Lectures - Acct 555

Week 1
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Profession, Standards, and Reporting
The Auditing Profession

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The CPA Vision Project gives an overall view of where the profession stands and where it is
headed. An understanding of the overall profession is crucial to a good foundation of the role
auditors have in the accounting profession and in the business world.
The Sarbanes-Oxley Act (SOX) of 2002 has created jobs for everyone in the accounting
profession. The Securities and Exchange Commission (SEC), Public Company Accounting
Oversight Board (PCAOB), and the American Institute of Public Accountants (AICPA) are all
integrally influential over the activities of registered CPA firms and impact the global
community.
An auditor's professional judgment of the representations of management leads to the all-

important end result, known as the auditor's report.
CPA Vision Project

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The objectives of the CPA Vision Project include leveraging CPA core competencies and values
in order to guide current and future initiatives to support the profession and the public interest.
The purpose of the CPA vision is to better define the CPA's role in an increasingly competitive
environment. This is being done by assembling a cross-functional team of experts composed of
internal and external experts and targeted focused groups of stakeholders. "Moving up the value
chain" refers to an incremental analysis (from the end customer to the CPA) of the services
provided and value generated by the profession.
Our first week's discussion together begins with your understanding of the CPA Vision Project
and the direction the accounting profession is headed to better serve the needs of the investing
public.
Auditing Standards and Regulation

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The auditing profession has generated 10 basic auditing standards that serve as guidelines for the
auditors to follow. In addition to the GAAS, there are auditing standards that are specifically
identified to government audits, known as Generally Accepted Government Auditing Standards
(GAGAS). We do not review the government standards in this course, but you should be aware
of their existence.
A significant aspect of any successful audit is the proper exercise of the auditor's professional
judgment. Following the standards is not enough without incorporating professional judgment.
An auditor's professional judgment is strongly influenced by many competing factors, including
the public's needs, client interests, and governmental regulation.
Security issuer clients are regulated closely by the SEC, a federal government agency. CPA firms
must register with the agency and are subject to particular rules and regulations beyond the rules
of the AICPA. The auditor is challenged to exercise professional judgment while complying with
the standards and reaching the appropriate conclusionary report on the fairness of the financial
statements presented as a whole. SOX established the PCAOB to oversee registered accounting
firms in the practice of servicing public entities issuing securities. This oversight board
establishes auditing and related professional standards to be used in the preparation and issuance
of audit reports for issuers.
Through the readings, your research, and the discussion we shall share in Week 1 of this course,
you will develop a better understanding of the external auditor's important role in the global
business community.
Audit Reports
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When we have finally completed the audit of our client, we will issue our findings in a report.
Investors and creditors place great reliance on our opinions regarding whether or not the
financial statements fairly present the financial position of the business.
Review Question
Please work Review Question 3-6 in the 14th edition; this is under the Review
Question section, not Problems.
What five circumstances are required for a standard unqualified report?
An unqualified report may be issued under the following five circumstances:

a) All statements- balance sheet, income statement, statement of retained
earnings, and statement of cash flows- are included in the financial statements.
b) The three general standards have been followed in all respects on the
engagement.
c) Sufficient evidence has been accumulated and the auditor has conducted the
engagement in a manner that enables him or her to conclude that the three
standards of field work have been met.
d) The financial statements are presented in accordance with generally accepted
accounting principles. This also means that adequate disclosures have been
included in the footnotes and other parts of the financial statements.
e) There are no circumstances requiring the addition of an explanatory paragraph
or modification of the wording of the report.
Click here to review the solution after you have come up with an answer.
Review Question
Please work Review Question 3-14 in the 14th edition; this is under the Review
Question section, not Problems.
Distinguish between a qualified opinion, an adverse opinion, and a disclaimer of

opinion, and explain the circumstances under which each is appropriate.
Click here to review the solution after you have come up with an answer.
Becker CPA ReviewAudit Reports

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Dear student,
In an effort to enhance your comprehension of this difficult subject and to introduce you to some
of the tools available from Becker Professional Education, you are being given access to a series
of links (see below) to Becker CPA Review materials on audit reports.
We hope you find this access to be an excellent complementary resource for you during Week 1
of this course. However, it must be emphasized that your eBook readings and other assigned
materials for this week will be covered in the graded assessments for this course, so you will
want to focus on those as you prepare for any exams, projects, quizzes, and so forth.
Becker CPA Review Content Links
Becker Multimedia Lecture on Audit Reports
Becker MCQs on Audit Reports
Becker Simulation on Audit Reports
Becker Lecture PDF download
Week 2
Ethics and Legal Responsibility
Rule 101 Independence
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This week, we more closely examine the rules by which the profession requires CPA auditors to
live. The professional is challenged to comply with federal regulations, AICPA rules, statutory
laws, and the common law. A violation of any of these can place the CPA in professional
jeopardy.
Independence is very important to our roles as auditors because the users of financial statements
want to be sure that we take an unbiased viewpoint when we perform our audits. Because of its
importance, independence is the first rule of conduct.
So, to protect our independence, we must be both independent in fact and independent in
appearance. Independence in fact exists when the auditor is actually able to maintain an unbiased
attitude throughout the audit, whereas independence in appearance is dependent on others'
interpretation of this independence (hence their faith in the auditor).
Video
The CPA profession at its core is highly dependent upon independence in fact and
appearance. Please view the video below for a discussion on independence and its
role in the auditing profession.
Independence (2:17, 1.4MB) Transcript
For 56K users: You may want to download these video clips to your local drive and watch them from your computer. (To download
a video clip, right-click the video clip link and choose "Save Target As...")
The profession is a blend of disciplines from accounting to consulting to auditing and more. The
public depends on the professional judgment of the hard-working CPA auditor to give members
of the investing public a greater understanding of the companies they are evaluating. As such,
CPA auditors must have the knowledge and ability to understand and access the value of the
client's financial statements.
Who in the United States has not heard of the downfalls of Arthur Andersen, Enron, WorldCom,
Tyco, and Bernie Madoff, among countless others? As a result of their misadventures, new
legislation has greatly affected the way business is done. It has also opened up new opportunities
for those in the accounting profession. A pitfall for CPAs to navigate is keeping their
independence and integrity intact when the client is pushing for more control over what is
reported.
Review Question
Please work Review Question 4-26 in the 14th edition.
Ann Archer serves on the audit committee of JKB Communications Inc., a

telecommunications start-up company. The company is currently a private
company. One of the audit committees responsibilities is to evaluate the external
auditors independence in performing the audit of the companys financial
statements. In conducting this years evaluation, Ann learned that JKB
Communications external auditor also performed the following IT and e-
commerce services for a company.
1. Installed JKB Communications information system hardware and

software selected by JKB management
2. Supervised JKB Communications personnel in the daily operation

of the newly installed information system
3. Customized a prepackaged payroll software application, based

on options and specifications selected by management
4. Trained JKB Communications employees on the use of the newly

installed information system
5. Determined which JKB Communications products would be

offered for sale on the companys Internet website
6. Operated JKB Communications local area network for several

months while the company searched for a replacement after the
previous network manager left the company
36
Consider each of the preceding services separately. Evaluate whether the
performance of each service violates the AICPAs Code of Professional Conduct.
Click here to review the solution after you have come up with an
answer.
Professional Ethics
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The CPA external auditor owes a primary duty to the investing public. The AICPA recognizes
that the CPA must adhere to higher standards of behavior if the profession is to be respected and
trusted. As such, it has developed specific guidelines or rules of conduct for CPA members. A
detailed discussion of the code of professional conduct appears in Chapter 4 of your readings.
Your comprehension of this material is key to understanding the professional standards of the
CPA auditor.
The code of professional conduct is divided into four parts.
Principles establish ideal standards of ethical conduct stated in philosophical

terms. They are not officially enforceable.
Rules of conduct are the minimum standards of ethical conduct stated as

specific rules. They are officially enforceable.
Interpretations of rules are intended to clarify the rules of conduct. They are
not officially enforceable, but a practitioner must justify any departure.
Ethical rulings are answers to specific questions submitted to the AICPA by

practitioners. They are not enforceable, but a practitioner must justify any
departure.
Students will find that the rules are not as straightforward as they may seem. You must read the
interpretation of the rules in Chapter 4 of your text in order for you to fully grasp the significance
of the professional rules of conduct. Spend time understanding the differences between
circumstances that challenge the auditor's independence Rule 101 versus their integrity Rule 102.
A diligent attempt at working through the homework problems assigned will enhance your
ability to grasp the TCO to understand the ethical responsibilities of auditors under various
business situations, including fraud auditing. They are not one and the same. A fuller
understanding of these significant rules helps the successful auditor in maintaining his or her
reputation and license!
Legal Liability
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When performing services for their clients, auditors have a duty to provide a level of care that is
reasonable. Auditors who fail to exercise due care in the performance of services to their clients
may be liable for breach of contract. Further, auditors may also be held liable to third parties
under civil law, liable to shareholders under federal securities law, and even liable under criminal
law. We must act prudently when we undertake our audit engagements.
As auditors, we can take steps to protect ourselves from legal liability, such as
keeping current on professional auditing standards;
participating in continuing professional education seminars on auditing;
hiring audit personnel with the requisite skills;

overseeing the performance of client services;
accepting engagements from honest clients;
making sure we remain independent;
taking whatever steps necessary to understand the clients business when

doing an audit;
carrying malpractice insurance;
performing quality audits;
properly documenting whatever client work is performed;
obtaining an engagement letter and a representation letter; and
seeking legal counsel whenever necessary.
Each of the Big Four firms has experienced the pain of making mistakes of varying degrees and
paying the price of a lawsuit. The auditor's legal liability extends from mere negligence ("Oops, I
made a simple mistake") to committing fraud that results in loss of money and possibly freedom!
The SEC has regulations that begin with bringing a company public to its continued regulation.
Violations of those regulations result in penalties, extending from requiring more continuing
professional education to barring the firm or auditor from participating in public company
services to imprisonment.
A thorough review of Chapters 5 and 11 of the electronic readings will give you a comprehensive
understanding of the legal pitfalls the CPA professional must negotiate in the performance of an
audit.
Review Question
In the CPA Exam Question Section, please work CPA Exam Question 5-16.
The following questions concern CPA firms liability under common law. Choose
the best response.
a. Sharp, CPA, was engaged by Peters & Sons, a partnership, to

give an opinion on the financial statements that were to be
submitted to several prospective partners as part of a planned
expansion of the firm. Sharp completed about half of the
necessary field work. Then, because of unanticipated demands
on his time by other clients, Sharp was forced to abandon the
work. The planned expansion of the firm failed to materialize
because the prospective partners lost interest when the audit
report was not promptly available. Sharp offered to complete the
task at a later date. This offer was refused. Peters & Sons
suffered damages of $400,000 as a result. Under the
circumstances, what is the probable outcome of a lawsuit
between Sharp and Peters & Sons?
1. Sharp will be compensated for the reasonable value of the

services actually performed.
2. Peters & Sons will recover damages for breach of contract.
3. Peters & Sons will recover both punitive damages and damages
for breach of contract.
4. Neither Sharp nor Peters & Sons will recover against the other.
b. In a common law action against an accountant, lack of privity is a

viable defense if the plaintiff
1. Is the clients creditor who sues the accountant for negligence.
2. Can prove the presence of gross negligence that amounts to a

reckless disregard for the truth.
3. Is the accountants client.
4. Bases the action upon fraud.
c. The 1136 Tenants case was important chiefly because of its emphasis
on the legal liability of the CPA when associated with
1. An SEC engagement.
2. Unaudited financial statements
3. An audit resulting in a disclaimer of opinion.
4. Letters for underwriters.
Click here to review the solution after you have come up with
an answer.
Review Question
In order to expand its operations, Barton Corp. raised $ 5 million in a public

offering of common stock, and also negotiated a $ 2 million loan from First
National Bank. In connection with this financing, Barton engaged Hanover & Co.,
CPAs to audit Bartons financial statements. Hanover knew that the sole purpose
of the audit was so that Barton would have audited financial statements to provide
to First National Bank and the purchasers of the common stock. Although
Hanover conducted the audit in conformity with its audit program, Hanover failed
to detect material acts of embezzlement committed by Barton Corp. s president.
Hanover did not detect the embezzlement because of its inadvertent failure to
exercise due care in designing the audit program for this engagement. After
completing the engagement, Hanover issued an unqualified opinion on Bartons
financial statements. The financial statements were relied upon by the purchasers
of the common stock in deciding to purchase the shares. In addition, First National
Bank approved the loan to Barton based on the audited financial statements.
Within sixty days after the sale of the common stock and the issuance of the loan,
Barton was involuntarily petitioned into bankruptcy. Because of the presidents
embezzlement, Barton became insolvent and defaulted on the loan from the bank.
Its common stock became virtually worthless. Actions have been brought against
Hanover by:
The purchasers of the common stock who have asserted that

