ACCY 6802 Final Exam Questions PDF

CH5 Fraud in F/S & Auditor Responsibility Written representation with a\. fairness of F/S & adequacy of I/C over ICFR b\. states allegations of fraud. Auditing Standards Board (ASB) establish GAAS. AU-C 240.10 objective of auditor: a\. to identify and assess the risks of material misstatement...

CH5 Fraud in F/S & Auditor Responsibility Written representation with a\. fairness of F/S & adequacy of I/C over ICFR b\. states allegations of fraud. Auditing Standards Board (ASB) establish GAAS. AU-C 240.10 objective of auditor: a\. to identify and assess the risks of material misstatement of F/S due to fraud b\. to obtain sufficient appropriate audit evidence regarding assessed risk of material misstatement due to fraud, through design and implement appropriate responses c\. to respond appropriately to fraud identified during the audit Materiality: the significance of omission or misstatement in accounting information is likely to impact the decision of a reasonable user of that information. What are the difference between omission and misstatement? Omission is a failure to state something and misstatement is a false statement What dollar amount separate material from immaterial? There is no fixed dollar amount that defines materiality; instead, it is typically assess by a percentage. **[Benson and the 2% Misstatement]** During the audit of Biologic Co., Benson discovered a misstatement of \$200,000 on the F/S. The misstatement was 2% of total assets, below 5% materiality threshold used on that audit. CFO asked Benson to ignore the misstatement due to immateriality because a \$200,000 adjustment would cause Biologic to be in violation of loan covenants on a \$1 million bank loan. A. What is a loan covenant? A condition in a loan agreement b/w debtor and creditor that borrowers must meet to avoid penalties. B. Can Benson justify ignoring the misstatement based on the 5% materiality threshold alone? No, because qualitative factors, such as impact on loan covenants, make the misstatement material despite the below threshold. C. Considering the consequences on the client of making the change to the financial statements, what should Benson do? Benson should require the change of F/S and investigate the cause of misstatement. Qualitative factors that make a small misstatement material: - Item capable of precise measurement - estimate and degree of imprecision inherent in the estimate - a change in earnings or trends - hides a failure to meet analysts' consensus expectations for the enterprise - changes a loss into income or vice versa - concerns a segment or portion of registrant's business that has been identified as playing a significant role in registrant's operation - affects the registrant's compliance with regulatory requirements and with loan covenants or other contracts requirement - effect of increasing management's compensation - involves concealment of unlawful transaction AU-C 240 Responsibility of auditor 240.05 in accordance with GAAS for obtaining reasonable assurance that F/S as a whole are free from material misstatement, whether caused by fraud or error. Due to inherent limitations, an unavoidable risk exists that some material misstatements of F/S may not be detected. Management correction error (override) and existence of motive & opportunity are some signs that misstatement was intentional. Common ways to commit F/S fraud: - intentional misstatements or omissions - not follow proper accounting principles - forging or altering accounting records - intentionally using unreasonable estimate Auditors are moving forward doing 100% Transactional based audits. A 100% transactional based audit involves examining every single transaction in the financial records, rather than using sample techniques. Performing this audit remains impractical and may not be entirely feasible in practice. If auditors did a 100% transactional based audit, cannot detect all material misstatements especially for the data based on estimates. Expectation Gap: the difference between what management and user expect from an audit and what auditors are actually capable of giving. What is collusion? Two or more party working together to do something bad. What is forgery? Faking signature, documents, authorization AU-C 240 Fraud risk factors (fraud triangle) -- pressure (exist when management has perceived need to achieve expected earnings or financial outcome because consequences for failing to meet goals can be significant), opportunities (may exist when individual believes internal control can be overridden), rationalization (may exist when individual possess an attitude, character, set of values that allow them commit dishonest act) **The Auditor\'s Duty with Respect to Errors** - **To Detect:** The auditor must use care to identify errors that would significantly affect the financial statements. - **To Report:** The auditor must report material errors to management or those in charge. There is no need to report immaterial errors. **The Auditor\'s Duty with Respect to Illegal Acts** - **To Detect:** The auditor must use care to find illegal acts that could have a direct and material impact on the financial statements. **Direct Violations:** Violations that directly affect the financial statements, like tax fraud or accounting law violations.