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This course provides case studies drawn from "real-life" situations involving CPAs in accounting and auditing practices. It helps you take a proactive, riskavoidance stance by pointing out common pitfalls and presenting alternative courses of action. You will explore ethical issues in the context of actual regulatory and court proceedings that were resolved both in favor of and against A&A professionals in public practice. Gain insights from placing yourself in situations that require application and understanding of relevant ethical considerations. You will consider real-world A&A cases that deal with professional responsibilities of engagement and engagement quality review partners, managers and staff in the context of key A&A ethical matters such as independence, permitted and prohibited services, earnings management issues, records management and client confidentiality. You’ll consider these issues in relation to key A&A topics faced by every business and their professionals, such as revenue recognition, materiality, controls and procedures and financial reporting questions or failures, among others. You will leave this course with a renewed sense of appreciation for the pitfalls faced by every financial professional in public practice and a heightened sensitivity for the types of ethical dilemmas you could face in the future.
Objectives:
Prerequisite: Experience in financial reporting
733601
Chapter 1 - Case 1 – Pointer Electronics, Inc. – You Are the Audit Partner
Learning Objectives
Introduction
In Chapter 1, you are placed in the position of being a concurring partner on an audit that is nearing its completion. You have identified certain excess reserves that do not appear to be presented in accordance with GAAP and have discussed these concerns with the engagement partner. The engagement partner has not yet proposed adjustments to eliminate the excess reserves, and has argued that the proposed adjustments are not material to the company’s financial statements taken as a whole. The company has received an unqualified audit opinion in the past and it appears that the reserves may have been an issue in prior years’ audits, although the work papers evidence no disagreements and there is no indication that the prior concurring partner was focused on the reserve issue. You are considering taking the position that the report be withheld unless the adjustments are made. As the concurring partner, you must decide to whom, and when, this position is communicated, whether the audit firm has conducted the audit in accordance with GAAS, and what recommendations you will make to the audit committee of the board. Issues raised by this case include integrity and objectivity, compliance with auditing standards and accounting principles, and procedures for investigating and reporting irregularities.
Focus Points
"Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation. As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; integrity may be losing out to illusion." Former SEC Chairman Arthur Levitt, speech before The NYU Center for Law and Business, September 28, 1998. [Emphasis added]
"The purpose of reserves are to reflect a company's true revenues...But these accounting practices do 'open up the door to earnings management, if not done right.'" SEC Is Investigating Microsoft's Accounting Practices, July 1, 1999 New York Times, quoting Jack Ciesielski of Analyst's Accounting Observer. [Emphasis added]
On June 3, 2002, the SEC announced that it had entered into a settlement with Microsoft Corp. following an investigation of Microsoft's accounting practices from July 1994 through June 1998. "The agency said Microsoft enhanced its financial results by setting aside artificially large reserves to reduce revenues, with the idea of reversing that procedure to record the revenues in less profitable times." CBSNews.com story dated June 3, 2002. [Emphasis added]
Regulatory Issues
Setting aside the issue of revenue recognition, the deliberate manipulation of reserves or estimates is clearly a primary focus of the SEC's enforcement program. Examples of recent enforcement actions addressing reserve manipulation include Xerox, Sunbeam, Enron, and Williams, not to mention Microsoft and the earlier case of W.R. Grace. In the regulatory context, the issues of reserve or estimate manipulations most often appear once there has been a failure or circumvention of internal controls.
SFAS 5, Accounting for Contingencies, permit a company to establish reserves for "identifiable, probable and estimable risks" and forbid the establishment of reserves for general or unknown business risks unless they meet the accrual criteria of SFAS 5. "Excess" reserves are to be treated just as a general reserve; that is, excess reserves that do not meet the accrual criteria should be immediately released into income once they are identified.
Changes in accounting estimates or accounting methods, including those estimates or methods that may alter existing reserves or result in the creation of new reserves, require disclosure under APB Opinions 20 and 28. Under SAS 61, if an auditor finds that management's recorded estimates are clustered at either end of the auditor's range of acceptable amounts, or if the cumulative effect of estimates used reflects a possible bias, the auditor should consider whether such matters should be communicated to the audit committee.
SASs 55 and 78 provide the outside auditor with a framework for defining and understanding a company's internal control structure in order to plan an audit. The auditor must understand the five interrelated components of the internal control system, being (1) the control environment, (2) risk assessment, (3) the control activities, (4) information and communication, and (5) monitoring. While the effectiveness and efficiency of operations and compliance with applicable laws are addressed by these SASs, they concentrate principally on controls that affect the reliability of financial reporting.
SAS 60 requires the outside audit firm to report to the audit committee any significant internal control deficiencies that could affect financial reporting. In a speech on September 4, 2002, the President of the AICPA outlined an agenda of six items as to which the Institute intends to take a leading role in addressing. One of the items: Revise standards so the public will be put on notice when an auditor communicates internal control weaknesses to an audit committee.
The interpretations of SAS No. 47 (AU Section 312) state that financial statements would be considered materially misstated if they "contain misstatements whose effect, individually or in the aggregate, is important enough to cause them not to be presented fairly, in all material respects, with GAAP."
AU Section 508.36 states that a judgment of materiality should take into account (1) the significance of an item to a particular entity, (2) the pervasiveness of the misstatement, and (3) the effect of the misstatement on the financial statements taken as a whole.
Recent Developments
On October 26, 2005, the Professional Ethics Executive Committee issued Ethics Rulings Nos. 113 and 114 under Rule 102 and Rule 101, respectively, under the AICPA Code of Professional Conduct. The rulings address an issue that is implicated in the following case study: the acceptance of gifts or entertainment from a client. The guidance provided by the rulings includes the following:
Additionally, a member is presumed to lack integrity if he or she accepts or offers gifts or entertainment knowing, or which the person was reckless in not knowing, that this would violate policies maintained by the member, client, customer, or vendor or applicable laws or regulations.
If the gift or entertainment is reasonable in the circumstances (see the factors listed above under "Objectivitiy" in evaluating reasonableness).
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