case 6 - Assignment Essays

Accounting ethical:

for #1-3: read the cases first, then answer the questions. (read the power point as needed, no less than 150 words per question)

for #4-6: answer the questions (read the power point as needed, around 100 words per question)

Case 4-4 Threats to Audit Independence

Katy Carmichael, CPA, was just promoted to audit manager in the technology sector at a large public accounting firm.

She started at the firm six years ago and has worked on a number of the same client audits for multiple years. She prefers being placed on same client audits year over year as she believes her knowledge about the client grows each year, resulting in a better audit. Public accounting firms tend to do this as it provides continuity between the firm and the client and often results in a more efficient (less costly) audit as well.

Katy was thrilled to learn that she would be retaining three of her prior audit clients, including what she considers her favorite client (DGS – Drako Gaming Solutions). She has friendships with those in the financial reporting area including the CFO with whom she has makes joint business investments.

The audit planning for DGS’s next audit is about to begin. As is common practice with all audits, each member of the audit engagement team is asked to fill out a questionnaire about any type of relationship (personal, business, or financial) they might have (or any other member of the engagement team might have with the client company, any of its customers, suppliers, employees, or direct family members of their employees. Katy will soon be meeting with the firm’s compliance partner assigned to the DGS audit to go through the completed questionnaire. In that regard, answer the following questions.

1. Identify any potential threats to independence that exists based on the facts of the case. [150 words]

Case 5-1

Assume Vick and Ethan are CPAs. Ethan Lester was seen as a “model employee” who deserved a promotion to CFO, according to Kelly Fostermann, the CEO of Fostermann Corporation, a Maryland-based, largely privately held company that is a prominent global designer and marketer of stereophonic systems. Kelly considered Lester to be an honest employee based on performance reviews and his unwillingness to accept the promotion, stating that he wasn’t ready yet for the position. Little did she know that Lester was committing a $50,000 fraud during 2015 by embezzling cash from the company. In fact, no one seemed to catch on because Lester was able to override internal controls. However, the auditors were coming in and to solidify the deception, he needed the help of Vick Jensen, a close friend who was the accounting manager. Lester could “order” Jensen to cover up the fraud but hoped he would do so out of friendship and loyalty. Besides, Lester knew Jensen had committed his own fraud two years ago and covered it up by creating false journal entries for undocumented sales, returns, transactions, and operating expenses.

Lester went to see Jensen and explained his dilemma. He could see Jensen’s discomfort in hearing the news. Jensen had thought he had turned the corner on being involved in fraud after he quietly paid back the $20,000 he had stolen two years ago. Here is how the conversation went.

“Vick, I need your help. I blew it. You know Mary and I split up 10 months ago.”

“Yes,” Vick said.

“Well, I got involved with another woman who has extravagant tastes. I’m embarrassed to say she took advantage of my weakness and I wound up taking $50,000 from company funds.”

“Ethan, what were you thinking?”

“Don’t get all moral with me. Don’t you recall your own circumstances?”

Vick was quiet for a moment and then asked, “What do you want me to do?”

“I need you to make some entries in the ledger to cover up the $50,000. I promise to pay it back, just as you did. You know I’m good for it.”

Vick reacted angrily, saying, “You told me to skip the bank reconciliations—that you would do them yourself. I trusted you.”

“I know. Listen, do this one favor for me, and I’ll never ask you again.”

Vick grew increasingly uneasy. He told Ethan he needed to think about it … his relationship with the auditors was at stake.

QUESTION:

2. Analyze the facts of the case using the Fraud Triangle. Include a discussion of the weaknesses in internal controls. [150 words]

Case 6-2 Solutions Network, Inc. (a GVV case)

“We can’t recognize revenue immediately, Paul, since we agreed to buy similar software from DSS,” Sarah Young stated.

“That’s ridiculous.” Paul Henley replied. “Get your head out of the sand, Sarah, before it’s too late.”

Sarah Young is the controller for Solutions Network, Inc., a publicly owned company headquartered in Sunnyvale, California. Solutions Network has an audit committee with three members of the board of directors that are independent of management. Sarah is meeting with Paul Henley, the CFO of the company on January 7, 2019, to discuss the accounting for a software systems transaction with Data Systems Solutions (DSS) prior to the company’s audit for the year ended December 31, 2018. Both Young and Henley are CPAs.

Young has excluded the amount in contention from revenue and net income for 2018, but Henley wants the amount to be included in the 2018 results. Without it, Solutions Network would not meet earnings expectations. Henley tells Young that the order came from the top to record the revenue on December 28, 2018, the day the transaction with DSS was finalized. Young points out that Solutions Network ordered essentially the same software from DSS to be shipped and delivered early in 2019. Therefore, according to Young, Solutions Network should delay revenue recognition on this “swap” transaction until that time. Henley argues against Sarah’s position, stating that title had passed from the company to DSS on December 31, 2018, when the software product was shipped FOB shipping point.

Background

Solutions Network, Inc., became a publicly owned company on March 15, 2014, following a successful initial public offering (IPO).

Solutions Network built up a loyal clientele in the three years prior to the IPO by establishing close working relationships with technology leaders, including IBM, Apple, and Dell Computer. The company designs and engineers systems software to function seamlessly with minimal user interface. There are several companies that provide similar products and consulting services, and DSS is one. However.

DSS operates in a larger market providing IT services management products that coordinate the entire business infrastructure into a single system.

Solutions Network grew very rapidly during the past five years, although sales slowed down a bit in 2018. The revenue and earnings streams during those years are as follows:

The Transaction

On December 28, 2018, Solutions Network offered to sell its Internet infrastructure software to DSS for its internal use. In return, DSS agreed to ship similar software 30 days later to Solutions Network for that company’s internal use. The companies had conducted several transactions with each other during the previous five years, and while DSS initially balked at the transaction because it provided no value added to the company, it did not want to upset one of the fastest-growing software companies in the industry. Moreover, Solutions Network might be able to help identify future customers for DSS’s IT service management products.

The $15 million of revenue would increase net income by $1.0 million. For Solutions Network, the revenue from the transaction would be enough to enable the company to meet targeted goals, and the higher level of income would provide extra bonus money at year-end for

Young, Henley, and Ed Fralen, the CEO.

Accounting Considerations

In her discussions with Henley. Young points out that the auditors will arrive on January 15, 2019; therefore, the company should be certain of the appropriateness of its accounting before that time. After all, says Young, “the auditors rely on us to record transactions properly as part of their audit expectations.” At this point Henley reacts angrily and tells Young she can pack her bags and go if she doesn’t support the company in its revenue recognition of the DSS transaction. Young is taken aback. Henley seems unusually agitated.

Perhaps he was under a lot more pressure to “meet the numbers” than she anticipated. To defuse the matter. Young makes an excuse to end the meeting prematurely and asks if they could meet on Monday morning, after the weekend. Henley agrees.

Over the weekend, Sarah Young calls her best friend, Shannon McCollough, for advice. Shannon is a controller at another company and Sarah would often commensurate with Shannon over their mutual experiences. Shannon suggests that Sarah should explain to Paul Henley exactly what her ethical obligations are in the matter. Shannon thinks it might make a difference because Paul is a CPA as well.

After the discussion with Shannon, Sarah considers whether she is being too firm in her position. On the one hand, she knows that regardless of the passage of title to DSS on December 31. 2018, the transaction is linked to Solutions Network’s agreement to take the DSS product 30 days later. While she doesn’t anticipate any problems in that regard, Sarah is uncomfortable with the recording of revenue on December 31 because DSS did not complete its portion of the agreement by that date. She has her doubts whether the auditors would sanction the accounting treatment.

On the other hand, Sarah is also concerned about the fact that another transaction occurred during the previous year that she questioned but, in the end, went along with Paul’s accounting for this transaction. On December 28, 2017, Solutions Network sold a major system for $20 million to Laramie Systems but executed a side agreement with Laramie on that date which gave Laramie the right to return the product for any reason within 30 days. Even though Solutions Network recorded the revenue in 2017 and Sarah felt uneasy about it, she did not object because Laramie did not return the product; her acceptance was motivated by the delay in the external audit until after the

30-day period had expired. Now, however, Sarah is concerned that a pattern may be developing.

