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accounting equation still balances. Cash, an asset, is stolen, and the recognition of an expense
results in owners equity being reduced by the same amount.
Assets Liabilities Owners Equity
(decreased by $5,000) (decreased by $5,000)

In addition, sometimes amounts for which there are no legitimate transactions are added
or deducted directly from financial statement balances. Examples are listing sales
Before reading about the that don t exist (as was the case with BAUSCH & LOMB, the eye care com-
safeguards designed to minimize the types pany, which was making false shipments to distributors at year-end resulting
in an overstatement of profits by over $80 million); not recording sales returns
of problems we have just discussed, can
or uncollectible receivables (as was the case with the vacuum maker, REGINA,
you think of things that could be done to
which did not record the return of over 40,000 vacuums); and not recording
ensure that errors, disagreements in judg- various expenses, understating liabilities, and overstating assets such as inven-
ment, and fraudulent financial reporting do tory or receivables (as was the case with Phar-Mor). Sometimes these types of
errors are unintentional, but in many cases they are intentional.
not occur?




to summarize
The accounting cycle and resulting financial reports of most organizations are
accurate and can be relied on. Nevertheless, unintentional errors, disagree-
ments in judgment, and fraudulent financial reporting can occur in the ac-
counting process, thereby producing erroneous financial reports.




2 SAFEGUARDS DESIGNED TO MINIMIZE
PROBLEMS
Describe the safeguards
employed within a firm to
ensure that financial
Accounting is a language just as English is. In the same way that a falsehood can be written in
statements are free from
English, a misleading story can be expressed by financial statements. By far, the vast majority of
problems.
financial statements are as accurate as possible, and the preparers are honest. Most organizations
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Adam s fraud went undetected until he became Adam that his embezzled funds were taxable, and
greedy and expanded his methods of embezzling. He since he hadn t paid timely taxes, he owed fines,
was caught when a customer of the bank twice made penalties, interest, and taxes totaling nearly $100,000.
interest payments of $10,000. Adam took the second When released from jail, Adam will probably spend
$10,000 payment and deposited it in his own account the rest of his life paying back the bank and the IRS
at the bank. The customer, realizing the error, notified the $250,000 he now owes.
the bank. The search for the missing $10,000 revealed
*All Business Environment Essays in this chapter are real cases. In
Adam s thefts. some instances, such as here, the names have been changed.
As a result of his fraud, Adam was sentenced to
four years in prison and entered into a restitution Source: This case is from the video The Red Flags of Fraud, The As-
agreement to repay the bank. The IRS also informed sociation of Certified Fraud Examiners, Austin, Texas.




prepare accounting records and financial reports with integrity, and in most cases, preparers are
even conservative when judgments and estimates are required. To help ensure that financial re-
ports are accurate, and to prevent problems such as those that occurred at PHAR-MOR, sev-
eral safeguards have been built into the financial reporting structure of most organizations in the
United States. As a future user of accounting information, you should be aware of these safe-
guards and the reasons for their existence.
Most organizations build controls into their organization and financial reporting processes
so that abuses are difficult. These safeguards, called the internal control structure, are internal
internal control structure
Safeguards in the form of to the organization preparing the financial statements. The American Institute of Certified Pub-
policies and procedures es-
lic Accountants (AICPA) has defined internal control as the policies and procedures established
tablished to provide man-
to provide reasonable assurance that specific entity objectives will be achieved. 3 These internal
agement with reasonable
controls protect investors and creditors and even help management in their efforts to run their
assurance that the objec-
organizations as effectively and efficiently as possible. As a future investor and financial state-
tives of an entity will be
achieved. ment user, you should be aware of these controls. When you encounter an organization or fi-
nancial statements that do not have these controls and safeguards, you should exercise extreme
care. Most companies have the following five concerns in mind when they are designing inter-
nal controls:
1. To provide accurate accounting records and financial statements containing reliable data
for business decisions.
2. To safeguard assets and records. Most companies think of their assets as including their fi-
nancial assets (such as cash or property), their employees, their confidential information,
and their reputation and image.
3. To effectively and efficiently run their operations, without duplication of effort or waste.
4. To follow management policies.
5. To comply with the Foreign Corrupt Practices Act, which requires companies to maintain
Foreign Corrupt Practices
proper record-keeping systems and controls.
Act (FCPA) Legislation re-
quiring any company that
The responsibility for establishing and maintaining the internal control structure belongs
has publicly traded stock to
to a company s management. Until several years ago, this responsibility was only implied; there
maintain records that accu-
rately and fairly represent was no formal legal requirement. However, in the wake of illegal political campaign contribu-
the company s transactions; tions, business frauds, and numerous illegal payments to foreign officials in exchange for busi-
additionally, requires any
ness favors, Congress passed the Foreign Corrupt Practices Act (FCPA) of 1977. As a result
publicly traded company to
of this legislation, all companies whose stock is publicly traded are required by law to keep records
have an adequate system
of internal accounting con-
trols. 3 AU Section 319, par. 06, Codification of Statements on Auditing Standards, CCH Inc., 1994, p. 98.
209
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Financial Reporting and the Accounting Cycle



business environment essay


Manipulating the Ledgers Jane W. was from the Federal Reserve, she would allow it to be de-
the bookkeeper and proof operator for ducted from the bank s master demand deposit ac-
a small bank. Over a period of four years count (the general ledger), but not from her specific
she embezzled over $3 million an account (in the subsidiary ledger). As a result, the
amount that exceeded 10% of the bank s master account total was reduced and became out of
assets. Jane s method of theft was sim- balance with the sum of the individual account bal-
ple. She would find something she ances. To cover the shortage, at the end of each month
wanted such as a new automobile. She she would pull some of her bank s previously used
would write the dealer a check for the cashier s checks and send them to the Federal Re-
car. Then, when her check came back serve. For one day, until it sorted the checks, the Fed-




that represent the firm s transactions accurately and fairly. In addition, they must maintain ad-
equate systems of internal accounting control.
A company s internal control structure can be divided into five basic categories: (1) the con-
trol environment, (2) risk assessment, (3) control activities, (4) information and communica-
tion, and (5) monitoring. In this chapter, we will cover the control environment and control ac-
tivities (sometimes called control procedures), as well as the need for monitoring. We will also
discuss elements of accounting systems that are important from a control perspective.

The Control Environment
The control environment consists of the actions, policies, and procedures that reflect the over-
control environment The
actions, policies, and proce- all attitudes of top management, the directors, and the owners about control and its importance
dures that reflect the over-
to the company. In a strong control environment, management believes control is important
all attitudes of top manage-
and makes sure that everyone responds conscientiously to the control policies and procedures.
ment, the directors, and the
Some of the key components of the control environment that relate to financial reporting are
owners about control and
described below.
its importance to the entity.


Does management set a good
MANAGEMENT PHILOSOPHY AND OPERATING STYLE
example by following controls? Do they stress the importance of controls to other employees?
What is their management style? Are they, for example, risk averse or apt to take risks, domi-
nated by one or two individuals or open to input from others, realistic or unrealistic about goals?
An example of a company with a poor management philosophy and operating style was
EQUITY FUNDING. Equity Funding was a life insurance company that sold policies to indi-
viduals and then resold those policies to other insurance companies called reinsurers. Equity
Funding s top managers were extremely dominant and dishonest; there were no clear lines of re-
sponsibility, budgets were unrealistic, and the company had no system of organizational checks
and balances in place. In that environment, top management wrote $2 billion of fictitious life
insurance policies and reported the sales and profits from those transactions on the company s
financial statements. Management s dishonest actions were so blatant that a climate of moral de-
cay filtered throughout the organization, resulting in widespread cheating by employees on travel
reimbursements and other abuses.

