Fraud in Financial Statements and Auditor ResponsibilitiesChap.docx

Fraud in Financial Statements and Auditor Responsibilities
Chapter 05
© 2023 McGraw Hill, LLC. All rights reserved. Authorized only
for instructor use in the classroom. No reproduction or further
distribution permitted without the prior written consent of
McGraw Hill, LLC.
Because learning changes everything.®
Learning Objectives
L O 5-1: Distinguish between audit requirements for errors,
fraud, and illegal acts.
L O 5-2: Explain the components of the Fraud Triangle and how
they are integrated into A U-C 240.
L O 5-3: Describe fraud risk assessment procedures and red
flags which might indicate that an individual may be
committing fraud, or susceptible to it.
L O 5-4: Describe the responsibilities of the External Auditor,
Board of Directors, and Company Management in regard to
internal controls over financial reporting (I C F R).
L O 5-5: Explain the standards for audit reports.
2
© McGraw Hill, LLC
2

Ethics Insight
The P C A O B has expressed significant concern over audit
quality.
Audit Quality relies on Integrity, Objectivity, Professional
Skepticism, Due Care and Independence.
Concerns found in:
Auditing of internal control over financial reporting.
Assessing and responding to risks of material misstatements.
Performing audit sampling procedures.
Auditing of estimates.
Auditing fair value measurements and disclosures.
3
© McGraw Hill, LLC
P C A O B Recommendations for
AuditorsRecommendationDescriptionResultInteractive
meetings/coaching workshopsEngagement Team, often tied to
audit milestonesIdentifying how financials might be materially
misstated
Identifying risks of material misstatementEarly involvement of
engagement quality reviewer (E Q R)From audit planning stage
forwardMay result in in early identification of potential or
actual audit challengesNarrative descriptions of quality
controlFirms created narratives of their quality control process
or prepared process flow maps of themUsed to monitor
engagement performance and enhance the audit
effectivenessIncreased partner involvement in planning of audit
tests and controlsEngagement team leadership held planning
meetings with whole engagement team Discussions and robust
risk assessment procedures improve staff ability to analyze
effectiveness of controlsUse of firm specialists during audit
planning to assist in risk assessmentEarly involvement of
specialists during audit planning stageEnhances the ability of
auditors to more effectively identify and assess risks of material

misstatementImplementing coaching programs and refining
audit tools for specific audit areasTargeting areas where the
firms have had audit deficiencies in the pastNoted improvement
in the auditing of estimates at firms that implemented these
programs
4
© McGraw Hill, LLC
Chapter Roadmap
Consider the following questions as you read the chapter
What are the auditor’s responsibilities to assess the risks of
material misstatement of the financial statements, whether due
to error or fraud?
What is the fraud triangle and how does it help to identify red
flags that are indicators fraud may exist?
What are the most common causes of financial statement fraud
and how can internal controls over financial reporting and the
audit firms’ quality controls keep them in check?
What information is communicated by the audit report?
5
© McGraw Hill, LLC
Learning Objective 1
Distinguish between audit requirements for errors, fraud, and
illegal acts.
6
© McGraw Hill, LLC
Fraud in Financial Statements
The primary responsibility for the prevention and detection of

fraud rests with both those charged with governance of the
entity and management.
An auditor conducting an audit in accordance with generally
accepted auditing standards is responsible for obtaining
reasonable assurance that the financial statements as a whole
are free from material misstatements, whether by fraud or error.
An unavoidable risk exists that some material misstatements of
the financial statements may not be detected, even though the
audit was conducted in accordance with G A A S.
When the financial statements are materially misstated, the
auditor should not give an unmodified or unqualified opinion
but should modify the opinion as either qualified or adverse
opinion.
7
© McGraw Hill, LLC
Fraudulent Financial Reporting
Involves either intentional misstatements or omissions of
amounts or disclosures in order to deceive financial statement
users.
Deception – manipulation, falsification or alteration of
accounting records or supporting documents.
Misrepresentation in, or intentional omission from, events,
transactions, or other significant information.
Intentional misapplication of accounting principles.
8
© McGraw Hill, LLC
Nature and Causes of Misstatements
Deception such as manipulation, falsification, or altering of
accounting records.
Misrepresentation of a financial statement disclosure that is not

presented in conformity with G A A P or is intentionally
omitted.
Intentional misapplication of accounting principles relating to
measurement, recognition, classification, presentation or
disclosure.
9
© McGraw Hill, LLC
Error, Fraud, and Illegal Acts
Error
Unintentional mistakes in math, application of G A A P, or
omission of information.
Fraud
Deliberate decision made to deceive others through.
Fraudulent financial reporting.
Misappropriation of assets.
Illegal Acts
Violations of laws or regulations.
Bribery.
10
© McGraw Hill, LLC
Exhibit 5.1 Auditors Responsibility to Detect Errors, Illegal
Acts and FraudResponsible for Detection for
MaterialResponsible for Detection for ImmaterialRequired to
Communicate Findings for MaterialRequired to Communicate
Findings for ImmaterialErrorsYesNoYes (audit
committee)NoIllegal actsYes (direct effect)NoYes (audit
committee)Yes (one level above)FraudYesNoYes (audit
committee)Yes (by low-level employee, to one level above) (by
management-level employee, to audit committee)
11

© McGraw Hill, LLC
Private Securities Litigation Reform Act (P S L R A)
Additional requirements upon public companies and their
auditors when:
The illegal act has a material effect on financial statements.
Senior management and the board have not taken appropriate
remedial action.
Failure to take remedial action may warrant departure from a
standard audit report (or resignation of auditors).
When illegal act has material effect on the financial statements.
Auditors must report act to the client.
Client must inform Board of Directors which has one day to
inform the S E C.
If client does not inform the S E C.
Auditors must furnish the report to the S E C within one day.
Or resign from the engagement within one day.
Ethical obligation of confidentiality is waived.
12
© McGraw Hill, LLC
Explain the components of the Fraud Triangle and how they are
integrated into A U-C 240.
13
© McGraw Hill, LLC
Questions for Consideration
What is the fraud triangle and how does it identify red flag
indicators of fraud?

What are the auditor’s responsibilities to detect and report
fraud?
What is the role of internal controls and risk assessment in
preventing and detecting fraud?
What information is communicated by the audit report?
14
© McGraw Hill, LLC
The Fraud Triangle 1
Integrated into A U-C Section 240: Consideration for Fraud in a
Financial Statement Audit.
Three conditions are generally present when fraud occurs:
Incentives/Pressures to Commit Fraud.
Opportunity.
Rationalization/Justification.
15
© McGraw Hill, LLC
Exhibit 5-2
16
© McGraw Hill, LLC
Incentives/Pressures to Commit Fraud.
Financial stability or profitability is threatened.
Excessive pressure for management to meet the requirements or
expectations of third parties.
Self-serving incentives such as bonuses or promotion.

Personal financial situation of management or those charged
with governance is threatened by the entity’s financial
performance.
17
© McGraw Hill, LLC
Financial Stability or Profitability is Threatened by Economic,
Industry, or Entity Operating Conditions
Potential Red Flags to Look for:
High degree of competition or market saturation, accompanied
by declining margins.
High vulnerability to rapid changes, such as changes in
technology, product obsolescence, or interest rates.
Significant declines in customer demand and increasing
business failures in either the industry or overall economy.
Operating losses suggesting going concern issues.
Recurring negative cash flows from operations while reporting
earnings growth.
Rapid growth or unusual profitability, especially compared to
that of other companies in the same industry.
18
© McGraw Hill, LLC
Excessive Pressure for Management to Meet the Requirements
or Expectations of Third Parties
Aggressive or unrealistic profitability or trend level
expectations (whether internally or externally generated).
Need to obtain additional debt or equity financing to stay
competitive.
Challenges meeting exchange listing requirements or debt
repayment/debt covenants.

