Chapter Ensuring the Integrity of Financial Information Albrecht, Stice, Stice, Swain COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation Thomson, the Star logo, and South-Western are trademarks used herein under license E5-1 Types of Problems • Errors – Unintentional mistakes • Disagreements – Accounting judgments – Different incentives • Fraud – Intentional errors – Management manipulates financial statements to deceive investors Accounting Errors • Errors in transactions and journal entries – Amounts are incorrect – Incorrect accounts involved • Errors in accounts and ledgers – Posting to the wrong account – Posting the wrong amount E5-2 Safeguards to Counter Problems • Internal Controls – Help to protect assets and increase reliability of accounting records • Internal Control Structure – The control environment • Actions, policies, and procedures that reflect the attitude of management about controls – The accounting systems – The control procedures (activities) Control Activities • Preventative Controls – Segregation of duties – Proper procedures for authorization – Physical control over assets and records • Detective Controls – Adequate documents and records – Independent checks on performance E5-4 Segregation of Duties Authorization – Authorizing or approving the execution of the transaction Record Keeping – Recording the transaction in the account A RK A RK C C Custody of Assets – Having physical possession of or control over the assets involved 10 Reasons for Earnings Management • Meet internal targets • Meet external expectations • Income smoothing – Carefully timing the recognition of revenues and expenses to even out earnings from year to year • Window dressing for an initial public offering or loan – Making the earnings look as good as possible for investors and/or bankers 11 AA5-18 12 13 Earnings Management Continuum Savvy Transaction Timing Strategic Matching Aggressive Accounting Deceptive Accounting Fraudulent Reporting Fraud Changes in Methods or Estimates with Full Disclosure Changes in Methods or Estimates but with Little or No Disclosure Non-GAAP Accounting Fictitious Transactions 14 The GAAP Oval D A B C E Which one is correct? 15 The Sarbanes-Oxley Act • Public Company Accounting Oversight Board (PCAOB) – Oversees the accounting firms • Constraints on Auditors – Accounting firms can no longer provide certain services to audit clients • Constraints on Management – Requirements to ensure stronger and more ethical management 16 The Role of Auditors • Provide a check and balance • Internal Auditors – Ensure integrity in the financial records – Evaluate and encourage adherence to internal controls • External Auditors – Ensure integrity in the financial reporting process through independent audits of financial statements 17 What Auditors Do • Processes used by auditors Processes (Who Performs Them) – – – – – Interview Observation Sampling Confirmation Analytical Procedures (internal and external) (internal and external) (internal and external) (external) (external) • Follow Generally Accepted Auditing Standards (GAAS) 18 ...2 E5-1 Types of Problems • Errors – Unintentional mistakes • Disagreements – Accounting judgments –... involved • Errors in accounts and ledgers – Posting to the wrong account – Posting the wrong amount E5-2 Safeguards to Counter Problems • Internal Controls – Help to protect assets and increase reliability... records • Detective Controls – Adequate documents and records – Independent checks on performance E5-4 Segregation of Duties Authorization – Authorizing or approving the execution of the transaction