Does the organizational structure identify clear lines
ORGANIZATIONAL STRUCTURE
organizational structure
Lines of authority and re- of authority and responsibility? Is the organizational structure so complex that dishonest trans-
sponsibility.
actions can be concealed?
An example of a complex organizational structure that was used to conceal a large fraud
(approximately $300 million) is the ESM COMPANY in Ohio. ESM was a brokerage business
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eral Reserve would treat her bank s canceled checks owing considerable taxes to the IRS on her stolen
as if they were legitimate checks received by the bank funds. Jane and her husband (who assisted with the
from its customers, and for which the Federal Reserve fraud) now owe a total of nearly $5 million to the bank
should credit her bank. Jane was caught when some- and the IRS. For the rest of their lives, they will be in
one at the Federal Reserve noticed that a cashier s financial bondage.
check she sent had been processed so many times
that it was completely black.
Source: W. S. Albrecht, G. Wernz, and T. Williams, Fraud: Bringing
As a result of her fraud, Jane was sentenced to Light to the Dark Side of Business, Irwin, 1995, p. 265.
eight years in prison. She also entered into a restitu-
tion agreement to repay her company and ended up




that bought and sold government securities. Over a period of seven years, the officers of the
company funneled cash to themselves until the company owed approximately $300 million more
in payables than it had in receivables. This net payable was concealed by setting up related en-
tities and reporting a fictitious receivable from one of those companies in ESM Company s fi-
nancial statements. If anyone had investigated the receivable, he or she would have found that
the related company from which it was supposedly collectible was bankrupt.
A good organizational structure requires that only one person in a department be respon-
sible for each function, such as cash receipts, cash disbursements, purchasing, payroll prepara-
tion, or credit approval. It takes little imagination to envision the confusion that would result
if a business gave every employee unlimited purchasing authority, for example. There would be
overstocking, duplication of orders, loss of quantity discounts, and tremendous waste. By des-
ignating responsibility for the purchasing function, or any other function, the organization runs
more smoothly and maintains control.
Normally, each company will have an organizational chart that not only specifies the for-
mal lines of authority, but also indicates departmental responsibilities. In addition to formal lines
of authority, each organization will have an informal hierarchy that develops based on the per-
sonalities of the individuals and the group dynamics of the situation.

audit committee Members Every major company has a board of directors. A good control envi-
AUDIT COMMITTEE
of a company s board of di-
ronment would suggest that a subset of these directors should form an audit committee. Gen-
rectors who are responsible
erally, the audit committee should be comprised of outside directors (members of the board who
for dealing with the exter-
are not officers of the company). The internal and external auditors would then be accountable
nal and internal auditors.
to this audit committee.
Companies listed on the New York Stock Exchange are required to have audit committees
comprised entirely of outside directors who are not employees of the company. The audit com-
accounting system The set
mittee is usually charged with the responsibility of supervising the company s financial report-
of manual and computer-
ized procedures and con- ing process, including internal control and compliance with applicable laws and regulations. Au-
trols that provide for identi-
ditors who suspect wrongdoing in financial reporting should forward those concerns to the audit
fying relevant transactions
committee.
or events, preparing accu-
rate source documents, en-
tering data into the ac-
The Accounting System
counting records
accurately, processing The purpose of a company s accounting system is to identify, assemble, classify, analyze, record,
transactions precisely, up-
and report the entity s transactions and to maintain accountability for assets. To be effective,
dating master files prop-
the accounting system should contain adequate controls to ensure that seven control objectives
erly, and generating correct
are met.
documents and reports.
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1. Validity. Only valid transactions are recorded. If fictitious sales are recorded, for example,
reported revenues will be too high, and the integrity of the financial statements will be lost.
2. Authorization. All transactions are properly authorized. If, for example, any employee could
authorize purchases, a company might make duplicate purchases of the same items or pur-
chase unneeded items.
3. Completeness. All legitimate transactions are recorded and the records are complete. If, for
example, all liabilities are not recorded, a company will report a more favorable financial
condition than actually exists.
4. Classification. All transactions are properly classified. For example, the current portion of
long-term debt should be classified as a current liability. Incorrect classification would re-
sult in incorrect liability subtotals that would affect such ratios as the current ratio.
5. Timeliness. All transactions are recorded in the proper time period. A company might try
to make its revenues and income look better than they are, for example, by recording early
January sales in December.
6. Valuation. All transactions are properly valued. For example, if a receivable is uncollectible,
it should not be classified as a current asset.
7. Posting and summarization. All transactions are properly included in subsidiary records and
correctly summarized. Errors could occur, for example, if an accounts receivable entry was
posted to the accounts payable account.

Control Activities (Procedures)
Control activities or control procedures are those policies and procedures, in addition to the
control activities (proce-
control environment and accounting system, that management has adopted to provide reason-
dures) Policies and proce-
dures used by management able assurance that the company s established objectives will be met and that financial reports
to meet their objectives;
are accurate. Generally, control activities fall into five categories: adequate segregation of duties,
generally divided into ade-
proper procedures for authorization, adequate documents and records, physical control over as-
quate segregation of duties,
sets and records, and independent checks on performance.
proper procedures for au-
thorization of transactions
and activities, adequate A good internal control system should provide
ADEQUATE SEGREGATION OF DUTIES
documents and records,
for the appropriate segregation of duties. This means that no one department or individual
physical control over assets
should be responsible for handling all phases of a transaction. In some small businesses, this seg-
and records, and indepen-
regation is not possible because the limited number of employees prevents division of all the dif-
dent checks on perfor-
ferent functions. Nevertheless, there are three functions that should be performed by separate
mance.
departments or by different people.
segregation of duties A
strategy to provide an inter- 1. Authorization. Authorizing and approving the execution of transactions; for example, ap-
nal check on performance
proving the sale of a building or land.
through separation of au-
2. Record keeping. Recording the transactions in the accounting journals.
thorization of transactions
3. Custody. Having physical possession of or control over the assets involved in transactions, in-
from custody of related as-
cluding operational responsibility; for example, having the key to the safe in which cash or in-
sets, separation of opera-
tional responsibilities from vestment securities are kept or, more generally, having control over the production function.
record-keeping responsibili-
By separating the responsibilities for these duties, a company realizes the efficiency derived
ties, and separation of cus-
tody of assets from ac- from specialization and also reduces the errors, both intentional and unintentional, that might
counting personnel.
otherwise occur.
An example of a problem resulting from the nonsegregation of the custody and record-
keeping functions occurred when a young employee of a wholesale candy distributor both opened
incoming mail and kept the accounts receivable file. Needing money for a family emergency,
she stole $300 and did not show the receivable as collected. After realizing how easy it was, over
time she took $76,000 by delaying the recording of receivables collected. She was eventually
caught, but her theft affected the financial statements because receivables were misstated, as was
the financial health of the company.

A strong system of internal control re-
PROPER PROCEDURES FOR AUTHORIZATION
quires proper authorization for every transaction. In the typical corporate organization, this au-
thorization originates with the stockholders who elect a board of directors. It is then delegated
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from the board of directors to upper-level management and eventually throughout the organi-
zation. While the board of directors and upper-level management possess a fairly general power
of authorization, a clerk usually has limited authority. Thus, the board would authorize divi-
dends, a general change in policies, or a merger; a clerk would be restricted to authorizing credit
or a specific cash transaction. Only certain people should be authorized to enter data into ac-
counting records and prepare accounting reports.

A key to good controls is an adequate sys-
ADEQUATE DOCUMENTS AND RECORDS
tem of documentation and records. As explained in Chapter 3, documents are the physical, ob-
jective evidence of accounting transactions. Their existence allows management to review any
transaction for appropriate authorization. Documents are also the means by which information
is communicated throughout an organization. In short, adequate documentation provides evi-
dence that the recording and summarizing functions that lead to financial reports are being per-
formed properly. A well-designed document has several characteristics: (1) it is easily interpreted
and understood, (2) it has been designed with all possible uses in mind, (3) it has been prenum-
bered for easy identification and tracking, and (4) it is formatted so that it can be handled quickly
and efficiently. Documents can be actual pieces of paper or information in a computer database.

