Fraud In Audit

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21 Aug, 2024

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Table Of Contents

What Is Fraud In Audit?

Fraud in audit is the unlawful and deliberate misstatement of financial statements. It occurs when an establishment distorts the information provided in its financial records. An entity performs fraud in audit report to paint a false picture of a company's financial health and hide the profits or losses.

It is illegal for a company to alter its financial statements and manipulate information in its favor. Such acts are gravely punishable by law. The financial statements are prepared to reveal a company's financial status. These frauds lead to an unethical misrepresentation which may adversely impact the decision-makers.

What Is Fraud In Audit?

Fraud in audit occurs when a company commits material misstatements in its financial records with the intent to misrepresent the company's actual financial position. It is an unlawful and gravely punishable act.
Companies commit these frauds to misguide the investors, creditors, and shareholders. They are also used to rope in potential investors and creditors by lying about the company's financial health.
One can prevent these frauds by employing stringent rules on planning and controlling methods. Proper fraud detection training and development programs can also help prevent such fraud.

Fraud In Audit Explained

Fraud in audit occurs when an entity alters its financial statements with the intent to present a misleading record of its financial status. It is an illegal practice and a severely punishable offense. A company may engage in this type of fraud by deliberately providing inaccurate information in its financial records or hiding its profits and losses to present a distorted image of its financial health.

Auditing is a process that ensures that a company's financial statements are accurate and valid. This process ensures that a company maintains global financial standards and accurately represents its economic state. Fraud in audit reports occurs when an entity embellishes its financial statements on purpose. For example, it may overstate its revenue or assets to display a higher profit margin. Additionally, it may misstate the transactions to manipulate the records in its favor.

Several people associated with the business, like the management, creditors, and investors, rely on a company's financial statements to make financial decisions. A falsified record will influence the findings of these concerned individuals. These unethical and unlawful practices affect the public's trust. They may suffer from negative consequences due to the risk of fraud in audits.

Types of Fraud in Audit

The types of fraud in audit are as follows:

#1 - Cash Misappropriation

Misappropriation of cash occurs when one wrongfully records the cash in the business for personal gain. One can carry out this fraud in the following ways:

Not registering or eliminating cash transactions.
Making fake entries in customer accounts.
Recording purchases that never happened.
Recording amount that is either more or less than actually paid amount.

#2 - Goods Misappropriation

Misappropriation of goods is when the employees wrongly record or eliminate goods belonging to the business from its financial statements. Workers may utilize such goods for their personal use. Workers can easily mishandle goods that are not bulky. These frauds can be detected in the following ways:

Checking incoming and outgoing goods properly.
Having strict rules in place for frequent stock valuation.
Maintaining the purchase and sales accounts properly.

#3 - Falsifying And Manipulating Accounts

The management usually commits these types of fraud in audits. They deliberately maintain wrong records to show a fake image of the company's financial health. They can be done in the following ways:

Writing off bad debts.
Overstating or understating opening and closing stocks.
Wrongly recording purchases and sales.
Inflating or deflating revenue, income, and expenditure.
Incorrectly charging excess or less depreciation.

#4 - Window Dressing

Window dressing occurs when the financial records are presented in a way where the company's financial status is shown to be better than what it actually is. This misrepresentation is carried out to gain more credit and lure in potential partners or investors. Furthermore, it can also attract more creditors and shareholders into the business.

#5 - Secret Reserves

A business may have hidden reserves not presented in its financial statements. As a result, the company portrays a worse financial state than it is in. A company creates these secret fund reserves to avoid any tax liability. It also helps refrain from displaying its actual status to its competitors.

Examples

Let us understand the concept with the following examples:

Example #1

Suppose a store name General Stores is run by a team of five people whom the store owner had employed. In May 2022, the employees took away five milk bottles and ten packets of cookies each for personal use. The total price of the goods amounted to $3000.

In June 2022, the store received an outstanding payment of $12,000 from one of its customers. The employees decided not to record that transaction and take the money by dividing it equally among themselves. Thus, General Stores went through a misappropriation of assets worth $15,000.

Example #2

In September 2022, the United States Securities and Exchange Commission, or SEC, levied a fine on the Chinese affiliate of Deloitte, one of the "big four" accounting firms. The Chinese affiliate of Deloitte was fined $20 million because it let some of its clients conduct their auditing. The clients also included some foreign companies listed on the US exchanges. The SEC's enforcement was issued to safeguard investors in the US markets, and the SEC ensured that the public could trust a company's financial numbers.

How To Detect?

These frauds can be detected in the following ways:

Discussions with the management teams and the employees can help detect such fraud. Additionally, the auditor should interview the workers who handle the day-to-day business operations as they are the ones who are responsible for maintaining the daily records.
Interviewing the engagement team may help the auditor detect misstatements or misrepresentations in the financial records. The employees must be made aware of all the factors that contribute to committing such fraud.
The auditors must assess and analyze the risks of material misstatements. They must review all the financial records and identify the risks of such misrepresentations in a company's financial statements.

How To Prevent?

The risk of fraud in audit can be prevented in the following ways:

Investing in audit management software tools can help an establishment prevent such fraud. Such software tools can efficiently display fraudulent activities by providing crucial data about the company. They can help investigate financial irregularities within the business. Additionally, they can be instrumental in adhering to company policies and legal obligations.
Training employees in awareness and fraud detection is an effective method to prevent such fraud.
The fraud detection controls must be reviewed periodically. Strict measures should be employed to identify and eliminate fraudulent activities.

Frequently Asked Questions (FAQs)

Why is fraud in audit not detected?

There are several reasons why such frauds are not detected. Auditors may not have the proper training necessary for detecting fraud. They may not be aware of all the methods they can engage for identifying scams effectively. Furthermore, their frequent interaction and connection with the management or employees may cloud their judgment and create an internal bias that would hold them back from successfully identifying fraud. Also, improper planning and inadequate fraud detection and control techniques may be why such scams go undetected.

What are the elements of fraud in auditing?

There are three elements of such fraud. These elements motivate individuals to commit fraud. They are as follows:
- An individual may apprehend some pressure to commit fraud.
- Individuals may find a window where they can benefit from committing fraud.
- An individual may rationalize or justify the act of committing fraud.

Who is responsible for detecting fraud in audit?

According to the auditing standards set by the Public Company Accounting Oversight Board or PCAOB, an independent auditor is responsible for detecting such fraud. They are held accountable to verify whether a material misrepresentation is a case of error or fraud. However, they are not expected to actively such for these misstatements.