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AUDIT The course in auditing is different from other courses in the accounting curriculum. The other financial and managerial accounting courses are aimed at conveying financial or managerial accounting principles and concepts and how they are applied in preparing and using financial information. The approach to these financial and managerial courses has been as a member of the organization’s management team, and the finished product—the financial statements—was used either by management for decision making or reporting the financial activities to stockholders, investors, lenders, or interested third parties. It is also possible to approach a course in auditing from the standpoint of a member of the organization, whose audits are performed by internal auditors. However, here we will discuss the role of the external auditor, the auditor who is not an employee of the organization. This approach requires the student to alter the orientation he or she has assumed in other accounting courses. The new role is that of an outsider, or an independent public accountant, hired not to prepare financial statements, but to give an opinion on the fairness of the financial statements prepared by the internal company accountants. This role will require a different approach to learning than previously encountered in accounting courses and will demand unique skills that enable the auditor to make decisions regarding the accuracy of an organization’s financial statements. The first skill is the ability to approach and solve audit problems. In addition, the auditor must possess an inquiring audit attitude to uncover problems and discrepancies when they exist. Some have suggested that auditing cannot be learned in the classroom, and that it is a subject that can only be learned by actual hands-on experience. While it is difficult to duplicate or simulate the actual practice environment in the classroom, it is possible to learn about auditing in the classroom. For those not intending to become professional auditors, this course will illuminate the process of auditing, as well as the role played by auditors in financial reporting. As potential users of independent audits, students will find it valuable to know not only what an audit represents, but also its limitations. Auditors are valued because of their technical knowledge and independence in providing assurances, as well as their competence and experience in assiting companies to improve operations. Auditors often make and help implement recommendations that improve profitability by enahncing revenue or reducing costs, including the reduction of errors and fraud, and by improving operational controls. Assurance Services Assurance services are independent professional services that improve the quality of information for decision makers. Individiuals who are responsible for making business decisions seek assurance services to help improve the reliability and relevance of the information used as the basis for their decisions. Assurance services are valued because the assurance provider is independent and perceived as being unbiased with respect to the information examined. Assurance services can be performed by certified public accountants (CPAs) or by a variety of other professionals. The need for assurance is not new. CPAs have provided many assurance services for years, particularly assurances about historical financial statement information.CPA firms have also performed assurance services related to lotteries and contents to provide assurance that winners were determined in an unbiased fashion in accordance with contest rules. More recently, CPAs have been expanding the types of assurance services they perform to include engagements that provide assurance about other types of information, such as assurance about company financial forecasts and assurance about Web site controls. The demand for assurance services is expected to grow as the demand for forward-looking information increases and as more real-time information becomes available through the Internet. Attestation Services The source of accounting information for financial decision makers creates a potential conflict of interest which is a condition that creates society’s demand for audit services. Users need reliable information and this creates the need for professional auditors to lend credibility to financial information. The lending of credibility is known as attestation, and the independent auditing of financial statements is described as the attest function. One category of assurance services provided by CPAs is attestation services. An attestation service is a type of assurance service in which the CPA firm issues a report about the reliability of an assertion that is the responsibility of another party. There are three categories of attestation services: audit of historical financial statements, review of historical financial statements, and other attestation services that may be applied to a broad range of subject matter. 1. Audit of Historical Financial Statements: An audit of historical financial statements is a form of attestation service in which the auditor issues a written report expressing an opinion about whether the financial statements are in material conformity with generally accepted accounting principles. Audits represent the predominant form of assurance performed by CPA firms. Auditing does not include financial report production. Auditors obtain evidence to determine whether financial statements information prepared by management is reliable. Auditors express an opinion that the company’s financial statements are in conformity with generally accepted accounting principles. Independent auditors work for clients. A client retains the auditor and pays their fee. An auditee is the entity being audited. The client and the auditee are typically the same entity, but can be different. When representing information in the form of financial statements, the client makes various assertions about its financial condition and results of operations. External users who rely on those financial statements to make business decisions look to the auditor's report as an indication of the statements' reliability. They value the auditor's assurance because of the auditor's independence from the client and knowledge of financial statement reporting matters. 