Some of the most crucial poli-
PHYSICAL CONTROL OVER ASSETS AND RECORDS
cies and procedures involve the use of adequate physical safeguards to protect resources. For
physical safeguards Physi-
cal precautions used to pro- example, a bank would not allow significant amounts of money to be transported in an ordi-
tect assets and records, nary car. Similarly, a company should not leave its valuable assets unprotected. Examples of
such as locks on doors,
physical safeguards are fireproof vaults for the storage of classified information, currency, and
fireproof vaults, password
marketable securities; and guards, fences, and remote control cameras for the protection of equip-
verification, and security
ment, materials, and merchandise. Records and documents are also important resources and
guards.
must be protected. Re-creating lost or destroyed records can be costly and time-consuming, so
companies make backup copies of records. The high cost of backup records (often on micro-
film) is usually more than justified in protecting such valuable resources.
Providing proper safeguards reduces opportunities for employees to misappropriate assets.
Each firm needs a comprehensive security program specifically engineered to protect its corpo-
rate assets. An example of a fraud committed in a setting of poor physical safeguards was the


Many companies use
physical safeguards, such
as surveillance cameras,
to protect their resources.
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Financial Reporting and the Accounting Cycle



business environment essay


An Example of Poor Controls Earlier in 2. The bank required every employee and every offi-
this chapter (pages 210 211), the $3.01 cer to take a consecutive two-week vacation. At
million theft by Jane W., proof operator Jane s request, management allowed this control
in a bank, was discussed. Her fraud was to be broken. Based on her memos that proof
possible because of poor internal con- would get behind if she took a two-week vacation,
trols in her bank. Here are some of the Jane was allowed to take her vacation one day at
major control weaknesses that existed. a time. In addition, no one was allowed to perform
Jane s most sensitive duties while she was away.
1. All documents were to be accessible 3. General ledger entries were supposed to be ap-
to external auditors. Yet Jane kept a proved by an individual other than the person who
locked cabinet next to her desk and completed the entries. In order to override this con-
only she had a key. A customer trol, Jane had her employees presign 10 or 12 gen-
whose statement had been altered eral ledger approvals, so she wouldn t have to
by Jane complained, but was told bother them when they were busy.
that he would have to wait until Jane 4. Opening and closing procedures were supposed to
returned from vacation; the docu- be in place to protect the bank, but many employ-
mentation relating to his account ees had all the keys necessary and could enter the
was in Jane s locked cabinet. bank at will.




crime against the PERINI CORPORATION. Approximately $1,150,000 of checks were writ-
ten on the company s accounts by an employee. Access to the checks was easy because Perini
kept its supply of unused checks in the same unlocked storeroom where the styrofoam coffee
cups were stored. Every clerk and secretary had access to the storeroom. The checks had been
written on a check-writing machine, which automatically signed the president s name. Despite
inherent control procedures in the machine, and its CPA firm s warning to implement specific
control procedures, the company found it inconvenient to use most of the control procedures.
For example, the machine deposited signed checks into a box that was supposed to be locked;
the key was supposed to be kept by an employee in a different department. No such employee
was assigned, however, and the box was left unlocked. Furthermore, no one paid attention to
the machine s counter, which kept track of the number of checks written for comparison with
vouchers authorized for payment.

Having independent checks on perfor-
INDEPENDENT CHECKS ON PERFORMANCE
independent checks Proce-
dures for continual internal mance is a valuable control technique. Independent checks incorporate reviews of functions, as
verification of other con-
well as the internal checks created from a proper segregation of duties.
trols.
There are many ways to independently check performance. Using independent reviewers,
such as auditors, is one of the most common. In addition, mandatory vacations, where another
employee performs the vacationing person s duties, periodic rotations or transfers, or merely hav-
ing someone independent of the accounting records reconcile the bank statement are all types
of independent checks.


Reporting on Internal Controls
Public companies are required to include in their annual report a statement signed by manage-
ment that acknowledges their responsibility for maintaining a good system of internal controls.
The statement shown in Exhibit 5-1 on page 216 was included in the 1999 annual report of
SARA LEE CORPORATION.
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Ensuring The Integrity Of Financial Information Ensuring the Integrity of Financial Information Chapter 5




5. An effective internal audit function was supposed made a $170,000 mortgage loan to Jane, without
to be in place. For a period of two years, however, requiring any explanation as to how the loan would
no internal audit reports were issued. Even when be repaid or how she could afford such a house.
the reports were issued, internal auditors did not 8. Managers were supposed to be reviewing key doc-
check employees bank accounts or perform a crit- uments and reports daily. Either managers didn t
ical control test, such as surprise openings of the review these reports, or they didn t pay close at-
bank s incoming and outgoing mail to and from the tention to the reports when they did perform the
Federal Reserve. reviews. There were daily fluctuations in the re-
6. Employees bank accounts were not regularly re- ports of over $3 million. The reports revealed huge
viewed by internal audit or by management. On the deposits to and checks drawn on Jane s account.
rare occasions when they were reviewed, numer- In addition, Jane appeared on the overdraft report
ous deposits to and checks drawn on Jane s ac- 97 times during the first four years she was em-
count that exceeded her annual salary were not ployed.
questioned.
7. Loans were supposed to be made to employees
only if the employees met all lending standards re- Source: W. S. Albrecht, G. Wernz, and T. Williams, Fraud: Bringing
quired of normal customers. At one point, the bank Light to the Dark Side of Business, Irwin, 1995, p. 265.




to summarize
Most organizations have an internal control system that, among other things,
helps ensure integrity in financial reports. The various elements of control that
relate to financial reporting are summarized as follows:
Control Environment Accounting System Control Procedures

1. Management 1. Valid transactions. 1. Segregation of duties.
philosophy and 2. Properly authorized 2. Proper procedures for
operating style. transactions. authorization.
2. Organizational 3. Completeness. 3. Adequate documents
structure. 4. Proper classification. and records.
3. Audit committee. 5. Proper timing. 4. Physical control over
6. Proper valuation. assets and records.
7. Correct 5. Independent checks
summarization. on performance.

Public companies are required to include in their annual report a statement
signed by management that describes and accepts responsibility for the inter-
nal controls of the company.




3 THE NEED FOR MONITORING
Understand the need for
A firm s internal control structure is designed to minimize the occurrence of intentional and un-
monitoring by independent
parties. intentional problems in a firm s financial statements. But a system of internal controls provides
215
f216 Part 1 Ensuring The Integrity Of Financial Information
Financial Reporting and the Accounting Cycle



Sara Lee s 1999 Management Letter
exhibit 5-1


Management s Report on Financial Information

Management of Sara Lee Corporation is responsible for the preparation and integrity of
the financial information included in this annual report. The financial statements have
been prepared in accordance with generally accepted accounting principles and, where
required, reflect our best estimates and judgments.
It is the corporation s policy to maintain a control-conscious environment through an
effective system of internal accounting controls supported by formal policies and
procedures communicated throughout the corporation. These controls are adequate to
provide reasonable assurance that assets are safeguarded against loss or unauthorized
use and to produce the records necessary for the preparation of financial information.
There are limits inherent in all systems of internal control based on the recognition that
the costs of such systems should be related to the benefits to be derived. We believe the
corporation s systems provide this appropriate balance.
The control environment is complemented by the corporation s internal auditors,
who perform extensive audits and evaluate the adequacy of and the adherence to these
controls, policies and procedures. In addition, the corporation s independent public
accountants have developed an understanding of our accounting and financial controls,
and have conducted such tests as they consider necessary to support their report below.
The Board of Directors pursues its oversight role for the financial statements through
the Audit Committee, which is composed solely of outside directors. The Audit Committee
meets regularly with management, the corporate internal auditors and Arthur Andersen
LLP, jointly and separately, to receive reports on management s process of
implementation and administration of internal accounting controls, as well as auditing
and financial reporting matters. Both Arthur Andersen LLP and the internal auditors have
unrestricted access to the Audit Committee.
The corporation maintains high standards in selecting, training and developing
personnel to help ensure that management s objectives of maintaining strong, effective
internal controls and unbiased, uniform reporting standards are attained. We believe it is
essential for the corporation to conduct its business affairs in accordance with the highest
ethical practices as expressed in Sara Lee Corporation s Global Business Standards.