3. Evaluate whether the actions of Paul Henley of Solutions Network represent ethical or unethical earnings management. [150 words]

4. Describe the basic features of the Revised AICPA Code of Professional Conduct. [100 words]

5. Campus Fast is a new audit client. Campus Fast uses public WiFi to place and deliver restaurant take out for students at the Up and Coming State University. Campus Fast was founded by three highly ambitious MBA students at the university. The business plan is to find a buyer or place an IPO of the company by graduation in two years. The founders expect to pay off all student loans, take a tour around the world, and then start another company. In order for the business plan to work on the timeline for graduation, the business must meet highly ambitious earnings numbers. Additionally, the company is dealing with two situations that the founders would like to keep from the auditors: [100 words]

6. Categorize the financial shenanigans in the fraud case at Lucent. [100 words]

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Motivation For Fraudulent Financial Reporting

Chapter 06

Because learning changes everything.®

Learning Objectives

L O 6-1: Describe the characteristics of earnings management.

L O 6-2: Explain the purpose of providing earnings guidance and motivation for making false and misleading disclosures.

L O 6-3: Explain how an auditor might look for red flags that indicate fraud may exist in the financial statements.

L O 6-4: Explain the working of financial shenanigans and its effect on reported earnings.

L O 6-5: Describe the makeup of non-GAAP amounts and whether they can distort reported earnings.

Questions for Consideration
What motivates fraudulent financial reporting?
How are financial statements manipulated to achieve a desired goal?
What are the red flags to look out for in spotting techniques that can lead to material misstatements of the financial statements?
Why do companies provide non-G A A P earnings?
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Ethics Reflections 1
Financial statements must be relevant and reliable. Relevance means the information being reported is meaningful. Reliability refers to the accuracy with which financial data is reported so that users know that information can be trusted.
An important quality of useful information is representational faithfulness. To represent the transactions and events faithfully in the financial statements, the effects of transactions and events should be reported on the basis of economic substance of the transactions instead of legal form of the transaction.
Fraudulent financial reporting occurs for a variety of reasons including to make the company look like it’s doing better than it really is. Some companies manipulate G A A P to achieve a higher level of earnings and mislead investors and creditors about the company’s current and expected future earnings.
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Ethics Reflections 2
Companies use a variety of techniques to produce fraudulent financial reports including accelerating the reporting of revenues and delaying the reporting of expenses, oftentimes by manipulating accrual amounts. These are called financial shenanigans.
Companies seem to look for an any advantage when they report G A A P earnings results. One approach that has caught on with virtually all public companies is to report non-G A A P earnings.
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Motivation to Manage Earnings
Companies manage earnings when they ask, “How can we best report desired results?” rather than “How can we best report economic reality?”
Pressure to “make the numbers”.
Emerged during 1990s and early 2000s.
Stock market awards firms that meet or beat analysts’ forecasts and punishes firms that miss earnings targets.
Management may also use earnings management to maximize bonuses and the value of stock options.
Another objective can be avoiding consequences of violation of debt covenants.
Board of Directors should focus on long term strategic goals and shield managers from short-term pressure.
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Nonfinancial Measures of Earnings
Constant pressure to report favorable earnings performance motivates many companies to report income numbers that exclude unusual events that almost always seem to be costly and depress earnings.
These non-G A A P numbers put a positive spin on what otherwise might not be such good results under G A A P.
Regulation G requires public companies that disclose or release non-G A A P financial measures to include a presentation of the most directly comparable G A A P financial measure and a reconciliation of the non-G A A P measure to the comparable G A A P measure.
Auditors should be tasked with at least reviewing non-G A A P measures as part of their annual audit requirements.
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Characteristics of Earnings Management
Gaa and Dunmore denote two basic possible earnings managements.
Alter the numbers in the financial records by using discretionary accruals and other adjustments.
Create or structure transactions to alter reported numbers.
Another perspective is to divide the techniques into two categories.
Operating earnings management – altering operating decisions to affect cash flows and net income for a period.
Accounting earnings management – using the flexibility in accounting standards to alter earnings numbers.
The end result of earnings management is to distort the application of G A A P, bringing into question the quality of earnings.
Earnings manipulation is a form of earnings management and can be legitimate, marginally ethical, unethical, or illegal.
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Income Smoothing
Motivation to smooth net income over time.
Steady increase each year over a period of time is ideal.
Investors are willing to pay premium for stocks with steady and predictable earnings streams.
These practices lead to erosion in quality of earnings.
Accelerate recognition of revenue.
Delay recognition of expenses.
“Cookie jar reserves”
Set aside reserves in good years.
Used to prop up earnings in bad years.
HealthSouth case.
Banks more aggressive using loan-loss reserves.
Companies also smooth tax liability over years.
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Definition of Earnings Management
Schipper defines it in a negative light- “purposeful intervention in the external reporting process, with the intent of obtaining some private gain”.
Healy and Wahlen define it as “when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers”.
Dechow and Skinner believe that a distinction should be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others.
McKee characterizes it as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”.
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How Do Managers and Accountants Perceive Earnings Management? 1
Akers, Giacomino, and Bellovary Survey.
Accounting manipulation is much less ethically acceptable than operating decision manipulation.
Practitioners have few ethical qualms about operating decision manipulation.
Operating decisions that influenced expenses were more suspect than those that influenced revenues.
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How Do Managers and Accountants Perceive Earnings Management? 2
Survey by Elias:
Accountants in organizations with high ethical values perceive earnings management as more unethical.
Accountants in industry significantly less likely than C P As in public practice to perceive high ethical values in their organizations.
Survey by Bruns and Merchant:
Managers disagree about ethics of earnings management.
Manipulation of operating decisions was more ethical than manipulation by accounting method.
Survey by Rosenzweig and Fischer:
Accounting manipulation.
Changing accounting methods.
Recording expense in wrong year.
Changing inventory valuation.
Operating decisions.
Deferring necessary expenditures to subsequent year.
Attracting customers at year-end to draw sales into current year.
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Ethics of Earnings Management 1
Use ethics framework to judge acceptability.
Virtue ethics examines reasons for the actions taken by decision maker AND the action itself.
McKee’s explanation is merely a rationalization.
Doesn’t hold true to virtues of honesty and dependability.
Ignores rights of shareholders and stakeholders to receive fair and accurate information.
Masks true performance.
Hopwood says ethics issue can be mitigated by disclosing aggressive accounting assumptions.
Nothing more than rationalization for unethical behavior: disclosure should not be used to cure ills of earnings management.
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Ethics of Earnings Management 2
Act Utilitarian
A decision made by weighing benefits of management/company to smooth net income versus. costs of providing false information to shareholders.
Rule Utilitarian.
Financial statements should never be manipulated for personal gain.
The problem is there is no clear limit between what is ethical and what isn’t.
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Needles Continuum of Earnings Management
Needles points out that the difference between an ethical and an unethical accounting choice is often merely the degree to which the choice is carried out.
The problem with many accounting judgments is that there is no clear limit beyond which a choice is obviously unethical.
A perfectly routine accounting decision, such as expense estimation, may be illegal if the estimated amount is extreme, but it is perfectly ethical if it is reasonable.
Needles provides an interesting example of how a manager might use the concept of an earnings continuum to decide whether to record the expense amount at the conservative end or aggressive end.
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Earnings Guidance
Earnings guidance reflects the comments management makes about what it expects the company will do in the future.
Earnings guidance is given by management to provide investors and financial analysts with data that indicates expected future earnings and earnings per share. These comments are known broadly as forward-looking statements.
Earnings guidance can be given in conference calls with investors and analysts and in press releases available to the public.
One concern with earnings guidance statements is they represent management’s subjective view of the company’s future financial performance, which is exposed to uncertainties and risks.
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Forward-looking Statements
“Forward-looking” statements focus on sales revenues or earnings expectations in light of industry and macro-economic trends.
Guidance to investors and financial analysts about the company’s earnings potential.
Can create liability for issuers, underwriters, officers and directors if material misstatements of fact or omissions are made for public offerings.
P S L R A enacted safe harbor provisions if forward-looking statements are identified as such and accompanied by meaningful cautionary statements that could cause actual results to differ from the statements.
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Green Mountain Coffee Roasters
Green Mountain used conference calls that provided earnings guidance to shareholders and analysts to mask a financial fraud.
Manufacturer of the Keurig brewing system and K-Cup portion packs.
Represented to investors that it was straining to meet consumer demand without accumulating excess inventory.
Deceived P w C auditors on inventory levels by hiding bags and bags of coffee loaded on trucks, and blocking parts of the plant from auditor access.
Hedge fund manager, David Einhorn, and Sam Antar, former C F O of Crazy Eddie, used analytical procedures to spot and warn of the red flags on inventory.
Should auditors monitor conference calls with investors, analysts, and the financial press to determine whether something is said that could be false, fraudulent, or deceptive?
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Using Social Media to Report Earnings Guidance and Financial Results
The S E C said in April 2013, that postings on sites such as Facebook and Twitter are just as good as news releases and company Web sites as long as the companies have told investors which outlets they intend to use.
The S E C guidelines on these matters are under the fair disclosure rule (Regulation F D) that requires companies to disseminate information in a way that wouldn’t be expected to give an advantage to one group of investors over another.
Filing an 8-K form or holding an earnings call are both ways to ensure compliance with the regulation.
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Audit Committee Responsibilities
Audit committee oversight of forward-looking guidance is part of the board of directors’ overall ongoing risk assessment process.
The audit committee should understand management’s processes for (1) developing assumptions and estimates, (2) accumulating guidance information, and (3) ensuring management judgment’s are reasonable. The audit committee should also inquire of possible earnings management to meet the guidance.
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Pull-in Sales
One technique used to meet earnings guidance is accelerating (or “pulling-in”) sales from a future quarter to the present in order to close the gap between actual and forecasted revenue.
Typically, this earnings management technique is triggered by offering various incentives, such as price rebates, discounted prices, and extended payment terms to entice customers to accept products in the current quarter that they would not need until next quarter.
Efforts to pull-in sales from a future quarter to a current one only delays the bad news and can create a more spectacular market disappointment when, after a few quarters, there were no more future sales to cannibalize.
Sunbeam Corporation learned this lesson the hard way by using the pull-in revenue technique known as “channel stuffing”.
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Red Flags
Auditors need to be attuned to the red flags that fraud may exist because of overly aggressive accounting and outright manipulation of earnings.
There are many examples of red flags including:
One-time sources of income.
Unexpected increase in accounts receivable.
Slowdown of inventory turnover.
Reduction in reserves.
Reduction in discretionary costs at year-end (i.e., advertising; R&D).
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Earnings Quality
Another way to spot potential fraud in the financial statements is through an assessment of earnings quality.
Dichev et al. conducted a survey in 2016 that examined the views of 375 C F Os on the prevalence and identification of earnings misrepresentation.
The C F Os were asked to rank order specific characteristics of earnings quality.
The leading answers were consistent reporting choices through time and the absence of long-term estimates, both features of sustainable earnings.
23