Hanover is liable for damages under Section 10( b) and Rule 10b-
5 of the Securities Exchange Act of 1934.
First National Bank, based upon Hanovers negligence.
Trade creditors who extended credit to Barton, based upon

Hanovers negligence.
a. Discuss whether you believe Hanover will be found liable

to the purchasers of common stock.
b. Indicate whether you believe First National Bank will be

successful in its claim against Hanover.
c. Indicate whether you believe the trade creditors will be

successful in their claim against Hanover.
an answer.
Review Question
The CPA firm of Bigelow, Barton, and Brown was expanding rapidly.
Consequently, it hired several junior accountants, including a man named Small.
The partners of the firm eventually became dissatisfied with Smalls production
and warned him they would be forced to discharge him unless his output increased
significantly. At that time, Small was engaged in audits of several clients. He
decided that to avoid being fired, he would reduce or omit some of the standard
auditing procedures listed in audit programs prepared by the partners. One of the
CPA firms clients, Newell Corporation, was in serious financial difficulty and had
adjusted several of the accounts being audited by Small to appear financially
sound. Small prepared fictitious audit documentation in his home at night to
support purported completion of auditing procedures assigned to him, although he
in fact did not examine the adjusting entries. The CPA firm rendered an
unqualified opinion on Newells financial statements, which were grossly
misstated. Several creditors, relying on the audited financial statements,
subsequently extended large sums of money to Newell Corporation. Will the CPA
firm be liable to the creditors who extended the money because of their reliance
on the erroneous financial statements if Newell Corporation should fail to pay
them? Explain.
an answer.
Auditors Liability for the Detection of Fraud
As auditors, we are certainly concerned with missing the signs of fraud when we undertake client
assignments. For our part, the fraud we may encounter concerns either fraudulent financial
reporting or the misappropriation of assets. These are the areas we should take into consideration
when we are doing a risk assessment of the business during our audit planning phases.
Auditors need to maintain their skepticism and a questioning mind throughout the audit so that
they can identify fraud risk and critically evaluate audit evidence.
Review Question
The following are activities that occurred at Franklin Manufacturing, a nonpublic

company.
1. Franklins accountant did not record checks written in the last

few days of the year until the next accounting period to avoid a
negative cash balance in the financial statements.
2. Franklins controller prepared and mailed a check to a vendor for

a carload of material that was not received. The vendors chief
accountant, who is a friend of Franklins controller, mailed a
vendors invoice to Franklin, and the controller prepared a
receiving report. The vendors chief accountant deposited the
check in an account he had set up with a name almost identical
to the vendors.
3. The accountant recorded cash received in the first few days of

the next accounting period in the current accounting period to
avoid a negative cash balance.
4. Discounts on checks to Franklins largest vendor are never taken,

even though the bills are paid before the discount period expires.
The president of the vendors company provides free use of his
ski lodge to the accountant who processes the checks in
exchange for the lost discounts.
5. Franklin shipped and billed goods to a customer in New York on

December 23, and the sale was recorded on December 24, with
the understanding that the goods will be returned on January 31
for a full refund plus a 5 percent handling fee.
6. Franklins factory superintendent routinely takes scrap metal

home in his pickup and sells it to a scrap dealer to make a few
extra dollars.
7. Franklins management decided not to include a footnote about

a material uninsured lawsuit against the company on the
grounds that the primary user of the statements, a small local
bank, will probably not understand the footnote anyway.
a. Identify which of these activities are frauds.
b. For each fraud, state whether it is a misappropriation of

assets or fraudulent financial reporting.
an answer.
Week 3
Planning the Audit
Introduction | Planning the Audit | Segregation of Duties | Gathering Evidence |

Analytical Procedures and the Audit | Practice Exercise
Introduction
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The planning stage of the audit is a perfect opportunity for the CPAs to meet the client
management and its staff. Getting to know the client's business during a face-to-face meeting in
the field and planning how the audit will proceed is a significant event that lays the groundwork
for a successful audit.
The audit staff will interview key people in various departments to determine how the
departments operate and what internal controls are in place. Tests will later be performed on
those internal controls to determine the success or failure of the controls represented.
TCO G, regarding analytical procedures, is the next key area we will review. The audit will also
start the process of performing analytical procedures to determine the testing of various accounts
as TCO F directs. These procedures are necessary at various stages of the audit and serve the
purpose of giving the auditor a basis from which to proceed.
Planning the Audit
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The primary objective of an audit is to express an opinion on the financial statements. The
clients management asserts that the financial statements are complete, that all recorded assets
and liabilities are the rights and obligations of the business, that there has been proper valuation
or allocation of amounts, that during the accounting period all components of the statements
existed or occurred, and that they have been properly classified and disclosed.
Planning the audit will entail inquiries of any predecessor auditor. Matters to be discussed should
cover such things as reasons for the change in auditors, disagreements over accounting
principles, internal control issues, fraud, and illegal acts and whether they were communicated to
the audit committee.
Preliminary meetings with the client give the auditor and client an opportunity to have an
understanding of the objective of the audit, both parties responsibilities, any engagement
limitations, and any other matters that have significance to the engagement.
An overall audit strategy should include gaining an understanding of the clients business,
analytical procedures required, and having an understanding about materiality and audit risk.
The auditor should go through analytical procedures, such as identifying the relationship of data
to prior periods and current periods, making comparisons of budgets to actual figures, and
identifying any relationships of financial data with nonfinancial data.
When determining materiality, the auditor should determine whether the amount or omission
would affect the judgment of a reasonable person. The auditor will use materiality to help
determine the type and extent of testing necessary to arrive at an opinion of the fair
representation of the financial statements. Efficiency and effectiveness of the audit work are
concerns at this stage in the audit. Professional judgment is used to assess areas of high risk and
total likely misstatement.
A total likely misstatement is often thought of as audit risk. Audit risks include inherent risk,
control risk, and detection risk. These different forms of risk are sometimes within the control of
the auditor and sometimes not within the auditors control. Detection risk relates to the audit
procedures used, and it is within the auditors control to detect a material misstatement existing
in a statements assertion. The other forms of risk are not within the auditors control and exist
independently of the audit.
Review Question
Auditors provide reasonable assurance that the financial statements are fairly
stated, in all material respects. Questions are often raised as to the responsibility
of the auditor to detect material misstatements, including misappropriation of
assets and fraudulent financial reporting.
a. Discuss the concept of reasonable assurance and the degree of

confidence that financial statement users should have in the
financial statements.
b. What are the responsibilities of the independent auditor in the

audit of financial statements? Discuss fully, but in this part do
not include fraud in the discussion.
c. What are the responsibilities of the independent auditor for the

detection of fraud involving misappropriation of assets and
fraudulent financial reporting? Discuss fully, including your
assessment of whether the auditors responsibility for the
detection of fraud is appropriate.
an answer.
Week 3 Lecture
Review Question #1
a. Auditing standards indicate that reasonable assurance is a high
level of assurance. Accordingly, financial statement users should have
a high degree of confidence in the financial statements. However,
reasonable assurance is not an absolute level of assurance, and there is
at least some risk that the audited financial statements may include
material misstatements.
b. The responsibility of the independent auditor is to express an opinion on

the financial statements he or she has audited. Inasmuch as the
financial statements are the representation of management,
responsibility rests with management for the proper recording of
transactions in books of account, for the safeguarding of assets, and for
the substantial accuracy and adequacy of the financial statements.
In developing the basis for his or her opinion, the auditor is

responsible for conducting an audit that conforms to auditing
standards. These standards constitute the measure of the adequacy of
the audit. Those standards require the auditor to obtain sufficient
appropriate evidence about material management assertions in the
The informed judgment of a qualified professional accountant is required

of an independent auditor. The auditor must exercise this judgment in
selecting the procedures he or she uses in the audit and in arriving at
an opinion.
In presenting himself or herself to the public as an independent auditor,

the auditor is responsible for having the abilities expected of a
qualified person in that profession. Such qualifications do not include
those of an appraiser, valuer, expert in materials, expert in styles,
insurer, or lawyer. The auditor is entitled to rely upon the judgment
of experts in these other areas of knowledge and skill.
c. Auditors are responsible for obtaining reasonable assurance that

material misstatements included in the financial statements are
detected, whether those misstatements are due to error or fraud.
Professional standards acknowledge that it is often more difficult to
detect fraud than errors because management or employees
perpetrating the fraud attempt to conceal the fraud. That difficulty,
however, does not change the auditors responsibility to properly
plan and perform the audit. Auditors are required to specifically
assess the risk of material misstatement due to fraud and should
consider that assessment in designing the audit procedures to be
performed.
There has been increased emphasis on auditors responsibility to evaluate factors

that may indicate an increased likelihood that fraud may be occurring. For
example, assume that management is dominated by a president who makes
most of the major operating and business decisions himself. He has a
reputation in the business community for making optimistic projections about
future earnings and then putting considerable pressure on operating and
accounting staff to make sure those projections are met. He has also been
associated with other companies in the past that have gone bankrupt. These
factors, considered together, may cause the auditor to conclude that the
likelihood of fraud is fairly high. In such a circumstance, the auditor should put
increased emphasis on searching for material misstatements due to fraud.
The auditor may also uncover circumstances during the audit that may cause
suspicions of fraudulent financial reporting. For example, the auditor may find
that management has lied about the age of certain inventory items. When such
circumstances are uncovered, the auditor must evaluate their implications and
consider the need to modify audit evidence.
Adequate internal control should be the principal means of thwarting and

detecting misappropriation of assets. To rely entirely on an independent audit for
the detection of misappropriation of assets would require expanding the auditor's
work to the extent that the cost might be prohibitive.
The auditor normally assesses the likelihood of material

misappropriation of assets as a part of understanding the entitys
internal control and assessing control risk. Audit evidence should be
expanded when the auditor finds an absence of adequate controls
or failure to follow prescribed procedures, if he or she believes a
material fraud could result.
Because the auditors responsibility is limited to material misstatements,

we believe that the auditors responsibility is appropriate. However, some
students may take the position that the auditors responsibility to detect fraud is
too great because of the potential for collusion and deception by management.
The independent auditor is not an insurer or guarantor. The auditors implicit

obligation is that the audit be performed with due professional skill and care in
accordance with auditing standards. A subsequent discovery of fraud, existent
during the period covered by the independent audit, does not of itself indicate
negligence on the auditors part.
Segregation of Duties
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video
Tim Gearty, CPA, JD, Becker Professional Review national instructor, explains in
a short but great example the significance of segregation of duties involving
computerized systems where there should be a control group, operators,
programmer, analyst, and librarian.
The Significance of Segregation of Duties (1:02, 0.4MB) Transcript
Gathering Evidence
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In order to perform our audit of the companys financial statements competently, we need to
gather evidence to support our conclusion. Generally, the types of evidence used by auditors
include
inquiry of management and employees regarding the companys operations

and procedures.
third-party confirmation in such areas as accounts receivable and accounts