2. Review of Historical Financial Statements: A review of historical financial statements is another type of attestation service performed by CPAs. Many nonpublic companies want to provide assurance on their financial statements, without incurring the cost of an audit. Whereas an audit provides a high level of assurance, a review service provides a moderate amount of assurance on the financial statements, and less evidence is necessary to support this level of assurance. A review is often adequate to meet users' needs and can be provided by the CPA firm at a much lower fee than an audit. 3. Other Attestation Services: CPAs provide numerous other attestation services. Many of these services are a natural extension of the audit of historical financial statements, as users seek independent assurances about other types of information. For example, banks often require debtors to engage CPAs to provide assurance about the debtor's compliance with certain financial covenant provisions stated in the loan agreement. CPAs also provide assurance about the effectiveness of a client's internal controls over financial reporting. The information about internal controls is closely related to the financial statements, but it is also forward- looking because effective internal controls reduce the likelihood of future misstatements in the financial statements. CPAs also can attest to the information in a client's forecasted financial statements, which are often used to obtain financing. Other Assurance Services: Most of the other assurance services that CPAs provide do not meet the formal definition of attestation services. They are similar to attestation services in that the CPA must be independent and must provide assurance about information used by decision makers. They differ in that the CPA is not required to issue a written report, and the assurance does not have to be about the reliability of another party's written assertion about compliance with specified criteria. Rather, in these other assurance services engagements, the assurance is about the reliability and relevance of information, which may or may not have been asserted by another party. The common feature of all assurance services, including audits and attestation services, is the focus on improving the quality of information used by decision makers. The demand for assurance on other types of information is expected to grow substantially with new types of risks faced by businesses and increases in the amount of available information sources. Assurance Services on Information Technology: One of the major factors affecting the demand for other assurance services is the growth of the Internet and electronic commerce. As transactions and information are shared online and in real time, there is even greater demand for assurances about computer controls surrounding information transacted electronically and the security of the information related to the transactions. CPAs can help provide assurance about these functions. Two examples of assurance services related to information technology are assurances over Web site controls and assurances about information system reliability. Assurance Services on Other Types of Information: CPA Performance View: Businesses need success factors other than financial information to manage their business. Examples include customer satisfaction and product quality. CPAs can help management identify and measure critical success factors. CPA Risk Advisory Services: To succeed in the economy, businesses must be successful in taking and managing risk. For example, a company expanding globally may face risks from changes in exchange rates or political upheaval in other countries. CPAs providing this service help their clients identify and manage risks. There are almost no limits to the types of services that CPAs can provide. Nonassurance Servives Provided by CPAs: CPA firms perform numerous other services that generally fall outside the scope of assurance services. Three specific examples of nonassurance services CPAs often provide include accounting and bookkeeping services, tax services, and management consulting services. The common feature of all assurance services, including audits and attestation services, is the focus on improving the quality of information used by decision makers. Economic Demand for Auditing To illustrate the need for auditing, consider the decision of a bank manager in making a loan to a business. This decision will be based on such factors as previous financial relationships with the business and the financial condition of the business as reflected by its financial statements. If the bank makes the loan, it will charge a rate of interest determined primarily by three factors: a) Risk-free interest rate: This is approximately the rate the bank could earn by investing in government treasury notes for the same length of time as the business loan. b) Business risk for the customer: This risk reflects the possibility that the business will not be able to repay its loan because of economic or business conditions such as a recession, poor management decisions, or unexpected competition in the industry. c) Information risk: Information risk affects the possibility that the information upon which the business risk decision was made was inaccurate. A likely cause of the information risk is the possibility of inaccurate financial statements. Auditing has no effect on either the risk-free interest rate or business risk, but it can have a significant effect on information risk. If the bank manager is satisfied that there is minimal information risk because a borrower's financial statements are audited, the risk is substantially reduced and the overall interest rate to the borrower can be reduced. The reduction of information risk can have a significant effect on the borrower's ability to obtain capital at a reasonable cost. Nature of Auditing So far, we have discussed the importance of audits of financial statements and their relation to other attestation and assurance services offered by CPA firms. We now examine auditing more specifically using the following definition: "Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria.” Auditing should be done by a competent, independent person. Kinds of Audits 1. External Auditing External auditors are certified public accountants who are independent of the organizations whose assertions or representations are being audited. These independent auditors offer their audit services on a contractual basis. The majority of audits performed by external auditors are financial statement audits. 