John H. Bryan Judith A. Sprieser
John H. Bryan Judith A. Sprieser
Chairman of the Board Senior Vice President
and Chief Executive Officer and Chief Financial Officer




assurance as to the quality of the resulting financial information only if the system is function-
ing properly. What, or who, makes sure the system is functioning properly? What happens when
disagreements in judgment arise? Who referees to ensure that the estimates and judgments that
are reflected in the financial statements are reasonable? In this section, we discuss a mechanism,
developed over time, that attempts to ensure that the financial statements provide an accurate
and fair presentation of a company s financial status.
Let s return to our landscaping example. You have determined that your annual salary is a fixed
monthly amount plus an annual bonus based on the net income of the business. The better the
business performs, the higher your pay. Many companies actually reward their top executives using
similar incentive plans (though many of these incentive plans can become quite complex). Now,
what is your incentive? Well, it seems pretty clear that your incentive is to report as high a net in-
come figure as possible. The higher your company s net income, the higher your annual bonus.
How can you increase net income given your current level of operations? Since you are a
person of integrity and honor, falsifying transactions (e.g., fraudulent financial reporting) is out
of the question. One possibility is to review your estimates regarding the percentage of revenues
to be recognized and the percentage of accounts receivable that may be uncollectible.
216 f217
Ensuring The Integrity Of Financial Information Ensuring the Integrity of Financial Information Chapter 5


Recall from a previous section that we had two of our landscaping friends provide us with
independent estimates of the percentage of completion on our condominium landscaping pro-
ject. Suppose that one estimate was that the project was 50% complete. The other was that the
project was 60% complete. Which would you select as being more accurate? Well, the 60% es-
timate would result in a higher net income, which would mean a higher year-end bonus this
year. Also, using the 60% estimate would be reasonable because it was provided by an inde-
pendent source.
You also examine your accounts receivable to determine what percentage of those receivables
might be uncollectible in the future.4 Since you are dealing with estimates about future events,
there is no right answer. You estimate that uncollectible receivables could be anywhere from 2 to
4% of the existing Accounts Receivable balance. Should you split the difference and say 3%? You
could, but why not say 2%? After all, 2% is a possible outcome, and if you use the estimate of
2%, net income will be higher, again resulting in a higher year-end bonus for you.
Financial statements are full of estimates and judgments. Here we have illustrated just
fyi two areas involving estimates revenues and uncollectible accounts. The financial state-
ments of large companies involve many estimates relating to the future life of equipment
In 1999, GENERAL MOTORS
and buildings, the amount to be paid in the future for warranties on products and ser-
estimated that the amount of
vices, and the amount of future benefits to be paid to retirees, to name a few. You might
its total pension and postretire-
expect all these estimates to average out. That is, sometimes those that have a favorable
ment health-care obligations to
effect on net income are used, and sometimes those that have an unfavorable effect are
be paid in the future relating to
used. If estimates were randomly chosen, this would probably happen. But remember that
past and current employees ex-
these estimates aren t randomly chosen. In the case of your landscaping business, you are
ceeded $127 billion.
choosing the estimates.
Suppose that in every case involving an estimate, you elected to present the estimate
that was most favorable to the firm s net income. Your annual bonus would certainly look nice,
but would the resulting financial statements provide a fair assessment of your company s finan-
cial performance? Maybe, maybe not.
As part owner5 of the landscaping company, and with your compensation based on
caution net income, you might have a tough time being objective when it comes to making esti-
mates; you have an economic incentive to influence net income in a certain direction. But
We are not accusing manage-
you also recognize the need to provide relevant and reliable financial information relating
ment of misrepresenting the fi-
to the performance of the company.
nancial results of their compa-
As you wrestle with this issue of estimates in the financial statements, there is another
nies. What we are saying is that
issue to consider as well. We stated that an internal control system is designed to mini-
management has an incentive
mize the occurrence of errors and irregularities in the financial reporting process. While
to make things look as favor-
the system should not allow errors in posting or transactions to be fabricated, how do we
able (within the bounds of eth-
know that the internal control system is running as designed? How can you obtain some
ical disclosure) as possible. assurance that errors, biased disagreements in judgment, and fraudulent financial report-
ing are not a part of your accounting system? In the next section, we discuss another ma-
jor factor that ensures that financial information is presented with reliability and integrity.



to summarize
Because accounting involves estimates and judgment, management has an op-
portunity to influence the outputs of the accounting process. Managers of a
business often have an incentive to provide financial statement information
that appears as favorable as possible. While the vast majority of managers
would not intentionally bias the financial statements, their incentives may cause
them to influence the process.



4 As you will learn in Chapter 6, the estimate of uncollectible accounts receivable will affect the expense for the
period, thereby affecting net income.
5 Recall that you own only part of the company. Your parents and the bank (we illustrated both of these pos-
sibilities) own the other part.
217
f218 Part 1 Ensuring The Integrity Of Financial Information
Financial Reporting and the Accounting Cycle



4 THE ROLE OF AUDITORS IN THE ACCOUNTING
PROCESS
Describe the role of
auditors and how their
presence affects the
Someone needs to check and make sure that the accounting system is running as designed and
integrity of financial
that the resulting financial statements fairly present the financial performance of the company.
statements.
Auditors are that someone. Auditors provide management (and stockholders) with some as-
surance that the internal control system is functioning properly and that the financial statements
fairly represent the financial performance of the firm. Two types of auditors are typically em-
ployed by management internal and external auditors.

Internal Auditors
Most large organizations have a staff of internal auditors, an independent group of experts in
internal auditors An inde-
pendent group of experts controls, accounting, and operations. This group s major purpose is to monitor operating results
(in controls, accounting,
and financial records, evaluate internal controls, assist with increasing the efficiency and effec-
and operations) who moni-
tiveness of operations, and even detect fraud. The internal audit staffs in some large organiza-
tor operating results and fi-
tions include over 100 individuals. The audit manager reports directly to the president (or other
nancial records, evaluate in-
high-level executive officer) and to the audit committee of the board of directors. By perform-
ternal controls, assist with
increasing the efficiency ing independent evaluations of an organization s internal controls, the internal auditors are help-
and effectiveness of opera-
ing preserve integrity in the reporting process. Employees who know that internal auditors are
tions, and detect fraud.
reviewing operations and reports are less likely to manipulate records. Even if they do, their ac-
tions may be revealed by the work of the internal auditors.
Internal auditors responsibilities vary considerably, depending upon the organization. Some
internal audit staffs consist of only one or two employees who spend most of their time perform-
ing reviews of financial records or internal controls. Other organizations may have a large number
of auditors who search for and investigate fraud, work to improve operational efficiency and ef-
fectiveness, and make sure their organization is complying with various laws and regulations.
Organizations that have a competent group of internal auditors generally have fewer fi-
nancial reporting problems than do organizations that don t have internal auditors. An example
of an industry that generally did not have effective internal audit staffs is the savings and loan
industry, where many companies went bankrupt during the late 1980s. In many of those com-
external auditors Indepen-
dent CPAs who are retained panies, managers who were committing fraud did not want internal auditors, who would have
by organizations to perform made it more difficult for management to manipulate financial statements.
audits of financial state-
ments.
External Auditors
generally accepted auditing
Probably the greatest safeguard in the financial reporting system in the United States is the re-
standards (GAAS) Auditing
quirement that firms have external audits. External auditors examine an organization s financial
standards developed by the
statements to determine if they are prepared and presented in accordance with generally accepted
AICPA.
accounting principles and are free from material (significant) misstatement. External audits
fyi are performed by certified public accounting (CPA) firms. CPA audits are required by the
Securities and Exchange Commission and the major stock exchanges for all companies
As of September 1, 2000, five
whose stock is publicly traded. Even companies that are not public, however, often employ
international public accounting
CPAs to perform audits of their financial statements. Banks and other lenders usually re-
firms the Big 5 were re-
quire audits, and audits can instill confidence in users of financial reports. In conducting
sponsible for auditing the ma-
audits, CPAs are required by generally accepted auditing standards (GAAS) to provide
jority of the Fortune 500 com-
reasonable assurance that significant fraud or misstatement is not present in financial state-
panies, as well as most other ments. Because CPAs cannot audit every transaction of an organization, and because de-
large, publicly traded compa- tecting collusive management deception is sometimes impossible, it is not possible for au-
nies in the United States. ditors to guarantee that financial statements are correct. Instead, they can only provide
reasonable assurance that financial statements are presented fairly. Even with audits, there
are still a few occasions when major financial statement fraud is not detected.
CPA audits of financial statements have become very important in the United States be-
cause of the enormous size of many corporations. Because the stockholders,
What could auditors do who own corporations, are usually different individuals from a company s man-
to ensure that the financial reporting sys- agement, audits provide comfort to these owners/investors that management is
carrying out its stewardship function appropriately.
tem is working properly? Be specific.
218 f219
Ensuring The Integrity Of Financial Information Ensuring the Integrity of Financial Information Chapter 5



What Do Auditors Do?
caution While management has the primary responsibility of ensuring that the internal control
system is functioning properly, internal auditors provide an independent assessment of
Auditors are responsible for
how well the controls are working. External auditors usually study the internal control sys-
evaluating the assumptions and
tem to see if they can rely on it as they perform their audits. After all, if the internal con-
estimates of management as
trol system is functioning correctly, it increases the likelihood that the resulting financial
well as testing the internal con-
information is reliable. Often the external auditors will rely on the assessment of the in-
trol system. The auditors do
ternal controls made by the internal auditors.
not make the assumptions and Auditors gain confidence in the quality of the reporting process using several differ-
estimates, nor are they respon- ent processes: interviews, observation, sampling, confirmation, and analytical procedures.
Several of these processes are used by both internal and external auditors, while some are
sible for designing the internal
used primarily by external auditors. Exhibit 5-2 provides a summary of these procedures
control system.
and indicates who uses them most often. A brief discussion of each process then follows.

