Fraud in a Financial Statement Audit

The primary purpose of an audit is to express an opinion on the financial statements as a whole. Audits are not specifically designed to detect fraud. While there are a variety of actions that the auditor must take to assess the risk of fraud in an audit, detecting fraud is not the primary purpose of an audit.

Fraud in Terms of Audit Standards

Let’s looks at the audit standards surrounding fraud. AU-C Section 240: Consideration of Fraud in a Financial Statement Audit addresses the auditor’s responsibilities related to fraud in a financial statement audit. Fraud is a broad legal concept. The distinguishing characteristic of fraud, which sets it apart from error, is that fraud is always intentional. Auditors may suspect or, in rare instances, identify the occurrence of fraud. However, it is the judicial system (and not the auditor) that makes the legal determination of whether fraud has actually occurred. AU-C Section 240 defines fraud in a financial statement context as an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception that results in a misstatement in financial statements that are the subject of an audit.

Responsibilities of Auditors, Management, and Governance

Auditors are primarily concerned with fraud that materially misstates the financial statements. This may be caused by two types of intentional misstatements: fraudulent financial reporting and misstatements resulting from misappropriation of assets (theft).

Within the financial statement audit, the auditor’s objectives are to:

1. Identify and assess risks of material misstatement due to fraud;
2. Obtain sufficient appropriate audit evidence concerning the assessed risks of material misstatement due to fraud by designing and implementing appropriate responses; and
3. Respond appropriately to fraud or suspected fraud that is identified in the audit.

The prevention and detection of fraud is the primary responsibility of management and those charged with governance (typically, the Board of Directors). However, several procedures are conducted by the auditor during the audit to address the risk of fraud, which may include, but are not limited to:

• Evaluation of fraud risk factors, including incentives/pressures to commit fraud, opportunities for fraud, and assessing the environment which may allow rationalizing of fraud.
• Designing the audit to assess the risks of fraud occurring.
• Inquiries of management, those charged with governance, and others within the entity regarding fraud.
• Evaluation of unusual or expected financial relationships identified by analytical procedures.
• Review of accounting estimates for possible management bias.
• Designing unpredictable audit procedures so that the audit process will vary from year to year.

If the auditor identifies the possible existence of fraud, those findings should be communicated timely to the appropriate level of management, which is ordinarily at least one level above the persons who appear to be involved. If the auditor suspects fraud involving management, the auditor should communicate those suspicions to those charged with governance and discuss with them the nature, timing, and extent of audit procedures necessary to complete the audit.

Any possible instances of fraud occurring must be communicated to those charged with governance. The auditor must then assess the actions taken to address the possible instances of fraud and determine if those actions are sufficient. The actions must also be designed to detect and prevent future instances of the potential fraud occurring. The auditor may have various outcomes as a result of this process, up to and including resigning of the engagement should the actions of those charged with governance be deemed insufficient to address the instances identified.

Fraud in an Audit

In summary, an auditor must design the audit to detect possible instances of material fraud occurring through fraudulent financial reporting or misappropriation of assets. An audit is not specifically designed to detect fraud, and it is unlikely that an auditor will conclude that fraud has occurred. Fraud is a broad legal concept requiring proof that the actions taken were intentional.

If you have questions about the information outlined above, McKonly & Asbury’s experienced professionals are here to help. Learn more about our Healthcare practice by visiting our Healthcare industry page or by contacting the Director of our Healthcare practice, Janice Snyder, Partner.

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