Financial Statement Analysis
Financial analysis can be used to identify red flags that the numbers in the financial statements may not make sense considering the relationship between selected items on the balance sheet and income statements.
Comparative statements over two or more years based on reported numbers can be converted into percentages to enhance the analysis. These are known as common size statements.
Ratios can be used to compare relationships between financial statement items or indicate trends over time.
24

Accruals and Earnings Management
Accruals are needed because of matching and timing problems that can give wrong financial picture of company.
Earnings are sum of a period’s change in accruals and its cash flows.
Revenue recognition and matching principles.
Can manage earnings through aggressive estimations or more conservative ones.
Discretionary accruals (items that management has full control over and is able to delay or eliminate)
Nondiscretionary accruals (management has no control over)
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Earnings Management: One More Thing
It is unethical if the primary motive for managing earnings is to deceive users of the true results of operations or reflect the economic substance.
Often earnings management is carried out by otherwise honest people who tell the company’s side of the story rather than adhere to G A A P.
Cycle of earnings manipulation.
Often a company begins with a track record of success.
It is becoming more difficult to maintain the sales and earnings growth expected.
Management runs special incentives to accelerate sales and uses overtime to ship product out.
Steps are repeated in the next quarter(s), as expectations are higher, only now the company may not accrue all of its expenses, and to keep the stock prices increasing.
One aggressive interpretation leads to another until the quality of the financial information is in doubt.
The company has gone from aggressive operating practices to financial fraud.
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Financial Shenanigans
Actions or omissions intended to hide or distort real financial performance or financial condition of an entity.
Overstate revenues and profits to enhance reported earnings and E P S.
Understate revenues and profits to smooth net income/decrease volatility.
Schilit’s 7 Common Financial Statement Shenanigans:
Recording Revenue too soon or of questionable quality.
Recording bogus revenue.
Boosting income with one-time gains.
Shifting current expenses to a later or earlier period.
Failing to record or improperly reducing liabilities.
Shifting current revenue to a later period.
Shifting future expenses to the current period as a special charge.
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Red Flags of Earnings Management
Auditors need to be attuned to red flags or signs of aggressive accounting and fraud:
Growth in the market share that seems unbelievable.
Frequent acquisitions of businesses.
Management growth strategy and emphasis on earnings and/or E P S.
Reliance on income sources other than core business.
One-time sources of income.
Growth in revenue that doesn’t line up well with receivables or inventory.
Unexpected increase in accounts receivable.
Slowdown of inventory turnover.
Reduction in reserves:
Not reserving for possible future losses.
Reduction in discretionary costs at year-end (i.e., advertising; R&D)
Unusual increase in borrowings; short-term borrowing at year-end.
Extension of trade payables longer than normal credit.
Change in members of top management, especially the C F O.
Change in auditors.
Changes in accounting policies toward more liberal applications.
One forensic accountant is needed on each audit to help identify the signs.
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Non-G A A P Financial Metrics
Most companies disclose non-G A A P financial metrics.
An Audit Analytics study shown in Exhibit 6.7 found the top five non-G A A P metrics were:
Income-related (including adjusted operating income)
Earnings-per-share (E P S)
Cash flow.
E B I T D A.
Funds from operations.
29

S E C Regulations and Non-G A A P Amounts
S E C Regulation G and Item 10(e) of Regulation S-K define a “non-G A A P financial measure” as a numerical measure of historical or future financial performance, financial position, or cash flows, that:
Excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with G A A P; or,
Includes amounts that are excluded from the most directly comparable measure so calculated and presented.
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EBITDA
One common non-G A A P measure is EBITDA (earnings before interest, taxes, depreciation, and amortization). Other variations include EBIT, EBITA, EBITD, EBITDAR (earnings before interests, taxes, depreciation, amortization, and restructuring costs), adjusted EBITDA, and so on. A joke making the rounds is perhaps the best measure is EBBS (earnings before the bad stuff)
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SEC Regulation S-K
Applies to non-G A A P financial measures that are included in S E C filings.
They should be presented with equal or greater prominence, of the most directly comparable financial measure or measures calculated and presented in accordance with G A A P.
A non-G A A P measure should be presented in proximity to the G A A P measure with an appropriate balance of discussion.
A quantitative reconciliation of the differences between the non-G A A P financial measure and the most directly comparable G A A P financial measure should be shown.
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Reconciliation of G A A P and Non-G A A P
The reconciliation should be presented with each adjustment clearly labeled and separately quantified;
A statement disclosing why the registrant’s management believes that presentation of the non-G A A P financial measure provides useful information to investors regarding the registrant’s financial condition and results of operations; and,
To the extent material, a statement disclosing the additional purposes, if any, for which the registrants management uses the non-G A A P financial measure.
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Concluding Thoughts
Earnings management is typically motivated by a desire to meet or exceed forecasted results, meet financial analysts’ earnings estimates, inflate share price to make stock options more lucrative, and enhance bonuses.
Financial reporting needs to focus more on representational faithfulness, there should be agreement between the accounting measures or descriptions in financial reports and the economic events they purport to represent.
Financial shenanigans have been used for years to manage earnings by choosing how and when to report and disclose financial information.
The motivation oftentimes is to smooth net income over time. These artificial maneuvers mislead investors and financial analysts about the true state of earnings in two or more years.
Auditors should look for the red flags that something is not right with the reported earnings.
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A I C P A Code of Professional Conduct

Chapter 04

Because learning changes everything.®

Learning Objectives

L O 4-1: Explain professional judgement and the C P A’s obligations under the A I C P A Code of Conduct.