Auditors interview employees to ensure that procedures are understood, proper
INTERVIEWS
documentation is being made, and proper authorization is being obtained. Through interviews,
auditors identify potential weaknesses in the control system that will be examined using testing
procedures.

Observation is done to verify compliance with procedures and to ensure that
net work OBSERVATION
accounting records agree with physical records. For example, auditors in a bank will count the
Access the AICPA s Web
cash in a vault to ensure that recorded amounts agree with the actual cash on hand. Auditors
site at http://www.aicpa.org
will also verify the existence of inventory by doing a physical count of product. In addition to
and locate the section on
Assurance Services.
using observation to verify the existence of assets, auditors will also use observation to ensure
In addition to auditing, with
that employees are complying with proper procedures.
what other assurance ser-
vices are CPAs involved?
As mentioned previously, auditors cannot examine every transaction. Typically,
SAMPLING
they will select a sample of transactions for analysis. Based on the results of their analysis of the
sample, they may conclude that the internal control procedures are being complied with, re-
sulting in reliable financial information. Auditors may also conclude from the results that the
internal control system is not reliable, resulting in further testing being required.

Used primarily by external auditors, confirmations are used to verify the
CONFIRMATION
balances in accounts that result from transactions with outsiders. For example, customers are of-
ten contacted and asked to verify account balances. Banks are contacted to verify loan amounts,
lines of credit, and other account balances. This procedure ensures that the balances listed on
the financial statements do, in fact, exist.

Analytical procedures are used to provide guidance to external
ANALYTICAL PROCEDURES
auditors as they attempt to identify areas that may deserve attention. Analytical procedures involve
the use of such techniques as comparative ratio analysis (the same ratio analysis we have been do-
ing in Chapters 2, 3, and 4). By comparing the results of ratio analysis from one period to the
next, auditors may be able to identify areas where additional investigation may be appropriate.


Audit Processes Used by Auditors
exhibit 5-2


Internal Auditors External Auditors

Interviews X X
Observation X X
Sampling X X
Confirmation X
Analytical procedures X
219
f220 Part 1 Ensuring The Integrity Of Financial Information
Financial Reporting and the Accounting Cycle


At the completion of an audit, the auditors issue a report that accompanies the financial
statements and describes to readers, in very general terms, what was done by the audit firm and
whether accounting rules were followed; the report also indicates an opinion as to whether the
financial statements and the accompanying notes fairly represent the financial condition of the
firm. As an example of an auditors report, PHAR-MOR s 1999 auditors report, taken from
the company s 1999 financial statements, is included in Exhibit 5-3.


Are Auditors Independent?
Auditors are hired by management to make sure that the financial statements prepared by man-
agement fairly represent the financial performance of the company. Since management is pay-
ing the auditors, is there a danger that the auditors may not be independent? Is there a pos-
sibility that auditors will go along with whatever management says because management is
paying them? That possibility exists, but there are a number of factors that work as a coun-
terbalance.
First, recall from our discussion of the internal control structure that the Foreign Corrupt
Practices Act requires companies to maintain an adequate system of internal controls. If man-
agement knowingly violate this law, they can go to jail (a number of top managers have) and
would be subject to personal fines. In addition, the company is subject to corporate fines. Thus,
management would be taking a big risk if they interfere with the auditors.



Phar-Mor s 1999 Independent Auditors Report
exhibit 5-3


INDEPENDENT AUDITORS REPORT

To the Board of Directors and Stockholders of Phar-Mor, Inc.:
We have audited the accompanying consolidated balance sheets of Phar-Mor, Inc. and
subsidiaries (the Company ) as of July 3, 1999 and June 27, 1998, and the related
consolidated statements of operations, changes in stockholders equity and cash flows for
the fifty-three weeks ended July 3, 1999, the fifty-two weeks ended June 27, 1998 and the
fifty-two weeks ended June 28, 1997. Our audits also included consolidated financial
statement Schedule II, Valuation and Qualifying Accounts. These financial statements and
financial statement schedules are the responsibility of the Company s management. Our
responsibility is to express an opinion on these financial statements and financial
statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a reasonable
basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Phar-Mor, Inc. and subsidiaries as of July
3, 1999 and June 27, 1998 and the results of its operations and its cash flows for the fifty-
three weeks ended July 3, 1999, the fifty-two weeks ended June 27, 1998 and the fifty-two
weeks ended June 28, 1997, in conformity with generally accepted accounting principles.
In our opinion, the financial statement schedules, when considered in relation to the
basic consolidated financial statements taken as a whole, present fairly in all material
respects the information set forth therein.


Deloitte & Touche LLP
Pittsburgh, Pennsylvania
September 17, 1999
220 f221
Ensuring The Integrity Of Financial Information Ensuring the Integrity of Financial Information Chapter 5


Second, external auditors have a responsibility to financial statement users to ensure that fi-
nancial statements are fairly presented. The legal system in the United States provides auditors
with financial incentives to remain independent. As an example, the auditors in the Phar-Mor
case were sued by plaintiffs for over $1 billion. A jury held the audit firm liable, and that firm
settled with the plaintiffs for a lesser, though undisclosed (but not insignificant), amount. Thus,
external auditors are taking a big risk if they allow their independence and integrity to be com-
promised.
Third, auditors have a reputation to protect. The reason auditors are hired at all is because
the investing public believes they provide an independent check on the reliability and integrity
of the financial information. If an audit firm were no longer perceived in this manner, compa-
nies would cease to employ it. CPA firms obtain audit clients based on the quality of their rep-
utation. Would they sell that reputation to the highest bidder? That would be very shortsighted
indeed.
Knowing the incentives that influence auditors to provide fair and reliable financial in-
formation, we can now begin to see how the issues relating to disagreements in judgment
can work themselves out. On the one hand, we have a management team that has an in-
centive to provide financial statement information that portrays the company in the most fa-
vorable position possible. On the other hand, we have auditors who are responsible to en-
sure that the information being provided is unbiased and fair. If auditors don t live up to
their charge, they can end up paying to litigants much more than they ever received in au-
dit fees.
fyi
The Securities and Exchange Commission (SEC) is working with public accounting
This give and take between the firms to ensure that independence remains a keystone of the auditing profession. To that
end, in a speech given at the New York University Center for Business and Law on May
auditors and management typ-
10, 2000, SEC chairman Arthur Levitt discussed the issue of independence and outlined
ically results in financial state-
the SEC s plan for safeguarding the independence of the auditing profession. That plan
ments that fairly reflect the fi-
includes (1) enhancing the role of the Public Oversight Board, an entity charged with
nancial performance of a
oversight of the profession; (2) working with the Independence Standards Board to mod-
business. For example, in 1998,
ernize investment rules that affect public accounting; and (3) developing initiatives to deal
of 7,016 audits conducted for
with conflicts that might arise because of the ever-expanding menu of services offered by
firms listed on the New York,
public accounting firms.
American, and NASDAQ stock
If management is allowed to paint an overly optimistic picture of the firm s perfor-
exchanges, only eight involved
mance by using estimates that bias the financial reports, the audit firm will pay (via liti-
significant issues on which au- gation) if those estimates prove to be materially wrong in the future. To protect itself, the
ditors and management could audit firm would actually prefer that management use conservative estimates, but man-
not reach agreement on disclo- agement will not always go along with the auditors in this regard. It is this tension, re-
sulting from differing incentives, that provides financial statement users with information
sure.
that, taken as a whole, fairly represents the financial performance of a business.