\ **Indirect Violations:** Violations that don\'t directly affect the financial statements, like environmental or labor law violations. - **After Finding an Illegal Act:** - Assess its impact on the F/S. - Direct and material, adjust the financial statements (including prior years if needed). - Indirect, check for material contingent liabilities (e.g., fines or penalties) and disclose them. - **To Report:** - The auditor should not report illegal acts without the client's consent but must report to the client's board or audit committee and ensure corrective actions are taken. If not, the auditor should consider withdrawing from the engagement. - In government audits, the auditor may need to notify regulatory authorities. **Withdrawal from the Engagement** - If there's a change in auditor, public companies must file Form 8-K with the SEC within four business days, stating: - If there were any disagreements with the auditor in the last two years. - If the audit committee recommended or approved the change. **SEC's View:** Disagreements must be disclosed if unresolved. CH6 Motivation for Fraudulent Financial Reporting Earnings Management: using accounting to achieve earnings targets. It is not necessarily fraudulent or illegal, but it is ongoing and a problem. Depending on who you ask, earnings management could be defined as: a\. using judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying performance of the company, or to influence contractual outcomes that depend on reported accounting numbers b\. Reasonable and legal management decision-making and reporting intended to achieve stable and predictable financial results What motivates companies to engage in earnings management? - Meat market expectations - Managing stock price - Tax minimization - M&A - To smooth income over time "accounting can influence contractual outcomes" refers to how companies might manipulate their reports to affect the terms of contracts with external parties such as loan covenant. Income smoothing is a strategy used in earnings might where a company attempts to reduce the fluctuations in its earnings by making its financial results appear more stable and predictable over time. To achieve income smoothing, companies use accounting to increase or decrease earnings as needed. Companies engage in income smoothing to reduce the unpredictability of earnings, to avoid a negative impact on stock price, and to ensure that the company meets analyst's expectations. Ethics of earnings management -- If we define this as the alteration of reports to affect the behavior of others, ethical issue become more apparent, especially if accounting is meant to provide unbiased and neutral info. Before the fact practice -- operational earnings management After the fact practice -- accounting earnings management After the fact creates a bigger problem because it directly impacts the integrity and reliability of financial reporting. Before the fact is also a problem because there might be economic substance to the transaction; may not be sustainable; and accounting may not reflect economic reality and therefore be deceiving. Proper accounting is based on the substance (what it is) rather than its form (what you call something). Defenders of income smoothing argue it is a\. done for a long time b\. everyone is doing c\. presents a better measure of long-term profitability (steady earnings over time and eliminate the impact of short-term fluctuations) Argument for income smoothing: if goal is to provide clearer view of L-T profitability or help in better decision making, might be ethical. Argument against: if potential for deception and lack of transparency that can be misleading, potential unethical. We would expect management would be willing to disclose a\. that they engaged in income smoothing b\. why they are smoothing earnings c\. what earnings would have been if they had not been smoothed Management might not be willing to give users both numbers because of the risk of negative perception, competitive concerns, difficult in explaining why was necessary, and legal concerns. Earning management/income smoothing can be achieved by accounting for a sale as a lease. Howard Schilit define Financial Shenanigans as "actions taken by management that mislead investors about a company's financial performance or economic health." - Recording revenue too soon: overstate revenue which should be belong to future years - Recording Bogus(false) revenue: recording which has not happened - Boosting income using one-time or unsustainable activities: it is not repeatable - Shifting current expenses to a later period: make revenue increase this year and make up next year - Employing other techniques to hide expenses or losses - Shifting current income to a later period: increase revenue this year - Shifting future expense to the current period: reduce income tax this year A frequently used way to engage in operational earnings management is by accelerating sales from future periods into the current period (pull in sales) Its business risk is that the company might face a fall in sales in the subsequent period and not sustainable. Ethical problems with pull in sales are: a\. misleading financial reporting b\. undermines transparency c\. S-T focus at expense of L-T sustainability Revenue recognition is a key area for earnings management. It usually involves recognizing and reporting revenue that has not been earned yet or may never be earned. To be earned means: a\. there is valid contract b\. company has performed the agreed upon actions c\. customer has a commitment to pay d\. collection is reasonably assured If company has multiple performance obligation in the contract, then the company must allocate contract price among all the obligations and recognize revenue as it is earned for each. Users of F/Ss wants to see Earnings Quality, in particular its core business activity. A high per-share stock price is not an indicator of high-quality earnings. What is