L O 4-2: Explain how to apply the threats and safeguards approach to independence.

L O 4-3: Discuss S E C actions taken against auditors because of a lack of independence.

L O 4-4: Describe the process to resolve ethical conflicts that may cause violations of the rules.

L O 4-5: Explain how the conceptual framework works to keep in check possible violations of integrity and objectivity for C P As in business.

L O 4-6: Explain how to apply the rules of conduct in the A I C P A Code to the performance of professional services.

L O 4-7: Analyze the ethics rules for tax practice and how they are influenced by the realistic possibility standard.

L O 4-8: Describe the P C A O B independence and ethics rules.

Questions for Consideration
How can professional judgment deal with cognitive biases that can influence ethical behavior?
What is the risk-based approach to deal with situations where independence, integrity and objectivity, and adherence to other professional standards, is threatened by external relationships?
What are effective measures to deal with ethical conflicts that pose challenges to ethics and professionalism?
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Professional Judgment in Accounting
Professional judgment is influenced by personal behavioral traits.
Attitudes.
Ethical values.
Personal values link to ethical sensitivity and judgment.
Ethical awareness of an ethical dilemma is a mediator of the personal factors and ethical judgment relationship.
Objectivity and due care are attitudes and behaviors that enable professional judgment.
Professional skepticism is essential in making professional judgments; helps frame auditors’ mindset of independent thought.
4

K P M G Professional Judgment Framework
Judgment is the process of reaching a decision or drawing a conclusion where there are a number of possible alternative solutions.
Judgment occurs in a setting of uncertainty, risk, and often conflicts of interest.
The K P M G Framework components revolve around one’s mindset.
Clarify issues and objectives.
Consider alternatives.
Gather and evaluate information.
Reach conclusion.
Articulate and document rationale.
Prescriptive framework is used but pressures, time constraints, and limited capacity may cause deviations.
Auditor should approach matters with objectivity and independence, with inquiring mind and critical assessment of audit evidence.
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Link between K P M G Framework and Cognitive Processes
Auditors need to use System 2 thought process.
Ethical awareness.
Application of ethical reasoning, ethical analysis of harms and benefits and stakeholder rights; and professional obligations.
Judgments can fall prey to cognitive traps and biases that negatively influence judgments.
Group-think.
Rush to solve problems.
Judgment triggers.
Judgment triggers – can lead to accepting a solution before it is properly identified and evaluated.
Availability tendency.
Confirmation tendency.
Overconfidence tendency.
Anchoring tendency.
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Role of Professional Skepticism
Professional skepticism links to professional judgment through the ethical standards of independent thought, objectivity and due care, which are incorporated in A I C P A Code of Professional Conduct.
C P A firm management should set an appropriate tone that emphasizes a questioning mind throughout the audit and the exercise of professional skepticism in gathering and evaluating evidence.
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A I C P A Revised Code: Independence for Members in Public Practice
Conceptual framework incorporates a “threats and safeguards” approach.
New section on “Ethical Conflicts.”
Violation of the rules for a C P A to permit others acting on his behalf to engage in behavior that would have been a violation for the C P A.
When differences exist between A I C P A and those of the licensing state board of accountancy, the C P A should follow the state board’s rules.
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Conceptual Framework for Independence Standards
Independence required for audit and other attestation services; in fact and in appearance.
A I C P A uses risk based approach for analyzing threats using the following steps:
Identifying and evaluating threats to independence.
Determining whether safeguards already eliminate or sufficiently mitigate identified threats and whether threats that have not yet been mitigated can be eliminated or sufficiently mitigated by safeguards.
If no safeguards are available to eliminate an unacceptable threat or reduce it to an acceptable level, independence would be considered impaired.
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Threats to Independence
EXHIBIT 4.1 Examples of Threats to Independence

Threat
Example

Self-Review Threat
Preparing source documents used to generate the client’s financial statements.

Advocacy Threat
Promoting Me client’s securities as part of an initial public offering or representing a client in U.S. tax court.

Adverse Interest Threat
Commencing, or the expressed intention to commence, litigation by either the client or the C P A against the other.

Familiarity Threat
A C P A on the attest engagement team whose spouse is the client’s C E O.

Undue Influence Threat
A threat to replace the C P A or C P A firm because of a disagreement with the client over the application of an accounting principle.

Financial Self-Interest Threat
Having a loan from Me client, from an officer or director of the client, or from an Individual who owns 10% or more of the client’s outstanding equity securities.

Management Participation Threat
Establishing and maintaining internal controls for the client.

Safeguards
EXHIBIT 4.2 Examples of Safeguards in Applying the Conceptual Framework

Source of Um Safeguard
Examples of Safeguards

Created by the profession, legislation, or regulation
Professional resources, such as hotlines, for consultation on ethical issues.

Implemented by the client
The client has personnel with suitable skill, knowledge, or experience who make managerial decisions about the delivery of professional services and makes use of third-party resources for consultation as needed.
The tone at the top emphasizes the client’s commitment to fair financial reporting and compliance With the applicable laws, rules, regulations, and corporate governance policies.
Policies and procedures are in place to achieve fair financial reporting and compliance WM the applicable laws, rules, regulations, and corporate governance policies.
Policies and procedures are In place to address ethical conduct.
Policies are in place that bar the entity from hiring a firm to provide services that do not serve the public interest or that would cause the firm’s Independence or objectivity to be considered Impaired.

Implemented by the firm
Policies and procedures addressing ethical conduct and compliance with laws and regulations.

S O X: Nonaudit Services
Financial information systems design and implementation.
Appraisal or valuation services, fairness opinions, or contribution-in-kind reports.
Actuarial services.
Internal audit outsourcing services.
Management functions or human resources.
Broker or dealer services, investment adviser, or investment banking services.
Legal services and expert services unrelated to the audit.
Any other service prohibited by B O D.
Tax services must be preapproved by the audit committee.
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Relationships that May Impair Independence
Financial relationships.
Business relationships.
Employment or association with attest clients.
Providing non-attest services to an attest client.
Nontraditional forms of ownership.
13

Employment or Association with Attest Clients
Independence may be impaired when a partner or professional employee leaves the firm and is subsequently employed by the client in a key position unless the following is met:
Amounts due to the former professional are not material to the firm.
The former professional is not in a position to influence the accounting firm’s operations or financial policies.
The former professional employee does not participate in or appear to participate in or is not associated with the firm once the relationship with the client begins.
Participating in the firm may be continuing to consult for it or have one’s name included in firm literature.
14

Providing Nonattest Services to an Attest Client
Certain lucrative nonattest services create a conflict of interests.
A C P A should not perform management functions or make management decisions for an attest client.
Client must agree to perform the following functions:
Assume all management responsibilities.
Designate competent overseer of these services.
Evaluate adequacy and results of services performed.
Accept responsibility for the results of the services.
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S E C Position on Independence
Emphasizes independence in fact and appearance in 3 ways:
Proscribing certain financial interests and business relationships with the audit client.
Restricting certain nonauditing services to audit clients.
Subjecting all auditor conduct to a general standard of independence.
Three principles that underlie auditor independence:
An auditor cannot function in the role of management.
An auditor cannot audit her own work.
An auditor cannot serve in an advocacy role for her client.
16