payable.
physical examination of the companys facilities and operations; and
review of documentation underlying the financial transactions of the

company.
Now, as we auditors say, Document, document, document! We want to be careful to document

our actions so that our supervisors or other responsible personnel can review our work. Further,
we want to use the documentation from this year to plan our audit for next year. In addition, in
case our audit results are ever challenged, we want to protect ourselves by being able to produce
the documentation we relied upon to come to our audit results. We must always remember that
leaving an audit trail is importantnot only to present evidence of a job well done but also to
protect us from charges that would leave us open to legal liability or a loss of good reputation.
When gathering our audit evidence, we consider that the six factors determining the reliability of
evidence are as follows.
1. Independence of provider: Evidence obtained from a source outside the entity

is more reliable and persuasive than that obtained from within.
2. Effectiveness of clients internal controls: When a clients internal controls are

effective, evidence obtained is more reliable than when they are weak.
3. Auditors direct knowledge: Evidence obtained directly by the auditor through
physical examination, observation, computation, and inspection is more
competent than information obtained indirectly.
4. Qualifications of individuals providing the information
5. Degree of objectivity: Objective evidence is more reliable than evidence that

requires considerable judgment to determine whether it is correct.
6. Timeliness
Review Question
The following are nine situations, each containing two means of accumulating
evidence:
1. Confirm receivables with consumers versus confirming accounts

receivable with business organizations.
2. Physically examine 3- inch steel plates versus examining

electronic parts.
3. Examine duplicate sales invoices when several competent

people are checking each others work versus examining
documents prepared by a competent person on a one- person
staff.
4. Physically examine inventory of parts for the number of units on

hand versus examining them for the likelihood of inventory being
obsolete.
5. Discuss the likelihood and amount of loss in a lawsuit against the

client with clients in- house legal counsel versus discussion with
the CPA firms own legal counsel.
6. Confirm the oil and gas reserves with a geologist specializing in

oil and gas versus confirming a bank balance.
7. Confirm a bank balance versus examining the clients bank

statements.
8. Physically count the clients inventory held by an independent

party versus con - firming the count with an independent party.
9. Obtain a physical inventory count from the company president

versus physically counting the clients inventory.
a. Identify the six factors that determine the reliability of

evidence.
b. For each of the nine situations, state whether the first or

second type of evidence is more reliable.
c. For each situation, state which of the six factors affected

the reliability of the evidence.
an answer.
Week 3 Lecture
Review Question #2
a. The six factors determining the reliability of evidence are:
1. Independence of provider
2. Effectiveness of client's internal controls
3. Auditor's direct knowledge
4. Qualifications of individuals providing the information
5. Degree of objectivity
6. Timeliness
b. and c.
TYPE OF EVIDENCE FACTOR

SITUATION THAT IS MORE RELIABLE AFFECTING RELIABILITY
Confirmation with business Qualifications of provider

1
organizations
Physically examine three- Qualifications of provider

2
inch steel plates (in this case the auditor)
Examine documents when Effectiveness of internal

3
several competent people controls
are checking each other's
work
Examine inventory of parts Degree of objectivity
4
for the number of units on
hand
Discuss potential lawsuits Independence of provider

5
with CPA firm's legal counsel
6 Confirm a bank balance Degree of objectivity
7 Confirm a bank balance Independence of provider
Physically count the client's Auditor's direct knowledge

8
inventory
Physically count the Independence of provider

9
inventory and auditor's direct
knowledge
Analytical Procedures and the Audit
We have three stages to our auditsplanning, testing, and completion. In all three stages, we use
analytical procedures.
When we plan our audits, we use analytical procedures to determine the nature, extent, and
timing of our audits. We also want to know where the audit risk lies and in what areas of
financial transactions we should concentrate our efforts. So, we perform a year-to-year
comparison of the financial accounts to see if there have been any material changes warranting
further investigation. We may also look to other companies in the same industry as our clients
and do a comparison of financial results. We want to have an understanding of our client so that
we can determine where material misstatements may possibly be occurring.
In the testing phase of our audits, we use analytical procedures to determine whether we have to
expand our audit testing in certain areas. These analytical procedures also give us an indication
that something is materially misstated.
When we are completing our audits, we again turn to analytical procedures to determine if there
are material misstatements and to assess ongoing concern.
Review Question
In the audit of the Worldwide Wholesale Company, you did extensive ratio and
trend analysis. No material exceptions were discovered except for the following:
1. Commission expense as a percent of sales has stayed constant

for several years but has increased significantly in the current
year. Commission rates have not changed.
2. The rate of inventory turnover has steadily decreased for 4

years.
3. Inventory as a percent of current assets has steadily increased

for 4 years.
4. The number of days sales in accounts receivable has steadily

increased for 3 years.
5. Allowance for uncollectible accounts as a percent of accounts

receivable has steadily decreased for 3 years.
6. The absolute amounts of depreciation expense and depreciation

expense as a percent of gross fixed assets are significantly
smaller than in the preceding year.
a. Evaluate the potential significance of each of the

exceptions just listed for the fair presentation of financial
statements.
b. State the follow- up procedures you would use to

determine the possibility of material misstatements.
Week 3 Lecture
Review Question #3
a.
1. Commission expense could be overstated during the

current year or could have been understated during each of the past
several years. Or, sales may have been understated during the current
year or could have been overstated in each of the past several years.
2. Obsolete or unsalable inventory may be present
and may require markdown to the lower of cost or market.
3. Especially when combined with 2 above, there is a high
likelihood that obsolete or unsalable inventory may be
present. Inventory appears to be maintained at a higher level
than is necessary for the company.
4. Collection of accounts receivable appears to be a problem.

Additional provision for uncollectible accounts may be
necessary.
5. Especially when combined with 4 above, the allowance for

uncollectible accounts may be understated.
6. Depreciation expenses may be understated for the year.
b.
ITEM 1
Make an estimated calculation of total commission expense by

multiplying the standard commission rate times commission sales
for each of the last two years. Compare the resulting amount to the
commission expense for that year. For whichever year appears to
be out of line, select a sample of individual sales and recompute the
commission, comparing it to the commission recorded.
ITEMS 2 AND 3
Select a sample of the larger inventory items (by dollar value) and
have the client schedule subsequent transactions affecting these
items. Note the ability of the company to sell the items and the
selling prices obtained by the client. For any items that the client is
selling below cost plus a reasonable markup to cover selling
expenses, or for items that the client has been unable to sell, propose
that the client mark down the inventory to market value.
ITEMS 4 AND 5
Select a sample of the larger and older accounts receivable and

have the client schedule subsequent payments and credits for each
of these accounts. For the larger accounts that show no substantial
payments, examine credit reports and recent financial statements
to determine the customers' ability to pay. Discuss each account
for which substantial payment has not been received with the
credit manager and determine the need for additional allowance
for uncollectible accounts.
ITEM 6
Discuss the reason for the reduced depreciation expense with the
client personnel responsible for the fixed assets accounts. If they
indicate that the change resulted from a preponderance of fully
depreciated assets, test the detail records to determine that the
explanation is reasonable. If no satisfactory explanation is given,
expand the tests of depreciation until satisfied that the provision is
reasonable for the year.
an answer.
Practice Exercise
Back to Top
Hide and Show
Match seven of the terms (ak) with the definitions provided below (17).
a. Tests of details of balances

b. Tests of controls
c. Substantive tests of transactions
d. Analytical procedures
e. Transaction-related audit objectives
f. Management assertions
g. Balance-related audit objectives
h. Fraud
i. Illegal act
j. Error
k. Management fraud
Definitions
1. An intentional misstatement of the financial statements
View Answer
h. Fraud
2. A set of six audit objectives the auditor must meet, including timing, posting
and summarization, and accuracy
View Answer
e. Transaction-related audit objectives
3. Implied or expressed representations made by the client about classes of

transactions, account balances, and disclosures in the financial statements
View Answer
f. Management assertions
4. Audit procedures testing for monetary misstatements to determine whether

the balance-related audit objectives have been satisfied for each significant
account balance
View Answer
a. Tests of details of balances
5. A set of nine audit objectives the auditor must meet, including completeness,
detail tie-in, and rights and obligations
(Click to view answer.)
g. Balance-related audit objectives
6. Audit procedures designed to test the effectiveness of control policies and

procedures
b. Tests of controls
7. Use of comparisons and relationships to assess whether account balances or

other data appear reasonable.
d. Analytical procedures
Week 4
Print
Materiality, Risk, and Internal Control
Introduction | New Audit Committee Rules | Materiality | Internal Control | Practice

Exercise
Introduction
Back to Top
The Sarbanes Oxley Act mandated many new changes to the field of auditing public companies.
The requirement for a specific form of audit committee was one new change. With that change
also came mandates for specific reporting by the auditors that affects how the auditor establishes
materiality and risk standards and assessment of the client's internal controls.
New Audit Committee Rules
Back to Top
We were first introduced to the concept of audit committees in Chapter 4 of our electronic
readings. The audit committee for a public company plays a significant role in the audit process.
As we learned from the prior weeks, auditors have special reporting concerns with the audit
committee.
Video
For a more expansive perspective of the audit committee, view the video clip
hosted by Alvin Arens.
New Audit Committee Rules, Due Diligence, and Documentation

(4:42, 2.8MB)
Materiality
Back to Top
When we are planning our audit, we must consider the materiality of the financial information.
Materiality means that if the accounting information is misstated or omitted, it would probably
change or influence the judgment of a reasonable person, which could possibly lead to financial
losses for the users of the financial statements.
Because there is little guidance provided to auditors in the area of materiality, we must use our
professional judgment in determining what financial areas are material and what financial areas
are not.
So when we plan our audit, we need to use our professional judgment about materiality, and we
need to consider
acceptable audit risk;
tolerable misstatement;
inherent risk;
risk of fraud;
control risk; and
planned detection risk.
The audit risk we consider in our audit planning lies in the possibility that the financial
statements prepared by management are materially misstated and that the auditor will not detect
such material misstatements.
We must also remember that when we are planning for a financial statement audit, we must
consider the risk of material misstatements in the financial statements resulting not only from
errors but also from fraud.
As auditors, we aim to reduce this audit risk to a low-enough level that, in our professional
judgment, is appropriate for expressing an opinion on the audit statements.
SAB No. 99: The SEC issued guidance on the need to consider quantitative as well as qualitative
factors in assessing materiality. Read the full text of SAB No.99 at the SEC's website.
Review Question
Please work Review Question 9-25 in the 14th edition..
You are evaluating audit results for current assets in the audit of Quicky Plumbing
Co. You set the preliminary judgment about materiality for current assets at $
15,000 for overstatements and at $ 22,500 for understatements. The preliminary
and actual estimates are shown next.
Tolerable Misstatement Estimate of Total Misstatement
Overstateme Understatem Overstateme Understatem