to summarize
Auditors provide a check and balance to ensure that the financial statements
fairly reflect the financial performance of a business. Most large organizations
have internal auditors whose role it is to ensure integrity in the financial records
and to evaluate and encourage adherence to the organization s internal con-
trols. Internal auditors are a very effective deterrent to fraud by employees and
to the overriding of controls by management. Integrity in the financial report-
ing process is ensured with independent audits of financial statements by ex-
ternal certified public accountants. Such independent financial statement au-
dits are required for all public companies, and often by creditors and other
users. While audits can t guarantee accuracy in the financial statements, they
do add credibility.
221
f222 Part 1 Ensuring The Integrity Of Financial Information
Financial Reporting and the Accounting Cycle



5 THE SECURITIES AND EXCHANGE COMMISSION
Explain the role of the
In addition to the role of independent internal and external auditors, the U.S. government plays
Securities and Exchange
Commission in adding a role in ensuring the integrity of financial information. The Securities and Exchange Com-
credibility to financial
mission (SEC) is responsible for ensuring that investors, creditors, and other financial statement
statements.
users are provided with reliable information upon which to make investment decisions.
The SEC is an agency of the federal government.6 The SEC was organized in the 1930s
Securities and Exchange
Commission (SEC) The gov- because of financial reporting and stock market abuses. One such abuse was price manipulation.
ernment body responsible
It was not uncommon in the 1920s for stockbrokers or dealers to indulge in wash sales or
for regulating the financial
matched orders, in which successive buy and sell orders created a false impression of stock ac-
reporting practices of most
tivity and forced prices up. This maneuver allowed those involved to reap huge profits before
publicly owned corpora-
tions in connection with the the price fell back to its true market level. Outright deceit by issuing false and misleading fi-
buying and selling of stocks nancial statements was another improper practice. The objective of these manipulative proce-
and bonds.
dures was to make profits at the expense of unwary investors.
One classic example of a major fraud that may have contributed to the formation of the
SEC is the Ivar Kreugar case. During the 1920s, the most widely held securities in the United
States, and perhaps the world, were the stocks and bonds of KREUGAR & TOLL, INC., a
Swedish match company. These securities were popular because they paid high dividends (over
20% annually) and were sold in small denominations, making them attractive to both large and
small investors. Ivar Kreugar, known as the Match King, became wealthy and famous
fyi as a financial genius, building his business into a multibillion-dollar international enter-
prise. In fact, Kreugar defrauded millions of investors by personally creating false and mis-
The first chairman of the SEC
leading financial statements. Instead of being paid out of profits, the dividends were paid
was Joseph P. Kennedy, father
out of capital that was raised by selling securities to unsuspecting investors. Eventually,
of the late President John F.
the giant pyramid collapsed, Kreugar committed suicide, and Kreugar & Toll, Inc., went
Kennedy.
bankrupt. On the day Kreugar died, his company s stock was selling for $5 a share. Within
weeks, it was selling for five cents a share. The American public was outraged, and some
have speculated that this major fraud was instrumental in causing Congress to enact securities
legislation to prevent such deception from happening again.
The Securities Act of 1933 requires most companies planning to issue new debt or stock
securities to the public to submit a registration statement to the SEC for approval. The SEC ex-
amines these statements for completeness and adequacy before permitting companies to sell se-
curities through securities exchanges. The Securities Exchange Act of 1934 requires all public
companies to file detailed periodic reports with the SEC.
The SEC requires a considerable amount of information to be included in these filings.
Among other things, a company must submit financial statements that have been audited by
CPAs and that contain an opinion issued by those CPAs.
Of the many reports required by the SEC, the following have the most direct impact on fi-
nancial reporting:
Registration statements. These include various forms that must be filed and approved before
a company can sell securities through the securities exchanges.
Form 10-K. This report must be filed annually within 90 days after the close of each fiscal
year. The report contains extensive financial information, including audited financial state-
ments by independent CPAs. The 10-K also requires additional disclosure beyond that typ-
ically provided in the audited financial statements. Examples of additional information in-
clude the executive compensation of top management and the details of property, plant,
and equipment transactions.
Form 10-Q. This report must be filed quarterly for all publicly held companies. It contains
certain financial information and requires a CPA s involvement.
Because the SEC has statutory power to mandate any reporting requirement it feels is needed,
it has considerable influence in setting generally accepted accounting principles and disclosure

6 Most of the information on the SEC was taken from K. Fred Skousen, An Introduction to the SEC, 5th ed.,
South-Western Publishing Co., 1991, pp. 3 6.
222 f223
Ensuring The Integrity Of Financial Information the Integrity of Financial Information EOC Chapter 5
Ensuring


requirements for financial statements. Generally, the SEC accepts the accounting pronounce-
ments of the Financial Accounting Standards Board and other bodies such as the AICPA. In
addition, the SEC has the power to establish rules for any CPA associated with audited finan-
cial statements submitted to the commission.
The SEC is given broad enforcement powers under the 1934 Act. If the rules of operation
for stock exchanges prove to be ineffectual in implementing the requirements of the SEC, the
SEC can alter or supplement them. The SEC can suspend trading of a company s stock for not
more than 10 days (a series of orders has enabled the SEC to suspend trading for extended pe-
riods, however) and can suspend all trading on any exchange for up to 90 days. If substantive
hearings show that the issuer failed to comply with the requirements of the securities laws, the
SEC can de-list any security. Brokers and dealers can be prevented, either temporarily or per-
manently, from working in the securities market, and investigations can be initiated, if deemed
necessary, to determine violations of any of the Acts or rules administered by the SEC.

The Effect of the 1934 Act on Independent Accountants
Accountants are involved in the preparation and review of a major portion of the reports and
statements required by the 1934 Act. Accountants also can be censured, and their work is sub-
ject to approval by the SEC. The financial statements in the annual report to stockholders and
in the 10-K report must be audited. In addition, accountants consult and assist in the prepara-
tion of the quarterly 10-Q reports and the other periodic reports.
More recently, the SEC under Chairman Arthur Levitt has initiated a major push to re-
duce the manipulation of reported earnings by a company s management. In a speech given on
September 28, 1998, Mr. Levitt identified several techniques of what he called Accounting Ho-
cus Pocus. The SEC s objective is to prevent the manipulation of earnings and reduce fraudu-
lent financial reporting by limiting the flexibility with which management is currently inter-
preting certain auditing and accounting standards.



to summarize
The Securities and Exchange Commission is an agency of the federal govern-
ment whose purpose is to assist investors in public companies by regulating
stock and bond markets and by requiring certain disclosures. Although the SEC
has statutory authority to establish accounting principles, it basically accepts
pronouncements of the FASB and AICPA as authoritative. Common reports re-
quired by the SEC are registration statements and Forms 10-K and 10-Q. Be-
cause the SEC can suspend trading and even de-list securities, it is a powerful
organization that significantly influences financial reporting in the United
States.




review of learning objectives

Identify the types of problems that can appear in fi- (2) Disagreements in judgment occur because of the differing
1 nancial statements. Three types of problems can affect incentives of those associated with the financial statements.
financial statements: (1) Errors involve unintentional mistakes While management may have an incentive to present an op-
that can enter the accounting system at the transaction and timistic view of the company s performance, auditors have an
journal entry stage or when journal entries are posted to ac- incentive to ensure full disclosure of all relevant issues. These
counts. These errors, when detected, are immediately fixed. differing incentives typically result in financial statements that
223
f224 Ensuring The Integrity Of Financial Information
Part 1 EOC Financial Reporting and the Accounting Cycle