2. Operational / Internal Auditing Internal auditing is practices by auditors employed by an organization. Internal auditing activity is known as operational auditing, performance auditing, or management auditing. Operational auditing refers to the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies. The goal of operational auditing is to help managers discharge their management responsibilities and improve profitability. Internal auditors can perform audits of financial reports for internal use. 3. Governmental Auditing Members of local, state and federal government units audit various organizational functions for a variety of reasons such as the following: Local and state government units audit businesses to determine whether sales taxes have been collected and remitted according to stipulated laws or regulations (a type of compliance audit). The Internal Revenue Service audits corporate and individual income tax returns to determine whether income taxes have been calculated according to the applicable laws or interpretations of these laws (another type of compliance audit). Governmental audits also includes: Financial audits that determine whether; Financial information is presented in accordance with established criteria The entity has adhered to the financial compliance requirements, and The entity’s internal control is suitably designed and implemented. Performance audits (a type of operational audit), that review for efficiency and economy in the use of resources. But as we have told before, we will commonly be interested in the external auditing. Accumulating and Evaluating Evidence Evidence is any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria. Evidence takes many different forms, including oral testimony of the auditee (client), written communication with outsiders, observations by the auditor, and electronic data about transactions. It is important to obtain a sufficient quality and volume of evidence to satisfy the purpose of the audit. Determining the types and amount of evidence necessary and evaluating whether the information corresponds to the established criteria is a critical part of every audit. Sufficient Competent Evidence in Auditing Competency of Evidence: To be considered competent, evidence must be valid, relevant, and unbiased. The relative competence and persuasive power of different kinds of evidence would be determined by the following hierarchy of evidential matter, from highest to lowest. 1. Auditors direct, personal knowledge obtained through physical observation, or mathematical computation 2. Documentary evidence obtained directly from independent external sources (external evidence). 3. Documentary evidence that has originated outside clients system, but which has been received and processed by the client (external-internal evidence). 4. Internal evidence consisting of documents that are produced, circulated, and stored within the clients system (internal evidence). 5. Verbal and written representations by the client’s officers, directors, owners, and employees. Sufficiency The auditor can rarely be certain of the validity of the financial statements. However, he needs to obtain sufficient, relevant and reliable evidence to form a reasonable basis for his opinion thereon. Sufficiency of Evidence: Sufficiency, a question of how much competent evidence is enough, a matter of auditor’s professional judgment. Relevance The relevance of the audit evidence should be considered in relation to the overall auditing objectives of forming an opinion and reporting on the financial statements. To achieve these objectives, the auditor needs to obtain evidence to enable him to draw reasonable conclusions in answering the questions such as: a) Balance Sheet 1. Have all of the assets and liabilities been recorded? 2. Are the assets owned by the enterprise and are the liabilities properly those of the enterprise? 3. Have the amounts attributed to the assets and liabilities been arrived at in accordance with the stated accounting policies on an acceptable and consistent basis? 4. Have the assets, liabilities and capital and reserves been properly disclosed? 5. Do the recorded assets and liabilities exist? b) Profit and loss account 1. Have all income and expenses been recorded? 2. Did the recorded income and expense transactions in fact occur? 3. Have the income and expenses been measured in accordance with the stated accounting policies, on an acceptable and consistent basis? 4. Have income and expenses been properly disclosed where appropriate? Reliability Although the reliability of audit evidence is dependent upon the particular circumstances, the following general presumptions may be found helpful: 1. Documentary evidence is more reliable than oral evidence. 2. Evidence obtained from independent sources outside the enterprise is more reliable than that secured solely from within the enterprise. 