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Chapter 5 Study Notes - Ensuring Integrity of Financial Information

Chapter 5 Study Notes - Ensuring Integrity of Financial Information
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   1 Chapter 5 Ensuring the Integrity of Financial Information Outsiders, the investing community, banks and other members of the financial community, rely on the financial statements of a corporation as the representation of the “worthiness” of a corporation regarding investment or as a credit or business risk. Assurance is needed that these financial statements appropriately represent the financial  position of the corporation. This chapter discusses the procedures and policies companies should employ internally and the role of the external auditor (CPA firm) in safeguarding the integrity of the financial statements and protecting the assets of the corporation. Types Of Problems That Can Appear In Financial Statements 1. Errors involve unintentional mistakes that can enter the accounting system at the transaction and journal entry stage or when journal entries are posted to accounts. 2. Disagreements in judgment occur because of the differing incentives of those associated with the financial statements. ã While management may have an incentive to present an optimistic view of the company’s performance (e.g. bonuses, stock options), external auditors have an incentive to ensure full disclosure of all relevant issues (protect professional reputation, protect against lawsuits from dissatisfied investors or creditors). ã These differing incentives typically result in financial statements that fairly reflect the financial performance of the company. ã Some recent accounting “scandals” (e.g. Enron) have brought charges that the external auditors (e.g. Arthur Andersen LLP) were providing such profitable outside or consulting services to the client that they were no longer sufficiently independent when it came to the audit of the financial statements. 3. Fraudulent financial reporting involves intentional misrepresentations in the financial statements. Safeguards are built into the accounting and reporting system to minimize the possibility that these problems will be reflected in the financial statements.  Internal Controls Internal controls are safeguards built into an organization that help to protect assets and increase reliability of the accounting records. The three basic internal control structure categories are: 1. the control environment, 2. the accounting systems, and 3. the control procedures. The five types of control procedures are: Preventive controls-- 1. segregation of duties 2. procedures for authorizations   23. documents and records  Detective controls-- 4. physical safeguards 5. independent checks The Role of Auditors in the Accounting Process Internal Auditors ã A group of experts in controls, accounting, and operations. They are employees of the Corporation. ã Major purpose is to monitor operating results and financial records, evaluate internal controls, assist with increasing the efficiency and effectiveness of operations, and even detect fraud. ã The audit manager reports directly to the president or other executive officer and to the audit committee of the board of directors. ã Employees aware of the internal audit system are less likely to manipulate records. ã Responsibilities vary depending on the organization. ã Firms with internal auditors generally have fewer financial reporting problems that do organizations without them. External Auditors ã Examine financial statements to determine if they are prepared and presented in accordance with GAAP and free from material misstatement. ã Employees of CPA firms, not the corporation being audited. ã Audits are required by the SEC and the major stock exchanges for all publicly-traded companies. ã Companies that are not public often hire CPAs to perform audits. ã Banks and other lenders usually require audits and these can instill confidence in users of their financial reports. ã CPAs are required by GAAS to provide reasonable assurance that significant financial statement fraud or misstatement is not present in financial statements. ã CPAs cannot audit every transaction. ã Collusive management deception is also difficult to detect. ã Therefore, CPAs cannot guarantee that financial statements are correct. ã Instead, they provide reasonable assurance that they are presented fairly. ã CPAs are important in the U.S. because of the size of many corporations. ã External audits assure stockholders that management is functioning properly. What Do Auditors Do? Management has the primary responsibility to ensure that the internal control system is functioning. Auditors provide an independent assessment. They study the system to see if they can rely on it as they audit. Interviews of employees. ã To see if procedures are understood. ã To see if proper documentation is being made. ã To see if proper authorization is being obtained.   3 ã To identify potential weaknesses in the control system. Observation. ã To verify compliance with procedures and to ensure that accounting records agree with  physical records. ã To verify inventory by doing a physical count of the product. ã To see if employees are complying with proper procedures. Sampling. ã Auditors select a sample of transactions for analysis. ã Based on this sample, they may conclude the internal control procedures are being complied with, or the system is not reliable, requiring further testing. Confirmations. ã Used to verify the balances in accounts that result from transactions with outsiders. ã Customers are contacted to verify account balances. ã Banks are asked to verify loan amounts, lines of credit, etc. Analytical Procedures. ã Used to provide guidance to auditors as they identify areas that need attention. ã These procedures involve the use of comparative ratio analysis.  Are Auditors Independent? ã Since management is paying the auditors, is there is a danger the auditors may not be independent? ã Foreign Corrupt Practices Act requires companies to maintain an adequate system of internal controls. ã External auditors have a responsibility to statement users to ensure they are fairly  presented. ã The U.S. legal system provides financial incentives for auditors to remain independent. ã They take a risk if they allow their integrity to be compromised. ã Auditors have a reputation to protect.  ã CPA firms obtain audit clients based on their reputation. ã It would be shortsighted to sell that to the highest bidder. ã The auditors avoid litigation and damages by providing unbiased and fair information and by not allowing management to paint an overly optimistic picture. ã Auditors would prefer that management use conservative estimates, but management will not always go along with this. ã It is this tension that provides financial statement users with information that, taken as a whole, fairly represents the business’ performance. R  ole of the Securities and Exchange Commission ã The SEC is the agency of the federal government charged with the responsibility of assisting investors by making sure they are provided with reliable information upon which to make investment decisions. ã It requires certain periodic reports such as the 10-Q and 10-K of companies who sell stock publicly in the U.S. ã It adds credibility to financial statements by < requiring independent audits,   4< reviewing financial statements itself, and < sanctioning firms that violate its standards. SEC-required financial reports: ã Registration statements-various forms that must be filed and approved before a company can sell securities through the exchanges. ã Form 10-K--Filed annually within 90 days of close of fiscal year. ã Contains audited financial statements by independent CPAs. ã Requires additional disclosure beyond typical audited financial statements. ã Form 10-Q--Filed quarterly for all publicly-held companies. ã Requires a CPA’s involvement. ã SEC has statutory power to mandate any reporting requirements it wants. ã It has considerable influence in setting GAAP and disclosure requirements. ã Generally the SEC accepts the pronouncements of the FASB and others like the AICPA. ã If the SEC feels the stock exchanges are ineffectual in implementing its requirements, it can alter or supplement them. ã It can suspend trading or a stock or an exchange, and can de-list any security. ã Brokers and dealers can be prevented from working in the securities market, and investigations can be initiated to determine violations.  


Jul 23, 2017
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