Fraudulent Financial Reporting & Misapp. of Assets: Auditor’s Responsibility

Ashish M. Shaji

14 Aug, 2021

Fraud can be of 2 types- fraudulent financial reporting and misappropriation of assets. You may have also heard of the term fraud risk factors, which means events or conditions that indicate incentives or pressures to commit fraud or provide an opportunity to commit fraud. In this article, we shall discuss auditor’s responsibility in identification of fraud and assessment.

Definition of Fraud as per SA 240

As per SA 240^[1], fraud is an intentional Act by one or more than one individual among management, charged with governance, employees or third parties using deception to get an unfair or illegal advantage.

Factors that lead to fraudulent financial reporting or misappropriation of assets

The following factors are responsible:

• Pressures– A Fraudulent financial reporting may occur when the management is under pressure from outside sources or sources inside the entity.
• Perceived opportunity– When a person thinks that internal controls can be overridden.
• Rationalization of Individuals– Some people have an attitude, character etc., that allows them intentionally to do a dishonest act.

Why does one commit fraudulent financial reporting?

It can be done to fulfil various objectives such as:

• To avoid incidence of income tax;
• To declare dividend in case of insufficient profits;
• To withhold the declaration of dividend even when there are enough profit;
• To get higher remuneration as managerial remuneration is payable with reference to profits earned.

Methods deployed to manipulate financials and misappropriation of assets

There are a number of techniques to manipulate financials and misappropriation of assets, such as:

• Inflation or suppressing
  1. Purchases and expenses;
  2. Sales and other items of income;
  3. Value of closing inventory.
• Not adjusting outstanding liabilities or prepaid expense;
• Charging item of capital expenditure to revenue or vice versa;
• Embezzling receipts;
• Making the entity pay for the services not obtained;
• Stealing physical assets or IP;
• Using assets of the entity for personal use;
• Suppressing cash receipts;
• Inflating cash payments.

What is the Auditor’s Responsibility?

The leading auditor’s responsibility is enumerated below:

• According to the SA (Standards on Auditing), the auditor is responsible for getting reasonable assurance of the fact that financial statements are free from material misstatements.
• At the time of receiving reasonable assurance, the auditor must maintain an attitude of professional scepticism during the audit.
•  The auditor must be aware about the fact that risk of non-detection of management fraud is greater than employee fraud.
• The auditor must be aware risk of non-detection of material misstatement is greater than the misstatement due to error.

As specified in the above points, an auditor is required to maintain professional scepticism during the audit. He may find instances that can indicate a possibility of misstatements resulting from fraud during the audit like-

• Discrepancies in accounting records;
• Conflicting or missing evidence;
• A problematic/unusual relationship between the auditor and the management.

Satyam Scam

In the context of our above discussion, we should take the case law of Satyam Scam, a scandal that hit the nation during recession. In this case, cash balances on the financials weren’t accurate, and the income was inflated at a vast rate. This case is a perfect example which tells us the importance of following audit procedures. Following audit procedures properly can help to identify manipulated financial statements very early.

Reporting of Fraud by Auditor: Auditor’s Responsibility

Companies Act states that:

• In case where a company’s auditor, in the course of performance of his duties as SA, has a reason to believe that fraud, involving or is expected to involve individually an amount of 1 crore rupees or above, is being or has been committed against the company by its officers/employees, the auditor will report it to the Central Government.
• The auditor shall do the following:
  1. Report the matter to the Board or to the audit committee, as per the case, immediately but not later than 2 days of his knowledge of fraud, seeking their reply/observations within 45 days;
  2. On receiving such reply or observations, the auditor will forward the report and reply or observations of board or audit committee along with his comments to Central Government within 15 days from date of receipt of such reply/observations;
  3. If the auditor doesn’t get any reply/observations from the board or from the audit committee within the prescribed time, then he shall forward the report to the central government with a note having the details of the report that as forwarded earlier to the board or to the audit committee for which no reply/observations was received.
• If the fraud is of less amount than specified, then the auditor will report the matter to audit committee constituted under the Section 177 or to board immediately but not more than 2 days of his knowledge of fraud. Further, he has to report the matter mentioning the following:
  1. Fraud nature and description;
  2. Approximate amount involved;
  3. Parties involved.

Conclusion

The auditor’s responsibility is crucial in identification of fraudulent financial reporting at an early stage. The auditor, during auditing must get reasonable assurance of the fact that financial statements are free from any material misstatements.

Read our article:Financial Reporting Disclosures & Global Ethical Standards: Auditor’s Role