General Standard of Independence
Judged by a reasonable investor with knowledge of all relevant facts and circumstances.
Auditor must be capable of exercising objective and impartial judgment on all issues within the engagement.
Principles.
Situations which impair independence.
Creates a mutual or conflicting interest between an accountant and his audit client.
Places an accountant in the position of auditing his own work.
Results in an accountant acting as management or employee of the audit client.
Places an accountant in position of being an advocate for the audit client.
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S E C Actions Against Big Four Audit Firms
P w C.
Violated independence rules when it performed restricted nonaudit services to audit clients.
E Y.
Audited partners engaged in personal relationships with client’s C F O.
K P M G.
Former partner engaged in insider trading of non-public information.
Deloitte.
Deloitte managers maintained bank accounts with audit client.
18

S E C Actions Because of Personal Conduct of Audit Partners
P w C.
Age Discrimination.
K P M G.
Hired former P C A O B staffers to obtain audit inspection information.
E Y.
Partner sexually harassed another partner.
Deloitte.
Partner traded in the securities of multiple clients.
19

Materiality Issues in Judging Whether Independence Has Been Impaired
Some firms are now using a materiality criterion to determine whether nonaudit services provided to an affiliate entity, that would be prohibited if the parent had provided them, violate the independence requirement in audit engagements.
Applying such a materiality standard can have the effect of dismissing otherwise improper relationships.
20

Materiality Issues
Using a materiality criterion to determine whether certain nonaudit services should be allowed opens a can of worms. Logical questions are: (1) Is independence a standard left to the individual judgment of the auditors or is it based on S E C regulations and P C A O B standards? and (2) Where do you draw the line in making materiality determinations?
21

Integrity and Objectivity
Conflicts of interest for public practice occur when a professional service, relationship, or specific matter creates a situation that might impair objective judgment.
A conflict of interest creates adverse and self-adverse threats to integrity and objectivity.
Safeguards include:
Implementing mechanisms to prevent disclosure or violation of confidentiality.
Senior individual not involved in the engagement regularly reviewing safeguards.
Member of the firm not involved in the conflict reviews the work performed to assess whether key judgments and conclusions are appropriate.
Consulting with third parties, such as professional body, legal counsel, or another C P A.
The C P A should disclose the nature of the conflict to clients and obtain their consent to perform professional services.
If consent is not received, then the C P A should either cease performing the services or take action to eliminate or reduce the threat to an acceptable level.
22

A I C P A Code: Ethical Conflicts
Assess whether an ethical conflict exists.
Ethical conflicts create challenges to ethical decision making because they present barriers to meeting the requirements of the rules of conduct.
Consider whether any departures exist to the rules, laws, or regulations and how they will be justified in order to ensure that conflicts are resolved in a way that permits compliance with these requirement.
Any unresolved conflicts can lead to a violation of the rules of conduct which should focus the C P A’s attention on any continuing relationship with the engagement team, specific assignment, client, firm, or employer.
23

Subordination of Judgment
Integrity rule prohibits a C P A from knowingly misrepresenting facts or subordinating one’s judgments when performing professional services for a client or employer.
Addresses differences of opinion between a C P A accountant/auditor and that person’s supervisor or others in the organization including top management on material accounting issues.
C P A should consider any threats to integrity and objectivity, and assess their significance whenever there is a material misrepresentation of fact.
C P A should assess if threats are at an acceptable level; if not, evaluate significance of safeguards to prevent impairment to independence/objectivity.
Follow prescribed process to protect against subordination of judgment (see Exhibit 3.11).
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A I C P A Code: Conceptual Framework for Members in Business
The conceptual framework for members in business applies to integrity and objectivity, as well as other rules of conduct, but not independence.
Threats.
Adverse interest threat.
Advocacy threat.
Familiarity threat.
Self-interest threat.
Self-review threat.
Undue influence threat.
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Safeguards to Mitigate Risk
Safeguards include:
Tone at the top.
Policies, procedures, implementation, and monitoring addressing ethical conduct and compliance with laws and regulations.
Internal policies and procedures for disclosure of interests and relationships.
Whistle-blower hotlines and reporting structure.
Internal auditors not allowed to audit areas where they have operational responsibilities.
Policies for promotion, rewards and enforcement of a culture of high ethics and integrity.
Use of third-party resources for consultation as needed.
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Rules of Professional Practice
The General Standards rule establishes requirements for competence, compliance with professional standards, and adherence to accounting principles.
Acts Discreditable covers a broad number of actions that may bring discredit to the profession including:
Discrimination and harassment.
Solicitation or disclosure of C P A examination questions and answers.
Failure of a C P A / C P A firm to file and pay taxes.
Negligence in preparation of financial statements or records.
Standards relating to governmental accounting and auditing.
Confidentiality of information gained through employment, except in specified situations.
Records Request governing what is client-provided records, member-prepared records, member’s work products, and member’s working papers.
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Contingent Fees, Commissions, and Referral Fees
Contingent fees and commissions are permitted when performing advisory-type services for a nonattest client.
Contingent fees are prohibited from an attest (audit) client.
Prohibits acceptance of contingent fees if C P A or firm performs any of the following:
An audit or review of a financial statement.
Compilation of financial statement that third party may use.
Examination of prospective financial information.
Prepares original/amended tax return.
Permits acceptance of contingent fee based upon initiation by and findings of governmental agencies (that is, I R S-initiated investigation of income taxes paid).
Commissions and Referral Fees.
Rule is similar to that for contingent fees; cannot accept commissions or referral fees from audit client.
Commissions and referral fees require disclosures by C P As when recommending or referring a service or product to which the commission relates.
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Advertising and Solicitation
Advertising and solicitation permitted.
Requires that advertising not be false, deceptive or misleading.
Imply ability to influence official bodies.
Contain a representation that specific services will be performed for a stated fee, when such fees would be substantially increased.
Prohibits solicitation by use of coercion, over-reaching, or harassing conduct.
Contain any representation that would be likely to cause a reasonable person to misunderstand or be deceived.
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Confidentiality
Confidential information.
C P A should not disclose confidential client information without specific consent of the client.
Internal whistleblowing allowed; external may violate confidentiality; consult legal counsel.
Permitted disclosure of confidential client information.
Response to validly issued subpoena or summons.
Adherence to applicable laws and regulations (i.e., Dodd-Frank whistle-blowing provisions).
Compliance with peer review of C P A practice under P C A O B, A I C P A, state C P A society, or board of accountancy authorization.
Defense in an investigation of the C P A.
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Ethics and Tax Services
Tax services include tax compliance, tax consulting, tax planning, and tax shelters.
A I C P A explicitly recognizes the tax professional’s dual obligations to the client to act as advocate and to foster integrity in the tax system by honesty and fairly administering the tax laws.
The tax accountant remains obligated to act objectively, with integrity, exercise due care, and follow the Statements on Standards for Tax Services (S S T S).
When auditing tax client’s financial statements: The tax C P A is expected to consider whether any threats to independence exist that cannot be reduced or eliminated by safeguards and how such matters will be handled to avoid a violation of audit independence.
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S S T S No. 1, Tax Return Position
7 statements explain C P As’ responsibilities to their clients and the tax systems:
S S T S No.1, Tax Return Positions.
A tax return position is a position reflected on a tax return on which a C P A has specifically advised a taxpayer, or a position about which a C P A has knowledge of all material facts and, based on those facts, has concluded whether the position is appropriate.
A taxpayer is a client, a C P A’s employer, or any other third-party recipient of tax services.
C P A’s obligation to advise a taxpayer of relevant tax return disclosure responsibilities and potential penalties.
C P A should not recommend a tax return position or sign a tax return unless she has a good-faith belief that the position has at least a “realistic possibility of success”.
C P A cannot recommend a tax return position that he knows exploits the audit selection process of a taxing authority.
C P A may recommend a tax return position if there is a “reasonable basis” for the position and advises the taxpayer to disclose that position appropriately.
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Tax Shelters
Sometimes called tax avoidance transactions.
“Prohibited tax shelter transaction” means listed transactions, transactions with contractual protection, or confidential transactions.
Investments to help wealthy clients avoid paying taxes.
In K P M G case, the firm prepared false documents to deceive regulators (fraud) and shelters generated $11B in fraudulent losses and $2.5B in tax evaded. K P M G settled criminal tax case for $456M.
Caterpillar shifted profits from the U S to a subsidiary in Switzerland to avoid $1B in taxes. I R S assessed $2B in back taxes and penalties.
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Treasury Circular 230
Regulations governing the practice before the I R S.
Knowledge of error return.
Advise client of the error and potential consequences.
Taxpayer decides whether to correct the error.
Determine if the taxpayer correct the return.
If not, what does this mean for future behavior of taxpayer?
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Concluding Thoughts
Whenever a C P A must render an opinion on an ethical dilemma, it must be grounded in specific, quoted, and explained rules of the profession.
However, rules are sterile without the application of principles in both their making and implementation.
The takeaway is to always apply rules in a principled way, and always apply your principles in harmony with the rules.
The thought process of dealing with an ethical dilemma is as simple (and as complicated) as aligning the profession’s rules with ethical principles.
The principles to follow are those in the A I C P A Code and those called for in ethical reasoning methods.
After all the various concepts, philosophies and models are discussed, the bottom line is that C P As are bound by a deontological system requiring adherence to the A I C P A rules of professional conduct.
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image1