transparency? Being open and honest with information; providing clear financial statements without hiding important information. Red flags that fraud may exist because of overly aggressive accounting and outright manipulation of earnings: - Growth in the market share that seems unbelievable - Frequent acquisitions - Management growth strategy and emphasis on earnings and EPS - Reliance on income sources other than core (may be engage in transactions to manage earning) - One-time sources of income - Growth in revenue that doesn't line up well with changes in receivables or inventory - Unexpected increase in A/R - Slowdown of inventory T/O - Reduction in reserves - Not reserving for possible future losses - Reduction in discretionary costs at Y/E (possibly want to cut the expense and boost earnings) - Unusual increase in borrowings; short-term borrowing at Y/E - Extension of trade payables longer than normal credit - Change in top management, auditors - Change in accounting policies towards more liveral applications These are not fraud, just indicators of an environment where there may be pressure or opportunity to manage earnings or commit fraud. Use Financial Statement Analysis Compare changes in revenue or expenses to changes in cash flows or changes in receivables or inventory. When a company's operations and accounting principles are consistent, then those interconnected numbers should change proportionally and in expected directions. If there are unexpected change, get a good explanation. Work with Certified Fraud Examiner. CH 7 Consequences of Earnings Management: the need for ethical leadership in accounting Company will discover that earlier F/Ss contained an error, misstatement, or omission. Concerns should include: - How it affect the company and stakeholders? - Can fix this issue and prevent harm? - How did it happened, how was it detected, how we prevent similar problem? The legal and professional obligations regarding changes to previous F/S depend on whether the change is due to a\. change in accounting principles used b\. change in an estimate used c\. error correction Change in accounting principle If principle used earlier violated GAAP, then that is an error. Change in accounting principle creates a risk that F/S are not comparable over time and the company is manipulating earning. Change only when either: required by new rule or change is made voluntarily on the basis that the new is preferrable. If done voluntarily, a public company must file preferability letter from its auditor. Companies must use new to restate all prior year shown in comparative F/S. Change in Accounting Estimate Change results from new info that requires adjusting the carrying amount of existing asset or liability. Estimate: subjective judgement, often used in earnings management, auditor should examine assumptions that underlie estimate. If material effect, must disclose the effect of change on earning. If data was available in previous period but was not used, then it is error correction. If data for the previous period is new, then it is change in accounting estimate. When change, explain why change is better, disclose the change, present comparative statement, and if public company, file a preferability letter from auditor. Error in Earlier Financial Statements When error discovered, next step depends on the materiality of the error to F/S. Even if SEC stated the item is material if the magnitude of item is probable, it does not mean that something with small dollar value is automatically immaterial. It can be material if key financial ratio. When judging the materiality of an error, companies and auditors must consider both quantitative and qualitative factors. The prior year F/S are not relevant to current decisions, and therefore error in the prior years is immaterial. It is not persuasive because prior F/S are still relevant for today's decision making. It needs to be comparable. Reporting Correction of an Error 1\. Out-of -Period adjustment (not in the period it occurred): used when error is immaterial to current and prior period. Simply make correction on the current F/S only. 2\. Revision Restatement (Little R): used when error is immaterial to prior period, but correcting it in current period could materially misstate the current period financials. Make a correction in current year for each year being reported. No need to reissue prior F/S, notify they can't rely on old F/S, or amend form 10k or form 10q. 3\. Re-issuance Restatement (Big R): used when error is material to prior period F/S. Must restate and reissue prior F/S. Correction made by filing amended form 10k and 10q for relevant periods. Therefore, restate prior F/S, file form 10k and 10Q, notify users, and disclose re-issuance. SEC requires that within 4 days of determination by public company or auditor that prior period F/S can no longer be relied on, the company must disclose this fact on Form 8k. CAVEAT: This can lead to misleading and undermining trust for concluding the errors are immaterial. The number and percent of Big R restatements are down. More often companies are issuing stealth restatements -- little R that simply disclose the prior period error on their next periodic report, either form 10k or 10q without filing form 8k. We call it 'stealth' because company is quietly or subtly correcting prior period error without drawing much attention to the correction. This can create an ethical problem when there is an intention to avoid and intention to influence users. Clawback Provisions allow a company to recover compensation from executives if F/S are late restated due to error and misconduct. This would make company