Perceived or real adverse effects of reporting poor financial
results on significant pending transactions.
Pressure for management to meet the expectations of legislative
or oversight bodies.
19
© McGraw Hill, LLC
Personal Financial Situation of Management or Those Charged
with Governance is Threatened by the Entity’s Financial
Performance
Significant financial interests in the entity.
Significant portions of their compensation (for example,
bonuses, stock options, and earn-out arrangements) tied to
achieving aggressive targets for stock price, operating results,
financial position, or cash flow.
Personal guarantees of debts of the entity.
20
© McGraw Hill, LLC
Opportunities to Commit Fraud
Nature of the industry or entity’s operations.
Significant operations located or conducted across jurisdictional
borders where differing business environments exist.
The monitoring of management is not effective.
The organizational structure is complex or unstable.
Internal control components are deficient.
21
© McGraw Hill, LLC

The Nature of the Industry or the Entity’s Operations
Related party transactions that are also significant unusual
transactions.
Significant transactions with related parties whose financial
statements are not audited or are audited by another firm.
Firms to dictate terms or conditions to suppliers or customers
that may result in inappropriate or non-arm’s-length
transactions.
Assets, liabilities, revenues, or expenses based on significant
estimates that involve subjective judgements or uncertainties.
Significant or highly complex transactions or significant
unusual transactions, especially those close to period end.
22
© McGraw Hill, LLC
Significant Operations Located or Conducted Across
Jurisdictional Borders Where Differing Business Environments
and Regulations Exist
Use of business intermediaries for which there appears to be no
clear business justification.
Significant bank account or subsidiary or branch operations in
tax-haven jurisdictions.
Contractual arrangements lacking a business purpose.
23
© McGraw Hill, LLC
The Monitoring of Management is Not Effective
Domination of management by a single person or small group.

Oversight by those charged with governance over the financial
reporting process and internal control.
The exertion of dominant influence by or over a related party.
24
© McGraw Hill, LLC
The Organizational Structure is Complex or Unstable
Difficulty in determining the organization or individuals that
have controlling interest in the entity.
Overly complex organizational structure involving unusual legal
entities or managerial lines of authority.
High turnover of senior management, legal counsel, or those
charged with governance.
25
© McGraw Hill, LLC
Internal Control Components are Deficient
Inadequate monitoring of controls.
High turnover rates or employment of staff in accounting, I T,
or internal audit.
Accounting and information systems that are not effective
Material Internal Control Weaknesses.
26
© McGraw Hill, LLC
Rationalizations/Attitudes to Justify Fraud.
Poor Tone at the Top.

Management Interest in Accounting.
A Strained Relationship between management and the current or
predecessor Auditor.
27
© McGraw Hill, LLC
Poor Tone at the Top
Poor communication, implementation, support, or enforcement
of the entity's values or ethical standards by management.
Communication of inappropriate values Ineffective ethical
standards.
Known history/claims of violations of securities or other laws
or regulations.
Low morale among senior management.
The owner-manager makes no distinction between personal and
business transactions.
Dispute between shareholders in a closely held entity.
28
© McGraw Hill, LLC
Management Interest in Accounting
Nonfinancial management's excessive participation
in/preoccupation with the selection of accounting policies or the
determination of estimates.
Excessive interest by management in maintaining or increasing
the entity's stock price or earnings trend.
Commitment to analysts, creditors, and other third parties to
achieve aggressive or unrealistic forecasts.
Management trying to justify marginal or inappropriate
accounting based on materiality.

Management failing to remedy known internal control
deficiencies or material weaknesses.
29
© McGraw Hill, LLC
A Strained Relationship Between Management and the Current
or Predecessor Auditor
Frequent disputes with the current or predecessor auditor.
Unreasonable demands on the auditor regarding the completion
of the audit or issuance of the auditor's report.
Restrictions on the auditor access to people or information.
Management attempting to influence audit scope.
30
© McGraw Hill, LLC
Describe fraud risk assessment procedures and red flags which
might indicate that an individual may be committing fraud, or
susceptible to it.
31
© McGraw Hill, LLC
Fraud Risk Assessment
A U-C240 requires the auditor to evaluate risk assessment
during the audit.
Evaluation of evidence about the potential client before
accepting engagement.
Communication with predecessor auditor.
Reasons for firing or the reasons for no longer servicing client.

Management’s and key accounting personnel’s integrity.
Disagreement with management over accounting principles.
Make inquiries about the risks of fraud and how they are
addressed.
Consider any unusual or unexpected relationships.
Consider whether one or more fraud risk factors exist.
Consider other information.
Approach each engagement with a healthy dose of skepticism.
32
© McGraw Hill, LLC
Assessing Management: Red Flags
Is there a Dark Triad Personality Risk?
Narcissism.
Obsessed with power, prestige and vanity.
Mentally unable to see the damage they cause.
Might drive unethical decisions to seek needed praise.
Machiavellianism.
Calculating and funny.
Use charm, friendliness, self-disclosure and guilt and bullying
to get what they want.
If they want to cook the books, then staff may go along.
Psychopathy.
Exude confidence, impressive and charming.
Often thought of as sociopaths and are controlling, manipulative
and master liars.
Lack empathy and remorse for wrongdoing.
33
© McGraw Hill, LLC
Describe the responsibilities of the External Auditor, Board of

Directors, and Company Management in regard to internal
controls over financial reporting (I C F R).
34
© McGraw Hill, LLC
Internal Control Over Financial Reporting (I C F R)
SOX 404 requires registered accounting firms to assess the
effectiveness of internal controls.
ICFR related deficiencies include:
Testing the design of controls or effectiveness.
Application of the top-down risk-based approach.
Identifying technology risks.
Performing extensive testing of the work done by third parties
in high risk areas.
Evaluating identified control deficiencies.
35
© McGraw Hill, LLC
Internal Controls Over Financial Reporting
The risk that internal controls will not help prevent or detect a
material misstatement is a critical evaluation to provide
reasonable assurance.
Components of internal control under the C O S O framework.
Control environment.
Risk assessment.
Control activities.
Monitoring.
Information and communication.
Attention should be focused on areas of highest risk that a
material weakness could exist in a particular area of the
company’s internal control over financial reporting.
36

© McGraw Hill, LLC
Medicis Pharmaceutical Case
Issued materially misstated financial statements from 2003 to
2007.
E&Y Audit failed to follow P C A O B standards.
Failed to follow G A A S.
Relied on management representations.
Developed alternative accounting methods.
Failed to act on its own A Q R and correct deficiencies.
Issued an unqualified opinion.
P C A O B censured E&Y and imposed $2M in penalties.
37
© McGraw Hill, LLC
Enterprise Risk Management – Integrated Framework
Internal control enhanced with corporate governance and risk
management.
Aligning risk appetite and strategy.
Enhancing risk response decisions.
Reducing operational surprises and losses.
Identifying and managing multiple and cross-enterprise risks.
Seizing opportunities.
Improving deployment of capital.
38
© McGraw Hill, LLC
C O S O Guidance on Monitoring Internal Control Systems
Management should monitor controls to determine whether they
are operating effectively and the need for redesign when risks

change.
Effective monitoring involves.
Establishing a baseline for control effectiveness.
Designing and executing monitoring procedures that are based
on the significance of business risks relative to the entity’s
objectives.
Assessing and reporting results, including follow-up on
corrective actions.
Framework adopts the position that management should
determine its risk appetite and align it with strategic objectives.
E R M seems to place emphasis in the wrong areas by focusing
on risk appetite.
Emphasis needed on the ethical dimensions of making strategic
decisions.
39
© McGraw Hill, LLC
Audit Committee Responsibilities for Fraud Risk Assessment
Audit Committee should.
Evaluate management’s identification of fraud risks.
Implementation of antifraud measures.
Creation of the appropriate tone at the top.
Active oversight by the audit committee can help reinforce
management’s commitment to create a culture with “zero
tolerance” for fraud.
Audit committee’s evaluation and oversight can serve as a
deterrent to senior management engaging in fraudulent activity.
Audit committee should encourage management to provide a
mechanism for employees to report concerns about unethical
behavior, suspected fraud, or violations of ethical codes or
policies.
40

© McGraw Hill, LLC
Auditor’s Communication with Those Charged with Governance
A U-C 240 requires communication by auditors of evidence of
fraud to appropriate level of management, even inconsequential
or minor misappropriation.
Fraud that causes a material misstatement should be reported
directly to those charged with governance.
Good governance principles suggest that.
The auditor has access to the audit committee as necessary.
The chair of the audit committee meet with the auditor
periodically.
The audit committee meets with the auditor without
management at least annually.
Auditors should communicate about accounting estimates.
Nature of significant assumptions/degree of subjectivity/relative
materiality.
Communicate to management/those charged with governance
risks due to fraud that have continuing control implications.
41
© McGraw Hill, LLC
Management Representations and Financial Statement
Certifications
Management responsible for preventing and detecting fraud.
Management can override internal controls and create deceptive
accounting.
Management representation letters from C E O, C F O, and
other appropriate officers (Section 302 of S O X).
Provides access to all known information bearing on fair
presentation of financial statements.
Confirms that management has performed an assessment of
effectiveness of internal control over financial reporting.
Concludes that effective internal controls have been maintained.

