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Obviously, most businesses do not engage in massive frauds like WorldCom.

Financial deception is rare


 The majority of business managers are honest, possess integrity, and would not be associated
with fraudulent activity
 Safeguards have been built into the accounting system to prevent and detect activities that are
inconsistent with the objectives of a business

Errors – result when unintentional mistake are made in recording transactions, posting transactions,
summarizing accounts and so forth. Errors are not intentional and when detected are immediately
corrected. Errors can result from sloppy accounting, bad assumptions, misinformation, miscalculation
and other factors

Disagreements – result when different people arrive at different conclusions based on the same set of
facts. Because accounting involves judgement and estimates, opportunities for honest disagreements in
judgement abound

Frauds – result from intentional errors.

Internal control structure – policies and procedures established to provide management with
reasonable assurance that the objectives of an entity will be achieved

Sarbanes-Oxley Act – a law passed by congress in 2002 that gives the SEC significant oversight
responsibility and control over companies issuing financial statements and their external auditors

Control Environment – the actions, policies and procedures that reflect the overall attitudes of top
management about control and its importance to the entity

Organizational structure – lines of authority and responsibility

Audit committee – members of a company’s board of directors who are responsible for dealing with the
external and internal auditors

Control activities (procedures) – policies and procedures used by management to meet their objectives

Preventative controls – internal control activities that are designed to prevent the occurrence of errors
and fraud

Detective controls – internal control activities that are designed to detect the occurrence of errors and

Segregation of duties – a strategy to provide an internal check on performance through separation of

authorizations of transactions from custody of related assets, operational responsibilities from record-
keeping responsibilities, and custody of assets from accounting personnel

Physical safeguards – physical precautions used to protect assets and records

Independent checks – procedures for continual internal verification of other controls

 Most organizations have an internal control system that among other things, helps ensure
integrity in financial reports. The various elements of control that relate to financial reporting
are summarized as follows

Control environment

 Management philosophy and operating style

 Organizational structure
 Audit committee

Control activities (procedures)

 Segregation of duties
 Proper procedures for authorization (preventative control)
 Physical control over assets and records (preventative control)
 Adequate documents and records (detective control)
 Independent checks on performance (detective control)

Internal earnings targets – financial goals established within a company

Income smoothing – the practice of carefully timing the recognition of revenues and expenses to even
out the amount of reported earnings form one year to the next year.

There are two common ways to engage in earning’s managements

- Modifying operating decisions such as delaying expenditures for research development and
- Modifying accounting such as massaging the timing of judgements involved in making
accounting estimates

Most financial statements observers believe the first type of earnings management is more appropriate
than the second

GAAP oval – a diagram that represents the flexibility a manager has. Within GAAP, to report one
earnings number form among many possibilities based on different methods and assumptions

The reasons that management might manage earnings include

- Pressure to meet internal earnings targets

- Pressure to meet external expectations
- Smoothing income
- Preparing to apply for a loan or to offer stock to the public

Earnings management can take the form of

- Careful timing of transactions

- Changing accounting methods or estimates with full disclosure
- Changing accounting methods or estimates WITHOUT adequate disclosure
- Non-GAAP accounting
- Fictitious transactions

Because of the possible abuses associated with earnings management, it is important that accountants
be persons of high personal integrity

Public Company Accounting Oversight Board (PCAOB) – board of five full-time members established by
the Sarbanes-Oxley Act to oversee the accounting and auditing profession

Internal auditors – an independent group of experts (in controls, accounting and operations) who
monitor operating results and financial records, evaluate internal controls, assist with increasing the
efficiency and effectiveness of operations, and detect fraud.

External auditors – independent CPAs who are retained by organizations to perform audits of financial

Generally accepted auditing standards (GAAS) auditing standards developed by the PCAOB for public
companies and AICPA for private companies

 Auditors provide a check and balance to ensure that the financial statements fairly reflect the
financial performance of a business
 Internal auditors ensure integrity in the financial records and evaluate and encourage adherence
to the organization’s internal controls
 External certified public accountants ensure the integrity of the financial reporting process with
independent audits of financial statements
 Independent financial statement audits are required for all public companies, and often by
creditors and other users

Securities and Exchange Commission (SEC) the government body responsible for regulating the financial
reporting practices of most publicly owned corporations in connection with the buying and selling of
stocks and bonds

 The securities and Exchange commission (SEC) is an agency of the federal government
 The SEC’s purpose is to assist investors in public companies by regulating stock and bond
markets and by requiring certain disclosures
 The SEC has statutory authority to establish accounting principles, but basically accepts
pronouncements of the FASB and AICPA authoritative
 Common reports required by the SEC are registration and forms 10-k and 10-Q
 The SEC can suspend trading and even de-list securities

Public Company accounting oversight board

 Register all public accounting firms

 Establish auditing standards
 Inspect public accounting firms

Constraint on auditors

 Auditors are prohibited from providing nonaudit services to audit clients

 Audit partners must rotate every five years
 Auditors must report to the audit committee of the board of directors

Constraints on management

 The CEO and CFO must personally certify the reliability of the financial statements
 Companies must have a code of ethics
 Loans to company executives are prohibited
 Audit committees must be strengthened

Internal auditors

 Evaluate internal controls

 Monitor operating results
 Ensure compliance with laws and company policy
 Detect fraud

External auditors

 Gather evidence to be able to certify the fairness of the financial statements

 External audits are required of most public companies by the SEC
 External audits must be performed by CPAs who are licensed by the individual states in which
they practice