Chapter 5
Ensuring the Integrity of
Financial Information
Albrecht, Stice, Stice, Swain
COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
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Types of Problems
• Errors
– Unintentional mistakes.
• Disagreements
– Accounting judgments.
– Different incentives.
• Fraud
– Intentional errors.
– Management manipulates financial
statements to deceive investors.
2
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.
3
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).
4
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.
5
Segregation of Duties
1. Authorization
– Authorizing or approving the execution of
the transaction.
2. Record Keeping
– Recording the transaction
in the account.
A
RK
A
RK
C
C
3. Custody of Assets
– Having physical possession of or control
over the assets involved.
6
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.
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Earnings Management
Continuum
Savvy
Transaction
Timing
Strategic
Matching
Aggressive
Accounting
Deceptive
Accounting
Fraudulent
Reporting
Fraud
Changes in
Methods or
Estimates
with Full
Disclosure
Changes in
Methods or
Estimates
but with Little
or No
Disclosure
Non-GAAP
Accounting
Fictitious
Transactions
8
The GAAP Oval
D
A
B
C
E
Which one is correct?
9
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.
10
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.
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What Auditors Do
• Processes used by auditors
Processes
(Who Performs Them)
–
–
–
–
–
Interview
Observation
Sampling
Confirmation
Analytical Procedures
(internal and external)
(internal and external)
(internal and external)
(external)
(external)
• Follow Generally Accepted Auditing
Standards (GAAS)
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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).
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