CHAPTER
5
Ensuring the Integrity
of Financial Information
Learning Objective 1
Identify the
types of
problems that
can appear in
financial
statements.
What Are Three Reasons for
Problems in the Financial
Statements?
Error—Occurs when care is not taken in
recording, posting, and/or summarizing
transactions. Corrected upon detection.
Disagreement—Because accounting
involves judgment and because auditors
and management have different
incentives, the possibility for honest
disagreement exists.
Fraud—Intentional manipulation.
Types of Errors in the Reporting
Process

Transactions and journal entries.
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Cash . . . . . . . . . . . . . . . .
100
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.
Types of Errors in the Reporting
Process

Accounts and ledgers.
? 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.
Describe Some Ways to Do
Fraudulent Financial Reporting.



Two entries are made:
one to match the invoice and
one for cash (which is kept).
False transactions for which there are
no legitimate invoices or receipts.
Listing sales that don’t exist.
Not recording sales returns or uncollectible
receivables.
Not recording expenses, understating liabilities, or
overstating assets.
Unreasonable estimates or judgments that mean the
difference between showing a profit or a loss.
Learning Objective 2
Describe the safeguards
employed within a firm to
ensure that financial
statements are free from
problems.
Define Internal Control
Structure
Policies and procedures established
to provide management with
reasonable assurance that the firm’s
objectives will be met.
Designed to protect investors
and creditors and help
management in their efforts to
effectively and efficiently run
their organization.
What Are Some Concerns When
Designing Internal Control
Structures?
 To provide accurate accounting records and
financial statements.
 To safeguard assets (cash, property,
employees, confidential information, reputation,
and image) and records.
 To effectively and efficiently run
operations without duplication of
effort or waste.
 To follow management policies.
 To comply with the Foreign
Corrupt Practices Act.
$
$
Policies and Procedures
1. The control environment.
2. The accounting system.
3. The control procedures.
What Are the Three Parts of the
Control Structure?
 Management
and

Segregation
ofphilosophy
duties:
Identifies,
assembles,
classifies,
operating style.
analyzes,
records, and reports the
 Authorization
 Does management follow
firm’s
transactions.
 Record keeping
Control Environment
Accounting System
Control Procedures
controls?
 Accountability
assets stress
 Custody
offor
assets
 Does management
importance
of controls?
 Valid
transactions

Proper
procedures
for
 Organizational structure.
authorization
 Properly
authorized transactions
 Are there clear lines of

Adequate
documents
and
 Completeness
ofand
records
authority
responsibility?
records
classification
Is just one person
 Proper
responsible
for
eachassets
 Physical
control
over
 Proper timing
function?
and records
 Proper
valuation
 Audit
committee.
 Independent checks on
 Typically
members are on the
 Correct
posting
and
performance
board of directors.
summarization
 Internal and external auditors
are accountable to the
committee.
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.
Learning Objective 3
Understand the
need for monitoring
by independent
parties.
Monitoring System
 Who makes sure the internal
control system is functioning
properly?
 What about disagreements in
judgment, and who decides what
is reasonable?
While the vast majority of
managers would not intentionally
bias the financial statements, their
incentives may cause them to
influence the process.
Learning Objective 4
Describe the role of
auditors and how
their presence affects
the integrity of
financial statements.
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.
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.”
What Do Auditors Do?
Provide an independent assessment of a
firm’s internal control system.
 Study the control system to determine if
they can rely upon it as they audit.
 Interview employees
to see if procedures are understood.
to see if proper documentation is being
made.
to see if proper authorization is being
obtained.
to identify potential weaknesses in the
system.
(continued)
What Do Auditors Do?
Observe operations
to verify compliance with procedures.
to verify inventory.
Sample a set of transactions for analysis
to conclude if procedures are complied with.
to determine if system is reliable.
Confirmation
of records to verify existence of accounts.
with customers to verify account balances.
Perform analytical procedures involving
comparative ratio analysis.
Are Auditors Independent?
AUDITORS
MANAGEMENT
 Responsible to financial
 Pays the


statement users to
ensure they are
represented fairly.
Avoid litigation
and damages by
providing unbiased
and fair information.
Have a reputation to
protect.


auditors.
Wants to use
the least
conservative
estimates.
Desires to
present the
most
favorable
position.
It is this tension that provides users with information
that fairly represents the business’s performance.
Learning Objective 5
Explain the role of the Securities and
Exchange Commission in adding
credibility to financial statements.
Securities and Exchange
Commission (SEC)
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.
What Are the SEC-Required Reports?
Registration statements
Form 10-K
Filed annually.
Contains audited financial
statements.
Requires disclosure
beyond audited statements.
Form 10-Q
Filed quarterly for publicly
held companies.
Requires a CPA’s
involvement.
End Chapter 5