Discloses any deficiencies in the design or operation of internal
controls.
42
© McGraw Hill, LLC
Explain the standards for audit reports.
43
© McGraw Hill, LLC
Audit Reports and Auditing Standards
Since 19 26, the New York Stock Exchange has required an
auditor’s report.
The Securities Exchange Act of 19 34 requires all public
companies to have an independent auditor’s report in annual
financial statements.
The P C A O B oversees public companies’ audits since S O X
in 2002.
The A I C P A Auditing Standards Board (A S B) oversees the
audits of nonpublic companies.
Independent auditors express or disclaim an opinion on whether
an entity’s financial statements and related disclosures are
presented in accordance with G A A P.
44
© McGraw Hill, LLC
P C A O B AS 1301 Communications with Audit Committee
Audit Committee should be aware of situations that may effect
the audit.
Significant accounting policies and practices.

Critical accounting policies and practices.
Critical accounting estimates.
Significant unusual transactions.
Quality of the company’s financial reporting.
Disagreements with management.
Significant difficulties encountered during the audit.
45
© McGraw Hill, LLC
P C A O B AS 3101 When Auditor Expresses and Unqualified
Opinion
P C A O B rules for communicating Critical Audit Matters.
Auditor’s assessment of risks of misstatement.
The degree of auditor judgment.
The nature and timing of unusual transactions.
The degree of auditor subjectivity in applying audit procedures.
The nature and extent of audit effort to address the matter.
The nature of the audit evidence obtained.
46
© McGraw Hill, LLC
Unmodified or Unqualified Audit Opinions
Financial statements “present fairly”
Financial position.
Results of operations.
Cash flows.
Stockholders’ Equity.
Optional additional paragraph.
Emphasis-of-matter.
Going concern.
Consistent application of accounting principles.
Litigation uncertainty.

Other-matter.
Supplemental information.
47
© McGraw Hill, LLC
Modified or Qualified Audit Opinions
Modifies the audit when.
Based upon evidence financial statements are materially
misstated, or.
Unable to obtain sufficient appropriate evidence.
Qualified.
Concludes misstatements, individually or in the aggregate, are
material but not pervasive to the financial statements, or.
Unable to obtain sufficient appropriate audit evidence; possible
effect on financial statements could be material but not
pervasive.
Adverse.
Concludes that misstatements, individually or in the aggregate,
are material and pervasive.
Basis for Modifications.
Separate paragraph describes matter giving rise to modification.
Placed immediately before the opinion paragraph.
Titled “Basis for (Qualified, Adverse, Disclaimer) Opinion”.
48
© McGraw Hill, LLC
Disclaimer/Withdrawal from the Engagement
Disclaimer.
Unable to gather sufficient evidence to warrant the expression
of an opinion on the statements as a whole.
Withdrawal.
If significant conflict exists with management or the auditor

decides that management cannot be trusted, then a withdrawal
may be justified.
Trust issues are a matter of ethics.
The auditor must consider whether the breakdown between
management and the auditor has advanced to the point that any
and all information provided by the client is suspect.
Withdrawal triggers the filing of the S E C’s 8-K form by
management.
49
© McGraw Hill, LLC
Limitations of the Audit Report Reasonable Assurance
Reasonable Assurance.
Due care.
Relation of independence and client relationships.
Not an absolute guarantee.
Followed G A A S, gathering sufficient competent evidential
matter.
Failure to follow G A A S: allegation of negligence.
50
© McGraw Hill, LLC
Limitations of the Audit Report Materiality
Magnitude of an omission or misstatement of accounting
information that the judgment of reasonable person relying on
the information would have been changed or influenced by the
omission or misstatement.
Judging Materiality.
Staff Accounting Bulletin (S A B 99) may not rely solely on a
quantitative threshold as a “rule of thumb”.
5% is a common materiality test.
S E C wants qualitative matters to be considered as well.

Unintended consequence of materiality is that it is subject to
manipulation.
51
© McGraw Hill, LLC
Limitations of the Audit Report Present Fairly
Auditor’s assessment of fair presentation depends on whether:
Accounting principles used have general acceptance.
Accounting principles are appropriate.
Financial statements are informative.
Information presented is classified and summarized in a
reasonable manner.
Financial statements reflect the underlying transactions and
events in a manner that is consistent with materiality and
reflects economic substance.
52
© McGraw Hill, LLC
Generally Accepted Auditing Standards (G A A S) 1
Auditing standards provide a measure of audit quality and the
objectives to be achieved in an audit.
Auditing standards differ from auditing procedures because the
procedures are steps taken by the auditor during the course of
the audit to comply with G A A S.
The application of auditing standards entails making judgments
with regard to the nature of audit evidence, sufficiency,
competency, and reliability.
Materiality considerations are important to assess whether the
audit opinion should be modified.
53

© McGraw Hill, LLC
Generally Accepted Auditing Standards (G A A S) 2
General Standards.
Adequate technical training and proficiency.
Independence in mental attitude.
Due care in the performance of the audit and preparation of the
report.
Standards of Field Work.
Adequately plan the audit work and supervise assistants.
Obtain a sufficient understanding of internal control to
adequately plan the audit and determine the nature, timing, and
extent of tests to be performed.
Gather sufficient competent evidential matter to provide a basis
for an opinion.
Standards of Reporting.
The statements have been in conformity with G A A P.
Accounting principles have been consistently applied.
Adequate informative disclosures have been made.
Expression of an opinion on statements taken as a whole, or
indication that an opinion cannot be expressed.
54
© McGraw Hill, LLC
Auditing Evidence
Consideration of the competency and sufficiency of evidence.
Management representations are not a substitute for application
of proper audit procedures.
Audit risk and materiality considered together.
Determination of nature, timing and extent of procedures.
Evaluation of results of procedures.
Assess risks of material misstatements due to fraud.
Application of professional skepticism.
Audit procedures – specific acts performed to gather evidence

about specific assertions.
55
© McGraw Hill, LLC
Professional Skepticism
An important role in gathering audit evidence and evaluating
usefulness.
Auditor should exercise professional judgment and skepticism.
Determining the nature, timing, and extent of audit procedures.
Determining the sufficiency, competency, and relevancy of
evidence.
Evaluating management’s judgments and estimates.
Considering fraud in the audit.
Determining the conclusions based on the audit evidence
obtained.
A state of mind and requires documentation to provide evidence
that the audit was planned and performed in accordance with G
A A S.
Document the thought process, alternative views considered,
judgments made, audit evidence gathered, and support for final
conclusion.
Document challenges to management’s views and assumptions.
Document the basis for unusual, one-time transactions and
related business rationale.
Include a complete and comprehensive record of discussions
with management.
Document assessments of the reliability of the source of
documents.
Document professional skepticism in significant matters.
56
© McGraw Hill, LLC

Concluding Thoughts
Financial statement fraud threatens the foundation of the
financial reporting process and jeopardizes the integrity of the
auditing function.
Auditors need to be more diligent in looking for signs that fraud
exists.
Aggressive judgments by management, such as those in the
Medicis Pharmaceutical creates challenges for auditors.
As the audit profession evolves and embraces the use of
machine-based learning systems, the profession needs to stay
vigilant and be aware that these systems require our expertise,
professional judgement and ethics.
High deficiency rates found in P C A O B inspection reports
indicate auditors are not meeting their obligations to the public.
57
© McGraw Hill, LLC
image2.png
image1.png
A I C P A Code of Professional Conduct
Chapter 04
McGraw Hill, LLC.

