Professional auditing standards outline the auditor’s consideration of material misstatements due to errors and fraud. (a) What responsibility does an auditor have to detect material misstatements due to errors and fraud? (b) What two main categories of fraud affect financial reporting? (c) What types of factors should auditors consider when assessing the likelihood of material misstatements

Question

due to fraud? (d) Which factors existed during the 1995 through 1997 audits of CUC that created an environment conducive for fraud?

What will be an ideal response?

Answer 1

[a] Auditors are required to plan and perform audit engagements to provide reasonable assurance that
the financial statements are free of material misstatement, whether the result of error or fraud. The
distinguishing feature between errors and fraud is whether the misstatement was unintentional or
intentional. Errors are unintentional misstatements while frauds are intentional misstatements.
The auditor provides reasonable assurance of detecting frauds leading to material misstatements by
evaluating the likelihood of fraud and expanding audit tests when there is a higher likelihood of fraud.
[b] Fraud misstatements can occur from fraudulent financial reporting or misappropriation of assets.
Financial statement misstatements or omissions intended to deceive users are referred to as fraudulent
financial reporting. Thefts of entity assets reported in the financial statements are referred to as
misappropriation of assets.
[c] Three broad conditions generally are present when fraud occurs. These broad conditions are:
Management’s or employees’ “incentive or pressure” to commit fraud
Circumstances exist to provide management or employees the “opportunity” to commit fraud (for
example, absence of controls, ineffective controls or ability to override controls)
Management or employees posses an “attitude” that allows them to commit fraud AU Section 240 provides extensive detail about potential indicators for each of these conditions. For
example, an “incentive” that would suggest a higher likelihood of fraud would be excessive pressure on
management or operating personnel to meet financial targets set up by those charged with governance.
[d] Factors that existed during the 1995 through 1997 audits of CUC that created an environment
conducive to fraud include:
The excessive emphasis of CUC management on meeting analyst expectations
The focus of CUC management on maintaining a strong stock price to provide opportunities to
use CUC stock to acquire and merge with other companies
The use of overly aggressive accounting practices as suggested by the Securities and Exchange
Commission’s previous requirement that CUC’s financial statements be restated because of
aggressive accounting practices
CUC’s rapid growth
Lack of board oversight because of the close financial ties of four of the directors with Walter
Forbes, chairman and chief executive officer for CUC
Many students will indicate that management did not properly communicate and display an appropriate
attitude regarding internal control and the financial reporting process. When this factor is raised, students
can be asked to indicate the information that was present at that time that would have suggested this
factor. Students normally note the audit committee report as the information source. Students can then
be told that in hindsight it appears that management did not communicate and display an appropriate
attitude related to controls and financial reporting. However, it is helpful to point out that they have the
benefit of hindsight that the auditors did not have at the time. Students can then be asked to identify
factors that suggested management’s lack of an appropriate attitude about internal control before the
fraud was discovered. This last question normally draws the students to the factors listed above.