EY Global Audit Methodology and Supplemental Audit Guidance / EY Global Audit Methodology / Planning and Risk Identification / P06

Identify risks of material misstatement due to fraud and determine

responses / P06_2 Identify risks of material misstatement due to fraud

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P06_2 Identify risks of material misstatement due to fraud

We use the information we have obtained at different points in the
identify risks of material misstatement due to fraud.

audit , including the identification of fraud

risk

factors, to

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We evaluate the collective knowledge we have obtained throughout the

audit , the information obtained from the sources

described in P06_1 Obtain information to identify risks of material misstatement due to fraud and the following when identifying
risks of material misstatement due to fraud:
l

The type of

The magnitude of the

risk

The likelihood that the

The pervasiveness of the

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(i.e., fraudulent financial reporting or misappropriation of assets)

risk
risk

will result in a material misstatement in the financial statements

risk

(i.e., whether the

risk

affects the financial statements as a whole or it is specifically related

to a particular account, assertion or of transaction)

Identifying risks of material misstatement due to fraud is more than reviewing a checklist of fraud
fraud

risk

factor does not automatically mean there is a

risk

risk

factors. The presence of a

of material misstatement due to fraud (refer to P06_2.7 Consider

likelihood and magnitude of risks of material misstatement due to fraud for further guidance).
The identification of risks of material misstatement due to fraud is also affected by our understanding of the control environment. A
control environment that supports the prevention or detection and correction of material misstatements relevant to financial reporting
is not an absolute deterrent to fraud, but may help reduce the risk of fraud thus allowing us to have more confidence in internal
control and the reliability of

audit

evidence gathered. Negative factors within the control environment may undermine the

effectiveness of controls and give rise to greater incidence of risks of material misstatement due to fraud.
When a

risk

of material misstatement due to fraud is considered pervasive to the financial statements as a whole, we identify the

account balance(s) and assertion(s) where we believe a potential misstatement is likely to arise and relate the

risk

of material

misstatement due to fraud to relevant assertions.

When a

risk

of material misstatement due to fraud is specifically related to a particular account, assertion or class of transaction,

we determine a specific response and consider some form of overall response.

EY Global Audit Methodology and Supplemental Audit Guidance / EY Global Audit Methodology / Planning and Risk Identification / P06 Identify risks of material misstatement due to fraud and determine
responses / P06_2 Identify risks of material misstatement due to fraud

Refer to P06_3 Determine responses to risks of material misstatement due to fraud for further requirements and guidance.

P06_2.1 Revenue recognition

We evaluate which types of revenue transactions give rise to risks of material misstatement due to fraud. If we do not identify a
risk of material misstatement due to fraud relating to revenue recognition, we document the reason(s) supporting this
conclusion.

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There is a presumption that we will identify one or more risks of material misstatement due to fraud relating to revenue recognition
since material misstatements due to fraudulent financial reporting often result from an overstatement of revenues (e.g., premature
revenue recognition or recording fictitious revenues) or an understatement of revenues (e.g., improperly shifting revenues to a later
period). There may be some instances when we determine that this presumption is not applicable.
For example, if an entity has a single type of revenue transaction (e.g., leasehold revenue from a single unit rental property), we
may conclude that there is no risk of material misstatement due to fraud relating to revenue recognition when the revenue
amount can be predicted with a high degree of confidence.

P06_2.2 Inquiries
We determine whether information obtained from our inquiries indicates the presence of risks of material misstatement due
to fraud.

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We exercise professional skepticism when we evaluate managements responses to our inquiries since management may be in the best
position to perpetrate fraud. We determine whether the responses to inquiries of others within the entity and other information we
obtained corroborates what management has told us.

P06_2.3 Analytical procedures

When the results of our overall analytical procedures of financial and non-financial information and other analytical procedures
performed do not meet our expectations, we evaluate whether these unusual or unexpected relationships, including those related to
revenue accounts, may indicate risks of material misstatement due to fraud.

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P06_2.4 Nature of the business

We evaluate fraud

risk

factors arising from our understanding of the entity and its environment (e.g., the nature of the business,

ownership characteristics, the industry in which the entity operates and the size and complexity of the entitys operations).

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EY Global Audit Methodology and Supplemental Audit Guidance / EY Global Audit Methodology / Planning and Risk Identification / P06 Identify risks of material misstatement due to fraud and determine
responses / P06_2 Identify risks of material misstatement due to fraud

We consider whether the knowledge we obtained in P03 Understand the business and throughout the engagement about the nature of
the entity indicates risks of material misstatement due to fraud.
For example, an entity that is predominately cash-operated increases the susceptibility of cash to misappropriation as compared to a
trading entity that processes its transactions primarily through third parties with limited cash transactions.