Fraud in Financial Statements and Auditor Responsibilities

Chapter 05

Because learning changes everything.®

Learning Objectives

L O 5-1: Distinguish between audit requirements for errors, fraud, and illegal acts.

L O 5-2: Explain the components of the Fraud Triangle and how they are integrated into A U-C 240.

L O 5-3: Describe fraud risk assessment procedures and red flags which might indicate that an individual may be committing fraud, or susceptible to it.

L O 5-4: Describe the responsibilities of the External Auditor, Board of Directors, and Company Management in regard to internal controls over financial reporting (I C F R).

L O 5-5: Explain the standards for audit reports.

Ethics Insight
The P C A O B has expressed significant concern over audit quality.
Audit Quality relies on Integrity, Objectivity, Professional Skepticism, Due Care and Independence.
Concerns found in:
Auditing of internal control over financial reporting.
Assessing and responding to risks of material misstatements.
Performing audit sampling procedures.
Auditing of estimates.
Auditing fair value measurements and disclosures.
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P C A O B Recommendations for Auditors

Recommendation
Description
Result

Interactive meetings/coaching workshops
Engagement Team, often tied to audit milestones
Identifying how financials might be materially misstated
Identifying risks of material misstatement

Early involvement of engagement quality reviewer (E Q R)
From audit planning stage forward
May result in in early identification of potential or actual audit challenges

Narrative descriptions of quality control
Firms created narratives of their quality control process or prepared process flow maps of them
Used to monitor engagement performance and enhance the audit effectiveness

Increased partner involvement in planning of audit tests and controls
Engagement team leadership held planning meetings with whole engagement team
Discussions and robust risk assessment procedures improve staff ability to analyze effectiveness of controls

Use of firm specialists during audit planning to assist in risk assessment
Early involvement of specialists during audit planning stage
Enhances the ability of auditors to more effectively identify and assess risks of material misstatement

Implementing coaching programs and refining audit tools for specific audit areas
Targeting areas where the firms have had audit deficiencies in the past
Noted improvement in the auditing of estimates at firms that implemented these programs

Chapter Roadmap
Consider the following questions as you read the chapter
What are the auditor’s responsibilities to assess the risks of material misstatement of the financial statements, whether due to error or fraud?
What is the fraud triangle and how does it help to identify red flags that are indicators fraud may exist?
What are the most common causes of financial statement fraud and how can internal controls over financial reporting and the audit firms’ quality controls keep them in check?
What information is communicated by the audit report?
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Learning Objective 1
Distinguish between audit requirements for errors, fraud, and illegal acts.
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Fraud in Financial Statements
The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management.
An auditor conducting an audit in accordance with generally accepted auditing standards is responsible for obtaining reasonable assurance that the financial statements as a whole are free from material misstatements, whether by fraud or error.
An unavoidable risk exists that some material misstatements of the financial statements may not be detected, even though the audit was conducted in accordance with G A A S.
When the financial statements are materially misstated, the auditor should not give an unmodified or unqualified opinion but should modify the opinion as either qualified or adverse opinion.
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Fraudulent Financial Reporting
Involves either intentional misstatements or omissions of amounts or disclosures in order to deceive financial statement users.
Deception – manipulation, falsification or alteration of accounting records or supporting documents.
Misrepresentation in, or intentional omission from, events, transactions, or other significant information.
Intentional misapplication of accounting principles.
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Nature and Causes of Misstatements
Deception such as manipulation, falsification, or altering of accounting records.
Misrepresentation of a financial statement disclosure that is not presented in conformity with G A A P or is intentionally omitted.
Intentional misapplication of accounting principles relating to measurement, recognition, classification, presentation or disclosure.
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Error, Fraud, and Illegal Acts
Error
Unintentional mistakes in math, application of G A A P, or omission of information.
Fraud
Deliberate decision made to deceive others through.
Fraudulent financial reporting.
Misappropriation of assets.
Illegal Acts
Violations of laws or regulations.
Bribery.
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Exhibit 5.1 Auditors Responsibility to Detect Errors, Illegal Acts and Fraud

Responsible for Detection for Material
Responsible for Detection for Immaterial

Required to Communicate Findings for Material
Required to Communicate Findings for Immaterial

Errors
Yes
No

Yes (audit committee)
No

Illegal acts
Yes (direct effect)
No

Yes (audit committee)
Yes (one level above)

Fraud
Yes
No

Yes (audit committee)
Yes (by low-level employee, to one level above) (by management-level employee, to audit committee)

Private Securities Litigation Reform Act (P S L R A)
Additional requirements upon public companies and their auditors when:
The illegal act has a material effect on financial statements.
Senior management and the board have not taken appropriate remedial action.
Failure to take remedial action may warrant departure from a standard audit report (or resignation of auditors).
When illegal act has material effect on the financial statements.
Auditors must report act to the client.
Client must inform Board of Directors which has one day to inform the S E C.
If client does not inform the S E C.
Auditors must furnish the report to the S E C within one day.
Or resign from the engagement within one day.
Ethical obligation of confidentiality is waived.
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Learning Objective 2
Explain the components of the Fraud Triangle and how they are integrated into A U-C 240.
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Questions for Consideration
What is the fraud triangle and how does it identify red flag indicators of fraud?
What are the auditor’s responsibilities to detect and report fraud?
What is the role of internal controls and risk assessment in preventing and detecting fraud?
What information is communicated by the audit report?
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The Fraud Triangle 1
Integrated into A U-C Section 240: Consideration for Fraud in a Financial Statement Audit.
Three conditions are generally present when fraud occurs:
Incentives/Pressures to Commit Fraud.
Opportunity.
Rationalization/Justification.
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The Fraud Triangle 2
Exhibit 5-2

