Under ISA 240, misstatements in the financial statements can arise from either fraud or error; the distinguishing factor between the two is whether the underlying action that results in the misstatement is intentional or unintentional.
How Does the Standard Define "Fraud"?
The standard defines fraud 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. "Fraud risk factors" are events or conditions that indicate an incentive or pressure to commit fraud or provide an opportunity to commit fraud.
Does the Auditor Bear the Primary Responsibility for Detecting Fraud?
No. The primary responsibility for the prevention and detection of fraud rests with both those charged with governance and management. Nevertheless, an auditor conducting an audit in accordance with the ISAs is responsible for obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error. Owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements may not be detected, even though the audit is properly planned and performed.
Why Is Fraud Harder to Detect Than Error?
The standard states that the risk of not detecting a material misstatement resulting from fraud is higher than the risk of not detecting one resulting from error, because fraud may involve sophisticated and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, or intentional misrepresentations made to the auditor. The standard also states that the risk of the auditor not detecting a material misstatement resulting from management fraud is greater than for employee fraud, because management is frequently in a position to directly or indirectly manipulate accounting records, present fraudulent financial information, or override controls designed to prevent similar frauds by other employees.
What Role Does Professional Skepticism Play Against Fraud Risk?
When obtaining reasonable assurance, the auditor is responsible for maintaining professional skepticism throughout the audit, considering the potential for management override of controls and recognizing the fact that audit procedures that are effective for detecting error may not be effective in detecting fraud.
What Are the Auditor's Objectives Regarding Fraud Risk?
The standard sets three objectives for the auditor: to identify and assess the risks of material misstatement of the financial statements due to fraud; to obtain sufficient appropriate audit evidence regarding the assessed risks of material misstatement due to fraud, through designing and implementing appropriate responses; and to respond appropriately to fraud or suspected fraud identified during the audit.
Legal References
- ISA 240 — The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements, Paragraphs 2, 5, 6, 7, 11 and 12.
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