Account
nts ents nts ents
Cash $2,000 $3,000 $1,000 $0
Accoun
ts
$10,000 $15,000 $9,000 $8,000
receivab
le
Inventor
$15,000 $22,000 $14,000 $5,000
y
Prepaid
$3,000 $5,000 $2,000 $1,000
expenses
Total $30,000 $45,000 $26,000 $14,000
a. Justify a lower preliminary judgment about materiality for

overstatements than understatements in this situation.
b. Explain why the totals of the tolerable misstatements exceed the

preliminary judgments about materiality for both
understatements and overstatements.
c. Explain how it is possible that three of the estimates of total

misstatement have both an overstatement and an
understatement.
d. Assume that you are not concerned whether the estimate of

misstatement exceeds tolerable misstatement for individual
accounts if the total estimate is less than the preliminary
judgment.
1. Given the audit results, should you be more concerned

about the existence of material overstatements or
understatements at this point in the audit of Quicky
Plumbing Co.?
2. Which account or accounts will you be most concerned

about in 1? Explain.
e. Assume that the estimate of total overstatement amount for

each account is less than tolerable misstatement, but that the
total overstatement estimate exceeds the preliminary judgment
of materiality.
an answer.
Week 4 Lecture
Review Question #1
a. The justification for a lower preliminary judgment about

materiality for overstatements is directly related to legal
liability and audit risk. Most auditors believe they have a
greater legal and professional responsibility to discover
overstatements of owners' equity than understatements
because users are likely to be more critical of
overstatements. That does not imply there is no
responsibility for understatements.
b. There are two reasons for permitting the sum of tolerable

misstatements to exceed overall materiality. First, it is
unlikely that all accounts will be misstated by the full amount
of tolerable misstatement. Second, some accounts are likely
to be overstated while others are likely to be understated,
resulting in net misstatement that is likely to be less than
overall materiality.
c. This results because of the estimate of sampling error for

each account. For example, the likely estimate of inventory is
an overstatement of $4,500 + or - a sampling error of $9,500.
You would be most concerned about overstatement for
inventory because the estimated overstatement of $14,000 is
close to tolerable misstatement and is the largest
overstatement amount.
d. You would be most concerned about overstatement amounts
since the total estimated overstatement amount ($26,000)
exceeds the preliminary judgment about materiality for
overstatements ($15,000). You would be most concerned about
inventory since it has the largest overstatement amount.
e. 1. This may occur because total tolerable misstatement

was allowed to exceed the preliminary judgment (see
Part b for explanation).
2. The auditor must determine whether the actual total

overstatement amount actually exceeds the preliminary
judgment by performing expanded audit tests or by
requiring the client to make an adjustment for
estimated misstatements.
SEC Staff Accounting Bulletin:

No. 99 Materiality
SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 211
[Release No. SAB 99]
Staff Accounting Bulletin No. 99
AGENCY: Securities and Exchange Commission
ACTION: Publication of Staff Accounting Bulletin
SUMMARY: This staff accounting bulletin expresses the views of the staff that
exclusive reliance on certain quantitative benchmarks to assess materiality in
preparing financial statements and performing audits of those financial
statements is inappropriate; misstatements are not immaterial simply because
they fall beneath a numerical threshold.
DATE: August 12, 1999
FOR FURTHER INFORMATION CONTACT: W. Scott Bayless, Associate Chief

Accountant, or Robert E. Burns, Chief Counsel, Office of the Chief Accountant (
202-942-4400), or David R. Fredrickson, Office of General Counsel (
202-942-0900), Securities and Exchange Commission, 450 Fifth

Street, N.W., Washington, D.C. 20549-1103; electronic addresses:
BaylessWS@sec.gov; BurnsR@sec.gov; FredricksonD@sec.gov.
SUPPLEMENTARY INFORMATION: The statements in the staff accounting

bulletins are not rules or interpretations of the Commission, nor are they
published as bearing the Commission's official approval. They represent
interpretations and practices followed by the Division of Corporation Finance
and the Office of the Chief Accountant in administering the disclosure
requirements of the Federal securities laws.
Jonathan G. Katz
Secretary
Date: August 12, 1999
Part 211 - (AMEND) Accordingly, Part 211 of Title 17 of the Code of Federal
Regulations is amended by adding Staff Accounting Bulletin No. 99 to the
table found in Subpart B.
STAFF ACCOUNTING BULLETIN NO. 99
The staff hereby adds Section M to Topic 1 of the Staff Accounting Bulletin
Series. Section M, entitled "Materiality," provides guidance in applying
materiality thresholds to the preparation of financial statements filed with the
Commission and the performance of audits of those financial statements.
STAFF ACCOUNTING BULLETINS
TOPIC 1: FINANCIAL STATEMENTS
*****
M. Materiality
1. Assessing Materiality
Facts: During the course of preparing or auditing year-end financial

statements, financial management or the registrant's independent auditor
becomes aware of misstatements in a registrant's financial statements. When
combined, the misstatements result in a 4% overstatement of net income and
a $.02 (4%) overstatement of earnings per share. Because no item in the
registrant's consolidated financial statements is misstated by more than 5%,
management and the independent auditor conclude that the deviation from
generally accepted accounting principles ("GAAP") is immaterial and that the
accounting is permissible.1
Question: Each Statement of Financial Accounting Standards adopted by the

Financial Accounting Standards Board ("FASB") states, "The provisions of this
Statement need not be applied to immaterial items." In the staff's view, may a
registrant or the auditor of its financial statements assume the immateriality
of items that fall below a percentage threshold set by management or the
auditor to determine whether amounts and items are material to the financial
statements?
Interpretive Response: No. The staff is aware that certain registrants, over
time, have developed quantitative thresholds as "rules of thumb" to assist in
the preparation of their financial statements, and that auditors also have used
these thresholds in their evaluation of whether items might be considered
material to users of a registrant's financial statements. One rule of thumb in
particular suggests that the misstatement or omission2 of an item that falls
under a 5% threshold is not material in the absence of particularly egregious
circumstances, such as self-dealing or misappropriation by senior
management. The staff reminds registrants and the auditors of their financial
statements that exclusive reliance on this or any percentage or numerical
threshold has no basis in the accounting literature or the law.
The use of a percentage as a numerical threshold, such as 5%, may provide

the basis for a preliminary assumption that without considering all relevant
circumstances a deviation of less than the specified percentage with respect
to a particular item on the registrant's financial statements is unlikely to be
material. The staff has no objection to such a "rule of thumb" as an initial step
in assessing materiality. But quantifying, in percentage terms, the magnitude
of a misstatement is only the beginning of an analysis of materiality; it cannot
appropriately be used as a substitute for a full analysis of all relevant
considerations. Materiality concerns the significance of an item to users of a
registrant's financial statements. A matter is "material" if there is a substantial
likelihood that a reasonable person would consider it important. In its
Statement of Financial Accounting Concepts No. 2, the FASB stated the
essence of the concept of materiality as follows:
The omission or misstatement of an item in a financial report is material if, in

the light of surrounding circumstances, the magnitude of the item is such that
it is probable that the judgment of a reasonable person relying upon the
report would have been changed or influenced by the inclusion or correction of
the item.3
This formulation in the accounting literature is in substance identical to the

formulation used by the courts in interpreting the federal securities laws. The
Supreme Court has held that a fact is material if there is
a substantial likelihood that the . . . fact would have been viewed by the
reasonable investor as having significantly altered the "total mix" of
information made available. 4
Under the governing principles, an assessment of materiality requires that one

views the facts in the context of the "surrounding circumstances," as the
accounting literature puts it, or the "total mix" of information, in the words of
the Supreme Court. In the context of a misstatement of a financial statement
item, while the "total mix" includes the size in numerical or percentage terms
of the misstatement, it also includes the factual context in which the user of
financial statements would view the financial statement item. The shorthand
in the accounting and auditing literature for this analysis is that financial
management and the auditor must consider both "quantitative" and
"qualitative" factors in assessing an item's materiality.5 Court decisions,
Commission rules and enforcement actions, and accounting and auditing
literature6 have all considered "qualitative" factors in various contexts.
The FASB has long emphasized that materiality cannot be reduced to a

numerical formula. In its Concepts Statement No. 2, the FASB noted that
some had urged it to promulgate quantitative materiality guides for use in a
variety of situations. The FASB rejected such an approach as representing only
a "minority view," stating
The predominant view is that materiality judgments can properly be made

only by those who have all the facts. The Board's present position is that no
general standards of materiality could be formulated to take into account all
the considerations that enter into an experienced human judgment. 7
The FASB noted that, in certain limited circumstances, the Commission and
other authoritative bodies had issued quantitative materiality guidance, citing
as examples guidelines ranging from one to ten percent with respect to a
variety of disclosures.8 And it took account of contradictory studies, one
showing a lack of uniformity among auditors on materiality judgments, and
another suggesting widespread use of a "rule of thumb" of five to ten percent
of net income.9 The FASB also considered whether an evaluation of materiality
could be based solely on anticipating the market's reaction to accounting
information.10
The FASB rejected a formulaic approach to discharging "the onerous duty of

making materiality decisions"11 in favor of an approach that takes into account
all the relevant considerations. In so doing, it made clear that
[M]agnitude by itself, without regard to the nature of the item and the
circumstances in which the judgment has to be made, will not generally be a
sufficient basis for a materiality judgment.12
Evaluation of materiality requires a registrant and its auditor to consider allthe
relevant circumstances, and the staff believes that there are numerous
circumstances in which misstatements below 5% could well be material.
Qualitative factors may cause misstatements of quantitatively small amounts
to be material; as stated in the auditing literature:
As a result of the interaction of quantitative and qualitative considerations in

materiality judgments, misstatements of relatively small amounts that come
to the auditor's attention could have a material effect on the financial
statements.13
Among the considerations that may well render material a quantitatively small
misstatement of a financial statement item are
whether the misstatement arises from an item capable of precise

measurement or whether it arises from an estimate and, if so, the
degree of imprecision inherent in the estimate14
whether the misstatement masks a change in earnings or other trends
whether the misstatement hides a failure to meet analysts' consensus

expectations for the enterprise
whether the misstatement changes a loss into income or vice versa
whether the misstatement concerns a segment or other portion of the

registrant's business that has been identified as playing a significant
role in the registrant's operations or profitability
whether the misstatement affects the registrant's compliance with

regulatory requirements
whether the misstatement affects the registrant's compliance with loan

covenants or other contractual requirements
whether the misstatement has the effect of increasing management's

compensation for example, by satisfying requirements for the award
of bonuses or other forms of incentive compensation
whether the misstatement involves concealment of an unlawful

transaction.
This is not an exhaustive list of the circumstances that may affect the
materiality of a quantitatively small misstatement.15 Among other factors, the
demonstrated volatility of the price of a registrant's securities in response to
certain types of disclosures may provide guidance as to whether investors
regard quantitatively small misstatements as material. Consideration of
potential market reaction to disclosure of a misstatement is by itself "too blunt
an instrument to be depended on" in considering whether a fact is material. 16
When, however, management or the independent auditor expects (based, for
example, on a pattern of market performance) that a known misstatement
may result in a significant positive or negative market reaction, that expected
reaction should be taken into account when considering whether a
misstatement is material.17
For the reasons noted above, the staff believes that a registrant and the
auditors of its financial statements should not assume that even small
intentional misstatements in financial statements, for example those pursuant
to actions to "manage" earnings, are immaterial.18 While the intent of
management does not render a misstatement material, it may provide
significant evidence of materiality. The evidence may be particularly
compelling where management has intentionally misstated items in the
financial statements to "manage" reported earnings. In that instance, it
presumably has done so believing that the resulting amounts and trends
would be significant to users of the registrant's financial statements.19 The
staff believes that investors generally would regard as significant a
management practice to over- or under-state earnings up to an amount just
short of a percentage threshold in order to "manage" earnings. Investors
presumably also would regard as significant an accounting practice that, in
essence, rendered all earnings figures subject to a management-directed
margin of misstatement.
The materiality of a misstatement may turn on where it appears in the

financial statements. For example, a misstatement may involve a segment of
the registrant's operations. In that instance, in assessing materiality of a
misstatement to the financial statements taken as a whole, registrants and
their auditors should consider not only the size of the misstatement but also
the significance of the segment information to the financial statements taken
as a whole.20 "A misstatement of the revenue and operating profit of a
relatively small segment that is represented by management to be important
to the future profitability of the entity"21 is more likely to be material to
investors than a misstatement in a segment that management has not
identified as especially important. In assessing the materiality of
misstatements in segment information - as with materiality generally -
situations may arise in practice where the auditor will conclude that a matter
relating to segment information is qualitatively material even though, in his or
her judgment, it is quantitatively immaterial to the financial statements taken
as a whole.22
Aggregating and Netting Misstatements
In determining whether multiple misstatements cause the financial statements

to be materially misstated, registrants and the auditors of their financial
statements should consider each misstatement separately and the aggregate
effect of all misstatements.23 A registrant and its auditor should evaluate
misstatements in light of quantitative and qualitative factors and "consider
whether, in relation to individual line item amounts, subtotals, or totals in the
financial statements, they materially misstate the financial statements taken
as a whole."24 This requires consideration of -
the significance of an item to a particular entity (for example, inventories to a