1
Learning Objectives
L O 4-1: Explain professional judgement and the C P A’s
obligations under the A I C P A Code of Conduct.
L O 4-2: Explain how to apply the threats and safeguards
approach to independence.
L O 4-3: Discuss S E C actions taken against auditors because
of a lack of independence.
L O 4-4: Describe the process to resolve ethical conflicts that
may cause violations of the rules.
L O 4-5: Explain how the conceptual framework works to keep
in check possible violations of integrity and objectivity for C P
As in business.
L O 4-6: Explain how to apply the rules of conduct in the A I C
P A Code to the performance of professional services.
L O 4-7: Analyze the ethics rules for tax practice and how they
are influenced by the realistic possibility standard.
L O 4-8: Describe the P C A O B independence and ethics rules.
2
© McGraw Hill, LLC
2
How can professional judgment deal with cognitive biases that
can influence ethical behavior?
What is the risk-based approach to deal with situations where
independence, integrity and objectivity, and adherence to other
professional standards, is threatened by external relationships?
What are effective measures to deal with ethical conflicts that
pose challenges to ethics and professionalism?

3
© McGraw Hill, LLC
3
Professional Judgment in Accounting
Professional judgment is influenced by personal behavioral
traits.
Attitudes.
Ethical values.
Personal values link to ethical sensitivity and judgment.
Ethical awareness of an ethical dilemma is a mediator of the
personal factors and ethical judgment relationship.
Objectivity and due care are attitudes and behaviors that enable
professional judgment.
Professional skepticism is essential in making professional
judgments; helps frame auditors’ mindset of independent
thought.
4
© McGraw Hill, LLC
K P M G Professional Judgment Framework
Judgment is the process of reaching a decision or drawing a
conclusion where there are a number of possible alternative
solutions.
Judgment occurs in a setting of uncertainty, risk, and often
conflicts of interest.
The K P M G Framework components revolve around one’s
mindset.
Clarify issues and objectives.
Consider alternatives.

Gather and evaluate information.
Reach conclusion.
Articulate and document rationale.
Prescriptive framework is used but pressures, time constraints,
and limited capacity may cause deviations.
Auditor should approach matters with objectivity and
independence, with inquiring mind and critical assessment of
audit evidence.
5
© McGraw Hill, LLC
Link between K P M G Framework and Cognitive Processes
Auditors need to use System 2 thought process.
Ethical awareness.
Application of ethical reasoning, ethical analysis of harms and
benefits and stakeholder rights; and professional obligations.
Judgments can fall prey to cognitive traps and biases that
negatively influence judgments.
Group-think.
Rush to solve problems.
Judgment triggers.
Judgment triggers – can lead to accepting a solution before it is
properly identified and evaluated.
Availability tendency.
Confirmation tendency.
Overconfidence tendency.
Anchoring tendency.
6
© McGraw Hill, LLC
Role of Professional Skepticism
Professional skepticism links to professional judgment through

the ethical standards of independent thought, objectivity and
due care, which are incorporated in A I C P A Code of
Professional Conduct.
C P A firm management should set an appropriate tone that
emphasizes a questioning mind throughout the audit and the
exercise of professional skepticism in gathering and evaluating
evidence.
7
© McGraw Hill, LLC
A I C P A Revised Code: Independence for Members in Public
Practice
Conceptual framework incorporates a “threats and safeguards”
approach.
New section on “Ethical Conflicts.”
Violation of the rules for a C P A to permit others acting on his
behalf to engage in behavior that would have been a violation
for the C P A.
When differences exist between A I C P A and those of the
licensing state board of accountancy, the C P A should follow
the state board’s rules.
8
© McGraw Hill, LLC
Conceptual Framework for Independence Standards
Independence required for audit and other attestation services;
in fact and in appearance.
A I C P A uses risk based approach for analyzing threats using
the following steps:
Identifying and evaluating threats to independence.
Determining whether safeguards already eliminate or
sufficiently mitigate identified threats and whether threats that

have not yet been mitigated can be eliminated or sufficiently
mitigated by safeguards.
If no safeguards are available to eliminate an unacceptable
threat or reduce it to an acceptable level, independence would
be considered impaired.
9
© McGraw Hill, LLC
Threats to Independence
EXHIBIT 4.1 Examples of Threats to
IndependenceThreatExampleSelf-Review ThreatPreparing
source documents used to generate the client’s financial
statements.Advocacy ThreatPromoting Me client's securities as
part of an initial public offering or representing a client in U.S.
tax court.Adverse Interest ThreatCommencing, or the expressed
intention to commence, litigation by either the client or the C P
A against the other.Familiarity ThreatA C P A on the attest
engagement team whose spouse is the client’s C E O.Undue
Influence ThreatA threat to replace the C P A or C P A firm
because of a disagreement with the client over the application
of an accounting principle.Financial Self-Interest ThreatHaving
a loan from Me client, from an officer or director of the client,
or from an Individual who owns 10% or more of the client’s
outstanding equity securities.Management Participation
ThreatEstablishing and maintaining internal controls for the
client.
10
© McGraw Hill, LLC
Safeguards
EXHIBIT 4.2 Examples of Safeguards in Applying the
Conceptual FrameworkSource of Um SafeguardExamples of

SafeguardsCreated by the profession, legislation, or
regulationProfessional resources, such as hotlines, for
consultation on ethical issues.Implemented by the clientThe
client has personnel with suitable skill, knowledge, or
experience who make managerial decisions about the delivery of
professional services and makes use of third-party resources for
consultation as needed.
The tone at the top emphasizes the client's commitment to fair
financial reporting and compliance With the applicable laws,
rules, regulations, and corporate governance policies.
Policies and procedures are in place to achieve fair financial
reporting and compliance WM the applicable laws, rules,
regulations, and corporate governance policies.
Policies and procedures are In place to address ethical conduct.
Policies are in place that bar the entity from hiring a firm to
provide services that do not serve the public interest or that
would cause the firm's Independence or objectivity to be
considered Impaired.Implemented by the firmPolicies and
procedures addressing ethical conduct and compliance with laws
and regulations.
11
© McGraw Hill, LLC
S O X: Nonaudit Services
Financial information systems design and implementation.
Appraisal or valuation services, fairness opinions, or
contribution-in-kind reports.
Actuarial services.
Internal audit outsourcing services.
Management functions or human resources.
Broker or dealer services, investment adviser, or investment
banking services.
Legal services and expert services unrelated to the audit.
Any other service prohibited by B O D.

Tax services must be preapproved by the audit committee.
12
© McGraw Hill, LLC
Relationships that May Impair Independence
Financial relationships.
Business relationships.
Employment or association with attest clients.
Providing non-attest services to an attest client.
Nontraditional forms of ownership.
13
© McGraw Hill, LLC
Employment or Association with Attest Clients
Independence may be impaired when a partner or professional
employee leaves the firm and is subsequently employed by the
client in a key position unless the following is met:
Amounts due to the former professional are not material to the
firm.
The former professional is not in a position to influence the
accounting firm’s operations or financial policies.
The former professional employee does not participate in or
appear to participate in or is not associated with the firm once
the relationship with the client begins.
Participating in the firm may be continuing to consult for it or
have one’s name included in firm literature.
14
© McGraw Hill, LLC
Providing Nonattest Services to an Attest Client

Certain lucrative nonattest services create a conflict of
interests.
A C P A should not perform management functions or make
management decisions for an attest client.
Client must agree to perform the following functions:
Assume all management responsibilities.
Designate competent overseer of these services.
Evaluate adequacy and results of services performed.
Accept responsibility for the results of the services.
15
© McGraw Hill, LLC
S E C Position on Independence
Emphasizes independence in fact and appearance in 3 ways:
Proscribing certain financial interests and business relationships
with the audit client.
Restricting certain nonauditing services to audit clients.
Subjecting all auditor conduct to a general standard of
independence.
Three principles that underlie auditor independence:
An auditor cannot function in the role of management.
An auditor cannot audit her own work.
An auditor cannot serve in an advocacy role for her client.
16
© McGraw Hill, LLC
General Standard of Independence
Judged by a reasonable investor with knowledge of all relevant
facts and circumstances.
Auditor must be capable of exercising objective and impartial
judgment on all issues within the engagement.
Principles.

