Ensuring the Integrityof Financial InformationEnsuring the Integrityof Financial Information

C H A P T E R 5

Learning Objective 1

Identify the types of problems that can appear in financial statements.

What Are Three Reasons for Problems in the Financial

Statements?

Disagreement—Because accounting involves judgment and because auditors and management have different incentives, the possibility for honest disagreement exists.

Fraud—Intentional manipulation.

Error—Occurs when care is not taken in recording, posting, and/or summarizing transactions. Corrected upon detection.

Transactions and journal entries.

Types of Errors in the Reporting Process

Aug 1 Supplies . . . . . . . . . . . . . . . 100

Cash . . . . . . . . . . . . . . . . 100

Postage stamps.

? What types of errors are possible?The receipt was lost and not recorded.The amount was entered incorrectly.The entry is fraudulent.

Accounts and ledgers.

Types of Errors in the Reporting Process

? What types of errors are possible?Journal entry data are not summarized

appropriately or accurately.

Amounts are included in expense or revenue accounts rather than asset or liability accounts.

Intentional fraud.

Describe Some Ways to Do Fraudulent Financial Reporting.

Two entries are made:one to match the invoice andone for cash (which is kept).

False transactions for which there are no legitimate invoices or receipts.

Listing sales that don’t exist.Not recording sales returns or uncollectible receivables.Not recording expenses, understating liabilities, or overstating assets.

Unreasonable estimates or judgments that mean the difference between showing a profit or a loss.

Learning Objective 2

Describe the safeguards employed within a firm to ensure that financial statements are free from problems.

Policies and procedures established to provide management with reasonable assurance that the firm’s objectives will be met.

Define Internal Control Define Internal Control StructureStructure

Designed to protect investors and creditors and help management in their efforts to effectively and efficiently run their organization.

What Are Some Concerns When Designing Internal Control

Structures? To provide accurate accounting records and

financial statements. To safeguard assets (cash, property,

employees, confidential information, reputation, and image) and records.

To effectively and efficiently run operations without duplication of effort or waste.

To follow management policies. To comply with the Foreign

Corrupt Practices Act.

Policies and Procedures

1.1. The control environment.The control environment.

2. The accounting system.2. The accounting system.

3. The control procedures.3. The control procedures.

What Are the Three Parts of the Control Structure?

Control Environment

Management philosophy and operating style. Does management follow

controls? Does management stress

importance of controls? Organizational structure.

Are there clear lines of authority and responsibility?

Is just one person responsible for each function?

Audit committee. Typically members are on

the board of directors. Internal and external auditors

are accountable to the committee.

Accounting System

Identifies, assembles, classifies, analyzes, records, and reports the firm’s transactions.

Accountability for assets Valid transactions Properly authorized transactions Completeness of records Proper classification Proper timing Proper valuation Correct posting and summarizationControl Procedures

Segregation of duties: Authorization Record keeping Custody of assets

Proper procedures for authorization

Adequate documents and records

Physical control over assets and records

Independent checks on performance

What Are the Guidelines on Reporting on Internal Controls?

Management of public companies* are required by law to issue a management statement in annual report.

* must acknowledge their responsibility for a good system of internal controls.

Learning Objective 3

Understand the need for monitoring by independent parties.

Monitoring System

Who makes sure the internal control system is functioning properly?

What about disagreements in judgment, and who decides what is reasonable?

While the vast majority of managers would not intentionally bias the financial statements, their incentives may cause them to influence the process.

Learning Objective 4

Describe the role of auditors and how their presence affects the integrity of financial statements.

Role of Internal Auditors

Who are internal auditors?

An independent group of experts in control, accounting, and operations.

What do they do? Monitor operating results

and financial records. Evaluate internal controls. Assist with increasing efficiency

and effectiveness of operations. Detect fraud.

Role of External Auditors

Who are external auditors?Employees of CPA firms.

What do they do? Perform SEC-required audits. Examine financial statements in

accordance with GAAP to becertain they are free frommaterial (significant) misstatement.

Provide reasonable assurance that financial statements are“presented fairly.”

What Do Auditors Do?

Provide an independent assessment of a firm’s internal control system.

Study the control system to determine if they can rely upon it as they audit.

Interview employees to see if procedures are understood. to see if proper documentation is being made. to see if proper authorization is being obtained. to identify potential weaknesses in the system.

(continued)

What Do Auditors Do? Observe operations

to verify compliance with procedures. to verify inventory.

Sample a set of transactions for analysis to conclude if procedures are complied with. to determine if system is reliable.

Confirmation of records to verify existence of accounts. with customers to verify account balances.

Perform analytical procedures involving comparative ratio analysis.

Are Auditors Independent?

Responsible to financial statement users to ensure they are represented fairly.

Avoid litigation and damages by providing unbiased and fair information.

Have a reputation to protect.

Pays the auditors.

Wants to use the least conservative estimates.

Desires to present the most favorable position.

AUDITORS MANAGEMENT

It is this tension that provides users with information that fairly represents the business’s performance.

Learning Objective 5

Explain the role of the Securities and Exchange Commission in adding credibility to financial statements.

Securities Act of 1933Requires companies issuing new debt to submit a registration statement to the SEC for approval.

Securities Act of 1934Requires public companies to file detailed periodic reports with the SEC, as well as to submit audited financial statements which contain a CPA opinion.

Securities and Exchange Commission (SEC)

What Are the SEC-Required Reports?

Registration statements Form 10-K

Filed annually. Contains audited financial

statements. Requires disclosure beyond

audited statements. Form 10-Q

Filed quarterly for publicly held companies.

Requires a CPA’s involvement.

End Chapter 5