manufacturing company), the pervasiveness of the misstatement (such as
whether it affects the presentation of numerous financial statement items),
and the effect of the misstatement on the financial statements taken as a
whole ....25
Registrants and their auditors first should consider whether each

misstatement is material, irrespective of its effect when combined with other
misstatements. The literature notes that the analysis should consider whether
the misstatement of "individual amounts" causes a material misstatement of
the financial statements taken as a whole. As with materiality generally, this
analysis requires consideration of both quantitative and qualitative factors.
If the misstatement of an individual amount causes the financial statements

as a whole to be materially misstated, that effect cannot be eliminated by
other misstatements whose effect may be to diminish the impact of the
misstatement on other financial statement items. To take an obvious example,
if a registrant's revenues are a material financial statement item and if they
are materially overstated, the financial statements taken as a whole will be
materially misleading even if the effect on earnings is completely offset by an
equivalent overstatement of expenses.
Even though a misstatement of an individual amount may not cause the

financial statements taken as a whole to be materially misstated, it may
nonetheless, when aggregated with other misstatements, render the financial
statements taken as a whole to be materially misleading. Registrants and the
auditors of their financial statements accordingly should consider the effect of
the misstatement on subtotals or totals. The auditor should aggregate all
misstatements that affect each subtotal or total and consider whether the
misstatements in the aggregate affect the subtotal or total in a way that
causes the registrant's financial statements taken as a whole to be materially
misleading.26
The staff believes that, in considering the aggregate effect of multiple

misstatements on a subtotal or total, registrants and the auditors of their
financial statements should exercise particular care when considering whether
to offset (or the appropriateness of offsetting) a misstatement of an estimated
amount with a misstatement of an item capable of precise measurement. As
noted above, assessments of materiality should never be purely mechanical;
given the imprecision inherent in estimates, there is by definition a
corresponding imprecision in the aggregation of misstatements involving
estimates with those that do not involve an estimate.
Registrants and auditors also should consider the effect of misstatements from
prior periods on the current financial statements. For example, the auditing
literature states,
Matters underlying adjustments proposed by the auditor but not recorded by

the entity could potentially cause future financial statements to be materially
misstated, even though the auditor has concluded that the adjustments are
not material to the current financial statements.27
This may be particularly the case where immaterial misstatements recur in

several years and the cumulative effect becomes material in the current year.
2. Immaterial Misstatements That are Intentional
Facts: A registrant's management intentionally has made adjustments to

various financial statement items in a manner inconsistent with GAAP. In each
accounting period in which such actions were taken, none of the individual
adjustments is by itself material, nor is the aggregate effect on the financial
statements taken as a whole material for the period. The registrant's earnings
"management" has been effected at the direction or acquiescence of
management in the belief that any deviations from GAAP have been
immaterial and that accordingly the accounting is permissible.
Question: In the staff's view, may a registrant make intentional immaterial

misstatements in its financial statements?
Interpretive Response: No. In certain circumstances, intentional immaterial

misstatements are unlawful.
Considerations of the Books and Records Provisions Under the

Exchange Act
Even if misstatements are immaterial,28 registrants must comply with Sections

13(b)(2) - (7) of the Securities Exchange Act of 1934 (the "Exchange Act").29
Under these provisions, each registrant with securities registered pursuant to
Section 12 of the Exchange Act,30 or required to file reports pursuant to
Section 15(d),31 must make and keep books, records, and accounts, which, in
reasonable detail, accurately and fairly reflect the transactions and
dispositions of assets of the registrant and must maintain internal accounting
controls that are sufficient to provide reasonable assurances that, among
other things, transactions are recorded as necessary to permit the preparation
of financial statements in conformity with GAAP.32 In this context,
determinations of what constitutes "reasonable assurance" and "reasonable
detail" are based not on a "materiality" analysis but on the level of detail and
degree of assurance that would satisfy prudent officials in the conduct of their
own affairs.33 Accordingly, failure to record accurately immaterial items, in
some instances, may result in violations of the securities laws.
The staff recognizes that there is limited authoritative guidance34 regarding

the "reasonableness" standard in Section 13(b)(2) of the Exchange Act. A
principal statement of the Commission's policy in this area is set forth in an
address given in 1981 by then Chairman Harold M. Williams.35 In his address,
Chairman Williams noted that, like materiality, "reasonableness" is not an
"absolute standard of exactitude for corporate records."36 Unlike materiality,
however, "reasonableness" is not solely a measure of the significance of a
financial statement item to investors. "Reasonableness," in this context,
reflects a judgment as to whether an issuer's failure to correct a known
misstatement implicates the purposes underlying the accounting provisions of
Sections 13(b)(2) - (7) of the Exchange Act.37
In assessing whether a misstatement results in a violation of a registrant's

obligation to keep books and records that are accurate "in reasonable detail,"
registrants and their auditors should consider, in addition to the factors
discussed above concerning an evaluation of a misstatement's potential
materiality, the factors set forth below.
The significance of the misstatement. Though the staff does not

believe that registrants need to make finely calibrated determinations
of significance with respect to immaterial items, plainly it is
"reasonable" to treat misstatements whose effects are clearly
inconsequential differently than more significant ones.
How the misstatement arose. It is unlikely that it is ever

"reasonable" for registrants to record misstatements or not to correct
known misstatements even immaterial ones as part of an ongoing
effort directed by or known to senior management for the purposes of
"managing" earnings. On the other hand, insignificant misstatements
that arise from the operation of systems or recurring processes in the
normal course of business generally will not cause a registrant's books
to be inaccurate "in reasonable detail."38
The cost of correcting the misstatement. The books and records

provisions of the Exchange Act do not require registrants to make
major expenditures to correct small misstatements.39 Conversely,
where there is little cost or delay involved in correcting a
misstatement, failing to do so is unlikely to be "reasonable."
The clarity of authoritative accounting guidance with respect to

the misstatement. Where reasonable minds may differ about the
appropriate accounting treatment of a financial statement item, a
failure to correct it may not render the registrant's financial statements
inaccurate "in reasonable detail." Where, however, there is little ground
for reasonable disagreement, the case for leaving a misstatement
uncorrected is correspondingly weaker.
There may be other indicators of "reasonableness" that registrants and their

auditors may ordinarily consider. Because the judgment is not mechanical, the
staff will be inclined to continue to defer to judgments that "allow a business,
acting in good faith, to comply with the Act's accounting provisions in an
innovative and cost-effective way."40
The Auditor's Response to Intentional Misstatements
Section 10A(b) of the Exchange Act requires auditors to take certain actions
upon discovery of an "illegal act."41 The statute specifies that these obligations
are triggered "whether or not [the illegal acts are] perceived to have a
material effect on the financial statements of the issuer . . . ." Among other
things, Section 10A(b)(1) requires the auditor to inform the appropriate level
of management of an illegal act (unless clearly inconsequential) and assure
that the registrant's audit committee is "adequately informed" with respect to
the illegal act.
As noted, an intentional misstatement of immaterial items in a registrant's

financial statements may violate Section 13(b)(2) of the Exchange Act and
thus be an illegal act. When such a violation occurs, an auditor must take
steps to see that the registrant's audit committee is "adequately informed"
about the illegal act. Because Section 10A(b)(1) is triggered regardless of
whether an illegal act has a material effect on the registrant's financial
statements, where the illegal act consists of a misstatement in the registrant's
financial statements, the auditor will be required to report that illegal act to
the audit committee irrespective of any "netting" of the misstatements with
other financial statement items.
The requirements of Section 10A echo the auditing literature. See, for
example, Statement on Auditing Standards No. ("SAS") 54, "Illegal Acts by
Clients," and SAS 82, "Consideration of Fraud in a Financial Statement Audit."
Pursuant to paragraph 38 of SAS 82, if the auditor determines there is
evidence that fraud may exist, the auditor must discuss the matter with the
appropriate level of management. The auditor must report directly to the audit
committee fraud involving senior management and fraud that causes a
material misstatement of the financial statements. Paragraph 4 of SAS 82
states that "misstatements arising from fraudulent financial reporting are
intentional misstatements or omissions of amounts or disclosures in financial
statements to deceive financial statement users."42 SAS 82 further states that
fraudulent financial reporting may involve falsification or alteration of
accounting records; misrepresenting or omitting events, transactions or other
information in the financial statements; and the intentional misapplication of
accounting principles relating to amounts, classifications, the manner of
presentation, or disclosures in the financial statements.43 The clear implication
of SAS 82 is that immaterial misstatements may be fraudulent financial
reporting. 44
Auditors that learn of intentional misstatements may also be required to (1)

re-evaluate the degree of audit risk involved in the audit engagement, (2)
determine whether to revise the nature, timing, and extent of audit
procedures accordingly, and (3) consider whether to resign.45
Intentional misstatements also may signal the existence of reportable

conditions or material weaknesses in the registrant's system of internal
accounting control designed to detect and deter improper accounting and
financial reporting.46 As stated by the National Commission on Fraudulent
Financial Reporting, also known as the Treadway Commission, in its 1987
report,
The tone set by top management - the corporate environment or culture

within which financial reporting occurs - is the most important factor
contributing to the integrity of the financial reporting process. Notwithstanding
an impressive set of written rules and procedures, if the tone set by
management is lax, fraudulent financial reporting is more likely to occur.47
An auditor is required to report to a registrant's audit committee any

reportable conditions or material weaknesses in a registrant's system of
internal accounting control that the auditor discovers in the course of the
examination of the registrant's financial statements. 48
GAAP Precedence Over Industry Practice
Some have argued to the staff that registrants should be permitted to follow
an industry accounting practice even though that practice is inconsistent with
authoritative accounting literature. This situation might occur if a practice is
developed when there are few transactions and the accounting results are
clearly inconsequential, and that practice never changes despite a subsequent
growth in the number or materiality of such transactions. The staff disagrees
with this argument. Authoritative literature takes precedence over industry
practice that is contrary to GAAP.49
General Comments
This SAB is not intended to change current law or guidance in the accounting
or auditing literature.50 This SAB and the authoritative accounting literature
cannot specifically address all of the novel and complex business transactions
and events that may occur. Accordingly, registrants may account for, and
make disclosures about, these transactions and events based on analogies to
similar situations or other factors. The staff may not, however, always be
persuaded that a registrant's determination is the most appropriate under the
circumstances. When disagreements occur after a transaction or an event has
been reported, the consequences may be severe for registrants, auditors, and,
most importantly, the users of financial statements who have a right to expect
consistent accounting and reporting for, and disclosure of, similar transactions
and events. The staff, therefore, encourages registrants and auditors to
discuss on a timely basis with the staff proposed accounting treatments for, or
disclosures about, transactions or events that are not specifically covered by
the existing accounting literature.
Footnotes
1 American Institute of Certified Public Accountants ("AICPA"),
Codification of Statements on Auditing Standards ("AU") 312,
"Audit Risk and Materiality in Conducting an Audit," states that the
auditor should consider audit risk and materiality both in (a)
planning and setting the scope for the audit and (b) evaluating
whether the financial statements taken as a whole are fairly
presented in all material respects in conformity with generally
accepted accounting principles. The purpose of this Staff Accounting
Bulletin ("SAB") is to provide guidance to financial management and
independent auditors with respect to the evaluation of the
materiality of misstatements that are identified in the audit process
or preparation of the financial statements (i.e., (b) above). This SAB
is not intended to provide definitive guidance for assessing
"materiality" in other contexts, such as evaluations of auditor
independence, as other factors may apply. There may be other rules
that address financial presentation. See, e.g., Rule 2a-4, 17 CFR
270.2a-4, under the Investment Company Act of 1940.
2 As used in this SAB, "misstatement" or "omission" refers to a

financial statement assertion that would not be in conformity with
GAAP.
3 FASB, Statement of Financial Accounting Concepts No. 2, Qualitative