Situations which impair independence.
Creates a mutual or conflicting interest between an accountant
and his audit client.
Places an accountant in the position of auditing his own work.
Results in an accountant acting as management or employee of
the audit client.
Places an accountant in position of being an advocate for the
audit client.
17
© McGraw Hill, LLC
S E C Actions Against Big Four Audit Firms
P w C.
Violated independence rules when it performed restricted
nonaudit services to audit clients.
E Y.
Audited partners engaged in personal relationships with client’s
C F O.
K P M G.
Former partner engaged in insider trading of non-public
information.
Deloitte.
Deloitte managers maintained bank accounts with audit client.
18
© McGraw Hill, LLC
S E C Actions Because of Personal Conduct of Audit Partners
P w C.
Age Discrimination.
K P M G.
Hired former P C A O B staffers to obtain audit inspection
information.

E Y.
Partner sexually harassed another partner.
Deloitte.
Partner traded in the securities of multiple clients.
19
© McGraw Hill, LLC
Materiality Issues in Judging Whether Independence Has Been
Impaired
Some firms are now using a materiality criterion to determine
whether nonaudit services provided to an affiliate entity, that
would be prohibited if the parent had provided them, violate the
independence requirement in audit engagements.
Applying such a materiality standard can have the effect of
dismissing otherwise improper relationships.
20
© McGraw Hill, LLC
Materiality Issues
Using a materiality criterion to determine whether certain
nonaudit services should be allowed opens a can of worms.
Logical questions are: (1) Is independence a standard left to the
individual judgment of the auditors or is it based on S E C
regulations and P C A O B standards? and (2) Where do you
draw the line in making materiality determinations?
21
© McGraw Hill, LLC
Integrity and Objectivity
Conflicts of interest for public practice occur when a

professional service, relationship, or specific matter creates a
situation that might impair objective judgment.
A conflict of interest creates adverse and self-adverse threats to
integrity and objectivity.
Safeguards include:
Implementing mechanisms to prevent disclosure or violation of
confidentiality.
Senior individual not involved in the engagement regularly
reviewing safeguards.
Member of the firm not involved in the conflict reviews the
work performed to assess whether key judgments and
conclusions are appropriate.
Consulting with third parties, such as professional body, legal
counsel, or another C P A.
The C P A should disclose the nature of the conflict to clients
and obtain their consent to perform professional services.
If consent is not received, then the C P A should either cease
performing the services or take action to eliminate or reduce the
threat to an acceptable level.
22
© McGraw Hill, LLC
A I C P A Code: Ethical Conflicts
Assess whether an ethical conflict exists.
Ethical conflicts create challenges to ethical decision making
because they present barriers to meeting the requirements of the
rules of conduct.
Consider whether any departures exist to the rules, laws, or
regulations and how they will be justified in order to ensure that
conflicts are resolved in a way that permits compliance with
these requirement.
Any unresolved conflicts can lead to a violation of the rules of
conduct which should focus the C P A’s attention on any
continuing relationship with the engagement team, specific

assignment, client, firm, or employer.
23
© McGraw Hill, LLC
23
Subordination of Judgment
Integrity rule prohibits a C P A from knowingly misrepresenting
facts or subordinating one’s judgments when performing
professional services for a client or employer.
Addresses differences of opinion between a C P A
accountant/auditor and that person’s supervisor or others in the
organization including top management on material accounting
issues.
C P A should consider any threats to integrity and objectivity,
and assess their significance whenever there is a material
misrepresentation of fact.
C P A should assess if threats are at an acceptable level; if not,
evaluate significance of safeguards to prevent impairment to
independence/objectivity.
Follow prescribed process to protect against subordination of
judgment (see Exhibit 3.11).
24
© McGraw Hill, LLC
A I C P A Code: Conceptual Framework for Members in
Business
The conceptual framework for members in business applies to
integrity and objectivity, as well as other rules of conduct, but
not independence.
Threats.

Adverse interest threat.
Advocacy threat.
Familiarity threat.
Self-interest threat.
Self-review threat.
Undue influence threat.
25
© McGraw Hill, LLC
Safeguards to Mitigate Risk
Safeguards include:
Tone at the top.
Policies, procedures, implementation, and monitoring
addressing ethical conduct and compliance with laws and
regulations.
Internal policies and procedures for disclosure of interests and
relationships.
Whistle-blower hotlines and reporting structure.
Internal auditors not allowed to audit areas where they have
operational responsibilities.
Policies for promotion, rewards and enforcement of a culture of
high ethics and integrity.
Use of third-party resources for consultation as needed.
26
© McGraw Hill, LLC
Rules of Professional Practice
The General Standards rule establishes requirements for
competence, compliance with professional standards, and
adherence to accounting principles.
Acts Discreditable covers a broad number of actions that may
bring discredit to the profession including:

Discrimination and harassment.
Solicitation or disclosure of C P A examination questions and
answers.
Failure of a C P A / C P A firm to file and pay taxes.
Negligence in preparation of financial statements or records.
Standards relating to governmental accounting and auditing.
Confidentiality of information gained through employment,
except in specified situations.
Records Request governing what is client-provided records,
member-prepared records, member’s work products, and
member’s working papers.
27
© McGraw Hill, LLC
Contingent Fees, Commissions, and Referral Fees
Contingent fees and commissions are permitted when
performing advisory-type services for a nonattest client.
Contingent fees are prohibited from an attest (audit) client.
Prohibits acceptance of contingent fees if C P A or firm
performs any of the following:
An audit or review of a financial statement.
Compilation of financial statement that third party may use.
Examination of prospective financial information.
Prepares original/amended tax return.
Permits acceptance of contingent fee based upon initiation by
and findings of governmental agencies (that is, I R S-initiated
investigation of income taxes paid).
Commissions and Referral Fees.
Rule is similar to that for contingent fees; cannot accept
commissions or referral fees from audit client.
Commissions and referral fees require disclosures by C P As
when recommending or referring a service or product to which
the commission relates.
28

© McGraw Hill, LLC
Advertising and Solicitation
Advertising and solicitation permitted.
Requires that advertising not be false, deceptive or misleading.
Imply ability to influence official bodies.
Contain a representation that specific services will be
performed for a stated fee, when such fees would be
substantially increased.
Prohibits solicitation by use of coercion, over-reaching, or
harassing conduct.
Contain any representation that would be likely to cause a
reasonable person to misunderstand or be deceived.
29
© McGraw Hill, LLC
Confidentiality
Confidential information.
C P A should not disclose confidential client information
without specific consent of the client.
Internal whistleblowing allowed; external may violate
confidentiality; consult legal counsel.
Permitted disclosure of confidential client information.
Response to validly issued subpoena or summons.
Adherence to applicable laws and regulations (i.e., Dodd-Frank
whistle-blowing provisions).
Compliance with peer review of C P A practice under P C A O
B, A I C P A, state C P A society, or board of accountancy
authorization.
Defense in an investigation of the C P A.
30

© McGraw Hill, LLC
Ethics and Tax Services
Tax services include tax compliance, tax consulting, tax
planning, and tax shelters.
A I C P A explicitly recognizes the tax professional’s dual
obligations to the client to act as advocate and to foster
integrity in the tax system by honesty and fairly administering
the tax laws.
The tax accountant remains obligated to act objectively, with
integrity, exercise due care, and follow the Statements on
Standards for Tax Services (S S T S).
When auditing tax client’s financial statements: The tax C P A
is expected to consider whether any threats to independence
exist that cannot be reduced or eliminated by safeguards and
how such matters will be handled to avoid a violation of audit
independence.
31
© McGraw Hill, LLC
S S T S No. 1, Tax Return Position
7 statements explain C P As’ responsibilities to their clients and
the tax systems:
S S T S No.1, Tax Return Positions.
A tax return position is a position reflected on a tax return on
which a C P A has specifically advised a taxpayer, or a position
about which a C P A has knowledge of all material facts and,
based on those facts, has concluded whether the position is
appropriate.
A taxpayer is a client, a C P A’s employer, or any other third-
party recipient of tax services.
C P A’s obligation to advise a taxpayer of relevant tax return
disclosure responsibilities and potential penalties.