3. Evidence originated by the auditor by such means as analysis and physical inspection is more reliable than evidence obtained from others. Audit Evidence The auditor should obtain relevant and reliable audit evidence sufficient to enable him to draw reasonable conclusion from the following items: Main accounting evidence from accounting system: balance sheet, profit and loss account, ledger, daily book, cashbook, trial balance sheet are main accounting evidence. Evidence in support of the overall audit opinion: invoices, receipts, checks, bank drafts and other documents. The auditor will obtain evidence from several sources, which, together, will provide him with the necessary assurance. Competent, Independent Person: The auditor must be qualified to understand the criteria used and must be competent to know the types and amount of evidence to accumulate to reach the proper conclusion after the evidence has been examined. The auditor must also have an independent mental attitude. Auditors reporting on company financial statments are often called independent auditors. Even though an auditor of published financial statements is paid a fee by a company, he or she is normally sufficiently independent to conduct audits that can be relied on by users. Although absolute independence is impossible, auditors strive to maintain a high level of independence to keep the confidence of users relying on their reports. Although internal auditors work for the company, they usually report directly to top management to help maintain independence from the operating units being audited. What is an independent auditor? The auditor is subject to both "legal" and "ethical" independence. Auditors' legal independence a. Election of the auditor must be legal. b. The auditing must be legal. Auditing must be made according to the articles of the Internal Accounting Standards, Uniform accounting plan, Capital Market Board, Turkish Tax regulations. Auditors’ legal independence can be stated as follows: The Auditor has a right and duty to investigate all accounting records that have been kept by the company. The Auditor must investigate the company 's balance sheet and profit and loss accounts with agreement of underlying accounting records. Every auditor has a right to access at all times to the company's books, accounts and vouchers and requirement from the company's officer for such information and explanation when the auditor thinks necessary for the performance of his duties. Auditors have a right to attend any general meeting or the board meeting of the company according to the Capital Market Board regulations. Auditors' ethical independence Fundamental principles: An Auditor should behave with integrity in all professional and business relationships. An Auditor should strive for objectivity in all professional and business judgments. An Auditor should not accept work, which he or she is not competent to undertake during the audit. An Auditor should carry out his or her professional work with due skill, care, diligence and expedition with proper regard for the technical and professional standards expected of him as an auditor. Independence and the Audit Auditor objectivity must be beyond question if he or she is report as an auditor. There are some areas showing that an auditor's independence is in risk. In the following areas the auditor's objectivity may be threatened or appear in the risk: a. Undue dependence on an audit client. b. Overdue fees for an Audit client or group of connected clients c. Actual or threatened litigation d. Family and other personal relationships e. Beneficial interests in shares and other investments f. Voting on audit appointments g. Loans h. Goods and services; hospitality i. Provision of other services to audit clients. Auditor 's qualifications The Capital Market Board and Central Bank must qualify an auditor. An auditor must be a member or officer of an independent auditing company and recognized by government (Capital Market Board, Ministry of Finance). Appointment of Auditor Every country has different rules for appointment of Auditor. In Turkey, Board of Directors of the company must appoint independent auditor by the approval of General Assembly for minimum 2, maximum 4 years. What the does the auditor need to know? Integrated business knowledge Primarily the auditor is an accountant, and auditing is one of the areas of his profession. The auditor needs to have a sound knowledge of all types of business organizations and how they trade. His knowledge must necessarily extend over their other disciplines, such as taxation, economics, computerization, business law, trade law, business organization and practice, statistics and quantitative techniques. The auditor must understand not only how the business of the client operates but also how the industry in which the business is a part operates. An appreciation of how Turkish economy and world economy operates in relation to the industry and the client's business is a necessary part of his knowledge. Statutory knowledge The auditor must familiar with the requirements of the Capital Market Board Regulations and Turkish Tax Regulations. The auditor also must appreciate the Trade Law and any other legal maters specifically applying to the client. Professional Skepticism This phrase embodies an auditor’s tendency to not believe management assertions, but rather to require management to “prove” assertions with evidence. Professional skepticism on the part of auditors reprsents a concern for objectivity. An auditor should carefully consider and investigate all material management assertions, whether they are oral, written, or incorporated in the accounting records. Professional ethical requirements The auditor must ensure that clients' financial statements comply with the requirements of Statements of Standard Accounting Practice and are audited in accordance with Auditing Standards such as International Accounting Standards, Uniform Accounting Plan. Other services As mentioned, auditors are qualified accountants, and auditing is one of the accounting professions. Professional firms of auditors and accountants provide a variety of services separate from auditing, including accountancy, consultancy, investigations, taxation advice, secretarial services, liquidations and any other area of financial advice. It must be stressed that audit must be kept totally separate from these other services in order to ensure that it is an independent operation and there is no conflict of interest where the auditor provides other services. Preparing for the examination The auditor should similarly emulate this possession of knowledge by integrating into the auditing profession the knowledge gained from other subject areas on his or her school and business life. This includes knowledge of data processing, accounting, law and statistics as a basic minimum, giving the auditor and appreciation of business systems and accounting within such systems. General Audit Procedures Auditors use seven basic types of evidence and seven general procedures to gather evidence. One or more of these procedures may be used to audit an account balance, control procedure, or class of transactions. An audit program is a list of procedures. 