The Fraud Triangle 3
Incentives/Pressures to Commit Fraud.
Financial stability or profitability is threatened.
Excessive pressure for management to meet the requirements or expectations of third parties.
Self-serving incentives such as bonuses or promotion.
Personal financial situation of management or those charged with governance is threatened by the entity’s financial performance.
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Financial Stability or Profitability is Threatened by Economic, Industry, or Entity Operating Conditions
Potential Red Flags to Look for:
High degree of competition or market saturation, accompanied by declining margins.
High vulnerability to rapid changes, such as changes in technology, product obsolescence, or interest rates.
Significant declines in customer demand and increasing business failures in either the industry or overall economy.
Operating losses suggesting going concern issues.
Recurring negative cash flows from operations while reporting earnings growth.
Rapid growth or unusual profitability, especially compared to that of other companies in the same industry.
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Excessive Pressure for Management to Meet the Requirements or Expectations of Third Parties
Potential Red Flags to Look for:
Aggressive or unrealistic profitability or trend level expectations (whether internally or externally generated).
Need to obtain additional debt or equity financing to stay competitive.
Challenges meeting exchange listing requirements or debt repayment/debt covenants.
Perceived or real adverse effects of reporting poor financial results on significant pending transactions.
Pressure for management to meet the expectations of legislative or oversight bodies.
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Personal Financial Situation of Management or Those Charged with Governance is Threatened by the Entity’s Financial Performance
Potential Red Flags to Look for:
Significant financial interests in the entity.
Significant portions of their compensation (for example, bonuses, stock options, and earn-out arrangements) tied to achieving aggressive targets for stock price, operating results, financial position, or cash flow.
Personal guarantees of debts of the entity.
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The Fraud Triangle 4
Opportunities to Commit Fraud
Nature of the industry or entity’s operations.
Significant operations located or conducted across jurisdictional borders where differing business environments exist.
The monitoring of management is not effective.
The organizational structure is complex or unstable.
Internal control components are deficient.
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The Nature of the Industry or the Entity’s Operations
Potential Red Flags to Look for:
Related party transactions that are also significant unusual transactions.
Significant transactions with related parties whose financial statements are not audited or are audited by another firm.
Firms to dictate terms or conditions to suppliers or customers that may result in inappropriate or non-arm’s-length transactions.
Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgements or uncertainties.
Significant or highly complex transactions or significant unusual transactions, especially those close to period end.
22

Significant Operations Located or Conducted Across Jurisdictional Borders Where Differing Business Environments and Regulations Exist
Potential Red Flags to Look for:
Use of business intermediaries for which there appears to be no clear business justification.
Significant bank account or subsidiary or branch operations in tax-haven jurisdictions.
Contractual arrangements lacking a business purpose.
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The Monitoring of Management is Not Effective
Potential Red Flags to Look for:
Domination of management by a single person or small group.
Oversight by those charged with governance over the financial reporting process and internal control.
The exertion of dominant influence by or over a related party.
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The Organizational Structure is Complex or Unstable
Potential Red Flags to Look for:
Difficulty in determining the organization or individuals that have controlling interest in the entity.
Overly complex organizational structure involving unusual legal entities or managerial lines of authority.
High turnover of senior management, legal counsel, or those charged with governance.
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Internal Control Components are Deficient
Potential Red Flags to Look for:
Inadequate monitoring of controls.
High turnover rates or employment of staff in accounting, I T, or internal audit.
Accounting and information systems that are not effective Material Internal Control Weaknesses.
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The Fraud Triangle 5
Rationalizations/Attitudes to Justify Fraud.
Poor Tone at the Top.
Management Interest in Accounting.
A Strained Relationship between management and the current or predecessor Auditor.
27

Poor Tone at the Top
Potential Red Flags to Look for:
Poor communication, implementation, support, or enforcement of the entity’s values or ethical standards by management.
Communication of inappropriate values Ineffective ethical standards.
Known history/claims of violations of securities or other laws or regulations.
Low morale among senior management.
The owner-manager makes no distinction between personal and business transactions.
Dispute between shareholders in a closely held entity.
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Management Interest in Accounting
Potential Red Flags to Look for:
Nonfinancial management’s excessive participation in/preoccupation with the selection of accounting policies or the determination of estimates.
Excessive interest by management in maintaining or increasing the entity’s stock price or earnings trend.
Commitment to analysts, creditors, and other third parties to achieve aggressive or unrealistic forecasts.
Management trying to justify marginal or inappropriate accounting based on materiality.
Management failing to remedy known internal control deficiencies or material weaknesses.
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A Strained Relationship Between Management and the Current or Predecessor Auditor
Potential Red Flags to Look for:
Frequent disputes with the current or predecessor auditor.
Unreasonable demands on the auditor regarding the completion of the audit or issuance of the auditor’s report.
Restrictions on the auditor access to people or information.
Management attempting to influence audit scope.
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Learning Objective 3
Describe fraud risk assessment procedures and red flags which might indicate that an individual may be committing fraud, or susceptible to it.
31

Fraud Risk Assessment
A U-C240 requires the auditor to evaluate risk assessment during the audit.
Evaluation of evidence about the potential client before accepting engagement.
Communication with predecessor auditor.
Reasons for firing or the reasons for no longer servicing client.
Management’s and key accounting personnel’s integrity.
Disagreement with management over accounting principles.
Make inquiries about the risks of fraud and how they are addressed.
Consider any unusual or unexpected relationships.
Consider whether one or more fraud risk factors exist.
Consider other information.
Approach each engagement with a healthy dose of skepticism.
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Assessing Management: Red Flags
Is there a Dark Triad Personality Risk?
Narcissism.
Obsessed with power, prestige and vanity.
Mentally unable to see the damage they cause.
Might drive unethical decisions to seek needed praise.
Machiavellianism.
Calculating and funny.
Use charm, friendliness, self-disclosure and guilt and bullying to get what they want.
If they want to cook the books, then staff may go along.
Psychopathy.
Exude confidence, impressive and charming.
Often thought of as sociopaths and are controlling, manipulative and master liars.
Lack empathy and remorse for wrongdoing.
33

Learning Objective 4
Describe the responsibilities of the External Auditor, Board of Directors, and Company Management in regard to internal controls over financial reporting (I C F R).
34

Internal Control Over Financial Reporting (I C F R)
SOX 404 requires registered accounting firms to assess the effectiveness of internal controls.
ICFR related deficiencies include:
Testing the design of controls or effectiveness.
Application of the top-down risk-based approach.
Identifying technology risks.
Performing extensive testing of the work done by third parties in high risk areas.
Evaluating identified control deficiencies.
35

Internal Controls Over Financial Reporting
The risk that internal controls will not help prevent or detect a material misstatement is a critical evaluation to provide reasonable assurance.
Components of internal control under the C O S O framework.
Control environment.
Risk assessment.
Control activities.
Monitoring.
Information and communication.
Attention should be focused on areas of highest risk that a material weakness could exist in a particular area of the company’s internal control over financial reporting.
36

Medicis Pharmaceutical Case
Issued materially misstated financial statements from 2003 to 2007.
E&Y Audit failed to follow P C A O B standards.
Failed to follow G A A S.
Relied on management representations.
Developed alternative accounting methods.
Failed to act on its own A Q R and correct deficiencies.
Issued an unqualified opinion.
P C A O B censured E&Y and imposed $2M in penalties.
37

Enterprise Risk Management – Integrated Framework
Internal control enhanced with corporate governance and risk management.
Aligning risk appetite and strategy.
Enhancing risk response decisions.
Reducing operational surprises and losses.
Identifying and managing multiple and cross-enterprise risks.
Seizing opportunities.
Improving deployment of capital.
38

C O S O Guidance on Monitoring Internal Control Systems
Management should monitor controls to determine whether they are operating effectively and the need for redesign when risks change.
Effective monitoring involves.
Establishing a baseline for control effectiveness.
Designing and executing monitoring procedures that are based on the significance of business risks relative to the entity’s objectives.
Assessing and reporting results, including follow-up on corrective actions.
Framework adopts the position that management should determine its risk appetite and align it with strategic objectives.
E R M seems to place emphasis in the wrong areas by focusing on risk appetite.
Emphasis needed on the ethical dimensions of making strategic decisions.
39

Audit Committee Responsibilities for Fraud Risk Assessment
Audit Committee should.
Evaluate management’s identification of fraud risks.
Implementation of antifraud measures.
Creation of the appropriate tone at the top.
Active oversight by the audit committee can help reinforce management’s commitment to create a culture with “zero tolerance” for fraud.
Audit committee’s evaluation and oversight can serve as a deterrent to senior management engaging in fraudulent activity.
Audit committee should encourage management to provide a mechanism for employees to report concerns about unethical behavior, suspected fraud, or violations of ethical codes or policies.
40

