Auditors must plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, which may be caused by either error or fraud. Errors are unintentional misstatements caused by factors such as mistakes in processing accounting data, misinterpretation of facts and confusion about accounting principles. Fraudulent financial reporting and misappropriation of assets are the only two types of financial statement fraud. Fraudulent financial reporting consists of intentional misstatements caused by factors such as manipulation of accounting data, misrepresentation of facts and intentional misapplication of accounting principles. Misappropriation of assets includes stealing assets such as inventory and causing an entity to pay for goods or services that were not received.

Auditors perform a variety of procedures to gather and evaluate information that will help them identify possible material misstatement. One potential audit procedure is to analyse a company’s cost variances, which might be caused by error or fraud.

Required

(a) For each of the following variances, describe in detail a possible error that could cause a variance even when no variance actually exists.

(i) Direct materials price

(ii) Direct materials efficiency

(iii) Direct labour price

(iv) Direct labour efficiency

(v) Variable overhead spending

(vi) Variable overhead efficiency

(vii) Fixed overhead budget

(viii) Production volume

(b) Suppose a material amount of raw materials inventory theft took place during the past year. Which of the variances in part (a) would most likely reflect this fraud? Explain.

(c) Discuss possible reasons why variance analysis might not uncover the theft described in part (b).

(d) Suppose a production manager fraudulently entered a fictitious employee into the payroll system during the past year. The fictitious employee’s salaries are deposited directly into a bank account that is then accessed by the production manager. Which of the variances in part (a) would most likely reflect this fraud? Explain.

(e) During the current year, suppose an accountant accidentally records a large equipment repair as an addition to property, plant, and equipment. Assume that equipment repairs and equipment depreciation are both recorded in variable overhead costs. Which of the variances in part (a) would most likely reflect this accounting error? Discuss how this error would affect the variance during the current year. Discuss how this error would affect the variance during the next year.

(f) Suppose an entity’s managers want to report higher earnings on the statement of profit or loss. Describe in detail a possible way that the managers could improve reported earnings by intentionally misapplying accounting principles for variances.