Auditing Principles: Earning Management and the NAB Fraud Analysis

This report provides an overview of earning management, which is a technique used to present financial statements in a positive light to attract investors. It highlights the critical role and relationship of the auditor in managing earnings and focuses on the impact of substantive procedures on financial statements. The report analyzes the National Australia Bank (NAB) misconduct and fraud case, examining how the auditor addressed the situation. The report emphasizes the importance of ethical earning management and discusses how auditors can minimize related risks, while also addressing the auditor's responsibility to comply with ASA 240 to detect and report fraud, highlighting the importance of identifying red flags and performing substantive procedures to detect misstatements.

Running Head: EARNING MANAGEMENT 0
Auditing Principles And Practice

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Executive Summary
Earning management is the technique of accounting that is used to provide a financial
statement to the people in a positive manner. This technique is used to make the investors
invest in the organization by presenting the statement in a positive way.
This report highlights about the role and relationship of the auditor with the earning
management and will focus the effect of substantive procedures on the financial statements
and in this report, the analysis is done on the issue of National Australian Bank misconduct
and fraud and the auditor dealing with the situation of misconduct and fraud.
This report will help in understanding the use of earning management in an ethical
way, along with the manner in which the auditors can minimize the risk.

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Table of Contents
Introduction..........................................................................................................................................3
Earning Management.............................................................................................................................3
Role of Auditor......................................................................................................................................4
Substantive Procedures.........................................................................................................................6
National Australia Bank........................................................................................................................7
Reduction of Earning Management.....................................................................................................10
Conclusion...........................................................................................................................................12
Bibliography........................................................................................................................................13

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Introduction
Earning management refers to the process of improving the financial statements.
When the investor aims on investing in any company, they go through the financial statement
due to which it is important to improve the financial statement of the company. The role of
the auditor is to provide surety about the financial statements that the statements are in the
interest of the stockholders and are present in a fair manner. The quality of the audit is
analysed based on the auditor’s ability to identify the misdoing activities of the company (Lo,
2017).
In this report, the role and relationship of the auditor with earning management will
be discussed and overall study about the procedures performed while auditing the financial
report.
Earning Management
Earning management means adjusting the statements in a way that presents a positive
view of the company’s financial statement. The financial statement shows overall profits and
losses of the firm. This process does not mean manipulating the financial statements to show
positive aspects of company. The activities of earning management arise when the managers
have to provide some kind of private information to the users of the financial statements
(Tabassum & Kaleem, 2015).
The term earning management can be more understood if two words are separated
like Earning and management. Earning means the profit of the company. The company uses
the earning management so that they can produce consistent profits and stability. Although
the fluctuations in net income or gains or losses are part of the company's processes. The

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investors see these fluctuations in different ways as the investors want stability and progress.
For management, it is quite difficult to manage the financial accounts as per the expectations.
There are various internal and external reasons to execute earning management (Lo, 2017).
The earning management is also known as the smoothing of the income and window
dressing. Earning management can be achieved in two ways, firstly through accounting
practices by Generally Accepted Accounting Principles (GAAP) and by the choices of the
operating system. In GAAP, the new accounting standards are to be adopted and in the
operating decision the decision is to be taken about the investment and the cash flows,
revenues and expenses are to be managed. Earning management is a tool, which provides
information to investors. The earning management also includes the smoothing of income,
maximization of income, minimization of expense (Putra, 2019).
Results of earning management can be both good and bad. If the earning management
is used ethically then it is good, and if earning management is not used in an ethical way then
it is bad. Earning management can bad because it can reduce the reliability on the statements
because of altering of financial statements and earning management can be good if flexibility
is there and the self-interest is excluded. The earning management is legal when it complies
the accounting standards and principles (Park, 2017).
Role of Auditor
The auditor’s role in earning management can be effective. The managers can
manipulate the earnings of business in so many ways. If abuse is known then the parties that
are involved in that particular thing have to suffer a lot ( Benz, 2014). This activity will affect
reputation and they will have to suffer high penalties in the environment. The concern was
raised on these practices, the earning management is losing their confidence in public and the

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external reports, and the flow of capital in the financial market is declining. This practice
creates a negative effect on financial reports and on earning quality ( Abou-Seada, 2017).
The independent auditor also gives the opinion about the financial statements that
these statements are fairly presented and truly viewed or not. The auditing procedures also
include the evaluation and understanding of the internal control system. This is the
responsibility of the management to provide the auditors with all the documents, information
and additional information or material documents on the request of auditor. The internal
auditor conducts the reviews and provides efficient materialistic information to the company.
The external auditor provides an opinion on the company's financial statement ( Ferguson,
2019). The audit quality can be increased if the firm has the reputational risk then it will not
perform any misconduct and the firm put extra efforts in auditing, as the audit should be fair
and correct. The audit quality may improve if the International Accounting Standards are
followed properly (Appelbaum, 2017).
The auditors need to understand the motive behind earning management. The main
role of the auditor is to ensure that the financial reports provide a fair view of the firm’s
financial performance. The auditing also minimizes the risk of wrong information and
missing of the material information. The aim of this process is to assure that only cost-
effective way is auditing. The audit committee is the essential committees because it
minimizes the irregular information between shareholders and managers (Khalil, 2016). The
auditor monitors the financial report and also manages the internal accounting and reduces
the risk of uncertainties in the environment. The effect of this function is directly on the audit
quality and improvement of the financial reports. It is the responsibility of the auditor to
study the fraud if there is any in financial statements ( Jorjani, 2018).

