1. Ensuring the Integrity of Financial Information Ensuring the Integrity of Financial Information C H A P T E R 5

2. Learning Objective 1 Identify the types of problems that can appear in financial statements.

3. What Are Three Reasons for Problems in the Financial Statements? Disagreement— Because accounting involves judgment and because auditors and management have different incentives, the possibility for honest disagreement exists. Fraud— Intentional manipulation. Error— Occurs when care is not taken in recording, posting, and/or summarizing transactions. Corrected upon detection.

4. 4 Transactions and journal entries. Types of Errors in the Reporting Process Aug 1Supplies...............100 Cash................100 Postage stamps. ?What types of errors are possible? 'The receipt was lost and not recorded. 'The amount was entered incorrectly. 'The entry is fraudulent.

5. 4 Accounts and ledgers. Types of Errors in the Reporting Process ?What types of errors are possible? 'Journal entry data are not summarized appropriately or accurately. 'Amounts are included in expense or revenue accounts rather than asset or liability accounts. 'Intentional fraud.

6. Describe Some Ways to Do Fraudulent Financial Reporting. n Two entries are made: u one to match the invoice and u one for cash (which is kept). n False transactions for which there are no legitimate invoices or receipts. u Listing sales that don’t exist. u Not recording sales returns or uncollectible receivables. u Not recording expenses, understating liabilities, or overstating assets. n Unreasonable estimates or judgments that mean the difference between showing a profit or a loss.

7. Learning Objective 2 Describe the safeguards employed within a firm to ensure that financial statements are free from problems.

8. Policies and procedures established to provide management with reasonable assurance that the firm’s objectives will be met. Define Internal Control Structure Designed to protect investors and creditors and help management in their efforts to effectively and efficiently run their organization.

9. What Are Some Concerns When Designing Internal Control Structures? å To provide accurate accounting records and financial statements. å To safeguard assets (cash, property, employees, confidential information, reputation, and image) and records. å To effectively and efficiently run operations without duplication of effort or waste. å To follow management policies. å To comply with the Foreign Corrupt Practices Act.

10. Policies and Procedures 1.The control environment. 1. The control environment. 2. The accounting system. 3. The control procedures.

11. What Are the Three Parts of the Control Structure? Control Environment n Management philosophy and operating style. u Does management follow controls? u Does management stress importance of controls? n Organizational structure. u Are there clear lines of authority and responsibility? u Is just one person responsible for each function? n Audit committee. u Typically members are on the board of directors. u Internal and external auditors are accountable to the committee. Accounting System Identifies, assembles, classifies, analyzes, records, and reports the firm’s transactions. n Accountability for assets n Valid transactions n Properly authorized transactions n Completeness of records n Proper classification n Proper timing n Proper valuation n Correct posting and summarization Control Procedures n Segregation of duties: u Authorization u Record keeping u Custody of assets n Proper procedures for authorization n Adequate documents and records n Physical control over assets and records n Independent checks on performance

12. What Are the Guidelines on Reporting on Internal Controls? Management of public companies * are required by law to issue a management statement in annual report. * must acknowledge their responsibility for a good system of internal controls.

13. Learning Objective 3 Understand the need for monitoring by independent parties.

14. Monitoring System Z Who makes sure the internal control system is functioning properly? Z What about disagreements in judgment, and who decides what is reasonable? è While the vast majority of managers would not intentionally bias the financial statements, their incentives may cause them to influence the process.

15. Learning Objective 4 Describe the role of auditors and how their presence affects the integrity of financial statements.

16. Role of Internal Auditors Who are internal auditors? An independent group of experts in control, accounting, and operations. What do they do? + Monitor operating results and financial records. + Evaluate internal controls. + Assist with increasing efficiency and effectiveness of operations. + Detect fraud.

17. Role of External Auditors Who are external auditors? Employees of CPA firms. What do they do? / Perform SEC-required audits. / Examine financial statements in accordance with GAAP to be certain they are free from material (significant) misstatement. / Provide reasonable assurance that financial statements are “presented fairly.”

18. What Do Auditors Do? ÊProvide an independent assessment of a firm’s internal control system. ËStudy the control system to determine if they can rely upon it as they audit. ÌInterview employees 4to see if procedures are understood. 4to see if proper documentation is being made. 4to see if proper authorization is being obtained. 4to identify potential weaknesses in the system. (continued)

19. What Do Auditors Do? ÍObserve operations 4to verify compliance with procedures. 4to verify inventory. ÎSample a set of transactions for analysis 4to conclude if procedures are complied with. 4to determine if system is reliable. ÏConfirmation 4of records to verify existence of accounts. 4with customers to verify account balances. ÐPerform analytical procedures involving comparative ratio analysis.

20. Are Auditors Independent? 6 Responsible to financial statement users to ensure they are represented fairly. 6 Avoid litigation and damages by providing unbiased and fair information. 6 Have a reputation to protect. 6 Pays the auditors. 6 Wants to use the least conservative estimates. 6 Desires to present the most favorable position. AUDITORSMANAGEMENT It is this tension that provides users with information that fairly represents the business’s performance.

21. Learning Objective 5 Explain the role of the Securities and Exchange Commission in adding credibility to financial statements.

22. Securities Act of 1933 Requires companies issuing new debt to submit a registration statement to the SEC for approval. Securities Act of 1934 Requires public companies to file detailed periodic reports with the SEC, as well as to submit audited financial statements which contain a CPA opinion. Securities and Exchange Commission (SEC)

23. What Are the SEC-Required Reports? nRegistration statements nForm 10-K uFiled annually. uContains audited financial statements. uRequires disclosure beyond audited statements. nForm 10-Q uFiled quarterly for publicly held companies. uRequires a CPA’s involvement.

24. End Chapter 5