Question

1. a. Explain and give an example of assertion/audit objective level as it relates to identified fraud risk.

b. Explain and give an example of management override risk.

Answer 1

a. ASSERTION :

An “assertion” is a statement given as absolute fact.

So the “assertion level” is the level at which statements are presented as completely true.

Example :

Management tells the auditor the financial statements show a true valuation of inventory – management are formally “asserting” this statement as being correct, so we call this at the “assertion level”.

Assertion levels are three. They are :
1.About classes of transaction
2.about account balances
3.about presentations&disclosure.

Transaction-level assertions. The following five items are classified as assertions related to transactions, mostly in regard to the income statement:

• Accuracy. The assertion is that the full amounts of all transactions were recorded, without error.

Example : Salaries and wages cost has been calculated accurately. Any adjustments such as tax deduction at source have been correctly reconciled and accounted for.

• Classification. The assertion is that all transactions have been recorded within the correct accounts in the general ledger.

Example : Salaries and wages cost has been fairly allocated between:
-Operating expenses incurred in production activities;
-General and administrative expenses; and
-Cost of personnel relating to any self-constructed assets other than inventory.

• Completeness. The assertion is that all business events to which the company was subjected were recorded.

Example : Salaries and wages cost in respect of all personnel have been fully accounted for.

• Cutoff. The assertion is that all transactions were recorded within the correct reporting period.

Example : Salaries and wages cost recognized during the period relates to the current accounting period. Any accrued and prepaid expenses have been accounted for correctly in the financial statements.

• Occurrence. The assertion is that recorded business transactions actually took place.

Example : Salaries & wages expense has been incurred during the period in respect of the personnel employed by the entity. Salaries and wages expense does not include the payroll cost of any unauthorized personnel.

Account balance assertions. The following four items are classified as assertions related to the ending balances in accounts, and so relate primarily to the balance sheet:

• Completeness. The assertion is that all reported asset, liability, and equity balances have been fully reported.

Example : All inventory units that should have been recorded have been recognized in the financial statements. Any inventory held by a third party on behalf of the audit entity has been included in the inventory balance.

• Existence. The assertion is that all account balances exist for assets, liabilities, and equity.

Example : Inventory recognized in the balance sheet exists at the period end.

• Rights and obligations. The assertion is that the entity has the rights to the assets it owns and is obligated under its reported liabilities.

Example : Audit entity owns or controls the inventory recognized in the financial statements. Any inventory held by the audit entity on account of another entity has not been recognized as part of inventory of the audit entity.

• Valuation. The assertion is that all asset, liability, and equity balances have been recorded at their proper valuations.

Example : Inventory has been recognized at the lower of cost and net realizable value in accordance with IAS 2 Inventories. Any costs that could not be reasonably allocated to the cost of production (e.g. general and administrative costs) and any abnormal wastage has been excluded from the cost of inventory. An acceptable valuation basis has been used to value inventory cost at the period end (e.g. FIFO, AVCO, etc.)

Presentation and disclosure assertions. The following five items are classified as assertions related to the presentation of information within the financial statements, as well as the accompanying disclosures:

• Accuracy. The assertion is that all information disclosed is in the correct amounts, and which reflect their proper values.
• Completeness. The assertion is that all transactions that should be disclosed have been disclosed.

Example : All related parties, related party transactions and balances that should have been disclosed have been disclosed in the notes of financial statements.

• Occurrence. The assertion is that disclosed transactions have indeed occurred.

Example : Transactions with related parties disclosed in the notes of financial statements have occurred during the period and relate to the audit entity.

• Rights and obligations. The assertion is that disclosed rights and obligations actually relate to the reporting entity.

Example : Related party transactions, balances and events have been disclosed accurately at their appropriate amounts.

• Understandability. The assertion is that the information included in the financial statements has been appropriately presented and is clearly understandable.

Example : The nature of related party transactions, balances and events has been clearly disclosed in the notes of financial statements. Users of the financial statements can clearly determine the financial statement captions affected by the related party transactions and balances and can easily ascertain their financial effect.

b. Management override risk :

The risk of management override of controls is considered to be a fraud risk and is therefore always a 'significant' risk as defined in ISA 31516 on risk assessment. The auditor needs to consider whether the entity has any controls to prevent, or detect and correct, such override.

Examining Journal Entries and Other Adjustments

Management can perpetrate financial reporting frauds by overriding established control procedures and recording unauthorized or inappropriate journal entries or other post closing adjustments (for example, consolidating adjustments or reclassifications). For example, SEC Accounting and Auditing Enforcement describes a situation in which the controller entered false journal entries debiting accounts payable and crediting purchases (cost of sales). The effect was to understate payables and significantly increase earnings.

To address situations such as these, requires you to test the appropriateness of journal entries recorded in the general ledger and other adjustments.

Retrospective Review of Accounting Estimates

Accounting estimates are particularly vulnerable to manipulation because they depend so heavily on judgment and the quality of the underlying assumptions. For that reason, requires you to perform a retrospective review of prior-year accounting estimates for the purpose of identifying bias in management's assumptions underlying the estimates.

Business Rationale for Significant Unusual Transactions

Many financial reporting frauds have been perpetrated or concealed by using unusual transactions that are outside the normal course of business. For that reason, requires auditors to understand the business rationale for these types of transactions. this provides an excellent list of items you should consider when understanding the business rationale for unusual transactions.