Fraud Risk in Audits: Red Flags, Rationalization & Auditor’s Response
Overview: Fraud is an intentional act that results in a material misstatement. Unlike errors, fraud requires both intent and opportunity. This guide explains how auditors identify and respond to fraud risks, following SAS 240 and using the fraud triangle framework.
✅ What is Fraud in an Audit?
Fraud is an intentional misstatement that can be due to:
- Fraudulent Financial Reporting: Manipulating financial statements (e.g., fictitious revenue, improper expense recognition).
- Misappropriation of Assets: Theft, embezzlement, or misuse of company resources.
📌 Fraud Triangle: The Classic Framework
Auditors use the fraud triangle to understand the conditions that make fraud more likely:
- Incentive/Pressure: Financial pressure, debt, unrealistic targets.
- Opportunity: Weak internal controls, override of controls.
- Rationalization: “Everyone does it”, “I’ll pay it back”, or unethical culture.
🔍 SAS 240: Auditor’s Responsibilities
Under SAS 240 (AU-C 240), the auditor must:
- Assess risks of material misstatement due to fraud.
- Discuss fraud risk with the engagement team.
- Perform inquiries of management and others.
- Evaluate unusual transactions and journal entries.
- Maintain professional skepticism throughout.
🚩 Common Fraud Red Flags
- Unexplained accounting adjustments.
- Overly complex transactions.
- Unusual relationships with third parties.
- Dominant management that overrides controls.
- Inconsistent or missing documentation.
✅ Auditor’s Response to Fraud Risk
When fraud risk is identified:
- Adjust audit procedures to address specific risks.
- Increase unpredictability in testing.
- Perform journal entry testing and review estimates for bias.
- Document all discussions and procedures.
- Communicate with those charged with governance as needed.
✅ Fraud vs. Error
Errors are unintentional mistakes; fraud is intentional. This affects how the auditor plans, tests, and evaluates findings. Maintaining professional skepticism helps auditors distinguish between the two.
🔗 Helpful References
👉 Stay alert: Spot fraud risks early and keep your audits clean and credible!