1. Recalculation. Recalculation of calculations previously performed by client personnel (mathematical evidence) 2. Physical Observation. Physical evidence of tangible assets provides evidence of existence and provides tentative evidence of condition and valuation 3. Confirmation. Confirmation by direct correspondence with independent parties can produce evidence of existence and ownership and sometimes valuation and cutoff. Two types of confirmations used in receivables and payables are: (a) positive confirmation, which requests a reply in all cases; and (b) negative confirmation, which requests a reply only if the account balance is considered incorrect. 4. Verbal inquiry. Collection of oral evidence from independent parties and client officials. Written representation letters must be obtained for all important inquiries. 5. Examination of documents. Gathering evidence by examining authoritative documents prepared by the client. The examination can be performed by vouching or tracing the documents. 6. Scanning. An “eyes-open” approach of looking for anything unusual. Does not produce direct evidence, but it can raise questions for which other evidence must be obtained. 7. Analytical procedures. Evaluate financial statements accounts with financial and non-financial data. Analytical procedures can take five general forms. Distinction Between Auditing & Accounting Many financial statement users and members of the general public confuse auditing with accounting. However, auditing and accounting do not define the same meaning. Accounting is the recording, classifying, and summarizing of economic events in a logical manner for the purpose of providing financial information for decision making. The function of accounting is to provide certain types of quantitative information that management and others can use to make decisions. To provide relevant information, accountants must have a thorough understanding of the principles and rules that provide the basis for preparing the accounting information. In addition, accountants must develop a system to make sure that the entity's economic events are properly recorded on a timely basis and at a reasonable cost. As a summary, accounting is the written history of the company 's transactions. Accounting is to reflect and communicate economic measurements of and information about the resources and performance of the company, useful to having reasonable rights to this information: a. Resources are set out in a balance sheet as at the specific date at the end of accounting period. As assets and liabilities, capital and reserves. b. Performance (transactions) is revealed as a net profit or net loss in a profit and loss account, which normally represents a financial accounting period of 12 months. The net profit or net loss is transferred to the balance sheet in equity with capital and reserves. In auditing accounting data, the concern is with determining whether recorded information properly reflects the economic events that occured during the accounting period. Because accounting rules are the criteria for evaluating whether the accounting information is properly recorded, any auditor involved with these data must also thoroughly understand those rules. In the context of the audit of financial statements, the rules are generally accepted accounting principles. In addition to understand accounting, the auditor must possess expertise in the accumulation and interpretataion of audit evidence. It is this expertise that distinguishes auditors from accountants. Determining the proper audit procedures, deciding the number and types of items to test, and evaluating the results are problems unique to the auditor. Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between assertions and establishing criteria and communicating the results to interested users. The auditor states whether his examination has been made in accordance with generally accepted auditing standards. A useful theoretical view considers auditing a risk reduction activity. Auditing is thought of as a process of reducing to a socially acceptable level the information risk to users of financial statements. Business risk relates to the fortunes of an entity, be they good or bad. Information risk is the risk that company financial statements will be materially false and misleading. Auditors cannot directly influence business risk, but auditors assume the social role of attesting to published financial information, thereby offering users some assurance that the information risk is low. The Audit Philosophy In modern organizations to the large volume of transactions, it would be impossible to test each transaction. The modern audit approach is first to test the system underlying the preparation of accounting information. If this system is soundly based, then the auditor will believe that the information produced the system is also reliable. The result of that the auditor can plan sample testing of transaction from the less amount of invoices, receipts, delivery, notes and other transactions. Where the auditor decided the system is unreliable, than the greater volume of testing the transactions is needed. The modern audit approach will include the following stages: a. The auditor will study the background to the business and its current position in the industry. b. The auditor will plan control and record the audit in his working papers. c. The auditor will search for audit evidence and test for its sufficiency relevance and reliability. d. The auditor will examine systems of accounting and management internal control for their reliability accurate and valid accounting information. e. The auditor will report to shareholders (owners) on his findings. The advantages of an audit Now we know