Professional 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 due to

Question

fraud? (d) Which factors existed during the 1997 through 2000 audits of Xerox 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] When assessing the likelihood fraud the auditor should consider:
Management’s incentives (are there industry conditions or operating characteristics putting
pressure on management to perpetuate a fraud?)
Management’s opportunity (are there significant accounts requiring subjective estimates, is the
control environment weak, are controls inadequate?)
Management’s attitude (is or has management exhibited questionable behavior in the past?)
[d] Factors that existed during the 1997 through 2000 audits of Xerox that created an environment
conducive to fraud include:
Changing business environment for document processing products (transition to color documents,
digital technology, network connected devices, and electronic documents),
Increasing competition from foreign competitors,
Investment climate of the 1990s for public companies to continuously report revenues and earning
growth,
Need for Xerox to maintain high credit rating to obtain the funds necessary to internally finance
customer purchases,
Linkage of senior management compensation to increasing revenues and earnings,
Negative operating cash flows.
Complexity and subjectivity of accounting related to lease transactions.
Management’s use of aggressive accounting practices to increase revenues and earnings,
Senior management’s view of accounting manipulations as accounting opportunities,
Senior management’s disregard for accounting concerns raised by non-senior managers.