P06_2.5 Engagement team discussion

We evaluate the information we obtained from our engagement team discussion on how and where the entitys financial statements
may be susceptible to material misstatement due to fraud and how fraud may occur in identifying risks of material misstatement
due to fraud.

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The engagement team discussion is a fundamental part of brainstorming how fraud could be perpetuated and is important to the
audit as it:
l

Provides an opportunity for more experienced team members to share their insights about how and where the financial statements
may be susceptible to material misstatement due to fraud
Allows consideration of appropriate responses to risks of material misstatement due to fraud and to determine which team member
will execute audit procedures to respond to the risks of material misstatement due to fraud
Facilitates our determination of how the results of our

audit

procedures to respond to the

risk

of material misstatement due

to fraud will be shared among the team and how to deal with any allegations of fraud that may come to our attention
Refer to S01 Team planning event and discussion of fraud and error for further requirements and guidance.

P06_2.6 Other information/sources

We determine other information that may be helpful in identifying the risks of material misstatement due to fraud.

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Refer to P06_1 Obtain information to identify risks of material misstatement due to fraud for a list of other information that may be
relevant in the identification of risks of material misstatement due to fraud and the stage in the audit when we are likely to obtain
this information.
Refer also to P06_Appendix 5 Examples of circumstances that may be indicative of fraud for further guidance.

P06_2.7 Consider likelihood and magnitude of risks of material misstatement due to

fraud

EY Global Audit Methodology and Supplemental Audit Guidance / EY Global Audit Methodology / Planning and Risk Identification / P06 Identify risks of material misstatement due to fraud and determine
responses / P06_2 Identify risks of material misstatement due to fraud

Fraud

risk

factors may be present in an entity but in light of the entitys circumstances and the nature of the business may not

present risks of material misstatement due to fraud.

For example, we may identify lack of independent oversight over the financial reporting process as a fraud

risk

factor in both a

more complex entity and a less complex entity. Lack of effective oversight by those charged with governance or an ineffective
internal audit function in a more complex entity is likely to be cause for concern that inappropriate or unauthorized transactions
may go undetected and we may identify this as a

risk

of material misstatement due to fraud.

In a less complex entity, we may not identify lack of independent oversight over the financial reporting process as a

risk

of

material misstatement due to fraud because of managements extensive involvement in the entity, the need for
management authorization of transactions and the fewer number of transactions being processed.
We evaluate information we have obtained throughout the

audit

due to fraud. In determining whether these conditions represent a

to determine if conditions indicate risks of material misstatement

risk

of material misstatement due to fraud or just a fraud

risk

factor we consider the likelihood of a misstatement, including the possibility of multiple misstatements and the magnitude of
potential misstatement if the conditions were to occur. Fraud

risk

factors may not necessarily indicate the existence of fraud,

however, they have often been present in circumstances where frauds have occurred and therefore may indicate risks of material
misstatement due to fraud.

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The likelihood is the possibility that the condition can occur. We evaluate the condition in the context of the fraud triangle (i.e., we
consider whether there is an incentive or pressure to commit fraud, an opportunity to commit fraud or whether individuals involved
can rationalize a fraudulent act).
The magnitude is the potential misstatement to the financial statements if the condition were to occur. In evaluating magnitude, we
determine whether the condition could have a material effect on the financial statements either individually or in the aggregate.
If we determine that a condition has a higher likelihood of occurrence and a higher magnitude of potential misstatement, we identify
the condition as a risk of material misstatement due to fraud.
For example, an entity that manufactures jewelry has numerous small inventory items that have a high monetary value. The
characteristics of the inventory items increase the susceptibility of these items to misappropriation. Consequently, we may
determine that there is a higher likelihood of misstatement. In addition, the potential magnitude of the misstatement is higher due
to the high monetary value of the inventory items. Therefore, we may identify a risk of material misstatement due to fraud.
If we determine that a condition is either likely to occur or has a higher magnitude of misstatement but not both, we may not identify

EY Global Audit Methodology and Supplemental Audit Guidance / EY Global Audit Methodology / Planning and Risk Identification / P06 Identify risks of material misstatement due to fraud and determine
responses / P06_2 Identify risks of material misstatement due to fraud

risk

of material misstatement due to fraud. However, we may identify this as a fraud

risk

factor.

For example, in a telecommunications entity, cloning telephone numbers and making free calls is a condition that may give rise to
business risk for the entity. We determine that it is likely that this condition can occur because the technology is available and is
not difficult to do. However, for this condition to have a material effect on the entitys financial statements numerous telephone
numbers would need to be cloned and a large number of calls would have to be made. Therefore, we may determine that the
risk would not result in a higher magnitude of misstatement. Consequently, we may identify a fraud risk factor and not a
risk

of material misstatement due to fraud, and therefore determine an

Go To Document ID: P06_2

System ID: 201001261~396497
Date: 15 Apr 2010

audit

response is not necessary.