that who are the users of Audit Reports. Also there are some advantages of an audit. Partners are assured that profits to be shared have been audited by an independent person. Partners will use audited accounts in respect of partner changes. The Tax Office prefers audited accounts for taxation. Banker and other lenders prefer audited accounts as a basis for making loans. Auditors will advice management of any weaknesses in the accounting system an internal control and suggest improvements. Primary purpose of an audit An appointed auditor defines the audit as an independent examination of the financial statements like balance sheet and income statements of a company or enterprise. After this examination, the auditor has to report to the shareholders or owners that the financial statements (balance sheet and profit and loss account) are "true and fair". This is the primary purpose of an audit. The responsibility for the preparation of the accounting records and the financial statements is by management or directors. What is "True and fair?" After the examination, an auditor must pass his opinion to the shareholders or owners that the financial statements are "True and Fair" or not. As for true; the auditors can say that each transaction; a. is completely recorded in the accounting records, b. is accurately, correctly recorded in the accounting records, c. is valid. After testing balances the auditor can say that each transaction; a. is presented correctly in the financial statements, b. is recorded completely and accurately and validly in the accounting records, c. is owned by the company or is properly due by it, d. is valued correctly, e. is in existence as a real asset or liability. All transactions together "fairly" represent the transactions of the company or enterprise. It means that all transactions are in compliance with the; a. International Accounting Standards, b. Capital Market Board Procedures, c. Turkish Tax Regulations. This compliance can be asked with the audit guideline one by one or together... Secondary purpose of an audit Auditor must plan the audit to avoid or minimize misstatements in the financial statements resulting from errors, fraud, irregulation and illegal acts. The Auditor is responsible if there are some errors, fraud, irregulation and illegal acts in the company but his report is not reflected those items. The Auditor would be liable, for not having used reasonable care and skill during the audit. The Auditor will need to test the detailed transactions in the accounting records for their completeness, accuracy and validity. Auditors undertake two types of activities before beginning an audit: (1) Risk management activities: Auditors try to reduce the risk (probability of something going wrong) by carefully managing the engagement. (2) Quality management: Auditors manage the audit in accordance with Quality Control Standards. Effectiveness of Audit Procedures Audits are designed to provide reasonable assurance of detecting material errors and fraud in financial statements. When found, adjustments are made to unaudited financial statements before an audit report is issued. Techniques of audit testing Inspection: reviewing or examining records, documents Observation: looking at an operation Inquiry: seeking relevant information from the people inside or outside of the company Computation: checking the arithmetical accuracy of accounting records Analytical review: studying with ratios, trends and other statistics Client Selection and Retention An important element of an accounting firm’s quality control policies and procedures is a system for deciding to: (a) accept a new client and (b) deciding whether to resign from audit engagements. Communication between Predecessor and Successor Auditors When companies change auditors, the former auditor is the predecessor and the new auditor is the successor. The successor auditor, with the consent of the client, is required to contact the predecessor auditor to obtain information about the change. Auditing standards require the successor to inquire about facts that might bear on the integrity of management; disagreements the predecessor may have had with management about accounting principles and auditing procedures; communications the predecessor gave the former client about fraud, illegal acts, and internal control recommendations; and the predecessor’s understanding about the reasons for the change of auditors. Engagement Letters When a new client is accepted, an engagement letter, setting forth the terms of the engagement, should be obtained. It represents the audit contract. Many accounting firms also send a termination letter to former clients. Staff Assignment When a new client is obtained, accounting firms assign a full-service team to the new client. The team consist of the audit engagement partner, the audit manager, one or more senior audit staff members; people with expertise in statistics, the client’s industry, and computers (as needed); a tax partner, a consulting services partner, and a second audit partner. Time Budget The partner and manager propose a plan for the timing of the work (interim and year-end) and number of hours for each segment. Time reports are recorded by budget categories for (1) evaluation of the efficiency of audit team members, (2) billing the client, and (3) planning for the next audit. Fraud Definitions Related to Fraud: Certain acts and devices that involve financial frauds are referred to as white-collar crime. Fraud consists of knowingly making a misrepresentation of facts with the intent of inducing someone to believe the falsehood and act upon it and, thus, suffer a loss or damage. Examples of fraud and related activities are employee fraud, embezzlement, defalcation, management fraud, fraudulent financial reporting, errors, inequalities, direct-effect, illegal acts, and fraud auditing. Characteristics of Fraudsters: White collar criminals are not like typical bank robbers. Usually they are people who hold high executive positions, are respected, trusted employees, have access to large amounts of money, have power to give orders, can override controls, and “look like” most everybody. The