Auditor’s Communication with Those Charged with Governance
A U-C 240 requires communication by auditors of evidence of fraud to appropriate level of management, even inconsequential or minor misappropriation.
Fraud that causes a material misstatement should be reported directly to those charged with governance.
Good governance principles suggest that.
The auditor has access to the audit committee as necessary.
The chair of the audit committee meet with the auditor periodically.
The audit committee meets with the auditor without management at least annually.
Auditors should communicate about accounting estimates.
Nature of significant assumptions/degree of subjectivity/relative materiality.
Communicate to management/those charged with governance risks due to fraud that have continuing control implications.
41

Management Representations and Financial Statement Certifications
Management responsible for preventing and detecting fraud.
Management can override internal controls and create deceptive accounting.
Management representation letters from C E O, C F O, and other appropriate officers (Section 302 of S O X).
Provides access to all known information bearing on fair presentation of financial statements.
Confirms that management has performed an assessment of effectiveness of internal control over financial reporting.
Concludes that effective internal controls have been maintained.
Discloses any deficiencies in the design or operation of internal controls.
42

Learning Objective 5
Explain the standards for audit reports.
43

Audit Reports and Auditing Standards
Since 19 26, the New York Stock Exchange has required an auditor’s report.
The Securities Exchange Act of 19 34 requires all public companies to have an independent auditor’s report in annual financial statements.
The P C A O B oversees public companies’ audits since S O X in 2002.
The A I C P A Auditing Standards Board (A S B) oversees the audits of nonpublic companies.
Independent auditors express or disclaim an opinion on whether an entity’s financial statements and related disclosures are presented in accordance with G A A P.
44

P C A O B AS 1301 Communications with Audit Committee
Audit Committee should be aware of situations that may effect the audit.
Significant accounting policies and practices.
Critical accounting policies and practices.
Critical accounting estimates.
Significant unusual transactions.
Quality of the company’s financial reporting.
Disagreements with management.
Significant difficulties encountered during the audit.
45

P C A O B AS 3101 When Auditor Expresses and Unqualified Opinion
P C A O B rules for communicating Critical Audit Matters.
Auditor’s assessment of risks of misstatement.
The degree of auditor judgment.
The nature and timing of unusual transactions.
The degree of auditor subjectivity in applying audit procedures.
The nature and extent of audit effort to address the matter.
The nature of the audit evidence obtained.
46

Unmodified or Unqualified Audit Opinions
Financial statements “present fairly”
Financial position.
Results of operations.
Cash flows.
Stockholders’ Equity.
Optional additional paragraph.
Emphasis-of-matter.
Going concern.
Consistent application of accounting principles.
Litigation uncertainty.
Other-matter.
Supplemental information.
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Modified or Qualified Audit Opinions
Modifies the audit when.
Based upon evidence financial statements are materially misstated, or.
Unable to obtain sufficient appropriate evidence.
Qualified.
Concludes misstatements, individually or in the aggregate, are material but not pervasive to the financial statements, or.
Unable to obtain sufficient appropriate audit evidence; possible effect on financial statements could be material but not pervasive.
Adverse.
Concludes that misstatements, individually or in the aggregate, are material and pervasive.
Basis for Modifications.
Separate paragraph describes matter giving rise to modification.
Placed immediately before the opinion paragraph.
Titled “Basis for (Qualified, Adverse, Disclaimer) Opinion”.
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Disclaimer/Withdrawal from the Engagement
Disclaimer.
Unable to gather sufficient evidence to warrant the expression of an opinion on the statements as a whole.
Withdrawal.
If significant conflict exists with management or the auditor decides that management cannot be trusted, then a withdrawal may be justified.
Trust issues are a matter of ethics.
The auditor must consider whether the breakdown between management and the auditor has advanced to the point that any and all information provided by the client is suspect.
Withdrawal triggers the filing of the S E C’s 8-K form by management.
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Limitations of the Audit Report Reasonable Assurance
Reasonable Assurance.
Due care.
Relation of independence and client relationships.
Not an absolute guarantee.
Followed G A A S, gathering sufficient competent evidential matter.
Failure to follow G A A S: allegation of negligence.
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Limitations of the Audit Report Materiality
Magnitude of an omission or misstatement of accounting information that the judgment of reasonable person relying on the information would have been changed or influenced by the omission or misstatement.
Judging Materiality.
Staff Accounting Bulletin (S A B 99) may not rely solely on a quantitative threshold as a “rule of thumb”.
5% is a common materiality test.
S E C wants qualitative matters to be considered as well.
Unintended consequence of materiality is that it is subject to manipulation.
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Limitations of the Audit Report Present Fairly
Auditor’s assessment of fair presentation depends on whether:
Accounting principles used have general acceptance.
Accounting principles are appropriate.
Financial statements are informative.
Information presented is classified and summarized in a reasonable manner.
Financial statements reflect the underlying transactions and events in a manner that is consistent with materiality and reflects economic substance.
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Generally Accepted Auditing Standards (G A A S) 1
Auditing standards provide a measure of audit quality and the objectives to be achieved in an audit.
Auditing standards differ from auditing procedures because the procedures are steps taken by the auditor during the course of the audit to comply with G A A S.
The application of auditing standards entails making judgments with regard to the nature of audit evidence, sufficiency, competency, and reliability.
Materiality considerations are important to assess whether the audit opinion should be modified.
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Generally Accepted Auditing Standards (G A A S) 2
General Standards.
Adequate technical training and proficiency.
Independence in mental attitude.
Due care in the performance of the audit and preparation of the report.
Standards of Field Work.
Adequately plan the audit work and supervise assistants.
Obtain a sufficient understanding of internal control to adequately plan the audit and determine the nature, timing, and extent of tests to be performed.
Gather sufficient competent evidential matter to provide a basis for an opinion.
Standards of Reporting.
The statements have been in conformity with G A A P.
Accounting principles have been consistently applied.
Adequate informative disclosures have been made.
Expression of an opinion on statements taken as a whole, or indication that an opinion cannot be expressed.
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Auditing Evidence
Consideration of the competency and sufficiency of evidence.
Management representations are not a substitute for application of proper audit procedures.
Audit risk and materiality considered together.
Determination of nature, timing and extent of procedures.
Evaluation of results of procedures.
Assess risks of material misstatements due to fraud.
Application of professional skepticism.
Audit procedures – specific acts performed to gather evidence about specific assertions.
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Professional Skepticism
An important role in gathering audit evidence and evaluating usefulness.
Auditor should exercise professional judgment and skepticism.
Determining the nature, timing, and extent of audit procedures.
Determining the sufficiency, competency, and relevancy of evidence.
Evaluating management’s judgments and estimates.
Considering fraud in the audit.
Determining the conclusions based on the audit evidence obtained.
A state of mind and requires documentation to provide evidence that the audit was planned and performed in accordance with G A A S.
Document the thought process, alternative views considered, judgments made, audit evidence gathered, and support for final conclusion.
Document challenges to management’s views and assumptions.
Document the basis for unusual, one-time transactions and related business rationale.
Include a complete and comprehensive record of discussions with management.
Document assessments of the reliability of the source of documents.
Document professional skepticism in significant matters.
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Concluding Thoughts
Financial statement fraud threatens the foundation of the financial reporting process and jeopardizes the integrity of the auditing function.
Auditors need to be more diligent in looking for signs that fraud exists.
Aggressive judgments by management, such as those in the Medicis Pharmaceutical creates challenges for auditors.
As the audit profession evolves and embraces the use of machine-based learning systems, the profession needs to stay vigilant and be aware that these systems require our expertise, professional judgement and ethics.
High deficiency rates found in P C A O B inspection reports indicate auditors are not meeting their obligations to the public.
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