Problem 6-22 (Pg 151)

Answer
a) It is noted in ISA 200 that an audit in accordance with ISAs is
designed to provide reasonable assurance that the financial
statements taken as whole are free from material misstatements.
Misstatements are usually considered material if the combined
uncorrected errors and fraud in the financial statements would likely
have changed or influenced the decisions of a reasonable person
using the statements. Although it is extremely difficult to quantify a
measure of materiality, auditors are responsible for obtaining
reasonable assurance that this materiality threshold has been
satisfied. It would be extremely costly (and probably impossible) for
auditors to have responsibility for finding all immaterial errors and
fraud.
Besides that, an auditor is also responsible for providing reasonable
assurance for the users of financial statements. Assurance is a
measure of the level of certainty that the auditor has obtained at the
completion of the audit. Reasonable assurance is not defined in the
literature, but it is presumably less than certainty or absolute
assurance and more than a low level of assurance. The concept of
reasonable, but not absolute assurance indicates that the auditor is
not an insurer or guarantor of the correctness of the financial
statements.
There are several reasons why the auditor is responsible for
reasonable but not absolute assurance. First, most audit evidence
results from testing a sample of a population such as accounts
receivable or inventory. Sampling inevitably includes some risk of not
uncovering a material misstatement. Also, the areas to be tested; the
type, extent and timing of those tests; and the evaluation of test
results require significant auditor judgment. Even with good faith and
integrity, auditors can make mistakes and errors in judgment.
Second, accounting presentations contain complex estimates, which
inherently involve uncertainty and can be affected by future events.
As a result, the auditor has to rely on evidence that is persuasive, but
not convincing. Third, fraudulently prepared financial statements are
 often extremely difficult, if not impossible, for the auditor to detect,
especially when there is collusion among management.
If the auditor was responsible for making certain that all the
assertions in the statements were correct, evidence requirements
and the resulting cost of the audit function would increase to such an
extent that audits would not be economically practical. Even then,
auditors would be unlikely to uncover all material misstatements in
every audit. The auditor’s best defense when material misstatements
are not uncovered in the audit is that the audit was conducted in
accordance with auditing standards.
ISA 240 distinguishes between two types of misstatements: error
and fraud. Either type of misstatement can be material or immaterial.
An error is an unintentional misstatement of the financial statements,
whereas fraud is intentional. Two examples of errors are a mistake in
extending prices times quantity on a sales invoice and overlooking
older raw materials in determining the lower of cost or market for
inventory.
For fraud, there is a distinction between misappropriation of assets,
often called defalcation or employee fraud, and fraudulent financial
reporting, often called management fraud. An example of
misappropriation of assets is a clerk taking cash at the time a sale is
made and not entering the sale in the cash register. An example of
fraudulent financial reporting is the intentional overstatement of
sales near the balance sheet date to increase reported earnings.
ISA 200 requires an audit be designed to provide reasonable
assurance of detecting both material errors and fraud in the financial
statements. To accomplish this, the audit must be planned and
performed with an attitude of professional skepticism in all aspects of
the engagement. Professional skepticism is an attitude that includes
a questioning mind and a critical assessment of audit evidence. The
auditor should not assume that management is dishonest, but the
possibility of dishonesty must be considered. The auditor also should
not assume that management is unquestionably honest.

b) Auditing standards make no distinction between the auditor’s

responsibility for searching for errors and fraud, whether from
 fraudulent financial reporting or misappropriation of assets. For both
errors and fraud, the auditor must obtain reasonable assurance
about whether the statements are free of material misstatements.
The standards also recognize that it is often more difficult to detect
fraud than errors because management or the employees
perpetrating the fraud attempt to conceal the fraud. The difficulty of
detection does not change the auditor’s responsibility to properly
plan and perform the audit.