C P A should not recommend a tax return position or sign a tax
return unless she has a good-faith belief that the position has at
least a “realistic possibility of success”.
C P A cannot recommend a tax return position that he knows
exploits the audit selection process of a taxing authority.
C P A may recommend a tax return position if there is a
“reasonable basis” for the position and advises the taxpayer to
disclose that position appropriately.
32
© McGraw Hill, LLC
Tax Shelters
Sometimes called tax avoidance transactions.
“Prohibited tax shelter transaction" means listed transactions,
transactions with contractual protection, or confidential
transactions.
Investments to help wealthy clients avoid paying taxes.
In K P M G case, the firm prepared false documents to deceive
regulators (fraud) and shelters generated $11B in fraudulent
losses and $2.5B in tax evaded. K P M G settled criminal tax
case for $456M.
Caterpillar shifted profits from the U S to a subsidiary in
Switzerland to avoid $1B in taxes. I R S assessed $2B in back
taxes and penalties.
33
© McGraw Hill, LLC
Treasury Circular 230
Regulations governing the practice before the I R S.
Knowledge of error return.
Advise client of the error and potential consequences.
Taxpayer decides whether to correct the error.

Determine if the taxpayer correct the return.
If not, what does this mean for future behavior of taxpayer?
34
© McGraw Hill, LLC
Concluding Thoughts
Whenever a C P A must render an opinion on an ethical
dilemma, it must be grounded in specific, quoted, and explained
rules of the profession.
However, rules are sterile without the application of principles
in both their making and implementation.
The takeaway is to always apply rules in a principled way, and
always apply your principles in harmony with the rules.
The thought process of dealing with an ethical dilemma is as
simple (and as complicated) as aligning the profession's rules
with ethical principles.
The principles to follow are those in the A I C P A Code and
those called for in ethical reasoning methods.
After all the various concepts, philosophies and models are
discussed, the bottom line is that C P As are bound by a
deontological system requiring adherence to the A I C P A rules
of professional conduct.
35
© McGraw Hill, LLC
image1.png
Motivation For Fraudulent Financial Reporting
Chapter 06

McGraw Hill, LLC.
Learning Objectives
L O 6-1: Describe the characteristics of earnings management.
L O 6-2: Explain the purpose of providing earnings guidance
and motivation for making false and misleading disclosures.
L O 6-3: Explain how an auditor might look for red flags that
indicate fraud may exist in the financial statements.
L O 6-4: Explain the working of financial shenanigans and its
effect on reported earnings.
L O 6-5: Describe the makeup of non-GAAP amounts and
whether they can distort reported earnings.
2
© McGraw Hill, LLC
2
What motivates fraudulent financial reporting?
How are financial statements manipulated to achieve a desired
goal?
What are the red flags to look out for in spotting techniques that
can lead to material misstatements of the financial statements?
Why do companies provide non-G A A P earnings?
3

© McGraw Hill, LLC
Ethics Reflections 1
Financial statements must be relevant and reliable. Relevance
means the information being reported is meaningful. Reliability
refers to the accuracy with which financial data is reported so
that users know that information can be trusted.
An important quality of useful information is representational
faithfulness. To represent the transactions and events faithfully
in the financial statements, the effects of transactions and
events should be reported on the basis of economic substance of
the transactions instead of legal form of the transaction.
Fraudulent financial reporting occurs for a variety of reasons
including to make the company look like it’s doing better than it
really is. Some companies manipulate G A A P to achieve a
higher level of earnings and mislead investors and creditors
about the company’s current and expected future earnings.
4
© McGraw Hill, LLC
Ethics Reflections 2
Companies use a variety of techniques to produce fraudulent
financial reports including accelerating the reporting of
revenues and delaying the reporting of expenses, oftentimes by
manipulating accrual amounts. These are called financial
shenanigans.
Companies seem to look for an any advantage when they report
G A A P earnings results. One approach that has caught on with
virtually all public companies is to report non-G A A P
earnings.
5

© McGraw Hill, LLC
Motivation to Manage Earnings
Companies manage earnings when they ask, “How can we best
report desired results?” rather than “How can we best report
economic reality?”
Pressure to “make the numbers”.
Emerged during 1990s and early 2000s.
Stock market awards firms that meet or beat analysts’ forecasts
and punishes firms that miss earnings targets.
Management may also use earnings management to maximize
bonuses and the value of stock options.
Another objective can be avoiding consequences of violation of
debt covenants.
Board of Directors should focus on long term strategic goals
and shield managers from short-term pressure.
6
© McGraw Hill, LLC
Nonfinancial Measures of Earnings
Constant pressure to report favorable earnings performance
motivates many companies to report income numbers that
exclude unusual events that almost always seem to be costly and
depress earnings.
These non-G A A P numbers put a positive spin on what
otherwise might not be such good results under G A A P.
Regulation G requires public companies that disclose or release
non-G A A P financial measures to include a presentation of the
most directly comparable G A A P financial measure and a
reconciliation of the non-G A A P measure to the comparable G
A A P measure.
Auditors should be tasked with at least reviewing non-G A A P
measures as part of their annual audit requirements.
7

© McGraw Hill, LLC
Characteristics of Earnings Management
Gaa and Dunmore denote two basic possible earnings
managements.
Alter the numbers in the financial records by using
discretionary accruals and other adjustments.
Create or structure transactions to alter reported numbers.
Another perspective is to divide the techniques into two
categories.
Operating earnings management – altering operating decisions
to affect cash flows and net income for a period.
Accounting earnings management – using the flexibility in
accounting standards to alter earnings numbers.
The end result of earnings management is to distort the
application of G A A P, bringing into question the quality of
earnings.
Earnings manipulation is a form of earnings management and
can be legitimate, marginally ethical, unethical, or illegal.
8
© McGraw Hill, LLC
Income Smoothing
Motivation to smooth net income over time.
Steady increase each year over a period of time is ideal.
Investors are willing to pay premium for stocks with steady and
predictable earnings streams.
These practices lead to erosion in quality of earnings.
Accelerate recognition of revenue.
Delay recognition of expenses.
“Cookie jar reserves”
Set aside reserves in good years.

Used to prop up earnings in bad years.
HealthSouth case.
Banks more aggressive using loan-loss reserves.
Companies also smooth tax liability over years.
9
© McGraw Hill, LLC
Definition of Earnings Management
Schipper defines it in a negative light- “purposeful intervention
in the external reporting process, with the intent of obtaining
some private gain”.
Healy and Wahlen define it as “when managers use judgment in
financial reporting and in structuring transactions to alter
financial reports to either mislead some stakeholders about the
underlying economic performance of the company, or to
influence contractual outcomes that depend on reported
accounting numbers”.
Dechow and Skinner believe that a distinction should be made
between making choices in determining earnings that may
comprise aggressive, but acceptable, accounting estimates and
judgments, as compared to fraudulent accounting practices that
are clearly intended to deceive others.
McKee characterizes it as “reasonable and legal management
decision making and reporting intended to achieve stable and
predictable financial results”.
10
© McGraw Hill, LLC
How Do Managers and Accountants Perceive Earnings
Management? 1
Akers, Giacomino, and Bellovary Survey.
Accounting manipulation is much less ethically acceptable than

operating decision manipulation.
Practitioners have few ethical qualms about operating decision
manipulation.
Operating decisions that influenced expenses were more suspect
than those that influenced revenues.
11
© McGraw Hill, LLC
How Do Managers and Accountants Perceive Earnings
Management? 2
Survey by Elias:
Accountants in organizations with high ethical values perceive
earnings management as more unethical.
Accountants in industry significantly less likely than C P As in
public practice to perceive high ethical values in their
organizations.
Survey by Bruns and Merchant:
Managers disagree about ethics of earnings management.
Manipulation of operating decisions was more ethical than
manipulation by accounting method.
Survey by Rosenzweig and Fischer:
Accounting manipulation.
Changing accounting methods.
Recording expense in wrong year.
Changing inventory valuation.
Operating decisions.
Deferring necessary expenditures to subsequent year.
Attracting customers at year-end to draw sales into current year.
12
© McGraw Hill, LLC
Ethics of Earnings Management 1