Characteristics of Accounting Information ("Concepts Statement No.
2"), 132 (1980). See also Concepts Statement No. 2, Glossary of
Terms - Materiality.
4 TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976). See also
Basic, Inc. v. Levinson, 485 U.S. 224 (1988). As the Supreme Court
has noted, determinations of materiality require "delicate
assessments of the inferences a 'reasonable shareholder' would
draw from a given set of facts and the significance of those
inferences to him . . . ." TSC Industries, 426 U.S. at 450.
5 See, e.g., Concepts Statement No. 2, 123-124; AU 312.10 (" . . .

materiality judgments are made in light of surrounding
circumstances and necessarily involve both quantitative and
qualitative considerations."); AU 312.34 ("Qualitative
considerations also influence the auditor in reaching a conclusion as
to whether misstatements are material."). As used in the accounting
literature and in this SAB, "qualitative" materiality refers to the
surrounding circumstances that inform an investor's evaluation of
financial statement entries. Whether events may be material to
investors for non-financial reasons is a matter not addressed by this
SAB.
6 See, e.g., Rule 1-02(o) of Regulation S-X, 17 CFR 210.1-02(o), Rule

405 of Regulation C, 17 CFR 230.405, and Rule 12b-2, 17 CFR
240.12b-2; AU 312.10 - .11, 317.13, 411.04 n. 1, and 508.36; In
re Kidder Peabody Securities Litigation, 10 F. Supp. 2d 398 (S.D.N.Y.
1998); Parnes v. Gateway 2000, Inc., 122 F.3d 539 (8th Cir. 1997); In
re Westinghouse Securities Litigation, 90 F.3d 696 (3d Cir. 1996); In
the Matter of W.R. Grace & Co., Accounting and Auditing
Enforcement Release No. ("AAER") 1140 (June 30, 1999); In the
Matter of Eugene Gaughan, AAER 1141 (June 30, 1999); In the
Matter of Thomas Scanlon, AAER 1142 (June 30, 1999); and In re
Sensormatic Electronics Corporation, Sec. Act Rel. No. 7518 (March
25, 1998).
7 Concepts Statement No. 2, 131 (1980).
8 Concepts Statement No. 2, 131 and 166.
9 Concepts Statement No. 2, 167.
1 Concepts Statement No. 2, 168-69.

0

1

2
1 AU 312.11.
3
1 As stated in Concepts Statement No. 2, 130:

4 Another factor in materiality judgments is the degree of precision
that is attainable in estimating the judgment item. The amount of
deviation that is considered immaterial may increase as the
attainable degree of precision decreases. For example, accounts
payable usually can be estimated more accurately than can
contingent liabilities arising from litigation or threats of it, and a
deviation considered to be material in the first case may be quite
trivial in the second. This SAB is not intended to change current law
or guidance in the accounting literature regarding accounting
estimates. See, e.g., Accounting Principles Board Opinion No. 20,
Accounting Changes 10, 11, 31-33 (July 1971).
1 The staff understands that the Big Five Audit Materiality Task Force
5 ("Task Force") was convened in March of 1998 and has made
recommendations to the Auditing Standards Board including
suggestions regarding communications with audit committees about
unadjusted misstatements. See generally Big Five Audit Materiality
Task Force, "Materiality in a Financial Statement Audit Considering
Qualitative Factors When Evaluating Audit Findings" (August 1998).
The Task Force memorandum is available at www.aicpa.org.
1 See Concepts Statement No. 2, 169.

6
1 If management does not expect a significant market reaction, a

7 misstatement still may be material and should be evaluated under
the criteria discussed in this SAB.
1 Intentional management of earnings and intentional misstatements,

8 as used in this SAB, do not include insignificant errors and omissions
that may occur in systems and recurring processes in the normal
course of business. See notes 38 and 50 infra.
1 Assessments of materiality should occur not only at year-end, but

9 also during the preparation of each quarterly or interim financial
statement. See, e.g., In the Matter of Venator Group, Inc., AAER
1049 (June 29, 1998).
2 See, e.g., In the Matter of W.R. Grace & Co., AAER 1140 (June 30,
0 1999).
2 AUI 326.33.
1
2 Id.
2
2 The auditing literature notes that the "concept of materiality

3 recognizes that some matters, either individually or in the
aggregate, are important for fair presentation of financial
statements in conformity with generally accepted accounting
principles." AU 312.03. See also AU 312.04.
2 AU 312.34. Quantitative materiality assessments often are made

4 by comparing adjustments to revenues, gross profit, pretax and net
income, total assets, stockholders' equity, or individual line items in
the financial statements. The particular items in the financial
statements to be considered as a basis for the materiality
determination depend on the proposed adjustment to be made and
other factors, such as those identified in this SAB. For example, an
adjustment to inventory that is immaterial to pretax income or net
income may be material to the financial statements because it may
affect a working capital ratio or cause the registrant to be in default
of loan covenants.
2 AU 508.36.
5
2 AU 312.34
6
2 AU 380.09.
7
2 FASB Statements of Financial Accounting Standards ("Standards" or

8 "Statements") generally provide that "[t]he provisions of this
Statement need not be applied to immaterial items." This SAB is
consistent with that provision of the Statements. In theory, this
language is subject to the interpretation that the registrant is free
intentionally to set forth immaterial items in financial statements in
a manner that plainly would be contrary to GAAP if the
misstatement were material. The staff believes that the FASB did
not intend this result.
2 15 U.S.C. 78m(b)(2) - (7).

9
3 15 U.S.C. 78l.
0
3 15 U.S.C. 78o(d).
1
3 Criminal liability may be imposed if a person knowingly circumvents

2 or knowingly fails to implement a system of internal accounting
controls or knowingly falsifies books, records or accounts. 15 U.S.C.
78m(4) and (5). See also Rule 13b2-1 under the Exchange Act, 17
CFR 240.13b2-1, which states, "No person shall, directly or
indirectly, falsify or cause to be falsified, any book, record or
account subject to Section 13(b)(2)(A) of the Securities Exchange
Act."
3 15 U.S.C. 78m(b)(7). The books and records provisions of section

3 13(b) of the Exchange Act originally were passed as part of the
Foreign Corrupt Practices Act ("FCPA"). In the conference committee
report regarding the 1988 amendments to the FCPA, the committee
stated,
The conference committee adopted the prudent man qualification in order to

clarify that the current standard does not connote an unrealistic degree of
exactitude or precision. The concept of reasonableness of necessity
contemplates the weighing of a number of relevant factors, including the costs
of compliance.
Cong. Rec. H2116 (daily ed. April 20, 1988).
3 So far as the staff is aware, there is only one judicial decision that
4 discusses Section 13(b)(2) of the Exchange Act in any detail, SEC v.
World-Wide Coin Investments, Ltd., 567 F. Supp. 724 (N.D. Ga.
1983), and the courts generally have found that no private right of
action exists under the accounting and books and records provisions
of the Exchange Act. See e.g., Lamb v. Phillip Morris Inc., 915 F.2d
1024 (6th Cir. 1990) and JS Service Center Corporation v. General
Electric Technical Services Company, 937 F. Supp. 216 (S.D.N.Y.
1996).
3 The Commission adopted the address as a formal statement of

5 policy in Securities Exchange Act Release No. 17500 (January 29,
1981), 46 FR 11544 (February 9, 1981), 21 SEC Docket 1466
(February 10, 1981).
3 Id. at 46 FR 11546.
6
3 Id.
7
3 For example, the conference report regarding the 1988

8 amendments to the FCPA stated,
The Conferees intend to codify current Securities and Exchange Commission

(SEC) enforcement policy that penalties not be imposed for insignificant or
technical infractions or inadvertent conduct. The amendment adopted by the
Conferees [Section 13(b)(4)] accomplishes this by providing that criminal
penalties shall not be imposed for failing to comply with the FCPA's books
and records or accounting provisions. This provision [Section 13(b)(5)] is
meant to ensure that criminal penalties would be imposed where acts of
commission or omission in keeping books or records or administering
accounting controls have the purpose of falsifying books, records or accounts,
or of circumventing the accounting controls set forth in the Act. This would
include the deliberate falsification of books and records and other conduct
calculated to evade the internal accounting controls requirement.
Cong. Rec. H2115 (daily ed. April 20, 1988).
3 As Chairman Williams noted with respect to the internal control

9 provisions of the FCPA, "[t]housands of dollars ordinarily should not
be spent conserving hundreds." 46 FR 11546.
4 Id., at 11547.
0
4 Section 10A(f) defines, for purposes of Section 10A, an "illegal act"

1 as "an act or omission that violates any law, or any rule or
regulation having the force of law." This is broader than the
definition of an "illegal act" in AU 317.02, which states, "Illegal
acts by clients do not include personal misconduct by the entity's
personnel unrelated to their business activities."
4 AU 316.04. See also AU 316.03. An unintentional illegal act

2 triggers the same procedures and considerations by the auditor as a
fraudulent misstatement if the illegal act has a direct and material
effect on the financial statements. See AU 110 n. 1, 316 n. 1,
317.05 and 317.07. Although distinguishing between intentional and
unintentional misstatements is often difficult, the auditor must plan
and perform the audit to obtain reasonable assurance that the
financial statements are free of material misstatements in either
case. See AU 316 note 3.
4 AU 316.04. Although the auditor is not required to plan or perform

3 the audit to detect misstatements that are immaterial to the
financial statements, SAS 82 requires the auditor to evaluate
several fraud "risk factors" that may bring such misstatements to
his or her attention. For example, an analysis of fraud risk factors
under SAS 82 must include, among other things, consideration of
management's interest in maintaining or increasing the registrant's
stock price or earnings trend through the use of unusually
aggressive accounting practices, whether management has a
practice of committing to analysts or others that it will achieve
unduly aggressive or clearly unrealistic forecasts, and the existence
of assets, liabilities, revenues, or expenses based on significant
estimates that involve unusually subjective judgments or
uncertainties. See AU 316.17a and .17c.
4 AU 316.34 and 316.35, in requiring the auditor to consider

4 whether fraudulent misstatements are material, and in requiring
differing responses depending on whether the misstatement is
material, make clear that fraud can involve immaterial
misstatements. Indeed, a misstatement can be "inconsequential"
and still involve fraud.
Under SAS 82, assessing whether misstatements due to fraud are material to
the financial statements is a "cumulative process" that should occur both
during and at the completion of the audit. SAS 82 further states that this
accumulation is primarily a "qualitative matter" based on the auditor's
judgment. AU 316.33. The staff believes that in making these assessments,
management and auditors should refer to the discussion in Part 1 of this SAB.
4 AU 316.34 and 316.36. Auditors should document their

5 determinations in accordance with AU 316.37, 319.57, 339, and
other appropriate sections.
4 See, e.g., AU 316.39.