Describe the role of auditors and how their presence
fairly reflect the financial performance of the company. (3)
4 affects the integrity of financial statements. Most large
Fraudulent financial reporting involves intentional misrepre-
organizations have internal auditors who are independent in-
sentations in the financial statements. Safeguards are built into
ternal control experts. They examine the various functions and
the accounting and reporting system to minimize the possi-
divisions of the business to evaluate internal controls, operat-
bility that these problems will be reflected in the financial
ing efficiency and effectiveness, and compliance with laws and
statements.
company policy. Internal auditors usually report to top man-
agement or the board of directors and increase the reliability
Describe the safeguards employed within a firm to
2 of financial statements by ensuring that internal controls func-
ensure that financial statements are free from prob-
tion as they should.
lems. Internal controls are safeguards built into an organiza-
External audits are required of most public companies by
tion that help to protect assets and increase reliability of the
the Securities and Exchange Commission. By conducting au-
accounting records. The three basic internal control structure
dits of financial statements according to generally accepted au-
categories are (1) the control environment, (2) the accounting
diting standards put into effect by the AICPA, external audits
systems, and (3) the control procedures. The five types of con-
provide reasonable assurance that financial statements are
trol procedures are (1) segregation of duties, (2) procedures for
presented fairly and are not materially misstated. External au-
authorizations, (3) documents and records, (4) physical safe-
dits must be performed by CPAs who are licensed by the in-
guards, and (5) independent checks. The control environment
dividual states in which they practice.
is comprised of such things as management s philosophy and
operating style, the organizational structure, and the audit
Explain the role of the Securities and Exchange Com-
committee.
5 mission in adding credibility to financial statements.
The SEC is the agency of the federal government charged with
Understand the need for monitoring by independent
3 the responsibility of assisting investors by making sure they are
parties. Because management has an incentive to por-
provided with reliable information upon which to make in-
tray the performance of the firm as positively as possible, there
vestment decisions. The SEC was organized in the 1930s and
may be a tendency to be overly optimistic when it comes to
requires certain periodic reports such as the Forms 10-Q and
making estimates and assessments regarding future events. As
10-K of companies that sell stock publicly in the United States.
a result, there is a need for someone to independently evalu-
It adds credibility to financial statements by requiring inde-
ate the projections made by management to ensure that those
pendent audits, reviewing financial statements itself, and sanc-
projections, taken as a whole, result in financial statements that
tioning firms that violate its standards.
fairly reflect the financial performance of the business.




key terms and concepts

accounting system 211 generally accepted auditing organizational structure 210
standards (GAAS) 218
audit committee 211 physical safeguards 213
independent checks 214
control activities (procedures) 212 Securities and Exchange
internal auditors 218 Commission (SEC) 222
control environment 210
internal control structure 209 segregation of duties 212
external auditors 218
Foreign Corrupt Practices Act
(FCPA) 209




discussion questions

1. How can a person tell whether an entry to an expense 2. How would it be possible to overstate revenues? What
account is payment for a legitimate expenditure or a effect would an overstatement of revenues have on total
means of concealing a theft of cash? assets?
224 f225
Ensuring The Integrity Of Financial Information the Integrity of Financial Information EOC Chapter 5
Ensuring



3. What is the Foreign Corrupt Practices Act, and how is being paid by that company, can be truly indepen-
it important to financial reporting? dent?
4. What are the major elements of a system of internal 9. The SEC requires companies to register with it when
controls? they sell stocks or bonds and also requires periodic re-
5. Identify five different types of control procedures. porting thereafter. Which of these reports, the initial
6. How do internal auditors add to the credibility of fi- registration statements or the subsequent periodic re-
nancial statements? ports, do you believe would be scrutinized more closely
7. What is the purpose of a financial statement audit by by the SEC?
CPAs? 10. What do you suspect is the relationship between the
8. Do you believe that outside auditors (CPAs) who ex- FASB and the SEC?
amine the financial statements of a company, while




discussion cases

CASE 5-1 AUDITING A COMPANY
Jerry Stillwell, the owner of a small company, asked Jones, a CPA, to conduct an audit of the
company s financial statements. Stillwell told Jones that the audit needed to be completed in
time to submit audited financial statements to a bank as part of a loan application. Jones im-
mediately accepted the assignment and agreed to provide an auditor s report within two weeks.
Because Jones was busy, he hired two accounting students to perform the audit. After two
hours of instruction, he sent them off to conduct the audit. Jones told the students not to spend
time reviewing the internal controls, but instead to concentrate on proving the mathematical ac-
curacy of the ledgers and other financial records.
The students followed Jones s instructions, and after 10 days, they provided the financial
statements, which did not include notes. Jones reviewed the statements and prepared an audi-
tor s report. The report did not refer to generally accepted accounting principles and contained
no mention of any qualifications or disclosures. Briefly describe the problems with this audit.

CASE 5-2 AUDITING PRACTICE
A few years ago, the owners of an electronics wholesale company committed massive fraud by over-
stating revenues on the financial statements. They recorded three large fictitious sales near the end
of the year to the retailers SILO, CIRCUIT CITY, and WAL-MART. The three transactions over-
stated revenues, receivables, and income by nearly $20 million. As part of the audit procedures, the
external auditors sent requests for confirmation to the three stores to ensure that they did, in fact,
owe the electronics company $20 million. In the meantime, the owners of the electronics company
rented mailboxes in the cities where the three customers were headquartered, using names very
similar to those of the three customers. The requests for confirmation were sent to the mailboxes.
The owners completed the confirmations and sent them back to the auditors, confirming the $20
million in receivables. With respect to the fraud, answer the following two questions:
1. What journal entries would the fraud perpetrators have entered into the financial records
to overstate revenues?
2. Should the external auditors be held liable for not catching the fraud?




exercises

EXERCISE 5-1 ACCOUNTING ERRORS TRANSACTION ERRORS
How would the following errors affect the account balances and the basic accounting equa-
tion, Assets Liabilities Owners Equity? How do the misstatements affect income?
225
f226 Ensuring The Integrity Of Financial Information
Part 1 EOC Financial Reporting and the Accounting Cycle


a. The purchase of a truck is recorded as an expense instead of an asset.
b. A cash payment on accounts receivable is received but not recorded.
c. Fictitious sales on account are recorded.
d. A clerk misreads a handwritten invoice for repairs and records it as $1,500 instead of
$1,800.
e. Payment is received on December 31 for the next three months rent and is recorded as
revenue.

EXERCISE 5-2 ERRORS IN FINANCIAL STATEMENTS
The following financial statements are available for SHERWOOD REAL ESTATE
COMPANY:

Balance Sheet

Assets Liabilities
Cash. . . . . . . . . . . . . . . . $00,001,300 Accounts payable . . . . . . . . . $0,100,000
Receivable from sale Mortgage payable . . . . . . . . . 6,000,000
of real estate . . . . . . . . 5,000,000 Total liabilities. . . . . . . . . . . . $ 6,100,000
Interest receivable* . . . . 180,000
Real estate properties. . . 6,000,000 Stockholders Equity
Capital stock . . . . . . . . . . . . . $0,010,000
Retained earnings . . . . . . . . . 5,071,300
Total stockholders equity . . . 5,081,300
Total liabilities and stock-
Total assets . . . . . . . . . . $11,181,300 holders equity . . . . . . . . . . $11,181,300

*Interest Receivable applies to Receivable from sale of real estate.




Income Statement

Gain on sale of real estate . . . . . . . . . . . . $3,200,000
Interest income* . . . . . . . . . . . . . . . . . . . . 180,000
Total revenues . . . . . . . . . . . . . . . . . . . . . $3,380,000
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . $2,180,000

*Interest Income applies to Receivable from sale of real estate.


Sherwood Company is using these financial statements to entice investors to buy stock in the
company. However, a recent FBI investigation revealed that the sale of real estate was a fabri-
cated transaction with a fictitious company that was recorded to make the financial statements
look better. The sales price was $5,000,000 with a zero cash down payment and a $5,000,000
receivable. Prepare financial statements for Sherwood Company showing what its total assets,
liabilities, stockholders equity, and income really are with the sale of real estate removed.

EXERCISE 5-3 APPROPRIATENESS OF ACCOUNTING RULES
In the early 1990s, the top executive of a large oil refining company (based in New York) was
convicted of financial statement fraud. One of the issues in the case involved the way the
company accounted for its oil inventories. In particular, the company would purchase crude
oil from exploration companies and then process the oil into finished oil products, such as jet
fuel, diesel fuel, and so forth. Because there was a ready market for these finished products, as
soon as the company purchased the crude oil, it would value its oil inventory at the selling
prices of the finished products less the cost to refine the oil. Although the case involved fraud,
the type of accounting used was also questioned because it allowed the company to recognize
profit before the actual sale (and even refining) of the oil. Nevertheless, one of the large CPA
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firms attested to the use of this method. If you were the judge in this case, would you be crit-
ical of this accounting practice?