Use ethics framework to judge acceptability.
Virtue ethics examines reasons for the actions taken by decision
maker AND the action itself.
McKee’s explanation is merely a rationalization.
Doesn’t hold true to virtues of honesty and dependability.
Ignores rights of shareholders and stakeholders to receive fair
and accurate information.
Masks true performance.
Hopwood says ethics issue can be mitigated by disclosing
aggressive accounting assumptions.
Nothing more than rationalization for unethical behavior:
disclosure should not be used to cure ills of earnings
management.
13
© McGraw Hill, LLC
Ethics of Earnings Management 2
Act Utilitarian
A decision made by weighing benefits of management/company
to smooth net income versus. costs of providing false
information to shareholders.
Rule Utilitarian.
Financial statements should never be manipulated for personal
gain.
The problem is there is no clear limit between what is ethical
and what isn’t.
14
© McGraw Hill, LLC
Needles Continuum of Earnings Management
Needles points out that the difference between an ethical and an
unethical accounting choice is often merely the degree to which

the choice is carried out.
The problem with many accounting judgments is that there is no
clear limit beyond which a choice is obviously unethical.
A perfectly routine accounting decision, such as expense
estimation, may be illegal if the estimated amount is extreme,
but it is perfectly ethical if it is reasonable.
Needles provides an interesting example of how a manager
might use the concept of an earnings continuum to decide
whether to record the expense amount at the conservative end or
aggressive end.
15
© McGraw Hill, LLC
Earnings Guidance
Earnings guidance reflects the comments management makes
about what it expects the company will do in the future.
Earnings guidance is given by management to provide investors
and financial analysts with data that indicates expected future
earnings and earnings per share. These comments are known
broadly as forward-looking statements.
Earnings guidance can be given in conference calls with
investors and analysts and in press releases available to the
public.
One concern with earnings guidance statements is they represent
management’s subjective view of the company’s future financial
performance, which is exposed to uncertainties and risks.
16
© McGraw Hill, LLC
Forward-looking Statements
“Forward-looking” statements focus on sales revenues or
earnings expectations in light of industry and macro-economic

trends.
Guidance to investors and financial analysts about the
company’s earnings potential.
Can create liability for issuers, underwriters, officers and
directors if material misstatements of fact or omissions are
made for public offerings.
P S L R A enacted safe harbor provisions if forward-looking
statements are identified as such and accompanied by
meaningful cautionary statements that could cause actual results
to differ from the statements.
17
© McGraw Hill, LLC
Green Mountain Coffee Roasters
Green Mountain used conference calls that provided earnings
guidance to shareholders and analysts to mask a financial fraud.
Manufacturer of the Keurig brewing system and K-Cup portion
packs.
Represented to investors that it was straining to meet consumer
demand without accumulating excess inventory.
Deceived P w C auditors on inventory levels by hiding bags and
bags of coffee loaded on trucks, and blocking parts of the plant
from auditor access.
Hedge fund manager, David Einhorn, and Sam Antar, former C
F O of Crazy Eddie, used analytical procedures to spot and warn
of the red flags on inventory.
Should auditors monitor conference calls with investors,
analysts, and the financial press to determine whether
something is said that could be false, fraudulent, or deceptive?
18
© McGraw Hill, LLC

Using Social Media to Report Earnings Guidance and Financial
Results
The S E C said in April 2013, that postings on sites such as
Facebook and Twitter are just as good as news releases and
company Web sites as long as the companies have told investors
which outlets they intend to use.
The S E C guidelines on these matters are under the fair
disclosure rule (Regulation F D) that requires companies to
disseminate information in a way that wouldn’t be expected to
give an advantage to one group of investors over another.
Filing an 8-K form or holding an earnings call are both ways to
ensure compliance with the regulation.
19
© McGraw Hill, LLC
Audit Committee Responsibilities
Audit committee oversight of forward-looking guidance is part
of the board of directors' overall ongoing risk assessment
process.
The audit committee should understand management's processes
for (1) developing assumptions and estimates, (2) accumulating
guidance information, and (3) ensuring management judgment's
are reasonable. The audit committee should also inquire of
possible earnings management to meet the guidance.
20
© McGraw Hill, LLC
Pull-in Sales
One technique used to meet earnings guidance is accelerating
(or "pulling-in") sales from a future quarter to the present in
order to close the gap between actual and forecasted revenue.
Typically, this earnings management technique is triggered by

offering various incentives, such as price rebates, discounted
prices, and extended payment terms to entice customers to
accept products in the current quarter that they would not need
until next quarter.
Efforts to pull-in sales from a future quarter to a current one
only delays the bad news and can create a more spectacular
market disappointment when, after a few quarters, there were no
more future sales to cannibalize.
Sunbeam Corporation learned this lesson the hard way by using
the pull-in revenue technique known as “channel stuffing”.
21
© McGraw Hill, LLC
Red Flags
Auditors need to be attuned to the red flags that fraud may exist
because of overly aggressive accounting and outright
manipulation of earnings.
There are many examples of red flags including:
One-time sources of income.
Unexpected increase in accounts receivable.
Slowdown of inventory turnover.
Reduction in reserves.
Reduction in discretionary costs at year-end (i.e., advertising;
R&D).
22
© McGraw Hill, LLC
Earnings Quality
Another way to spot potential fraud in the financial statements
is through an assessment of earnings quality.
Dichev et al. conducted a survey in 2016 that examined the
views of 375 C F Os on the prevalence and identification of

earnings misrepresentation.
The C F Os were asked to rank order specific characteristics of
earnings quality.
The leading answers were consistent reporting choices through
time and the absence of long-term estimates, both features of
sustainable earnings.
23
© McGraw Hill, LLC
Financial Statement Analysis
Financial analysis can be used to identify red flags that the
numbers in the financial statements may not make sense
considering the relationship between selected items on the
balance sheet and income statements.
Comparative statements over two or more years based on
reported numbers can be converted into percentages to enhance
the analysis. These are known as common size statements.
Ratios can be used to compare relationships between financial
statement items or indicate trends over time.
24
© McGraw Hill, LLC
Accruals and Earnings Management
Accruals are needed because of matching and timing problems
that can give wrong financial picture of company.
Earnings are sum of a period’s change in accruals and its cash
flows.
Revenue recognition and matching principles.
Can manage earnings through aggressive estimations or more
conservative ones.
Discretionary accruals (items that management has full control
over and is able to delay or eliminate)

Nondiscretionary accruals (management has no control over)
25
© McGraw Hill, LLC
Earnings Management: One More Thing
It is unethical if the primary motive for managing earnings is to
deceive users of the true results of operations or reflect the
economic substance.
Often earnings management is carried out by otherwise honest
people who tell the company’s side of the story rather than
adhere to G A A P.
Cycle of earnings manipulation.
Often a company begins with a track record of success.
It is becoming more difficult to maintain the sales and earnings
growth expected.
Management runs special incentives to accelerate sales and uses
overtime to ship product out.
Steps are repeated in the next quarter(s), as expectations are
higher, only now the company may not accrue all of its
expenses, and to keep the stock prices increasing.
One aggressive interpretation leads to another until the quality
of the financial information is in doubt.
The company has gone from aggressive operating practices to
financial fraud.
26
© McGraw Hill, LLC
Financial Shenanigans
Actions or omissions intended to hide or distort real financial
performance or financial condition of an entity.
Overstate revenues and profits to enhance reported earnings and
E P S.