6
4 Report of the National Commission on Fraudulent Financial

7 Reporting at 32 (October 1987). See also Report and
Recommendations of the Blue Ribbon Committee on Improving the
Effectiveness of Corporate Audit Committees (February 8, 1999).
4 AU 325.02. See also AU 380.09, which, in discussing matters to

8 be communicated by the auditor to the audit committee, states,
The auditor should inform the audit committee about adjustments arising from
the audit that could, in his judgment, either individually or in the aggregate,
have a significant effect on the entity's financial reporting process. For
purposes of this section, an audit adjustment, whether or not recorded by the
entity, is a proposed correction of the financial statements....
4 See AU 411.05.
9
5 The FASB Discussion Memorandum, Criteria for Determining

0 Materiality, states that the financial accounting and reporting
process considers that "a great deal of the time might be spent
during the accounting process considering insignificant
matters . . . . If presentations of financial information are to be
prepared economically on a timely basis and presented in a concise
intelligible form, the concept of materiality is crucial." This SAB is
not intended to require that misstatements arising from insignificant
errors and omissions (individually and in the aggregate) arising from
the normal recurring accounting close processes, such as a clerical
error or an adjustment for a missed accounts payable invoice,
always be corrected, even if the error is identified in the audit
process and known to management. Management and the auditor
would need to consider the various factors described elsewhere in
this SAB in assessing whether such misstatements are material,
need to be corrected to comply with the FCPA, or trigger procedures
under Section 10A of the Exchange Act. Because this SAB does not
change current law or guidance in the accounting or auditing
literature, adherence to the principles described in this SAB should
not raise the costs associated with recordkeeping or with audits of
http://www.sec.gov/rules/acctrps/sab99.htm
Home | Previous Page
Internal Control
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The internal control safeguards that a client institutes help to prevent, correct, and detect
material misstatements affecting the overall reliability and fairness of the financial
statements. As such, the auditor will seek to evaluate the internal controls to determine whether
they are adequate and whether they are being implemented as designed.
The strength of the control environment begins at the top of the organization. The management's
handling of issues affecting internal control set the tone of the control environment. The control
environment will influence the ethical behavior and integrity of the personnel who are
responsible for the financial representations on which the auditor bases his or her opinions. The
auditor will look for the client to clearly communicate and administer the controls with a
commitment to competency in the workplace. Management's operating style, human resource
policies and procedures, sense of accountability, and the organizational structure are evaluated
closely by the diligent auditor to assess the overall audit plan that should apply to that specific
client.
Ultimately, it is the auditors professional judgment of the internal control environment that
determines the extent of substantive procedures and timing of those procedures the auditor will
perform over the course of the audit. A weak environment will demand more substantive testing
at the balance sheet date, rather than on interim dates. If the environment has strong controls, the
auditor might decide that interim testing and less overall testing will be sufficient. More testing
leads to higher audit fees. This is the trade-off the client will want to be made aware of when
designing and implementing its entity's internal control policies and procedures.
Practice Exercise
Back to Top
Hide and ShowMateriality Topic
Match nine of the terms (ai) with the definitions

provided below (19).
a. Business risk
b. Preliminary judgment about materiality
c. Inherent risk
d. Planned detection risk
e. Audit assurance
f. Acceptable audit risk
g. Tolerable misstatement
h. Control risk
i. Materiality
1. A measure of the risk that audit evidence

for a segment will fail to detect
misstatements exceeding a tolerable amount,
should such misstatements exist
d. Planned detection risk
2. The risk that the auditor or audit firm will

suffer harm because of a client relationship,
even though the audit report rendered for the
client was correct
a. Business risk
3. A measure of the auditors assessment of

the likelihood that misstatements exceeding a
tolerable amount in a segment will not be
prevented or detected by the clients internal
controls
h. Control risk
4. A measure of how much risk the auditor is

willing to take that the financial statements
may be materially misstated after the audit is
completed and an unqualified audit opinion
has been issued
f. Acceptable audit risk
5. The materiality allocated to any given

account balance
g. Tolerable misstatement
Hide and ShowInternal Controls
Match seven of the terms (ai) with the definitions provided below (17).
a. Control environment
b. Control activities
c. Independent checks on performance
d. Internal control
e. Monitoring
f. Separation of duties
g. General authorization
h. Specific authorization
i. Risk assessment
1. Managements ongoing and periodic

assessment of the quality of internal control
performance to determine that controls are
operating as intended and modified when
needed
e. Monitoring
2. Company-wide policies for the approval of

all transactions within stated limits
g. General authorization
3. The actions, policies, and procedures that

reflect the overall attitudes of top
management, directors, and owners of an
entity about control and its importance to
the entity
a. Control environment
4. Segregation of the following activities in
an organization: custody of assets,
accounting, authorization, and operational
responsibility
f. Separation of duties
5. Managements identification and analysis

of risks relevant to the preparation of
financial statements in accordance with
GAAP
i. Risk assessment
6. Policies and procedures that help ensure

necessary actions are taken to address risks
in the achievement of the entitys objectives
b. Control activities
7. A process designed to provide reasonable

assurance regarding the achievement of
managements objectives in the following
categories: (1) reliability of financial
reporting, (2) effectiveness and efficiency of
operations, and (3) compliance with
applicable laws and regulations
d. Internal control
Week 5
Print
Impact of IT and Audit Programs

Fraud, Evidence, and Computer Sabotage | Internal Control and IT Systems |
Governance of Information Technology
Fraud, Evidence, and Computer Sabotage
Back to Top
This week, we begin our journey into understanding the client's internal controls of the
information technology (IT) system.
Videos
These two very informative and entertaining clips will provide you with an
excellent oversight of internal control over the client's computer based technology.
Review these videos to gain an overall understanding of the IT internal control
concepts.
Fraud, Evidence, and Computer Sabotage Planning, Part 1 (2:59, 1.8MB)

Transcript
Fraud, Evidence, and Computer Sabotage Planning, Part 2 (2:31, 1.5MB)

Transcript
Internal Control and IT Systems
Back to Top
The CPA exam tests the candidate's understanding of the significance of IT systems and how that
affects the auditor. This is done in both the audit exam and in the business environment concepts
exam.
Most businesses in the United States use some form of technical information systems to manage
their financial accounts. To imagine a Fortune 500 business not using a computerized system,
you would have to think back to pre-1980. However, once you move out of the range of mid- to
large-sized businesses, you would discover that use of sophisticated computerization in the small
business community is not as widespread. Those smaller businesses will still sometimes require
the services of the auditor. Even if you are fortunate enough to not have any smaller, computer-
less clients, an auditor must consider that the client's computerized system could be severely
corrupt and unreliable. Therefore, an astute auditor must understand how to audit around the
computerized accounting system.
As we learned last week, the auditor must have an understanding of the client's internal controls.
This includes the IT system. Under GAAS, the CPA auditor must document how he or she
evaluated the internal controls of the IT system and determined the degree of risk the IT system
presents. The risk includes reliance on inaccurate systems; unauthorized access to data leading to
inaccurate data; unauthorized changes to the data, system, or programs; and failure to make
relevant and required updates to the programs or systems.
A clients IT system is affected by the software, hardware, data, personnel, and network on which
the system is set up. A weakness in any of these areas is a weakness in the internal control of the
system. The system itself consists of accounting information, transaction processing, decision
support, management information, and executive information systems. Each of these systems
interacts with at least one other system in the series. The accounting information system creates
an excellent audit trail for accounting transactions. The auditor can determine whether the
accounting transactions are valid, properly classified, recorded at their proper values in the
proper accounting period, and fairly represented on the financial statements.
The readings and homework assignment this week will assist you greatly in understanding the
auditors internal control concerns involving the IT system and how the auditor works with those
systems.
Governance of Information Technology
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Businesses and auditors are certainly concerned with the governance of IT. The IT Governance
Institute (www.itgi.org) has developed a wide range of excellent resources for organizations and
auditors to use in looking at IT governance matters.
The use of technologies leads to different risks that the organization needs to manage to make
sure that IT supports the implementation of the organizations strategy and goals. IT governance
is an important part of the internal control environment. The board and senior management are
responsible for IT governance.
Auditors will likely consider the extent of the boards and senior managements involvement in
overseeing IT governance, which information would likely be used in the auditors evaluation of
the companys control environment, and the general controls over IT.
IT Governance Executive Summary
http://www.isaca.org/Knowledge-
Center/Research/Documents/An-Executive-View-of-
IT-Gov-Research.pdf
Week 6
Print
Sales and Collection Cycle and Sampling
Introduction | Sampling Risk | Statistical Versus Nonstatistical Sampling | Monetary

Unit Sampling | Revenue Recognition | Becker CPA ReviewSampling and
Communications
Introduction
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Auditors are concerned with performing a sufficient audit in order to be able to have a reasonable
basis for rendering an opinion on the client's financial statements. Therefore, auditors employ
sampling techniques to help them determine where to most beneficially allocate their audit
resources for a proper result.
Sampling Risk
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Videos
These short video clips will give you a better grasp

of the basic concept of sampling. The instructional
videos are of Becker CPA Review Course national
instructor Rick Duffy, CPA.
Audit Sampling, Part 1 (4:06, 3.5MB)

Transcript
Audit Sampling, Part 2 (0:35, 0.6MB)

Transcript
Statistical Versus Nonstatistical Sampling
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Generally accepted auditing standards approve of both statistical and nonstatistical

sampling. Statistical sampling occurs when the auditor specifies the sampling risks he or she
is willing to accept and calculates the sample size that will provide the desired degree of
reliability. The difficulty is determining how much risk the auditor is willing to acceptmore
risk, less sampling; less risk, more sampling. A mistake many auditors fall into is substituting
mathematical analysis and results for professional judgment.
In nonstatistical sampling, the auditor's sample size is not determined mathematically. Instead,
the auditors will use their professional judgment to determine the sample size and analyze the
results of the sample taken.
Attribute sampling and variable and PPS sampling are other means of sampling that the auditor
relies upon during the audit. Attribute sampling is primarily used for testing internal controls,
whereas variable sampling and PPS sampling are typically used in substantive tests of account
balances, gathering evidential material, or verifying numbers.
Monetary Unit Sampling
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An auditor will perform tests of controls and substantive tests of transactions when testing how
effective the internal controls are and determining the rate of monetary misstatements.
On the other hand, the auditor will test the details of balances when there is a concern that the
monetary amount of the account balance is materially misstated.
Monetary unit sampling is used in audit sampling for tests of details of balances. Indeed, it is the
commonly used method of statistical sampling for tests of details of balances because
it is easy to use;
it increases the likelihood of selecting high-cost items from the audit

population;
it can decrease audit cost because several sample items are tested at once;
and
it provides a statistical result in dollars, which can help the auditor make
more defensible conclusions.
There are disadvantages to monetary unit sampling, such as the following.
Because there is a greater likelihood of higher cost items being selected for
the sample, there is a lesser likelihood that this account will be in the audit
sample if the auditor suspects an account balance may be understated.
It is burdensome to select probability proportional to size samples from large

populations without using a computer.
Monetary Unit Sampling Using
Excel
http://www.nysscpa.org/cpajournal/2005/50
5/essentials/p36.htm
Revenue Recognition
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In their audits of the sales and collection cycle, the auditors use the sales cutoff test to see if the
sales were recorded in the proper period. There is always the potential for the client holding the
books open and recording January sales as December sales, therefore overstating sales, accounts
receivable, operating income, and total assets.
Typically, the auditor will perform the sales cutoff date as of the balance sheet date. The auditor
will select invoices from those recorded in the sales journal prior and subsequent to year-end,
typically for 5 to 10 days. The auditor will compare the terms on the invoices to the terms on the
shipping documents to make sure that the sales have been recorded in the correct year.
Due to the huge potential for fraud in the area of revenue recognition, which poses considerable
audit risks to the auditor, the auditor must take extreme care in this area in order to preserve the
integrity of the damaged financial reporting process. Such damage that has been imposed on this
process has resulted from recent financial frauds, of which the public is well aware.
IFRS UPDATE
In general, both U.S. GAAP and IFRS

state that revenue recognition must be
tied to the completion of the earning
process and the actual or expected
cash flows that should result. Both
require that revenue be recognized
only when it is realized or realizable
and earned. U.S. GAAP provides more
extensive guidance in this area and is
more industry specific.
More specific
differences occur
while assessing the
completion of the earning cycle,
particularly when evaluating the sale
of goods, rendering of services,
multiple elements, deferred receipt of
receivables, and construction
contracts. For more detailed analysis
of these differences, please refer to
SAB 104 and IAS 18.
Revenue Recognition in Financial

