Auditors' Responsibility for Fraud Risk Assessment

Auditors have a duty to assess fraud risks in every audit engagement. Fraud is distinguished from errors by the intentional misrepresentation of financial information. Auditors must conduct fraud risk assessments as part of their overall risk evaluation for material misstatements​.

Professional auditing standards (e.g., AU-C 240) require auditors to:

• Identify fraud risk factors (i.e., conditions that make fraud more likely).

• Assess the risk of material misstatement due to fraud in financial statements.

• Perform audit procedures tailored to the identified fraud risks, such as increasing the scrutiny of management estimates or performing extended procedures like surprise inventory counts​.

A brainstorming session is required for the audit team to discuss potential fraud risks. This step ensures that the engagement team is aware of fraud possibilities and considers them throughout the audit process​.

Types of Fraud and Errors

Auditors differentiate between two main types of fraud:

Fraudulent Financial Reporting (Management Fraud)

• Intentional misstatements or omissions designed to deceive financial statement users.

• Often involves revenue recognition manipulation, improper asset valuations, or expense understatement.

• Can be motivated by pressure to meet earnings expectations, bonuses, or stock performance​.

Misappropriation of Assets (Employee Fraud)

• The theft of an entity’s assets, typically committed by employees.

• Includes embezzlement, larceny (simple theft), and fraudulent disbursement schemes such as falsified expense reports.

• Usually involves falsified documents to cover up the theft​.

Errors, in contrast, are unintentional misstatements or omissions in financial statements. These can occur due to clerical mistakes, misinterpretation of accounting standards, or system errors​.

Fraud Risk Factors

Auditors evaluate three categories of fraud risk factors:

• Management Characteristics and Influence – Overly aggressive earnings management, lack of internal controls, dominance by a single executive.

• Industry Conditions – High competition, declining industries, changing regulations.

• Operating Characteristics and Financial Stability – Poor cash flows, complex transactions, tax haven jurisdictions​.

Auditors use these factors to adjust the nature, timing, and extent of audit procedures to detect fraud effectively.