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When the financial statement reflects the fraud, there is presence of deliberate
misstatement or disclosure in a statement to cheat the users. Due to the client pressure,
auditors reduce the risk of misstatement but they are not alert about all the misstatements.
Even though the auditors, who observe the risk minimizes the probability of repetition of the
statement for clients who have high earning management. The auditor who responds
mitigates the risk of the wrong misstatement. The auditors comply with the audit standard
and the compliances help to improve the audit quality. The earning management occurs at the
year-end so as to meet the expectations of clients and society. The auditors need to notice the
pressure of their clients and respond to the risky areas of the company. After identification of
the risk, the auditor has to increase their planning and they have to involve the senior staff or
specialist. If the risk factor is identified early then the auditors get sufficient time to make
adjustments and prepare audit plan to alleviate their risks (Hosseini & Tareq, 2016).
It is the role of auditor to comply with the ASA 240 in the business so as to detect
fraud and report it as well. The auditing standard 240 relates to the responsibility of the
auditor to report fraud in the auditing reports. The ASA 240 expands to ASA 315 and ASA
330 in relation to risk of material misstatement due to fraud in business. It is the
responsibility of auditor to prevent and detect fraud. The role of auditor is to commit to
provide honest reports to the prospective people in the environment. Red flag is the warning
or indicator that suggests the potential problems or threat to the stock of business. These are
undesirable characteristics that stand out the investors. It is the responsibility of the auditor to
highlight the red flag areas to the investors and analyse the case with honesty.
Substantive Procedures
The auditor to detect that whether there is any important misstatement or omission of
information in accordance with the accuracy of the financial records executes the substantive

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procedures. There are two approaches to detect the earning management. They are Specific
and Aggregate accrual methods. The aggregate accruals are results of the managerial
decisions and the result due to the fluctuation in the economic condition. This approach is
used to meet the expectation of earning management. The specific accrual shows the
relationship between probability and accuracy ( Beaudoin, 2015).
There are two types of effects, which are relevant for the auditor. The first effect is the
misstatement, which arises from fraud of financial report, and the second effect is the misuse
of assets. The fraudulent or tampered financial report shows the deliberate omission or
misstatement in the financial records. The misuse of assets is implemented in several ways
like the wrong receipts, stealing the assets and cheating with the firm making the firm liable
for those goods that are not received. An individual or the employees may perform
misappropriation of assets and it may involve management or third parties ( Appuhami &
Tashakor, 2017).
During the audit, if the auditor detects any fraud then the auditor has to find out the
effects of the fraud and take the steps to minimize the audit risk. The auditor has to execute
the substantive procedures for the important allegations. While auditing the financial report,
the auditor has to find out the essential process of auditing which is required to perform for
the effectiveness of the financial statements. While detecting fraud, the auditor has to find out
if there is any illegal act or any transaction related to dishonesty has occurred, or if any sign
implies the biasness in the accounting principles or accounting standards ( Beaudoin, 2015).
When the auditor identifies the wrong statement by the substantive procedures then
the statements may change the judgment of the auditor based on the efficiency of internal
control. To find out whether internal control is effective or not, internal control is tested. The
test can be conducted directly. While auditor doing the audit it is the duty of the management

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to provide all the information to the auditor and if the auditor requires any document then the
management is responsible to provide the document. This is the responsibility of the auditor
to choose the right technique and there should be an independent audit committee in the
company (Ali & Zhang, 2015). Analytical tools and techniques should be implemented by the
auditor while considering several ASA present in the environment. Fraud should not be
modified and be hidden if it is acknowledged by the auditor. Risk fact in the stock or
company profile should be presented using red flag.
National Australia Bank
NAB is the leading organization in Australia. NAB was involved in scandals and
frauds. The financial advisor exposed that NAB silently compensated to clients in the year
2009 to 2015. The license of the NAB workers was expelled. NAB was involved in
misconduct related to credit cards, home lending, personal loans, and operational or
administrative errors. The company breached the policies and false documentation, using the
signature of customers dishonestly, charged the fees on the customers for those services,
which had not provided and charged the fees, even on the deceased person (nab, 2019).
The royal commissioner Kenneth Hayne focused on bank failure, lack of
accountability and management system. The home loan affected 2480 customers and the
credit cards were below the approved standards. In 2010 and 2011, approx. 70,000 customers
did not receive the payments. The customers who used NAB debit cards were charged in the
wrong way. NAB paid dollar 100 million commissions to introducers between 2013 and
2016. The statements of NAB were shown in a way that misconduct was not able to detect.
HAYNE acknowledged that NAB did not have an adequate system to detect fraud and non-
compliance. Hayne asked the bank for the documents and the bank was not able to provide
the documents. It became difficult for the royal commissioner to identify the laws, policies

