The Motivations and Intentions of Management
When performing an audit, it is important to determine the motivations and intentions of management, as this will greatly assist with identifying potential fraud risks and ensuring the integrity of financial reporting. This can only be determined through a thorough understanding of the entity, and its management and compensation structures, business model, controls and related business plans. Once determined, appropriate audit procedures shall be designed to respond to the fraud risks.
Key audit areas to consider
The intentions of management should be evaluated by applying professional scepticism and appropriate procedures in the following audit areas:
Knowledge of the business
Understanding the entity’s business model and operations is crucial for identifying industry-specific risks and potential fraud areas. This includes a thorough review of historical financial performance and trends to establish a baseline for normal activity. Consequently, the auditor may identify, for example, falsification of sales figures in highly competitive industries to appear more successful than competitors.
Preliminary analytical review
Conducting a preliminary analysis of financial data involves comparing current-period data with prior periods, and industry benchmarks. This helps with the identification of unusual fluctuations or inconsistencies that may indicate fraudulent activity. Inflated revenue or expense figures may be identified through ratio analysis and comparison with previous periods.
Evaluation as a going concern
Assessing the entity’s ability to continue as a going concern involves evaluating financial stability and liquidity, and identifying any indications of financial distress or bankruptcy risk. This evaluation helps auditors understand whether the entity may be hiding financial troubles, for example, concealing liabilities, or inflating assets to hide financial distress and avoid bankruptcy.
JSE regulation compliance
Ensuring compliance with Johannesburg Stock Exchange regulations requires a detailed review of disclosures and regulatory filings for accuracy. This assists with the identification of any regulatory issues that might indicate potential fraud, such as manipulation of financial statements to meet listing criteria.
Assessment of significant agreements
Evaluating major contracts and agreements involves understanding their terms, and how they could affect financial statements. This assessment is crucial for identifying misrepresented terms of significant agreements, or premature revenue recognition.
Fraud discussions
Engaging in discussions with management and employees about fraud risks provides insights into attitudes, and rationalisation regarding fraudulent behaviour. These discussions help auditors incorporate management’s perspective into the audit plan to better detect fraud. ISA240 stipulates enquiries about incidents of fraud, management’s assessment of fraud risk, and management’s communication with staff and those charged with governance on fraud. The auditor may identify that management is rationalising aggressive accounting practices to meet financial targets.
Conditions for fraud
There are three fundamental components that contribute to the risk of fraud, with each playing a critical role in understanding the motivations and circumstances that may lead to fraudulent activities within an organisation:
Incentives or pressures are the driving force that compels individuals or management to commit fraud. These may include financial pressures, such as the need to meet financial targets or personal financial obligations, as well as non-financial pressures, such as the desire to achieve professional success, or maintain a company’s reputation.
Opportunities refer to the circumstances that allow fraud to occur. These opportunities often arise from weaknesses in internal controls, lack of oversight, or complex organisational structures that make it easier to conceal fraudulent activities. Identifying and mitigating these opportunities is crucial in preventing fraud.
Attitudes or rationalisation involve the mindset and justification of individuals to rationalise fraudulent behaviour. This may include a perceived sense of entitlement, a belief that the particular fraud is harmless or justified, or a disregard for the ethical standards and regulations that govern their actions. Understanding the rationalisation helps auditors to anticipate and detect fraudulent intentions.
In summary
By applying the right focus and mindset throughout the audit, auditors may be able to identify and respond to fraudulent intentions of management, thereby ensuring the integrity of financial reporting.
References
1. ISA 240, The auditor’s responsibilities relating to fraud in an audit of financial statements
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