Graded Questions 2024

Q6.4

YOU ARE REQUIRED TO:

Answer the following questions.

1. Misstatements in the financial statements can arise from either fraud or error. What is the
distinguishing factor between fraud and error? (1)

2. Why is the auditor interested in fraud at an audit client? (2)

3. Is it the auditor’s duty to report fraud to the police? Explain. (2)

4. Distinguish between ‘management fraud’ and ‘employee fraud’ and explain why the distinction is
made. (2)

5. In terms of ISA 240 – The Auditor’s Responsibilities relating to Fraud in an Audit of Financial
Statements, two types of intentional misstatement are relevant to the auditor. They are
misstatements resulting from (a) fraudulent financial reporting and (b) misappropriation of assets.
Give three examples of how each of the two types of intentional misstatements can be
accomplished. (6)

6. What are the responsibilities of management and those charged with governance, with regard to
fraud? (2)

7. What is the general responsibility of the auditor for detecting material misstatement due to fraud?
(2)

8. Should the auditor adopt the attitude that there is no fraud unless he finds it, or should he adopt
the attitude that there is fraud, and he should specifically look for it? Explain. (2)

9. What is management override and why is it important in relation to fraud? (2)

10. Why is it important that the auditor tests journal entries at an audit client (for authority in
particular)? (2)
Q6.11

YOU ARE REQUIRED TO:

Consider each of the following situations individually. Indicate whether each of the below amounts
to misappropriation of assets or fraudulent financial reporting.

Briefly justify your answers.

1. The directors obtained fake title deeds for a fictitious property included in the company’s
statement of financial position. (1)

2. The operations director used the company’s staff transport vehicles over the weekend as taxis for
his account. (1)

3. The chief buyer places orders with the supplier who provides the largest discount for the company
but only if the supplier deposits 5% of the purchase price into the chief buyer’s bank account,
provided the goods supplied are of the required quality. (2)

4. The directors accounted for a complex transaction in a way that favoured the company. (2)

5. The financial director elected not to disclose a contingent liability in the notes to the financial
statements because it might be harmful to the company. All the information pertaining to the matter
was deliberately hidden from the auditors. (2)

6. All scrap materials from the manufacturing activities of the company are sold for cash. The cash is
not accounted for in the accounting records and is not banked in the company’s bank account. The
cash is kept in the safe and then used to pay for the official, very expensive year-end function held in
December for all employees. The company has an October year end. (3)

7. The financial director increased the sales revenue for the year by pre-invoicing several large orders
to be filled in the new financial year. All the customers concerned were related parties of the
company. (3)

8. The warehouse manager, in collusion with a supplier and the warehouse administration clerk,
receives short deliveries from the supplier but has them recorded as full deliveries. (1)

9. The company has a sophisticated financial system which is highly automated. However, the
depreciation per category on the application does not align with the depreciation percentages on the
policy, and are slightly lower in comparison. (2)

10. A CEO of a JSE listed company made inappropriate comments on his personal twitter account.
Many people follow the influential CEO and, subsequently, the comment was retweeted over two
million times within 24 hours. In addition, nearly one million comments were made on other social-
media platforms, calling for the organisation to be boycotted. This occurred over year end. No
adjustments were made to the financial statements. (2)
SUGGESTED SOLUTION TO EXERCISE 6.4

1. The distinguishing factor is whether the underlying action that results in the misstatement of
the financial statements is intentional or unintentional.
2. 2.1 The auditor is interested because the fraud may lead to material misstatement in the financial statements
on which the auditor is reporting.
2.2 Fraud discovered on the audit may also give rise to a reportable irregularity which will
result in a duty for the auditor to report in terms of the Auditing Profession Act.
3. No, the auditor does not have a duty to report fraud to the police; in fact, he would be in breach of the Code of
Professional Conduct if he did so. (The auditor reports to the management or those charged with governance or
to the IRBA, depending on the circumstances.)
4. As the terms suggests, management fraud is fraud committed by management or those
charged with governance, while employee fraud is fraud involving employees of the
company. The distinction is made because the manner in which the auditor proceeds (steps
to follow) will differ – e.g. with management fraud, an external body (IRBA) may be
contacted by the auditor, but with employee fraud the auditor deals with management.

5. Fraudulent financial reporting

5.1 Manipulation or falsification of accounting records, e.g. including fictitious sales.
5.2 Intentional omission of significant information, e.g. leaving out a large contingent
liability.
5.3 Intentional misapplication of accounting principles – recognising contract revenue
prematurely by claiming that the contract is 90% complete when it is only 30%
complete.
5.4 Engaging in complex transactions that are structured to misrepresent the financial
position, e.g. setting up fictitious joint ventures, associated companies etc.
Misappropriation of assets
5.5 Embezzling receipts from debtors and writing off the accounts as bad debts.
5.6 Stealing physical assets, e.g. inventory.
5.7 Stealing intellectual property, e.g. selling company secrets to a competitor.
5.8 Getting the company to pay for goods or services not received, e.g. payments to
fictitious suppliers.
5.9 Using company assets for personal use, e.g. using the company’s trucks to run a private
delivery service at weekends.
6. They have the primary responsibility for the prevention and detection of fraud, with an
emphasis on prevention (reducing opportunities for fraud) and deterrence. They are
responsible for creating a culture of honesty and ethical behaviour, which can be reinforced
by active oversight by those charged with governance.