Understate revenues and profits to smooth net income/decrease
volatility.
Schilit’s 7 Common Financial Statement Shenanigans:
Recording Revenue too soon or of questionable quality.
Recording bogus revenue.
Boosting income with one-time gains.
Shifting current expenses to a later or earlier period.
Failing to record or improperly reducing liabilities.
Shifting current revenue to a later period.
Shifting future expenses to the current period as a special
charge.
27
© McGraw Hill, LLC
Red Flags of Earnings Management
Auditors need to be attuned to red flags or signs of aggressive
accounting and fraud:
Growth in the market share that seems unbelievable.
Frequent acquisitions of businesses.
Management growth strategy and emphasis on earnings and/or E
P S.
Reliance on income sources other than core business.
One-time sources of income.
Growth in revenue that doesn’t line up well with receivables or
inventory.
Unexpected increase in accounts receivable.
Slowdown of inventory turnover.
Reduction in reserves:
Not reserving for possible future losses.
Reduction in discretionary costs at year-end (i.e., advertising;
R&D)
Unusual increase in borrowings; short-term borrowing at year-
end.
Extension of trade payables longer than normal credit.

Change in members of top management, especially the C F O.
Change in auditors.
Changes in accounting policies toward more liberal
applications.
One forensic accountant is needed on each audit to help identify
the signs.
28
© McGraw Hill, LLC
Non-G A A P Financial Metrics
Most companies disclose non-G A A P financial metrics.
An Audit Analytics study shown in Exhibit 6.7 found the top
five non-G A A P metrics were:
Income-related (including adjusted operating income)
Earnings-per-share (E P S)
Cash flow.
E B I T D A.
Funds from operations.
29
© McGraw Hill, LLC
S E C Regulations and Non-G A A P Amounts
S E C Regulation G and Item 10(e) of Regulation S-K define a
“non-G A A P financial measure” as a numerical measure of
historical or future financial performance, financial position, or
cash flows, that:
Excludes amounts that are included in the most directly
comparable measure calculated and presented in accordance
with G A A P; or,
Includes amounts that are excluded from the most directly
comparable measure so calculated and presented.
30

© McGraw Hill, LLC
EBITDA
One common non-G A A P measure is EBITDA (earnings before
interest, taxes, depreciation, and amortization). Other variations
include EBIT, EBITA, EBITD, EBITDAR (earnings before
interests, taxes, depreciation, amortization, and restructuring
costs), adjusted EBITDA, and so on. A joke making the rounds
is perhaps the best measure is EBBS (earnings before the bad
stuff)
31
© McGraw Hill, LLC
SEC Regulation S-K
Applies to non-G A A P financial measures that are included in
S E C filings.
They should be presented with equal or greater prominence, of
the most directly comparable financial measure or measures
calculated and presented in accordance with G A A P.
A non-G A A P measure should be presented in proximity to the
G A A P measure with an appropriate balance of discussion.
A quantitative reconciliation of the differences between the
non-G A A P financial measure and the most directly
comparable G A A P financial measure should be shown.
32
© McGraw Hill, LLC
Reconciliation of G A A P and Non-G A A P
The reconciliation should be presented with each adjustment
clearly labeled and separately quantified;

A statement disclosing why the registrant’s management
believes that presentation of the non-G A A P financial measure
provides useful information to investors regarding the
registrant’s financial condition and results of operations; and,
To the extent material, a statement disclosing the additional
purposes, if any, for which the registrants management uses the
non-G A A P financial measure.
33
© McGraw Hill, LLC
Concluding Thoughts
Earnings management is typically motivated by a desire to meet
or exceed forecasted results, meet financial analysts’ earnings
estimates, inflate share price to make stock options more
lucrative, and enhance bonuses.
Financial reporting needs to focus more on representational
faithfulness, there should be agreement between the accounting
measures or descriptions in financial reports and the economic
events they purport to represent.
Financial shenanigans have been used for years to manage
earnings by choosing how and when to report and disclose
financial information.
The motivation oftentimes is to smooth net income over time.
These artificial maneuvers mislead investors and financial
analysts about the true state of earnings in two or more years.
Auditors should look for the red flags that something is not
right with the reported earnings.
34
© McGraw Hill, LLC
image1.png

Case 4-4 Threats to Audit Independence
Katy Carmichael, CPA, was just promoted to audit manager in
the technology sector at a large public accounting firm.
She started at the firm six years ago and has worked on a
number of the same client audits for multiple years. She prefers
being placed on same client audits year over year as she
believes her knowledge about the client grows each year,
resulting in a better audit. Public accounting firms tend to do
this as it provides continuity between the firm and the client
and often results in a more efficient (less costly) audit as well.
Katy was thrilled to learn that she would be retaining three of
her prior audit clients, including what she considers her favorite
client (DGS - Drako Gaming
Solution
s). She has friendships with those in the financial reporting area
including the CFO with whom she has makes joint business
investments.
The audit planning for DGS's next audit is about to begin. As is
common practice with all audits, each member of the audit
engagement team is asked to fill out a questionnaire about any
type of relationship (personal, business, or financial) they might
have (or any other member of the engagement team might have
with the client company, any of its customers, suppliers,
employees, or direct family members of their employees. Katy
will soon be meeting with the firm's compliance partner
assigned to the DGS audit to go through the completed

questionnaire. In that regard, answer the following questions.
1. Identify any potential threats to independence that exists
based on the facts of the case. [150 words]
Case 5-1
Assume Vick and Ethan are CPAs. Ethan Lester was seen as a
“model employee” who deserved a promotion to CFO, according
to Kelly Fostermann, the CEO of Fostermann Corporation, a
Maryland-based, largely privately held company that is a
prominent global designer and marketer of stereophonic
systems. Kelly considered Lester to be an honest employee
based on performance reviews and his unwillingness to accept
the promotion, stating that he wasn’t ready yet for the position.
Little did she know that Lester was committing a $50,000 fraud
during 2015 by embezzling cash from the company. In fact, no
one seemed to catch on because Lester was able to override
internal controls. However, the auditors were coming in and to
solidify the deception, he needed the help of Vick Jensen, a
close friend who was the accounting manager. Lester could
“order” Jensen to cover up the fraud but hoped he would do so
out of friendship and loyalty. Besides, Lester knew Jensen had
committed his own fraud two years ago and covered it up by
creating false journal entries for undocumented sales, returns,

transactions, and operating expenses.
Lester went to see Jensen and explained his dilemma. He could
see Jensen’s discomfort in hearing the news. Jensen had thought
he had turned the corner on being involved in fraud after he
quietly paid back the $20,000 he had stolen two years ago. Here
is how the conversation went.
“Vick, I need your help. I blew it. You know Mary and I split
up 10 months ago.”
“Yes,” Vick said.
“Well, I got involved with another woman who has extravagant
tastes. I’m embarrassed to say she took advantage of my
weakness and I wound up taking $50,000 from company funds.”
“Ethan, what were you thinking?”
“Don’t get all moral with me. Don’t you recall your own
circumstances?”
Vick was quiet for a moment and then asked, “What do you
want me to do?”

“I need you to make some entries in the ledger to cover up the
$50,000. I promise to pay it back, just as you did. You know
I’m good for it.”
Vick reacted angrily, saying, “You told me to skip the bank
reconciliations—that you would do them yourself. I trusted
you.”
“I know. Listen, do this one favor for me, and I’ll never ask you
again.”
Vick grew increasingly uneasy. He told Ethan he needed to
think about it … his relationship with the auditors was at stake.
QUESTION:
2. Analyze the facts of the case using the Fraud Triangle.
Include a discussion of the weaknesses in internal controls.
[150 words]
Case 6-2

Fraud in Financial Statements and Auditor ResponsibilitiesChap.docx

Fraud in Financial Statements and Auditor ResponsibilitiesChap.docx

Recommended

Recommended

More Related Content

Similar to Fraud in Financial Statements and Auditor ResponsibilitiesChap.docx

Similar to Fraud in Financial Statements and Auditor ResponsibilitiesChap.docx (20)

More from pauline234567

More from pauline234567 (20)

Recently uploaded

Recently uploaded (20)

Fraud in Financial Statements and Auditor ResponsibilitiesChap.docx