c) Throughout an audit, the auditor continually evaluates whether

evidence gathered and other observations made indicate material
misstatement due to fraud. All misstatements the auditor finds
during the audit should be evaluated for any indication of fraud.
When fraud is suspected, the auditor gathers additional information
to determine whether fraud actually exists. Often, the auditor begins
by making additional inquiries of management and others.
Inquiry can be an effective audit evidence gathering technique.
Interviewing allows the auditor to clarify unobservable issues and
observe the respondent’s verbal and nonverbal responses.
Interviewing can also help identify issues omitted from
documentation or confirmations. The auditor can also modify
questions during the interview based on the interviewee’s responses.
Inquiry as an audit evidence technique should be tailored to the
purpose for which it is being used. Depending on the purpose, the
auditor may ask different types of questions and change the tone of
the interview. One or more of three categories of inquiry can be
used, depending on the auditor’s objectives: informational inquiry,
assessment inquiry and interrogative inquiry. Besides that, for
inquiry to be effective, auditors need to be skilled at listening and
evaluating responses to questions. Typically, the interviewee’s initial
response will omit important information. Effective follow-up
questions often lead to better information to assess whether fraud
exists. Good listening techniques and observation of behavioral cues
strengthen the auditor’s inquiry techniques.
When the auditor suspects that fraud maybe present, the auditor
needs to obtain additional evidence to determine whether material
fraud has occurred. Auditors often use inquiry, as previously
discussed, as part of that information-gathering process. The auditor
also has to consider the implications for other aspects of the audit.
For example, fraud involving the misappropriation of cash from a
small petty cash fund normally is of little significance to the auditor,
unless the matter involves higher-level management. In the latter
situation, the petty cash fraud may indicate to the auditor a need to
re-evaluate the fraud risk assessment and the impact on the nature,
timing and extent of audit evidence.
When the auditor determines that fraud maybe present, the auditor
is required to discuss the matter and audit approach for further
investigation with an appropriate level of management, even if the
matter might be considered inconsequential. The appropriate level of
management should be at least one level above those involved, as
well as senior management and the audit committee. If the auditor
believes that senior management may be involved in the fraud, the
auditor should discuss the matter directly with the audit committee.
The discovery that fraud exists also has implications for the public
company auditor’s report on internal control over financial reporting.
Fraud of any magnitude by senior management is at least a
significant deficiency and may be a material weakness in internal
control over financial reporting. This includes fraud by senior
management that results in even immaterial misstatements. If the
auditor decides the fraud by senior management is a material
weakness, the auditor’s report on internal control over financial
reporting will contain an adverse opinion.
Sometimes, auditors identify risks of material misstatements due to
fraud that have internal control implications. There may also be
cases where the auditor’s consideration of management’s antifraud
programs and controls identify deficiencies that fail to mitigate these
risks of fraud. The auditor must communicate those items to the
audit committee if they are considered significant deficiencies or
material weaknesses. When auditing the financial statements of a
public company, the auditor should consider those deficiencies when
auditing internal controls over financial reporting. The disclosure of
possible fraud to parties other than the client’s senior management
and its audit committee ordinarily is not part of the auditor’s
responsibility. Such disclosure is prevented by the auditor’s
professionalism code of conduct and may violate legal obligations of
confidentiality. The results of the auditor’s procedures may indicate
such a significant risk of material misstatement due to fraud that the
auditor should consider withdrawing from the audit. Withdrawal may
depend on management’s integrity and the diligence and
cooperation of management and the board of directors in
investigating the potential fraud and taking appropriate action.
Apart from this, when the auditor knows of a non-compliance during
the audit, the action to be taken is to consider the effects on the
financial statements, including the adequacy of disclosures. These
effects may be complex and difficult to resolve. For example, a
violation of civil rights laws could involve significant fines, but it could
also result in the loss of customers or key employees, which could
materially affect future revenues and expenses. If the auditor
concludes that the disclosures relative to a non-compliance are
inadequate, the auditor should modify the audit report accordingly.
However, if the non-compliance has a material effect on the accounts
and was not reflected in the accounts, ISA 250 states that the auditor
should express a qualified or an adverse opinion.
The auditor should also consider the effect of such non-compliance
on its relationship with management. If management knew of the
non-compliance and failed to inform the auditor, it is questionable
whether management can be believed in other discussions. The
auditor should communicate with the audit committee or others of
equivalent authority to make sure that they know of the non-
compliance. The communication can be oral or written. If it is oral,
the nature of the communication and discussion should be
documented in the audit files. If the client refuses to accept the
auditor’s modified report or fails to take appropriate remedial action
concerning the illegal act, the auditor may find it necessary to
withdraw from the engagement. If the client is publicly held, the
auditor must also report the matter directly to the SC. Such decisions
are complex and normally involve consultation by the auditor with
the auditor’s legal counsel.
Problem 6-23 (Pg 151)
Answer
In our opinion, we felt that the management should bear the loss of
fraudulent financial reporting. The responsibility for adopting sound
accounting policies, maintaining adequate internal control, and making
fair representations in the financial statements rests with the
management rather than with the auditor. Because they operate the
business daily, a company’s management knows more about the
company’s transactions and related assets, liabilities, and equity than
the auditor does. In contrast, the auditor’s knowledge of these matters
and internal control is limited to that acquired during the audit. ISA 200
also states; while the auditor is responsible for forming and expressing
an opinion on the financial statements, the responsibility for preparing
and presenting the financial statements is that of the management of
the entity. The audit of the financial statements does not relieve
management of its responsibilities. Since the fraud was perpetrated by
the management, therefore it is the management’s responsibility to
bear the loss of fraudulent financial reporting.
Since the SC was satisfied that the auditor had done a high-quality
audit and had followed the Malaysian Approved Standards on Auditing
in every aspect, the auditors should not bear the loss of the fraudulent
financial reporting perpetrated by the management. An auditor is
responsible for providing reasonable assurance for the users of financial
statements. Assurance is a measure of the level of certainty that the
auditor has obtained at the completion of the audit. Reasonable
assurance is not defined in the literature, but it is presumably less than
certainty or absolute assurance and more than a low level of assurance.
The concept of reasonable, but not absolute assurance indicates that
the auditor is not an insurer or guarantor of the correctness of the
financial statements. Most audit evidence results from testing a sample
of a population such as accounts receivable or inventory. Sampling
inevitably includes some risk of not uncovering a material
misstatement. Also, the areas to be tested; the type, extent and timing
of those tests; and the evaluation of test results require significant
auditor judgment. Even with good faith and integrity, auditors can
make mistakes and errors in judgment. Accounting presentations
contain complex estimates, which inherently involve uncertainty and
can be affected by future events. As a result, the auditor has to rely on
evidence that is persuasive, but not convincing. Fraudulently prepared
financial statements are often extremely difficult, if not impossible, for
the auditor to detect, especially when there is collusion among
management. Hence, it is not right to blame the auditors for fraudulent
financial reporting. However, there are circumstances where the
auditors are to be held liable for not uncovering the fraudulent financial
reporting. Lawsuits can be made by clients for not discovering a
material fraud during the audit as a result of negligence in the conduct
of the audit. Potential claims also can be made by third parties under
common law and federal securities law. Third parties include actual and
potential stockholders, vendors, bankers and other creditors,
employees and customers. A public accounting firm may be liable to
third parties if a loss was incurred by the claimant due to reliance on
misleading financial statements. Under the common law, a bank may
sue the auditor for not discovering that a borrower’s financial
statements are materially misstated. For the latter, a combined group
of stockholders sues the auditor for not discovering materially
misstated financial statements. But, we believe that the auditor should
not bear the loss even if there is a lawsuit against them because there
are reasonable defenses available to them and it is only necessary for
the profession and society to determine a reasonable trade-off between
the degrees of responsibility the auditor should take for fair
presentation and the audit cost to society.

