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How Financial Statements Can Be Erroneously Prepared

Jun 2, 2008
The misuse or misunderstanding of the proper application of materiality can lead to manipulating reported income through "earnings management" techniques. This type of fraudulent financial reporting receives ample attention in the financial press. This is a subject relevant to the preparation and audit of all financial statements. SEC Staff Accounting Bulletin (SAB) no. 99, Materiality, helps advise preparers and independent auditors how to evaluate materiality misstatements in the financial reporting and auditing processes considering certain GAAP and the federal securities laws that relate to materiality.

Materiality is defined by the FASB as, "The magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement." The criteria for determining materiality by the FASB is that if the presentations of financial information are to be prepared economically on a timely basis and presented formally, then the concept of materiality is crucial. Misstatements occurring from clerical error or adjustments for missed invoices are not required to always be corrected as long as the error is identified in the audit process and management is notified.

Reliance on quantitative benchmarks to determine whether items are material to the financial statements is not acceptable. Qualitative, as well as quantitative factors, must be considered in determining the materiality of differences and/or omissions. Abuse of materiality, errors that are intentionally recorded within a defined percentage ceiling, and then dismissed as not enough to affect the bottom line, is not tolerated as well.

The SAB describes several qualitative factors that management and auditors can refer to when determining the materiality of misstatements. In a financial statement, a quantitatively small misstatement may become material if:

1) The misstatement came from an item that can be precisely measured.
2) It is from an estimate.
3) It disguises a change in earnings.
4) It covers up a failure to meet analysts' expectations of the endeavor.
5) It changes a loss into income.
6) It involves a portion of the business that has been classified as a significant business segment regarding profitability.
7) It affects the business's ability to adhere to regulations.
8) It affects the business's ability to comply with contractual obligations.
9) It effects the management's incentive compensation.
10) It involves the covering up of illegal activity.

The appropriate use of materiality should strengthen the effectiveness of financial reporting.1.

The American Institute of Certified Public Accountants' (AICPA) Auditing Standards Board recently issued a new standard that requires CPAs to perform additional procedures to help detect potentially fraudulent actions. SAS No. 82, Consideration of Fraud in a Financial Statement Audit, meets the public's expectations of assurance that financial statements are devoid of material misstatement caused by error or fraud. SAS no. 82 is designed to help define the responsibilities of the auditor in detecting fraud.

Errors that are unintentional can occur at any time or place causing unpredictable financial statement effects. A thorough internal control system can reduce the risk of material errors. Fraud, however, is intentional and is usually accomplished by avoiding internal controls. Fraud is difficult to detect using internal controls and requires the expertise of the auditor.

SAS No. 82 provides auditors with guidelines on how to address potential fraudulent situations in a financial statement audit. It describes the different types of fraud and advises the auditor of how to differentiate between the risk of material fraud, fraudulent financial reporting, and misappropriation of assets. SAS also requires auditors to record the risk factors identified and their response to them in both employee and management fraud.

Employee fraud usually involves the misappropriation of assets or improper record keeping. Employees are known to commit fraud due to or in combination with various factors:

1) Emotional duress
2) A perceived opportunity to get away with something
3) Resentment due to perceived pay inequity.

Management fraud usually involves manipulative financial reporting. There are several incentives for management fraud. They include:

1) Incentive to affect stock price
2) Expectations of investors
3) To avoid debt
4) To avoid tax liability
5) To meet budget
6) To influence creditors
7) To achieve bonuses
8) To avoid punishment.

To avoid the fraudulent activities of employees and management several things need to be implemented. Internal controls must be maintained to insure ethical practices are maintained. Top management's support of internal control must be assured so as to not lose its effectiveness. Unusual or difficult transactions should be monitored thoroughly. Top management sets the tone for financial activity, if the ethical code is weak, a third party must become involved.

SAS No. 82 provides that the auditor accepts responsibility for detecting fraudulent practices and communicating with managers. It also contains performance guidelines to assess the risk of material misstatement due to fraud and how to respond to the risks involved. This standard raises public expectations and gives auditors greater responsibility in assuring that fraudulent practices no longer go undetected.2.

1. C. Terry Grant, "Earnings Management And The Abuse Of Materiality." Journal of Accountancy (September, 2000)

2. Alan Reinstein; Gregory A. Coursen, "Considering The Risk Of Fraud: Understanding the Auditor's New Requirements," The National Public Accountant (March/April, 1999): 34-38
About the Author
Jason McGraw is a Financial Consultant in the San Francisco area. He is currently a member of the management team at Select Debt Relief. The increasingly large number of bankruptcy filings in recent years has prompted him to lend is expertise in resolving consumer debt. For more financial information please visit www.selectdebtrelief.com
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