COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1 Chapter 5 Ensuring the Integrity of Financial Information Albrecht, Stice, Stice, Swain

2 Types of Problems Errors –Unintentional mistakes. Disagreements –Accounting judgments. –Different incentives. Fraud –Intentional errors. –Management manipulates financial statements to deceive investors.

3 Accounting Errors Errors in transactions and journal entries. –Amounts are incorrect. –Incorrect accounts involved. Errors in accounts and ledgers. –Posting to the wrong account. –Posting the wrong amount.

4 Safeguards to Counter Problems Internal Controls –Help to protect assets and increase reliability of accounting records. Internal Control Structure –The control environment. Actions, policies, and procedures that reflect the attitude of management about controls. –The accounting systems. –The control procedures (activities).

5 Control Activities Preventative Controls –Segregation of duties. –Proper procedures for authorization. –Physical control over assets and records. Detective Controls –Adequate documents and records. –Independent checks on performance.

6 Segregation of Duties 1.Authorization –Authorizing or approving the execution of the transaction. 2.Record Keeping –Recording the transaction in the account. 3.Custody of Assets –Having physical possession of or control over the assets involved. A RK C A C

7 Reasons for Earnings Management Meet internal targets. Meet external expectations. Income smoothing. –Carefully timing the recognition of revenues and expenses to even out earnings from year to year. Window dressing for an initial public offering or loan. –Making the earnings look as good as possible for investors and/or bankers.

8 Earnings Management Continuum Savvy Transaction Timing Aggressive Accounting Deceptive Accounting Fraudulent Reporting Fraud Strategic Matching Changes in Methods or Estimates with Full Disclosure Changes in Methods or Estimates but with Little or No Disclosure Non-GAAP Accounting Fictitious Transactions

9 The GAAP Oval BACDE Which one is correct?

10 The Sarbanes-Oxley Act Public Company Accounting Oversight Board (PCAOB) –Oversees the accounting firms. Constraints on Auditors –Accounting firms can no longer provide certain services to audit clients. Constraints on Management –Requirements to ensure stronger and more ethical management.

11 The Role of Auditors Provide a check and balance Internal Auditors –Ensure integrity in the financial records. –Evaluate and encourage adherence to internal controls. External Auditors –Ensure integrity in the financial reporting process through independent audits of financial statements.

12 What Auditors Do Processes used by auditors Processes(Who Performs Them) –Interview(internal and external) –Observation(internal and external) –Sampling(internal and external) –Confirmation(external) –Analytical Procedures(external) Follow Generally Accepted Auditing Standards (GAAS)

13 The Securities and Exchange Commission Created to assist investors in public companies by regulating stock and bond markets. Has authority to establish accounting standards. (Usually accepts pronouncements of FASB). Can suspend trading and de-list securities. Requires certain disclosures and reports (10-K, 10-Q, and Registration Statements).