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Case #4.

5 Waste Management: Top-Side Adjusting Journal Entries


I. Technical Audit Guidance
To maximize the knowledge acquired by students, this book has been designed to be read in
conjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB Auditing
Standards that are referenced in this book are available for free at:
http://pcaobus.org/Standards/Pages/default.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:
http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisions
of the Sarbanes-Oxley Act of 2002 is available for free at:
http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarban
es-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge
PCAOB Auditing Standard No. 5
Paragraph #14
Paragraphs #26-27
Paragraphs #A8 (in Appendix A)
AU Section 316
Paragraphs # 58-60
III. Classroom Hints
This case provides students with an opportunity to understand what is meant by company
level controls and recognize their importance in completing an audit of internal control over
financial reporting as mandated by Section 404 of SOX. By providing details about Waste
Management's upper management behavior, including their use of top-side adjusting journal
entries in the period-end financial reporting process, students are able to see the relationship
between an audit client's tone at the top and their audit testing strategy. Finally, the case
questions provide an opportunity to discuss the role of the internal control system in helping to
prevent or detect material misstatements.

We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
acquisition of technical/factual type knowledge increases dramatically when such knowledge can
be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to
impart the relevant post-Sarbanes technical audit knowledge, outlined above.
This case assignment will work best if it is scheduled to coincide with the internal
controls topic or at the beginning of an instructors discussion of the audit of internal control
over financial reporting as required by Section 404 of SOX. Importantly, in Auditing Standard
No. 5, the PCAOB stressed the importance of identifying, understanding and evaluating the
effectiveness of an audit clients entity level controls (e.g., tone at the top and period-end
financial reporting process) as the first step in an audit of internal control over financial
reporting. Because of their pervasiveness throughout the internal control system, the PCAOB
believes it to be essential to carefully evaluate the entity level controls first in order to complete
an effective and efficient audit of internal control. Thus, one of the ways that the PCAOB
believes that the audit can be made more efficient (and effective) is to evaluate entity level
controls first as a way to provide a foundation towards the understanding of a clients system of
internal control.
Since the concept of entity level controls is likely to be new to students, we believe that
instructors should allocate enough time to carefully explain this concept in class (see paragraphs
#22-27 of Auditing Standard No. 5). In particular, we recommend that instructors take the time
to explain the special importance of the period-end financial reporting process to students and the
special risks presented by top-side adjusting journal entries. The bottom line is that the upper
management team at Waste Management helped to perpetrate their fraud using "top-side"

adjusting journal entries at the end of the reporting process. Since these journal entries are
typically not generated at the business process level, they can often provide a mechanism for
upper managers to circumvent the internal control system and possibly perpetrate a fraud. Thus,
auditors must always pay close attention to these entries.
This case also provides an opportunity to focus on the auditors responsibility to help
prevent and/or detect fraud in the post-Sarbanes audit environment. For example, when
discussing the student responses to question #4, we recommend that instructors point out that the
PCAOB has made it clear that preventing and detecting fraud MUST be the focus of the audit
process (the term fraud was mentioned 19 times in their Auditing Standard No. 5). In addition,
we recommend that instructors use the class discussion to illustrate the importance of identifying
specific control activities to support specific relevant assertions for each significant financial
statement account, a critically important consideration in the post-Sarbanes audit environment.
IV. Assignment Questions & Suggested Answers
1. In your own words, explain what is meant by a top-side adjusting journal entry. If
you were auditing Waste Management, what type of documentary evidence would
you require to evaluate the propriety of a top-side adjusting journal entry?
Top-side journal entries are adjustments that are typically made by top management at the
corporate level. According to the AICPA, these adjustments are typically made at the end of the
financial reporting period and are not always posted to the general ledger.1 Often, these entries
are not directly associated with actual economic activity as they do not emanate from the
business operations of a division or a business unit.
In evaluating the propriety of a top-side journal entry, an auditor would want to first
interview management and review any set policies and procedures related to top-side journal
entries. The auditors would also want to vouch the supporting documentation for economic
1

AICPA. Journal Entries and Other Adjustments. The CPA Letter/Public Accounting Firms. June 2003.