INTERNAL CONTROL PROCEDURES
EXERCISE 5-4
As an auditor, you have discovered the following problems with the accounting system con-
trol procedures of Jefferson Retailers. For each of the following occurrences, tell which of the
five internal control procedures was lacking. Also, recommend how the company should
change its procedures to avoid the problem in the future.
a. Jefferson Retailers losses due to bad debts have increased dramatically over the past year.
In an effort to increase sales, the managers of certain stores have allowed large credit sales
to occur without review or approval.
b. An accountant hid his theft of $200 from the company s bank account by changing the
monthly reconciliation. He knew the manipulation would not be discovered.
c. Steve Meyer works in the storeroom. He maintains the inventory records, counts the in-
ventory, and has unlimited access to the storeroom. He occasionally steals items of inven-
tory and hides the theft by including the value of the stolen goods in his inventory
count.
d. Receiving reports are sometimes filled out days after shipments have arrived.

EXERCISE 5-5 INTERNAL AUDITING STAFFING INTERNAL AUDITS
A manufacturing corporation recently reassigned one of its accounting managers to the inter-
nal audit department. He had successfully directed the western-area accounting office, and the
corporation thought his skills would be valuable to the internal audit department. The direc-
tor of the internal audit division knew of this individual s experience in the western-area ac-
counting office and assigned him to audit that same office.
Should the internal auditor be assigned to audit the same office in which he recently
worked? What problems could arise in this situation?

EXERCISE 5-6 INTERNAL AUDITING
Which of the following is not applicable to the internal audit function?
a. Deter or catch employee fraud.
b. Issue an opinion for investors regarding the reliability of the financial statements.
c. Be guided by its own set of professional standards.
d. Help to ensure that the accounting function is performed correctly and that the financial
statements are prepared accurately.

EXERCISE 5-7 INTERNAL AUDITING EXTERNAL AUDITOR S RELIANCE ON
INTERNAL AUDITORS
North, CPA, is planning an audit of the financial statements of General Company. In deter-
mining the nature, timing, and extent of the auditing procedures, North is considering Gen-
eral s internal audit function, which is staffed by Tyler.
1. In what ways may Tyler s work be relevant to North?
2. What factors should North consider and what inquiries should North make in deciding
whether to rely on Tyler s work?

EXERCISE 5-8 ENSURING THE INTEGRITY OF FINANCIAL REPORTING
Three college seniors with majors in accounting are discussing alternative career plans. All
three want to enter careers that will help to ensure the integrity of financial reporting. The
first wants to become an internal auditor. She believes that by ensuring appropriate internal
controls within a company, the financial statements will be reliable. The second wants to go
to work in public accounting and perform external audits of companies. He believes that ex-
ternal auditors are independent and can make sure that financial statements are correct. The
third student believes that neither choice will be adding much value to the integrity of finan-
cial statements because, in both cases, the auditors will be receiving their pay (either directly
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Part 1 EOC Financial Reporting and the Accounting Cycle


or indirectly) from the companies they audit. He believes the only way to make a real differ-
ence is to work for the Securities and Exchange Commission, using the arm of government
regulation to force companies to issue appropriate financial statements and then punishing
them (through jail sentences and large fines) when their financial statements are misleading.
In your opinion, which of these three students will make the largest contribution toward en-
suring integrity in the financial statements?

EXERCISE 5-9 EXTERNAL AUDITORS PURPOSE OF AN AUDIT
What is the purpose of external auditors providing an opinion on a company s financial state-
ments?

EXERCISE 5-10 AUDITING FINANCIAL STATEMENTS
The Utah Lakers professional basketball team has recently decided to sell stock and become a
public company. In determining what it must do to file a registration statement with the
SEC, the company realizes that it needs to have an audit opinion to accompany its financial
statements. The company has recently approached two accounting students at a major univer-
sity and asked them to audit its financial statements to be submitted to the SEC. Should
the two accounting students accept the work and perform the audit?

EXERCISE 5-11 SECURITIES AND EXCHANGE COMMISSION AUTHORITY TO
SET ACCOUNTING STANDARDS
Which organization the Securities and Exchange Commission, the American Institute of
Certified Public Accountants, or the Financial Accounting Standards Board has federal gov-
ernment authority to set accounting standards and reporting requirements? Some people have
argued that all accounting rule making should be done by the federal government. Do you
agree? Why or why not?

EXERCISE 5-12 SECURITIES AND EXCHANGE COMMISSION ROLE OF THE SEC
Describe the role of the Securities and Exchange Commission and its influence on the prac-
tice of auditing.

EXERCISE 5-13 SECURITIES AND EXCHANGE COMMISSION INFORMATION
NEEDED FOR INVESTING
As an investor you are considering buying stock in a relatively new company. American Ship-
ping, Ltd., has been in existence for 10 years and is now about to go public. The first stock
offering will be listed on the New York Stock Exchange next week.
1. What kind of information would you like to know before investing in the company?
Where can you find this information?
2. How does the SEC protect the securities market from companies that are fraudulent or
in poor financial condition?
3. Besides stock market investors, what other parties might be interested in knowing finan-
cial data about companies?

EXERCISE 5-14 AUDITING NEGLIGENCE
A few years ago, the officers of PHAR-MOR, a discount retail chain, were convicted of issu-
ing fraudulent financial statements. It was learned at the trial that the company overstated its
inventory by moving inventory from store to store and counting the same inventory several
times. For example, a case of Coca-Cola would be counted at one store and then moved to
another store and counted again. In a separate civil trial, Phar-Mor s auditors were accused of
performing negligent audits because they didn t catch these inventory movements. Do you be-
lieve that the external auditors were negligent in this case?

EXERCISE 5-15 SECURITIES AND EXCHANGE COMMISSION
Many people have argued that the purpose of the SEC is to protect investors. Some believe
that the best way to do this is by preventing weak companies from issuing stock. Others say
that the SEC should require full disclosure and then let the buyer beware. Which do you
think is more appropriate: a preventive role or a disclosure role?
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competency enhancement opportunities




LLL
LLLL




Analyzing Real Company Information The Debate
International Case Cumulative Spreadsheet Project
Ethics Case Internet Search
Writing Assignment




The following additional assignments provide opportunities for students to de-
velop critical thinking, ethical perspectives, oral and written communication
skills, experience with electronic research, and teamwork through group and
business activities.
LL




ANALYZING REAL COMPANY INFORMATION
Analyzing 5-1 (Microsoft)
The 1999 annual report for MICROSOFT is included in Appendix A. Locate that
annual report and consider the following questions:
1. With respect to the report of the external auditors to the Board of Direc-
tors and Stockholders of Microsoft Corporation :
a. Who is Microsoft s external auditor?
b. How long after the end of Microsoft s fiscal year did the external audi-
tor complete the audit?
2. With respect to the report of management concerning the financial state-
ments:
a. Who is responsible for the financial statements?
b. After reading the paragraph on internal control, indicate whether you
agree or disagree with the following statement: The purpose of an in-
ternal control system is to ensure that all transactions are always
recorded and that all assets are always completely safeguarded.
c. After looking at the description of the members of the audit commit-
tee, do you think that Bill Gates is a member of that committee?
Analyzing 5-2 (Circle K)
At one time, CIRCLE K was the second-largest convenience store chain in the
United States (behind 7-ELEVEN). At its peak, Circle K, based in Phoenix, Ari-
zona, operated 4,685 stores in 32 states. Circle K s rapid expansion was financed
through long-term borrowing. Interest on this large debt, combined with in-
creased price competition from convenience stores operated by oil companies,
squeezed the profits of Circle K. For the fiscal year ended April 30, 1990, Cir-
cle K reported a loss of $773 million. In May 1990, Circle K filed for Chapter 11
L




bankruptcy protection. Subsequently, Circle K was taken over by TOSCO, a
large independent oil company.
1. In the fiscal year ended April 30, 1989, Circle K experienced significant fi-
nancial difficulty. Reported profits were down 74.5% from the year before.
In the president s letter to the shareholders, Circle K explained that 1989
was a disappointing year and that management was seeking some out-
side company to come in and buy out the Circle K shareholders. How do
you think all this bad news was reflected in the auditor s report accompa-
nying the financial statements dated April 30, 1989?
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Part 1 CEO Financial Reporting and the Accounting Cycle




2. As mentioned, Circle K reported a loss of $773 million for the year ended
April 30, 1990. Just a week after the end of the fiscal year, the CEO was
fired. One week after that, Circle K declared bankruptcy. The audit report
was completed approximately two months later. How do you think the news
of the bankruptcy was reflected in the auditor s report accompanying the
financial statements dated April 30, 1990?
L

INTERNATIONAL CASE

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