1. Describe how the correction of the overstated inventory, Retained Earning, an
ID: 2406161 • Letter: 1
Question
1. Describe how the correction of the overstated inventory, Retained Earning, and earnings would be recorded in financial statements following current US GAAP.
2. What factors do you believe influenced management’s decision not to raise the issue(s) with the auditors? Be specific.
3. Explain why auditors were concerned about the financial reporting problem that was overstate inventory, retained earnings, and earnings. If you were a member of the board of directors of the company during that time (for example, a member of the Audit Committee), state whether you would have agreed with the auditor’s concerns. Be specific.
4. As a member of board of directors at that time, what would you have done to respond to the auditor’s request that the CFO (and possibly the CEO) be replaced? Explain the implications of replacing or not replacing the CFO. Be specific.
Explanation / Answer
Ans 1
1. Errors include mathematical mistakes, mistakes in the application of accounting principles, oversights, or intentional misstatements of accounting records. FASB Statement requires that a company account for the correction of the material error made in previous periods as a prior period restatement (adjustment).
2. The correction of an error (net of the related income tax effects) is reflected as an adjustment to the beginning balance of a company's retained earnings for each period presented (with corresponding adjustments to the carrying values of assets and liabilities that are affected by the error). This method is similar to the retrospective application of a new accounting principle discussed earlier.
3. Errors may affect only a company's income statement or only its balance sheet, or both financial statements. Errors affecting only the classification of either income statement or balance sheet items can be corrected without a journal entry because the particular financial statement item only needs to be reclassified. 19. Errors affecting both the income statement and the balance sheet can be classified as counterbalancing or non-counterbalancing. Counterbalancing errors are automatically corrected in the next accounting period as a natural part of the accounting process.
The following table summarizes the effects of common counterbalancing errors.
Type of Adjustment Error Net Income current year Net Income next year
Ending inventory overstated over under
Ending inventory understated under over
Failure to accrue expense at year-end over under
Overstatement of accrued expense at year-end under over
Failure to accrue earned revenue at year-end under over
Overstatement of accrued revenue at year-end over under
Failure to expense prepaid expense at year-end over under
Understatement of year-end prepaid expense under over
4. A correcting journal entry is necessary for any counterbalancing error that is detected before it has counterbalanced. If the error is discovered after it has counterbalanced, no correcting journal entry is necessary, but the financial statements should be restated so that they are not misleading.
5. Non-counterbalancing errors are those that will not be automatically offset in the next accounting period. A correcting journal entry is necessary for a non-counterbalancing error and any applicable financial statements must be restated
ans 2
Aspects to be considered ISA 315 states that there are five main aspects of the client’s business and environment which the auditor should understand. 1. Industry, regulatory and other external factors, including the applicable financial reporting framework This means having an understanding of the industry in which the company operates, including the level of competition, the nature of the relationships with suppliers and customers, and the level of technology used in the industry. The industry may have specific laws and regulations which impact on the business. The auditor should also consider wider economic factors such as the level and volatility of interest rates and exchange rates and their potential impact on the client. The importance of these issues is their potential impact on the financial statements and on the planning of the audit. For example, if a client operates in a highly regulated industry, it may be worth considering the inclusion in the audit team of a person with specific experience or knowledge of those regulations. Regulations include the financial reporting framework, for example, whether the company uses local or international financial reporting standards. 2. Nature of the entity and it's accounting policies This includes having an understanding of the legal structure of the company (and group where relevant), the ownership and governance structure, and the main sources of finance used by the company. Complex ownership structures with multiple subsidiaries and/or locations may increase the risk of material misstatement. Understanding the nature of the company also includes an understanding of the accounting policies selected and applied to the financial statements. The auditor must consider whether the accounting policies applied are consistent with the applicable financial reporting framework. 3. Objectives and strategies and related business risk The management of the company should define the objectives of the business, which are the overall plans for the company. Strategies are the operational approaches by which management intend to meet the defined objectives. For example, an objective could be to maximize market share, and the strategy to achieve this could be to launch a new brand or product every year. Business risks are factors which could stop the company achieving its stated objectives, for example, launching a product for which there is limited demand. Most business risks will eventually have financial consequences, and thus an effect on the financial statements. This is why auditors perform a business risk assessment as part of their planning procedures. 4. Measurement and review of the entity’s financial performance Here the auditor is looking to gain an understanding of the performance measures which management and others consider to be of importance. Performance measures can create pressure on management to take action to improve the financial statements through deliberate misstatement. For example, a bonus payable to the management based on revenue growth could create pressure for revenue to be overstated. Thus the auditor must gain an understanding of the company’s financial and non-financial key performance indicators, targets, budgets and segmental information. 5. Internal control The auditor must gain knowledge of internal control in order to consider how different aspects of internal control could impact on the audit. Internal control includes the control environment, the entity’s risk assessment procedures, information systems, control activities, and the monitoring of controls. Put simply, the evaluation of the strength or weakness of internal control is a crucial consideration in the assessment of audit risk, and so will have a significant impact on the audit strategy. The design and implementation of controls should be considered as part of gaining an understanding. The auditor should also understand whether controls are manual or automated. ISA 315 contains a great deal of detailed guidance on the understanding of controls, which these briefing notes do not cover.
Ans. 3
Ans 4.
Major is a term tied to materiality. So depending on your business, it can mean many things.
The crux is that most times, law enforcement is not brought into the situation, allowing the perpetrator to continue their behavior(s) at someone else's company.
Is that good governance (another term tied to materiality)?
If my CFO came to me and said we just caught employee cashing a client check; and we believe the problem occurred previously. I would need to weigh three pieces of information prior to recommending involvement by the authorities –
1) Do all facts lead you to the same conclusion that Bob committed fraud? Making a claim of Fraud requires irrefutable evidence.
2) Do we have any ability to recoup the monies from the employee?
3) Must I engage my clients to help me understand if there was fraud committed in my company?
It does not make sense to replace one fraud, with two risks, i.e. risk of a lawsuit from Bob, and the risk of losing the client.
Involving law enforcement does not require you to have irrefutable evidence. You need to have reasonable suspicions; it is the job of the Police and the Prosecutor's office to obtain irrefutable evidence.
At the moment, a key challenge for CFOs is that data systems and their hierarchies often do not reflect business structures or reporting needs. At the same time, the business continues to change, which means that technology plays catch up and finance spends significant time reworking data in spreadsheets.
Analytics takes business intelligence one step further. It involves not just querying data and reporting on required information, but regressing, correlating, forecasting and predicting future business scenarios by connecting the data points. For example, when analyzing customer profitability, business intelligence will identify which customers are the most profitable, while analytics will answer why they are.
There is also the question of who owns responsibility for this great opportunity? Business intelligence and its successor, analytics, initially developed in the domains of computer science, information systems, and marketing. Finance professionals are the business’s natural analysts. To this end, we would expect analytics increasingly to fall within the remit and ownership of the CFO.
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