substance and ensure that it has been properly entered in the financial statements. If, for
instance, the top-side entries resulted in decreased depreciation due to increasing the salvage
value of the trucks, the auditor may want to obtain written confirmation from an appraiser, or
other evidence from a third party. Students may discuss various examples and types of evidence
that would be required to evaluate the propriety of a top-side journal entry. Students answers
should support their examples as in the example above. The absolute key for the auditor is to
evaluate the economic substance of the entry with sufficient and competent evidence.
2. Consult Paragraph 14 of PCAOB Auditing Standard No. 5. Based on the case
information, do you think this paragraph relates to the use of top-side adjusting
journal entries at an audit client like Waste Management in any way? Why or why
not?
Paragraph #14 of Auditing Standard #5 focused on the importance of auditors utilizing the
results of their fraud risk assessments as part of the audit. Specifically, according to the
paragraph, the auditor should evaluate whether the company's controls sufficiently address
identified risks of material misstatement due to fraud and controls intended to address the risk of
management override of other controls. Since top-side entries are a mechanism used by upper
managers to circumvent the internal control system, paragraph #14 of Standard No. 5 clearly
identifies the danger of unusual journal entries and entries made late in the reporting process
explicitly, in the standard.
At Waste Management, the management team was improperly overriding internal controls by
making fraudulent top-side adjusting entries. The entries had no economic substance.
Interestingly, the operating groups were not even aware of the adjusting entries that were being
attributed to their operating groups. As such, they were being used as a way for internal control
to be circumvented, essentially by management override.

3. Consult Paragraphs 26-27 of PCAOB Auditing Standard No. 5. Do you believe that
the period-end financial reporting process should always be evaluated by auditors as
a significant and material process during an audit of internal control? Why or why
not?
Paragraphs #26-27 of Standard No. 5 highlight the importance for auditors to understand and
evaluate the period-end financial reporting process at a detailed level. Indeed, according to
paragraph #26, because of its importance to financial reporting and to the auditor's opinions on
internal control over financial reporting and the financial statements, the auditor must evaluate
the period-end financial reporting process. The period-end financial reporting process includes
the following:
Procedures used to enter transaction totals into the general ledger;
Procedures related to the selection and application of accounting policies;
Procedures used to initiate, authorize, record, and process journal entries
in the general ledger;
Procedures used to record recurring and nonrecurring adjustments to the
annual and quarterly financial statements; and
Procedures for preparing annual and quarterly financial statements and
related disclosures.
Paragraph # 27 describes what the auditor should evaluate when obtaining an understanding
and evaluating the period-end process. Specifically, As part of evaluating the period-end
financial reporting process, the auditor should assess:
Inputs, procedures performed, and outputs of the processes the company
uses to produce its annual and quarterly financial statements;
The extent of information technology ("IT") involvement in the period-end
financial reporting process;

Who participates from management;


The locations involved in the period-end financial reporting process;
The types of adjusting and consolidating entries; and
The nature and extent of the oversight of the process by management, the
board of directors, and the audit committee.
The period-end financial reporting process should always be a significant process in the
audit of internal control since many frauds can occur at this point of the process, especially if a
company is falling short of the targets and/or projections set by the company and/or the analysts.
It is also important to understand the period-end financial reporting process in detail to ensure
that no one manager has too much power to override controls and make material adjustments to
the financial statements. As a result, it should always be considered a significant process since
the understanding and evaluation of the process has such a large impact on the financial reporting
process.
4. Consult Paragraphs .58-.60 of AU Section 316. Identify one specific control
procedure that could be designed to prevent or detect a misstatement related to a
top-side adjusting journal entry.
According to Paragraph #60 of AU Section 316, An entity may have implemented specific
controls over journal entries and other adjustments. For example, an entity may use journal
entries that are preformatted with account numbers and specific user approval criteria, and may
have automated controls to generate an exception report for any entries that were unsuccessfully
proposed for recording or entries that were recorded and processed outside of established
parameters. The auditor should obtain an understanding of the design of such controls over
journal entries and other adjustments and determine whether they are suitably designed and have
been placed in operation. As a result, it is very important that the auditor take the time to

explicitly link internal control activities to the risk of material misstatement posed by adjusting
journal entries.
Clearly, there are a number of allowable answers to this question. Importantly, this question
is also designed to help the students understand the differences between preventive controls and
detective controls and the importance of each in a well-functioning internal control system.
And, it would be difficult to design control procedures that are likely to be effective against topside entries at Waste Management because of the weak control environment and the lack of
ethics and integrity exhibited by top management. This point should be made because it
illustrates the pervasiveness of the control environment. The bottom line is how effective are
control procedures if management has the power to override internal controls?
With that said, one specific control procedure that could be designed to prevent a
misstatement related to a top-side adjusting entry from occurring would be to involve
management from the operating units in the decisions to make all top-side adjusting entries
related to their own operating units. For example, the company can implement a policy that both
the top corporate executives and the management from the operating units must sign off on the
entries. Another specific control procedure that could be designed to detect a misstatement that
originated from a top-side adjusting entry would be to require that all significant top-side entries
be reviewed by the audit committee.