auditor should also design audit procedures to obtain sufficient appropriate audit evidence
about compliance with those laws and regulations generally recognized by the auditor to have
an effect on the determination of material amount and disclosures in financial statements.

Testing Phase

4. When the auditor becomes aware of information concerning a possible instances of

noncompliance, the auditor should obtain an understanding of the nature of the act and
 circumstances in which it has occurred, and sufficient other information to evaluate the
possible effect on the financial statements.

When evaluating the possible effect on the financial statements, the auditor considers:

 The potential financial consequences, such as fines, penalties, damages, threat, of

expropriation of assets, enforced discontinuation of operations and litigations
 Whether the potential financial consequences require disclosure
 Whether the potential financial consequences are so serious as to call into question the
fair presentation given by the financial statements.

5. When the auditor believes there may be noncompliance, the auditor should document the
findings, discuss them with management, and considered the implication and other aspects
of the audit.

Completion Phase

6. The auditor should obtain written representations that management has disclosed to the auditor
all known actual or possible noncompliance with laws and regulations that could materially
affect the financial statements.

Reporting Phase

7. When the auditor believes that there is noncompliance with laws and regulations that materially
affect the financial statements, the auditor should request the management to revise the financial
statement. Otherwise, the auditor will have to express either qualified or adverse opinion.

8. If a scope limitation as precluded the auditor from obtaining sufficient appropriate evidence to
evaluate the effect of noncompliance with laws and regulations, the auditor should express a
qualified opinion or a disclaimer of opinion.

An audit is subject to the unavoidable risk that some material misstatements in the financial statements
will not be detected, even though the audit is properly planned and performed in accordance with PSAs.

Auditors are primarily concerned with noncompliance that cause financial statements to contain material
misstatements.

Fraud Risk Factors Relating to Misstatements Resulting from Fraudulent Financial Reporting

1. Management's Characteristics and Influence over the Control Environment

These fraud risk factors pertain to management's abilities, pressures, style and attitude relating to
internal control and the financial reporting process.
2. Industry Conditions

These fraud risk factors involve the economic and regulatory environment in which the entity
operates.

3. Operating Characteristics and Financial Stability

These fraud risk factors pertain to the nature and complexity of the entity and its transactions,
the entity's financial condition and its profitability.

Fraud Risk Factors Relating to Misstatements from Misappropriation of Assets

The extent of the auditor’s consideration of the fraud risk factors in category 2 is influenced by the degree
to which fraud risk factors in category 1 are present.

1. Susceptibility of Assets to Misappropriation

These fraud risk factors pertain to the nature of an entity's assets and the degree to which they
are subject to theft.

2. Fraud Risk Factors Relating to Controls

These fraud risk factors involve the lack of controls designed to prevent or detect
misappropriation of assets.