Question

A Hong Kong listed company has over 80% voting shares being held by the Chief Executive Officer (“CEO”) and the Executive Director (“ED”). Both the CEO and the ED are graduated from famous universities and from wealthy families. They involved in the daily operations of the listed company and all sales and purchase transactions above HK$100,000 have to be approved by both of them.

They have weekly meetings with the respective department heads discussing each department’s financial and operational affairs. Each department is assigned with financial budget which is achievable, and meeting financial budget is not the only criterion in assessing employees’ performance.

The company’s board of directors emphasizes ethical behavior seriously, and serious breach in those ethical guidelines will not be tolerated. The company has maintained a stable performance during the past seven years with moderate increment of profit and a relatively high dividend pay-out ratio.

The company has engaged a consulting firm to redesign its internal control system at the beginning of the year, and the system has just been implemented. The CEO and the ED expect the new system will further strengthen the company’s information flow.

Required:

1. Discuss the THREE characteristics of fraud.

2. Assume you are the audit engagement senior manager and you are now assessing the risk of fraud for this listed company. Based on information provided, discuss and explain your risk assessment of fraud due to the management and the employees.

Answer 1

1. Three characteristics of fraud are-

a. Multi-layered transactions

b. Ordinary people commits fraud under pressure e.g financial pressure, risk apetite

c. Made knowingly and with the intent to deceive

2. Risk assessment due to management-

a. Risk of override of control as CEO and ED holds more than 80% of voting power and thus have oppourtunity to commit fraud. Further, all sales and purchase transactions above HK100,000 requires these two people's approval only.

b. ISA 240 Auditor's Responsibilities Relating to Frad in an audit of financial statements provides that Management is in a unique position to perpetrate fraud because of management’s ability to manipulate accounting records and prepare fraudulentfinancial statements by overriding controls that otherwise appear to be operating effectively. Although the level of risk of management override of controls will vary from entity to entity, the risk is nevertheless present in all entities. Due to the unpredictable way in which such override could occur, it is a risk of material misstatement due to fraud and thus a significant risk. Hence, an auditor should obtain sufficient and reasonable assurance.

3. Risk of fraud due to employees-

Risk of fraud due to employee is low compared to risk of fraud due to management because one employee cannot commit a fraud. Collussion of employees to create fraud is a real risk and manageement should implement sufficient control to prevent such situation. Further, an auditor should obtain appropriate evidence. Control should be tested to test its effectiveness.