Art of Fraud Awareness Auditing: Fraud awareness auditing involves familiarity with: the human element, organization behavior, knowledge of common fraud schemes, evidence and its sources, standards of proof, and sensibility to red flags. Differences between the audit approach of financial auditors and fraud examiners Financial/Auditors Fraud Examiners - Follow a program procedural/ - Follow a mind-set of sensitibility to unusual and approach nonstandard - Make note of errors and - Focus on exception and oddities ommisions - Access control risk in general - “Think like a crook” to imagine ways of controls and specific terms to design that could be subverted other audit approaches - Use a concept of materiality - Think of cumulative materiality - Perform audits based on - Perform examinations based on theory of financial accounting and behavioral motive, opportunity, and integrity auditing Auditors and Investigators Responsibilities The audit standards of external audits, internal audits, government audits, and fraud examiners explain the responsibilities for errors, frauds, and illegal acts. External Auditors Responsibilities: (a) Auditors are required to understand fraud, assess fraud risks, design audits to provide reasonable assurance of detecting material management fraud and employee fraud that could have a material effect on financial statements, and report findings to management, directors, users of financial statements (sometimes) ands, outside agencies (under certain conditions). (b) Illegal acts by clients. Auditors have the same responsibility for direct-effect illegal acts as they do for errors and frauds. Auditors have far less responsibility to find illegal acts that are far removed from financial statement effects. (c) Auditing accounting estimates. Auditors are responsible for evaluating the reasonableness of managements estimates. (d) Communication with audit committees. Auditors must communicate certain information to audit committees about specific topics. Internal Auditors Responsibilities: The internal auditing standards are carefully written to impose no positive obligation for fraud detection and investigation work in the ordinary examination. The standards given for the basic charge to fraud awareness are; (a) reliability and integrity of information, (b) compliance with policies, plans, procedures, laws and regulations, (c) safeguarding of assets, (d) deterrence, detection, investigation, and reporting of fraud. Generally Accepted Government Auditing Standards: The basic government audit requirements are to know the applicable laws and regulations, design the audit to detect abuse or illegal acts, and report to the proper level of authority. Fraud Examiner Responsibilities: Fraud examiners attitudes and responsibilities are different from the other auditors. They begin with a predication that fraud may have occurred. Fraud examiners interest in internal control is to evaluate weaknesses. Fraud examiners think of materiality as a cumulative amount. Conditions That Make Fraud Possible, Even Easy Motive: Motive is a pressure experienced by a person and unshareable with friends or confidants. Psychotic motivation is characterized by a habitual criminal who steals for the sake of stealing. Egocentric motivation is based on the desire for more personal prestige. People with ideological motivation think their cause is morally superior and justifies making someone else a victim. Economic motivation is represented by a need for money. Opportunity: An opportunity is an open door for solving the unshareable problem in secret by violating a trust which leads to fraud. Lack of Integrity: Integrity is the ability to act in accordance with the highest moral and ethical values all the time. Lack of integrity permits motive and opportunity to take form as fraud. Fraud Prevention Managing People Pressures in the Workplace:.Organizations can set up various facilities to share the pressures of their employees. The most effective long-run prevention is showing genuine concern for the professional and personal needs of people in the organization. Control Procedures and Employee Monitoring: Employees need some structure and control so that they know what they need to accomplish. Controls also provide a mechanism to detect fraud. Integrity by Example and Enforcemen:. The key to integrity is accountability. Proper personnel decisions and the right “tone” support the goal of integrity. Fraud Detection Frauds consist of the fraud act itself, the conversion of assets to the fraudsters use, and the cover-up. Red Flags: Employee fraud can sometimes be found by observing a persons habits and lifestyles. Any changes may reveal reed flags of potential fraud and cover-up. The cover- up can often be detected through unusual items in the accounting records. Management frauds (fraudulent financial reporting) often affect the financial statements. Fraud and creative accounting may cause financial statements to be materially misleading by (a) overstating revenues and assets, (b) understating expenses and liabilities, and (c) giving disclosures that are misleading. Certain conditions may exist that would suggest a potential for management fraud. Internal control: Authorization, record keeping, custody, and reconciliation are the four functions that should be separated for good internal control. A person acting alone, or in a conspiracy, may perform two or more internal control functions to commit a fraud. Schemes and Detection Procedures The format for fraud case analysis and the related audit approach includes: (1) Case Situation: (a) Problem—nature of fraud; (b) Method of fraud; (c) Paper trail; (d) amount of fraud. (2) Audit Approach: (a) objective of audit; (b) Control; (c) test of controls; (d) Audit of balances; (e) Discovery summary. After Discovering A Fraud The post-discovery activity proceeds with a special prosecutional assignment under the cooperation or leadership of management and possibly police officials. Prosecution of frauds is advised to discourage future stealing. Some professional guidelines exist for handling discovery of fraud.
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