ISA 240, “The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements,” is an international standard on auditing issued by the International Auditing and Assurance Standards Board (IAASB). It provides guidance to auditors on their responsibility to consider the risk of fraud in an audit of financial statements and how to respond to that risk. Fraud is intentional misrepresentation of financial information or the misappropriation of assets, and it poses a significant risk to the integrity and reliability of financial statements.
Definition of Fraud:
Fraud is defined as “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” (ISA 240, paragraph 7). Fraud can be categorized into two types:
Fraudulent Financial Reporting: This refers to intentional misrepresentation of financial information in the financial statements, such as overstating revenues, understating expenses, manipulating reserves, or presenting false disclosures.
Misappropriation of Assets:
This refers to theft or misuse of an entity’s assets, such as embezzlement of cash, theft of inventory, or misuse of company resources for personal gain.
Explanation of ISA 240:
ISA 240 requires auditors to plan and perform the audit with an attitude of professional skepticism, recognizing the possibility of fraud, and taking appropriate actions to address the risk of fraud. The standard provides guidance on the auditor’s responsibilities in three main areas:
The auditor is required to assess the risk of fraud in the financial statements, considering factors such as the nature of the entity, its industry, the entity’s internal control, and the results of preliminary analytical procedures. The auditor should also obtain an understanding of the entity’s controls related to fraud, including management’s anti-fraud programs and controls, and evaluate their effectiveness.
Response to Risk of Fraud:
The auditor is required to respond to the assessed risk of fraud by designing and implementing audit procedures that are specifically tailored to address the risk of fraud. This may include performing additional audit procedures, modifying the nature, timing, or extent of audit procedures, or using different audit procedures. The auditor should also consider the need to involve specialists, such as forensic accountants or IT experts, to assist in the audit procedures related to fraud.
Communication and Reporting:
The auditor is required to communicate with those charged with governance and management about the results of the audit procedures related to fraud. If the auditor identifies a fraud or suspected fraud, they are required to communicate it promptly to those charged with governance, management, and, in some cases, to regulatory authorities, as appropriate. The auditor is also required to include a statement regarding the auditor’s responsibility for detecting fraud in the audit report.
Examples of Fraud in an Audit:
Fraud can occur in various ways, and auditors should be vigilant in considering the risk of fraud in their audits. Here are some examples of fraud that auditors may encounter during an audit:
Management may create fake sales transactions to overstate revenues and inflate financial results.
Manipulation of Expenses:
Management may manipulate expenses, such as recording fictitious expenses or improperly capitalizing expenses to inflate profits.
Misappropriation of Cash:
Employees or management may steal cash from the company, such as by diverting customer payments or skimming cash from sales.
Employees may steal inventory, such as by removing inventory without recording the transaction or misappropriating inventory for personal use.
Management may provide false or misleading disclosures in the financial statements, such as omitting important information or misrepresenting facts to deceive users of the financial statements.
Let’s take a look at some real-world case studies where fraud was identified during audits, highlighting the importance of ISA 240 in detecting and addressing fraud risks.
One of the most infamous cases of financial statement fraud is the Enron Corporation scandal. In the early 2000s, Enron, an energy company, engaged in fraudulent financial reporting, overstating its revenues and concealing its debts through complex accounting manipulations. The auditors failed to identify the fraud, leading to the collapse of the company and significant losses for investors and other stakeholders. This case highlighted the importance of auditors’ responsibility to consider fraud risks, assess the effectiveness of internal controls, and exercise professional skepticism in their audits.
Satyam Computer Services Limited:
In 2009, Satyam Computer Services Limited, an Indian IT services company, revealed a massive financial fraud perpetrated by its chairman and founder. The fraud involved the fabrication of bank balances, fictitious invoices, and inflated revenue figures in the financial statements. The auditors failed to identify the fraud despite issuing unqualified audit opinions for several years. This case highlighted the need for auditors to carefully assess the risk of fraud and perform appropriate audit procedures, including verifying the existence and accuracy of significant account balances and transactions.
In 2015, Toshiba, a Japanese multinational conglomerate, admitted to overstating its profits by $1.2 billion over several years. The fraud involved inappropriate accounting practices, including the understatement of costs and the overstatement of revenues. The auditors were criticized for not adequately addressing the risks of fraud and for failing to exercise professional skepticism in their audits. This case emphasized the importance of auditors’ responsibility to consider the risk of fraud and to thoroughly evaluate the appropriateness of accounting policies and estimates.
ISA 240, “The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements,” is a critical standard that guides auditors in addressing the risk of fraud in their audits. Auditors need to exercise professional skepticism, carefully assess the risk of fraud, design and implement appropriate audit procedures, and communicate effectively with those charged with governance and management. Real-world case studies demonstrate the serious consequences of failing to detect fraud and the importance of auditors’ role in safeguarding the integrity and reliability of financial statements. By adhering to ISA 240 and conducting thorough and effective audits, auditors can contribute to the trust and confidence in financial reporting and help prevent and detect fraud in financial statements.