Statements
http://www.sec.gov/interps/account/sab101.
htm
Becker CPA ReviewSampling and Communications
Back to Top
Dear student,
In an effort to enhance your comprehension of this difficult subject and to introduce you to some
of the tools available from Becker Professional Education, you are being given access to a series
of links (see below) to Becker CPA Review materials on Sampling and Communications.
We hope you find this access to be an excellent complementary resource for you during Week 6
of this course. However, it must be emphasized that your eBook readings and other assigned
materials for this week will be covered in the graded assessments for this course, so you will
want to focus on those as you prepare for any exams, projects, quizzes, etc.
Week 7
Print
Acquisition, Payment Cycle, and Inventory
Introduction | Check Fraud | The Accounts Payable Cycle | The Inventory Cycle |
Completing the Audit | Practice Exercise
Introduction
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We are entering our final week of lectures together and the end of the auditing cycle. We start
this lecture with a review of the concepts of check fraud. The accounts payable cycle is the
prelude to the client acquiring inventory. We also focus on the final work of the audit to arrive at
our audit report. The subsequent events and final analysis stage are where the auditor can
determine if the financials taken as a whole fairly represent the financial condition of the client's
business.
Check Fraud
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The tests of acquisition and cash disbursement transactions have two purposes.
To determine whether related internal accounting controls are functioning

(tests of controls)
To determine whether the transactions actually contain any monetary

misstatements (substantive)
Cash disbursements are an area highly susceptible to fraudulent schemes, including
employees causing their employers to pay for fictitious invoices for goods and
services;
employees making claims for reimbursements of fictitious or inflated business

expenses;
employees stealing the employer's funds by forging or altering a check on

one of the company's bank accounts or stealing a check the company
legitimately issued to another payee;
employees causing their employers to issue payments to them by making

false claims for compensation;
employees stealing their employer's funds by making fraudulent wire

transfers out of the company's bank accounts; and
employees making false entries on a cash register to conceal the fraudulent

removal of cash.
Auditors need to be aware of such schemes to properly prepare their audits of the acquisition and
payment cycles.
Videos
The following two videos show a

reformed check-fraud criminal
discussing techniques criminals use
and what businesses can do to stop
them.
Reformed Check Fraud Criminal,

Part 1 (4:28, 2.7MB) Transcript
Reformed Check Fraud Criminal,

Part 2 (3:35, 2.1MB) Transcript
The Accounts Payable Cycle
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Accounts payable is an audit area that is concerned with the specific issues of unrecorded
liabilities and the proper recording of purchases.
In the search for unrecorded liabilities, the auditor reviews the supporting documentation for
significant cash disbursements after year-end to the last day of the auditor's fieldwork to
determine whether they are disbursements for transactions that occurred in the year of audit. If
they are, then the expenses should be accrued and added to accounts payable. Also, the auditor
should review all significant unpaid invoices to determine whether any should be accrued as of
the end of the year. If this is the case, the invoices should also be included in accounts payable.
Regarding the proper recording of purchases, for all significant purchases in the purchases
journal for a period prior to and subsequent to the year-end, the auditor should examine the
supporting documentation to determine whether the purchase was recorded for the proper period.
Further, on the last day of the year, the auditor should observe that the last receiving report is
issued, and the auditor should then review a sample of the supporting documents of prior and
subsequent reports to verify that each purchase was recorded in the proper period.
IFRS UPDATE
Both U.S. GAAP and IFRS require

companies to present the liabilities in
order of liquidity, and both prohibit
the recognition of liabilities for future
losses. Both allow for the contingent
liabilities, but U.S. GAAP is less
stringent in its recognition criteria.
IFRS requires that contingencies must
be virtually certain before recognition
is permitted. Also in IFRS, a best
estimate of the contingency is
allowed, whereas under U.S. GAAP, a
minimum amount in a range is
employed. For more detailed analysis
of these differences, please refer to
IAS 37.
The Inventory Cycle
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The audit of inventory can be quite complex, because
inventory is often the largest account in the working capital;
inventory is often in different locations;
diverse items in inventory are often difficult to value;
inventory valuation is difficult due to the estimates involved; and
there are several acceptable methods of valuing inventory, and some entities
use different methods for different types of inventory.
Further, inventory is a category that has been highly susceptible to fraudulent manipulation. In
the past 50 years, some of the companies that have been involved in inventory manipulations
include McKesson and Robbins, Equity Funding, ZZZZ Best, Phar-Mor, Rite Aid, and Crazy
Eddie's.
For example, Phar-Mor significantly overstated the value of its inventory and then moved
inventory back and forth between stores so that it could be counted multiple times. In the case of
Rite Aid, this corporation overstated net income by managing the value of its inventory. That is,
the senior management allegedly failed to record millions in shrinkage of its physical inventory
due to loss or theft. They also made journal entries that lowered the cost of goods sold.
When auditing inventory, therefore, auditors should consider using analytical analyses for
accounts where inventory-related financial statement fraud symptoms are generally present, such
as
inventory;
accounts payable;
cash; and
cost of goods sold.
Consequently, some of the analytical procedures the auditor might consider using might include
the following.
Compare gross margin percentage with that of previous years.
Compare inventory turnover ratio with that of previous years.
Compare unit costs of inventory with that of previous years.
Compare extended inventory value with that of previous years.
Compare current-year manufacturing costs with that of previous years.
IFRS UPDATE
In general, both U.S. GAAP and IFRS

agree on the definition of inventory as
an asset being held for sale in the
normal course of business and that the
primary basis for inventory accounting
is its cost, whether the asset is used in
the production process or available as
a finished good. Both agree that costs
incurred while readying the inventory
for sale, including allocable overhead,
may be included in the cost. Selling
costs, storage costs, and general
administrative costs may not be
included when assessing the holding
value of inventory.
The two methods

differ as to costing
methods, (LIFO is not
allowed under IFRS), measurement,
reversal of inventory write-downs,
(not allowed under U.S. GAAP), and
permanent inventory markdowns
under the retail inventory method
(RIM). For more detailed analysis of
these differences, please refer to ARB
43 and IAS 2. The FASB issued FAS
151, in November of 2004 in order to
address the differences between U.S.
GAAP and IFRS relating to
accounting for inventory costs.
Completing the Audit
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When we are ready to wrap up the audit, we also have the responsibility to consider other audit
procedures in areas that could potentially have a material impact on disclosure and financial
statement presentation.
Such areas of concern include the following.
Reviewing for contingent liabilities
Reviewing for subsequent events
Reviewing for related party transactions
Reviewing the company's ability to continue as a going concern
Evaluation of significant unusual transactions
Retrospective review of significant accounting estimates
Final fieldwork assessment of the risks of material misstatement due to fraud
Final analytical review
Obtaining a client representation letter documenting management's most

important oral representations during the audit
Contingent liabilities are future obligations to an outside party for an unknown amount resulting
from activities that have already taken place. Examples include
litigation where the audit client is a defendant;
income tax disputes where additional tax liability may result;
product warranties where the client may incur liability; and
guarantees of the obligations of third parties, in which the client is

contingently liable for the debt if the third party defaults.
Subsequent events are those events that happen between the balance sheet date and the date the
financial statements were issued. Auditors are responsible for reviewing the subsequent events
that occur between the balance sheet date and the date of the audit report. Examples include the
following.
There are events that have a direct effect on the financial statements and
require adjustment, such as declaration of bankruptcy by a customer with an
outstanding accounts receivable balance due to deteriorating financial
conditions and settlement of litigation at an amount different from the
amount recorded on the books.
There are events that have no direct effect on the financial statements but for
which disclosure is advisable, such as
o a decline in the market value of securities held for temporary

investment or resale during the subsequent period;
o issuance of bonds or equity securities during the subsequent period;
o loss of inventory due to fire;
o declaration of a cash or stock dividend; and
o sale of a stock issue.
Practice Exercise
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Hide and Show
The fieldwork for the December 31, 2007,

audit of Tribble Corporation ended on
March 17, 2008. The financial statements
and auditor's report were issued and mailed
to stockholders on March 29, 2008. In each
of the material situations (15) below,
indicate the appropriate action (a, b, c, d, or
e).
The possible actions are as follows.
a. Adjust the December 31, 2007,

b. Disclose the information in a
footnote in the December 31, 2007,
c. Request that the client revise and
reissue the December 31, 2007,
financial statements. The revision
should involve an adjustment to the
December 31, 2007, financial
statements.
d. Request that the client revise and
reissue the December 31, 2007
should involve the addition of a
footnote, but no adjustment, to the
December 31, 2007, financial
statements.
e. No action is required.
The situations are as follows.
1. On January 16, 2008, a lawsuit was

filed against Tribble for a patent
infringement action that allegedly
took place in early 2005. In the
opinion of Tribble's attorneys, there is
a reasonable (but not probable)
danger of a significant loss to Tribble.

footnote in the December 31, 2007
2. On February 19, 2008, Tribble

settled a lawsuit out of court that had
originated in 2002 and is currently
listed as a contingent liability.
a. Adjust the December 31, 2007

3. On March 30, 2008, Tribble settled

a lawsuit out of court that had
originated in 2004 and is currently
listed as a contingent liability.
e. No action is required.
4. On February 2, 2008, you

discovered an uninsured lawsuit
against Tribble that had originated on
August 30, 2007.

footnote in the December 31, 2007
5. On April 7, 2008, you discovered

that a debtor of Tribble went
bankrupt on January 22, 2008, due to
a major uninsured fire that occurred
on January 2, 2008.
d. Request the client revise and

reissue the December 31, 2007
should involve the addition of a
footnote, but no adjustment, to the
December 31, 2007 financial
statements.

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Week 1

Profession, Standards, and Reporting

The Auditing Profession

An auditor's professional judgment of the representations of management leads to the all-

CPA Vision Project

Auditing Standards and Regulation

What five circumstances are required for a standard unqualified report?

An unqualified report may be issued under the following five circumstances:

Distinguish between a qualified opinion, an adverse opinion, and a disclaimer of

Becker CPA ReviewAudit Reports

Becker CPA Review Content Links

Becker Multimedia Lecture on Audit Reports

Becker MCQs on Audit Reports

Becker Simulation on Audit Reports

Becker Lecture PDF download

Rule 101 Independence

Independence (2:17, 1.4MB) Transcript

Please work Review Question 4-26 in the 14th edition.

Ann Archer serves on the audit committee of JKB Communications Inc., a

1. Installed JKB Communications information system hardware and

2. Supervised JKB Communications personnel in the daily operation

3. Customized a prepackaged payroll software application, based

4. Trained JKB Communications employees on the use of the newly

5. Determined which JKB Communications products would be

6. Operated JKB Communications local area network for several

The code of professional conduct is divided into four parts.

Principles establish ideal standards of ethical conduct stated in philosophical

Rules of conduct are the minimum standards of ethical conduct stated as

Ethical rulings are answers to specific questions submitted to the AICPA by

keeping current on professional auditing standards;

participating in continuing professional education seminars on auditing;

hiring audit personnel with the requisite skills;

accepting engagements from honest clients;

making sure we remain independent;

taking whatever steps necessary to understand the clients business when

carrying malpractice insurance;

performing quality audits;

properly documenting whatever client work is performed;

obtaining an engagement letter and a representation letter; and

seeking legal counsel whenever necessary.

a. Sharp, CPA, was engaged by Peters & Sons, a partnership, to

1. Sharp will be compensated for the reasonable value of the

2. Peters & Sons will recover damages for breach of contract.

b. In a common law action against an accountant, lack of privity is a

1. Is the clients creditor who sues the accountant for negligence.

2. Can prove the presence of gross negligence that amounts to a

3. Is the accountants client.

4. Bases the action upon fraud.

2. Unaudited financial statements

3. An audit resulting in a disclaimer of opinion.

4. Letters for underwriters.

Please work Review Question 5-22 in the 14th edition.

In order to expand its operations, Barton Corp. raised $ 5 million in a public

The purchasers of the common stock who have asserted that

First National Bank, based upon Hanovers negligence.

Trade creditors who extended credit to Barton, based upon

a. Discuss whether you believe Hanover will be found liable

b. Indicate whether you believe First National Bank will be

c. Indicate whether you believe the trade creditors will be

Please work Review Question 5-20 in the 14th edition.

Auditors Liability for the Detection of Fraud

Please work Review Question 11-30 in the 14th edition.