7. The auditors’ general responsibility is to obtain reasonable assurance that material

misstatement is not present in the financial statements, whether it be due to fraud or error.
Thus, he/she must plan and perform the audit in such a manner (with the intention) that all
material misstatements will be identified. There is the unavoidable risk that some material
misstatements may not be detected even if the audit is properly planned and performed.
This is due to the inherent limitations of the audit.

8. It is really a little bit of each. In terms of ISA 240, the auditor is required to assume an
attitude of professional scepticism recognising that circumstances may exist that cause the
financial statements to be materially misstated due to fraud. The auditor does not let himself
be ‘led around by the nose’ but at the same time does not adopt an aggressive ‘bloodhound’
 approach. He must be guided by his risk identification and evaluation which he is required to
carry out with an attitude of professional scepticism.
9.1 Management override is any instance where a member of the management team overrides a
control which otherwise appears to be operating efficiently, e.g. applying the normal control
procedures relating to creditworthiness of a debtor, reveal that a sale should not be made to
a particular debtor. The financial manager overrides the control by authorising the sale (usually
for unsound reasons, e.g. the customer is a friend or family member).
9.2 Management override of internal controls is important with regard to fraud because internal
controls are designed (inter alia) to prevent fraud. If the control can simply be overridden, the
risk of fraud occurring, is significantly increased.
10.1 Material misstatements of financial statements due to fraud, often involve manipulation of the
financial reporting process, by the passing of fictitious general journal entries, to adjust the
accounts being manipulated or to hide the fraud.
10.2 Journal entries are also an easy way of effecting management override, i.e. the system
produces figures which have been subjected to controls, but management simply overrides
the controls by passing an adjusting journal entry to produce a fictitious desired result.

SUGGESTED SOLUTION TO EXERCISE 6.11

1. Fraudulent financial reporting. Deliberate overstatement of assets by management.

2. Misappropriation of assets. Using the company’s assets for personal gain.

3. This may well be neither as the company itself does not appear to be losing anything (in fact
they appear to be gaining big discounts). It is a ‘bribe’ outside of the company which will
most likely be a breach of the company’s employment rules, but there is neither
misappropriation from the company nor any fraudulent financial reporting.

4. Potentially fraudulent financial reporting, but if the manner in which the transaction was
accounted for complied with the accounting standards and appropriate there is no problem
and would not be either.

5. Fraudulent financial reporting. The financial director is deliberately misleading users of the
financial statements by omitting what is important information. The fact that he kept
relevant information from the auditors confirms this. Because it may be ‘harmful to the
company’ does not mean that the disclosure requirement falls away. Intentionally omitting,
obscuring, or misstating disclosures required by IFRS or Companies Act, or which are
necessary to achieve fair presentation, is considered by ISA 240 to be fraudulent financial
reporting.
6. 6.1 This amounts to a bit of both. In a sense the cash from scrap materials is being misappropriated (not
accounted for in the company’s accounting records) but it is also being used for the benefit of the
company’s employees.
6.2 Obviously management approves, so there is a bit of a question as to why the money
is not accounted for in the records. This would ‘legitimise’ the practice and is an easy
thing to do.

6.3 Although the financial statements will be misstated as at 31 October, it does not
appear to be a deliberate intention to deceive users.

6.4 Another consideration is the question of taxation payable (also VAT implications).
The proceeds from the sale of scrap materials are taxable. So, in a sense, failure to
 declare the income and not paying the taxation due could be viewed as fraudulent
financial reporting. This situation would certainly be of interest to the auditor and a
full explanation from the directors should be sought as there is something
suspicious/risky going on!

7. Fraudulent financial reporting. It is unclear what incentive the financial director had to
overstate sales revenues. He may not have had specifically fraudulent intentions, but the fact
remains that he has prepared AFS, which includes ‘fictitious’ sales, overstated profits and
overstated accounts receivable. It is most unlikely that this pre-invoicing was an ‘honest’
mistake as all these are also with related parties.

8. Misappropriation of assets. Theft of inventory for which the company will pay (but has never
received). The supplier, warehouse manager and administration clerk will most probably
share the proceeds of their collusion.

9. Fraudulent financial reporting, as the company has overstated their assets and has not
deducted the correct percentage depreciation. One could argue that they might not be
aware of this, but the depreciation percentage ratified in the policy should align with the
sophisticated financial system per category.

10. Fraudulent financial reporting, as one million comments were made on other social-media
platforms that the organisation needs to be boycotted. As this occurred over year end, and
no adjustments were made, it seems a deliberate exclusion from the financial statements,
because as a minimum, it should at least have been acknowledged in subsequent events.
Potential overstatement of the financial position, as the company may suffer severe losses
due to the boycott and social media attention.