more cautious about issuing restatement, as it may result in financial and reputational costs. Many problems can be prevented by good corporate governance and ethical leadership. If company's corporate governance model gives priority to the shareholder interests and little concern for the interests of other stakeholders, it can lead to earnings management and other financial reporting issues. Corporate governance system can be failed due to: a\. not setting an ethical tone at the top b\. management override of I/C c\. creating excessive pressure to achieve financial targets d\. lack of an independent audit committee e\. lack of ethical leadership Leadership is motivating collective efforts to accomplish shared objectives. - Motivating: inspiring and encouraging / put forth their best efforts - Collective efforts: combined contributions and actions of a group, working together toward a common purpose - Shared objectives: common goals or outcomes that are agreed upon by all members A traditional form of leadership is Transactional Leadership with a focus on S-T goals, structure, and top-down direction. It emphasizes planning, monitoring, and controlling performance using rewards and punishment. Ethical leadership differ in that it places emphasizes values, openness, and trust. It supports long term success because: a\. Transactional leadership creates more pressure b\. Ethical leadership reduces the likelihood of ethical problems Social Learning Theory says that within organizations, individuals look to role models and imitate their behavior. Role models are among the most powerful means of transmitting values, attitudes, and behaviors. This suggests leaders should model ethical behavior. 3 recommended models of leadership: 1\. Authentic Leadership: reflected in the definition of ethical leadership from the Center for Ethical Leadership: which is knowing your core values and having the courage to live them in all parts of your life in the service of common good. 2\. Transformation Leadership: brings about change to improve systems or to cause followers to support higher organizational goals. 3\. Servant Leadership: puts the needs, growth, and wellbeing of their organization, employees, and community above their own needs. Focuses on getting employees what they need to succeed. Case study: 1\. under-reporting time on audit is a problem because it leads to inaccurate billing which affect reliability. 2\. prematurely signing-off on audit procedures is a problem because it indicates there is a potential error or fraud, which affects trust. 3\. accepting weak client explanations for accounting choices is a problem because it can lead to misleading F/S, which affects transparency and accuracy. These reflect failed leadership due to inadequate oversight, poor audit practices, and setting unrealistic time to complete the job. CH8 Auditors' Legal Liability and Defenses Differences between "being liable", "being guilty", and "being illegal"? "being liable": related to civil side such as breach of contract. "being guilty": related to criminal "being illegal": related to wrongful act Legal Liability of Auditors: Three bases (theories of recovery) for auditor legal liability: Contract (breach of a promise), Tort (negligence -- carelessness & Fraud -- intentional), Securities Laws (civil & criminal) Contract liability Liability is based on contract between the auditor and audit client. Engagement letter Auditor can be held liable for breach of an implied promise of due care (implied promise is not written but implied by law). Due care = reasonably competence, which requires the knowledge, skill, and judgement of reasonable professional. Whether professional exercised due care is a question for the judge or jury. Judge or jury do not need to be accountant or CPA but need to get expert test. Professional auditing standards are set by: a\. GAAS b\. AICPA Code of Professional Conduct c\. Federal and state regulation Privity of Contract (one of defense): only those who signed a contract can enforce it, excluding third parties from suing or being sued under its terms. Tort Liability Torts are wrongful act other than a broken promise. Two torts can arise in a failed audit: Negligence and Fraud Negligence: failure to use the required amount of care. Plaintiff must prove: a\. auditor owed a duty of care b\. auditor breached the duty of care c\. caused d\. Plaintiff's injury Auditor owe their duty of care (different states have different rules): 1\. Ultramares Rule: auditor's duty extends only to the client. The rule was modified to included third parties in a near-privity relationship (someone to whom the auditor directly provided the audit report) -- New York mostly 2\. Foreseen User (restatement) Rule: auditor is liable for negligence only to its client and third parties who are foreseen, or member's of a limited class of third parties foreseen, relying on the F/S -- majority of states 3\. Foreseeable User Rule: All whose injuries are a foreseeable consequence of the negligence. Defenses to Negligence Once Plaintiff meets its burden of proof, the burden shifts to the defendant to prove a defense. Two alternative defenses apply in negligence cases when Plaintiff also was at fault: a\. Contributory Negligence: Defendant has no liability if Plaintiff's carelessness b\. Comparative audit: Plaintiff's fault is compared to Defendant's fault, and Plaintiff can only recover that proportion of its loss that was the Defendant's share of total audit. Recovery amount depends on what rules States follow. If the company use traditional rule, should consider either jointly or separately. Joint and several liability: where there are multiple defendants at fault, the plaintiff can recover from all of them jointly, or recover severally from any one or more of them severally. In many states, a different allocation rules applies (comparative fault systems) Proportionate Liability: each defendant is liable for the share of the loss that is their share of the total fault. Fraud Elements of fraud: a\. defendant made a material false statement or omission b\. which knowledge it was false ("Scienter") c\. reliance by the Plaintiff d\. Injury Scienter is proved by showing the defendant either: a\. knew (had actual knowledge) b\. did not believe it is true, which acted with reckless disregard An auditor that commits fraud can be sued by all whom injuries are a foreseeable consequence of the fraud. This is the usual scope of liability for negligence. A person normally is liable to all foreseeable users of the wrongful act. In practice, an auditor's liability for fraud extends to all who were hurt by relying on the false statements. This is not the rule when auditors are sued for negligence. Statutory Liability Found primarily in two major federal securities law: 1\. Securities Act of 1933 -- regulates the issuance of a security to the public Purpose: to ensure investors have the information they need to make intelligent investment decisions. Issuers must file with SEC a registration statement containing audited F/S. Section 11 liability -- if registration materials are false, investors can sue issuer and everyone who signs the registration statement for the false statements. All Plaintiffs have to prove: a\. they lost money b\. registration materials contained a material false statement or omission What the investor need not prove: a\. fraud b\. negligence c\. reliance d\. privity of contract The most important defense is to prove they did Due Diligence (no negligence) The defendant must prove: a\. made a reasonable investigation b\. reasonably believed the statement was true 2\. Securities Exchange Acy of 1934 Public companies must file an annual report on Form 10k, including audited F/S. This exposes auditors to potential liability under the 1934 Act. Section 10b and Rule 10b-5 -- it is a crime to commit any fraud in any securities transaction (no exception) Courts allow private, civil suits to enforce the rule to recover their losses. The 1934 Act is very different from 1933 act, because it requires: a\. Scienter = fraudulent intent b\. Reliance by the Plaintiff Fraud on the Market Theory Based on two premises: a\. Typical investors (mostly rely on market stock price by not making independent calculation) b\. The efficient market hypothesis (information become available and quickly reflect to market) Good news: liability under federal securities law is proportionate not joint and several (not liable for all the damages), except where there was intentional wrongdoing. Bad news: a\. both 1933 and 1934 Act have criminal provisions for intentional violations. b\. The SEC can punish professionals under Rule of Practice 102€ for: \- lacking qualification to do SEC work (incompetence) \- willingly violating or aiding another in violating securities law \- engaging in "improper professional conduct" - Any intentional violation, or multiple careless violations of professional standards. Sanctions (punishment) = civil (not criminal) penalties up to \$500K and bar (permanent) or suspension (temporary) from SEC practice. When auditing firm violates auditing standards, it can be penalized by PCAOB. Individual auditors can also be liable for the firm's violation of audit standards (not only firm but also individual auditors). This is called "Associated person liability." Individual auditor could be held secondarily liable only when they acted recklessly. But in 2024, PCAOB modified the rule to make individual auditors to be held liable when acted negligently. It is bad news because negligence is easier to prove than recklessness, increasing legal exposure and making to meet high standards. Recklessness is an extreme form of negligence. The rule applies only to people in a position to contribute to the firm's violation directly and substantially. As a result, it is partners and senior auditors who bear the risk. Foreign Corrupt Practices Act (FCPA) Two major provisions: 1\. Anti-bribery provisions: offering a bribe is a violation, regardless of whether bribe is accepted or effective. Rule: illegal for any US person to pay or offer to pay a bribe to a foreign politician, party, or government officials to influence a government decision. Bribing private party is not prohibited by FCPA, unless there is reason to know (not absolute know) it will be passed on to a politician or government official. Red flags are large consulting fee, family contract (conflict of interest) and incentive, etc. Exception: under FCPA, bribes to foreign are allowed: - Facilitation (Grease) payments that merely facilitate non-discretionary government actions. Ex. routine, just paying to lower level of employee who does not have power to affect government actions. 2\. Accounting provisions All public companies must have a system of I/C and Financial Reporting to ensure that all payments are properly authorized and reported. These controls help prevent bribery by ensuring all payments, including bribes, are documented and not hidden. It applies even to Grease Payments. US is increasing the enforcement of the FCPA. Auditors need to evaluate client's I/C over bribery and plan the audit to detect bribes that could materially affect the F/S. Whistleblower can share in SEC recoveries in FCPA bribery cases and receive up to 30% of SEC recovery.