Problem 6-23 (Pg 151)

Answer
 Classes of Financial Titles of Journals Transaction
transactions Statement cycles
Balance
Purchase returns Income Acquisitions Inventory and
Statement Journal warehousing
Rental Revenue Income Cash Receipts Sales and
Statement Journal Collection
Charge-off of Income General Journal Sales and
uncollectible Statement Collection
accounts
Acquisition of Income Acquisitions Acquisition and
goods and services Statement and Journal, Cash Payment
(except payroll) Balance Sheet disbursements
Journal
Rental Allowances Income Cash Acquisition and
Statement Disbursements Payment
Journal
Adjusting entries Balance Sheet General Journal Payroll and
(for payroll) personnel
Payroll service and Income Payroll Journal Payroll and
payments Statement personnel
Cash Balance Sheet Cash Acquisition and
Disbursements Disbursements Payment
(except payroll) Journal
Cash Receipts Balance Sheet Cash Receipts Sales and
Journal Collection

d) Rental revenue transactions are recorded in the Sales Journal if it is a

receivable from trade debtors and in the Cash Receipts Journal if it is
received in the form of cash. Ensure that the transaction is properly
recorded and stated in the correct amounts. We need to classify the
transaction into the rightful client’s journal too. Transactions must be
recorded at the correct date. We must also ensure the accuracy of
the transfer of information from the Sales Journal to Client’s Journal
(subsidiary records) and the general ledger. Adjusting entries are
made in the general journal and later posted to the general ledger
and the relevant subsidiary records.