Possible audit procedures to address the assessed risks of material misstatement (RMM) due to fraud

Possible audit procedures to address the assessed risks of material misstatement (RMM) due to fraud

The auditor has three main purposes when evaluating fraud in a financial statement audit; First, identifying and assessing the risk of material misstatement of the financial statements due to fraud, second, obtaining sufficient and appropriate evidence of fraud by designing and implementing appropriate interventions, and finally responding appropriately to detected or suspected fraud.

Specific responses to the auditor’s assessment of the risks of material misstatement due to fraud will vary depending upon the types or combinations of fraud risk factors or conditions identified, and the classes of transactions, account balances, disclosures, and assertions they may affect.

The following in AU-C 240 provides examples of possible audit procedures to address the assessed risks of material misstatement due to fraud arising from both fraudulent financial reporting and misappropriation of assets.

Consideration at the Assertion Level

• Visiting locations or performing certain tests on a surprise or unannounced basis (for example, observing inventory at locations where auditor attendance has not been previously announced or counting cash at a particular date on a surprise basis)
• Requesting that inventories be counted at the end of the reporting period or on a date closer to period end to minimize the risk of manipulation of balances in the period between the date of completion of the count and the end of the reporting period
• Altering the audit approach in the current year (for example, contacting major customers and suppliers orally in addition to sending written confirmation, sending confirmation requests to a specific party within an organization, or seeking more or different information)
• Performing a detailed review of the entity’s quarter-end or year-end adjusting entries and investigating any that appear to have an unusual nature or amount
• For significant and unusual transactions, particularly those occurring at or near year-end, investigating the possibility of related parties and the sources of financial resources supporting the transactions
• Performing substantive analytical procedures using disaggregated data (for example, comparing sales and cost of sales by location, line of business, or month to expectations developed by the auditor)
• Conducting interviews of personnel involved in areas in which a risk of material misstatement due to fraud has been identified, to obtain their insights about the risk, and whether, or how, controls address the risk
• When other independent auditors are auditing the financial statements of one or more subsidiaries, divisions, or branches, discussing with them the extent of work necessary to be performed to address the assessed risk of material misstatement due to fraud resulting from transactions and activities among these components
• If the work of an expert becomes particularly significant with respect to a financial statement item for which the assessed risk of misstatement due to fraud is high, performing additional procedures relating to some or all of the expert’s assumptions, methods, or findings to determine that the findings are not unreasonable, or engaging another expert for that purpose
• Performing audit procedures to analyze selected opening balance sheet accounts of previously audited financial statements to assess how certain issues involving accounting estimates and judgments, for example, an allowance for sales returns, were resolved with the benefit of hindsight
• Performing procedures on account or other reconciliations prepared by the entity, including considering reconciliations performed at interim periods
• Performing computer-assisted techniques, such as data mining to test for anomalies in a population
• Testing the integrity of computer-produced records and transactions
• Seeking additional audit evidence from sources outside of the entity being audited

Specific Responses— Misstatement Resulting From Fraudulent Financial Reporting

Revenue Recognition

• Performing substantive analytical procedures relating to revenue using disaggregated data; for example, comparing revenue reported by month and by product line or business segment during the current reporting period with comparable prior periods or with revenue related to cash collections (computer-assisted audit techniques may be useful in identifying unusual or unexpected revenue relationships or transactions)
• Confirming with customers certain relevant contract terms and the absence of side agreements because the appropriate accounting often is influenced by such terms or agreements and basis for rebates or the period to which they relate are often poorly documented (for example, acceptance criteria, delivery and payment terms, the absence of future or continuing vendor obligations, the right to return the product, guaranteed resale amounts, and cancellation or refund provisions often are relevant in such circumstances)
• Inquiring of the entity’s sales and marketing personnel or in-house legal counsel regarding sales or shipments near the end of the period and their knowledge of any unusual terms or conditions associated with these transactions
• Being physically present at one or more locations at period end to observe goods being shipped or being readied for shipment (or returns awaiting processing) and performing other appropriate sales and inventory cutoff procedures
• For those situations for which revenue transactions are electronically initiated, processed, and recorded, testing controls to determine whether they provide assurance that recorded revenue transactions occurred and are properly recorded

Inventory Quantities

• Examining the entity’s inventory records to identify locations or items that require specific attention during or after the physical inventory count
• Observing inventory counts at certain locations on an unannounced basis or conducting inventory counts at all locations on the same date
• Conducting inventory counts at or near the end of the reporting period to minimize the risk of inappropriate manipulation during the period between the count and the end of the reporting period
• Performing additional procedures during the observation of the count; for example, more rigorously examining the contents of boxed items, the manner in which the goods are stacked (for example, hollow squares) or labeled, and the quality (that is, purity, grade, or concentration) of liquid substances such as perfumes or specialty chemicals (using the work of an expert may be helpful in this regard)
• Comparing the quantities for the current period with prior periods by class or category of inventory, location or other criteria, or comparison of quantities counted with perpetual records
• Using computer-assisted audit techniques to further test the compilation of the physical inventory counts (for example, sorting by tag number to test tag controls or by item serial number to test the possibility of item omission or duplication)

Management Estimates

• Using an expert to develop an independent estimate for comparison to management’s estimate
• Extending inquiries to individuals outside of management and the accounting department to corroborate management’s ability and intent to carry out plans that are relevant to developing the estimate

Specific Responses — Misstatements Due to Misappropriation of Assets

Different situations would necessarily necessitate different responses. Normally, the audit response to an assessed risk of material misstatement due to fraud relating to misappropriation of assets will be directed toward certain account balances and classes of transactions. Although some of the audit responses noted in the preceding two categories may apply in such circumstances, the scope of the work is to be linked to the specific information about the misappropriation risk that has been identified.

• Counting cash or securities at or near year end
• Confirming directly with customers the account activity (including credit memo and sales return activity as well as dates payments were made) for the period under audit
• Analyzing recoveries of written-off accounts
• Analyzing inventory shortages by location or product type
• Comparing key inventory ratios to industry norm
• Reviewing supporting documentation for reductions to the perpetual inventory records
• Performing a computerized match of the vendor list with a list of employees to identify matches of addresses or phone numbers
• Performing a computerized search of payroll records to identify duplicate addresses, employee identification or taxing authority numbers, or bank accounts
• Reviewing personnel files for those that contain little or no evidence of activity; for example, lack of performance evaluations
• Analyzing sales discounts and returns for unusual patterns or trends
• Confirming specific terms of contracts with third parties
• Obtaining evidence that contracts are being carried out in accordance with their terms
• Reviewing the propriety of large and unusual expenses
• Reviewing the authorization and carrying value of senior management and related party loans
• Reviewing the level and propriety of expense reports submitted by senior management