IN this video, I discuss response to identified fraud risk.
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When the auditor identifies risks of material misstatements due to fraud, auditing standards require the auditor to develop responses to those risks at three levels: overall responses, responses at the assertion level, and responses related to management override. Some responses to fraud risks relate to overall engagement management, such as the types of personnel assigned to the engagement, while other responses are specific to assertions, such as procedures to evaluate the timing of the recording of a revenue transaction. Responses are also needed to address the risk of management override given it is present in all organizations.

Overall Responses to Fraud Risks

Auditors can choose among several overall responses to an increased fraud risk. The auditor should first discuss the auditor’s findings about fraud risk with management and obtain management’s views of the potential for fraud and existing controls designed to prevent or detect misstatements. As described in the previous section, management may have programs designed to prevent, deter, and detect fraud, as well as controls designed to mitigate specific risks of fraud. Auditors should then consider whether such antifraud programs and controls mitigate the identified risks of material misstatements due to fraud or whether control deficiencies increase the risk of fraud.

If the risk of misstatement due to fraud is increased, more experienced personnel may be assigned to the audit. In some cases, a fraud specialist may be assigned to the audit team. Greater emphasis should also be placed on the importance of increased professional skepticism, such as greater sensitivity in the selection and extent of documentation examined in support of transactions and more corroboration of management explanations about unusual matters affecting the financial statements.

Auditors should also consider management’s choice of accounting principles. Careful attention should be placed on accounting principles that involve subjective measurements or complex transactions. Because auditors are required to presume fraud risk is present in revenue recognition, they should also evaluate the company’s revenue recognition policies.

Fraud perpetrators are often knowledgeable about audit procedures. For this reason, auditing standards require auditors to incorporate unpredictability in the audit strategy. For example, auditors may visit inventory locations or test accounts that were not tested in prior periods. Auditors should also consider tests that address misappropriation of assets, even when the amounts are not typically material.

Responses to Fraud Risk at the Assertion Level

When the auditor identifies fraud risk at the assertion level, the auditor designs appropriate audit procedures to respond to specific fraud risks related to the account being audited and type of fraud risk identified. For example, if concerns are raised about revenue recognition because of cutoff or channel stuffing, the auditor may review the sales journal for unusual activity near the end of the period and review the terms of sales.

The auditor’s response to fraud risk at the assertion level may involve changing the nature, timing, and extent of audit procedures. audits. Because management is in a unique position to perpetrate fraud by overriding controls that are otherwise operating effectively, auditors must perform procedures in every audit to address the risk of management override. Three procedures must be performed in every audit.

Examine Journal Entries and Other Adjustments for Evidence of Possible Misstatements Due to Fraud
Fraud often results from adjustments to amounts reported in the financial statements, even when effective internal controls exist over the rest of the recording processes. The auditor should first obtain an understanding of the entity’s financial reporting process, as well as controls over journal entries and other adjustments, and inquire of employees involved in the financial reporting process about inappropriate or unusual activity in processing journal entries and other adjustments. In some organizations, management uses spreadsheet software to make adjustments to financial information generated by the accounting system. These “topside adjustments” have been used to manipulate financial statements. Auditing standards require testing of journal entries and other financial statement adjustments. The extent of testing is affected by the effectiveness of controls and results of the inquiries.