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that not followed. Banks involved in the fraud paid around dollar 110 million to the auditor in
2018. NAB paid around dollar 21 million to Ernst and Young and jagged to the policies so
that auditors' independence can be protected ( Vercoe, 2019).
In the final meeting, the internal documents showed typical internal system of NAB.
The documents involved the conduct risk of the company. Conduct risk includes the issue of
false advertising, misconduct in the market, inappropriate decision, unfair contracts, and
these issues lead to compensation, fines, penalties, lawsuits, and reputational losses. Internal
document also revealed that NAB had breached the Know Your Customer (KYC) obligation.
The law was breached around 84 times between the years 2014 and 2017. NAB had failed to
prove that the financial service provided was fair and efficient. The report of the Australian
Securities and Investment Commission implied that the senior managers were aware of the
problem and about the complaints of a customer for paying fees for no services. Customers
paid more than dollar 155000 until 2015 and in the year 2015, the customer complained about
the financial planning advice not received and charged about dollar 12,300. This act can
evaluated that there was a lack of accountability, control, and monitoring not pursued in an
inadequate way and it resulted in misconduct and fraud ( Kaye & Duran, 2019).
As it was discussed earlier that earning management can be used in both a positive
and negative ways. The NAB used earning management in the wrong way. The earning
management is the technique which should be utilized in an ethical way. The earning
management turns out to be a fraud when the company provides the material misstatements.
Here, earning management used in a wrong and illegal way. After misconduct, the bank had
made many changes in their system. They decided to focus more on the customer instead of a
sales target. Banks are spending dollars to upgrade the old IT systems and even focusing to
compensate the customers affected. The auditor suggests that the GRC solution will help for
audit management. The GRC solution is governance, risk management, and compliance. To

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use the software the culture of the organization is supportive and this includes resource and
portfolio management and manages the risk. Fraud and earning management differ from each
other. Fraud is outside Generally Accepted Accounting Principles whereas earning
management includes Generally Accepted Accounting Principles. The manipulation of
financial statements occurs when the managers perpetrate fraud or manage the earnings. The
firms perpetuate the fraud for many reasons including the reversal of accrual and control
earning management ( Letts, 2019).
Earning management means altering financial statements. It does not mean to show
the financial statement in a fraudulent way. The NAB was pursued fraud in the financial
statements and used earning management beyond the accounting standards. The objective
behind the alteration of the financial report due to earning management or fraud, this
examines that the same type of incentives motivates both earning management and fraud.
Fraud incentives relate to debt and compensation whereas earning management incentives
relate to the capital market expectation. Here the earning management was used unethically
due to which the organization faced several consequences, fines, and penalties. NAB will run
the reward programs under which 40 per cent will be compensated in cash and at the financial
year-end, the amount left will pay in shares. NAB paid around dollar 67 million to the
customers who were affected. The reasons behind fraud or misconduct are the lack of the
internal system, poor management, and lack of transparency, lack of audit department (Lo,
2017).
The earning management is also used to manage the earnings. This not used for
illegal activities performed by management to manage the earnings. To manage the earnings
various techniques are used and to ensure that earning are not managed through misconduct
or fraud. The companies may use the technique of selling the securities, which have gained or
lost value, changing of holding to sell the securities or to sell the securities that have long-

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term decline. These techniques are used to manage the earnings. The earning management
turns into the fraud financial statement when the company goes beyond the accounting
practice. Earning management is legal when financial reports have complied with the
standards. The company involves in the earning management when the benefits of including
the earning management are higher than the cost and risk involved. Therefore, the NAB used
the earning management in the wrong way so the company had to face fines and penalties and
if the earning management is used with the compliance of accounting standards and
principles then this will help the company in altering the financial statements (Putra, 2019).
Reduction of Earning Management
The means of reducing the earning management is to make the internal control system
effective. The internal system can be effective if the duties are segregated. The segregating
duties make the record-keeping, reviewing and authorization of the process. The segregating
of duties will involve more than a single person to prepare the financial statement. The strong
internal control system helps the organization to prevent its employees to commit fraud.
Strong environment control is to be established. The International financial reporting
standards adoption improves the market performance and helps in reducing the earning
management The International financial reporting standards are because of the smoothing of
the financial statements ( Christensen, Lee, & Walker, 2015).
If the policies and procedures have complied clearly then, this will help in the
minimization of fraud. Many consequences are there for non-compliance of charges. In most
cases, management is compelling fraud. There is more pressure on management for achieving
the financial goals (Al-Deen Al-Sraheen & Ahmad Al Daoud, , 2018).
The auditor performs the review of financial statements and audit discourages
workers to present the incorrect information in the financial statements knowingly. Due to the