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CHAPTER 3

Accounting System &


control
Learning Objective 1

Identify the
types of
problems that
can appear in
financial
statements.
What Are Three Reasons for
Problems in the Financial
Statements?

Error—Occurs when care is not taken in


recording, posting, and/or summarizing
transactions. Unintentional. Corrected
upon detection.
Disagreement—Because accounting
involves judgment and because auditors
and management have different
incentives, the possibility for honest
disagreement exists.

Fraud—Intentional manipulation.
Types of Errors in the
Reporting Process

Transactions and journal entries.

Aug 1 Supplies . . . . . . . . . . . . . . . 100


Cash . . . . . . . . . . . . . . . . 100
Postage stamps.

• What types of errors are possible?


• The receipt was lost and not recorded.
• The amount was entered incorrectly.
• The account was incorrectly identified.
Describe Some Ways to Do
Fraudulent Financial Reporting.
Two entries are made:
one to match the invoice and
one for cash (which is kept).
False transactions for which there are
no legitimate invoices or receipts.
Listing sales that don’t exist.
Not recording sales returns or uncollectible
receivables.
Not recording expenses, understating liabilities, or
overstating assets.
Unreasonable difference of a profit or a loss.
Learning Objective 2

Describe the
safeguards
employed within a
firm to ensure that
financial statements
are free (?) from
problems.
Define Internal Control
Structure

Policies and procedures


established to provide
management with reasonable
assurance that the firm’s objectives
will be met.
Designed to protect investors
and creditors and help
management in their efforts
to effectively and efficiently
run their organization.
What Are Some Concerns When
Designing Internal Control
Structures?
To provide accurate accounting records and
financial statements.
To safeguard assets (cash, property, employees,
confidential information, reputation, and image)
and records.
To effectively and efficiently run
operations without duplication of
effort or waste.
To follow management policies. $
To comply with the Malaysian Corrupt
$
Practices Act
Policies and Procedures

1. The control environment.

2. The accounting system.

3. The control procedures.


What Are the Three Parts of the
Control Structure?
  Management
Segregation
Identifies, ofphilosophy
duties:
assembles, and
classifies,
operating style.
Authorization
analyzes, records, and reports the
 Does management follow
firm’s transactions.
Record keeping
controls?
Custody
 Accountability of assets
 Does management
for assetsstress
Control Environment  Properimportance
proceduresof controls?
for
 Valid transactions
 Organizational structure.
authorization
 Properly
 Are authorized
 Adequate there clear lines of
documents and
authority
transactions and responsibility?
records
 Is just one person responsible
Accounting System  Completeness
 Physical control
for each of records
over assets
function?
 and
Proper
 Audit classification
records
committee.
 Independent
 Typically
Proper members are
timing checks on on the
board of directors.
performance
 Proper valuation
Control Procedures  Internal and external auditors
are accountable to the
 Correct posting and
committee.
summarization
What Are the Guidelines on
Reporting on Internal Controls?

Management of public
companies are required
by law to issue a
management statement in
annual report.
They must acknowledge
their responsibility for a
good system of internal
controls.
Learning Objective 3

Understand the
concept of
earnings
management and
why it occurs.
List and Discuss Four Reasons
to Manage Earnings

Meet Internal

$
Targets
Meet External
Expectations $

Income Smoothing
Window Dressing
for an IPO or a
Loan
Control in Accounting:
The Accounting System

Accounting Information should contain:


1. Validity
2. Authorization
3. Completeness
4. Classification
5. Timeliness
6. Valuation
7. Posting and summarization
Independent checks and the
need for monitoring

Reporting on internal controls


Assurance services
Learning Objective 4

Describe the
role of auditors
and how their
presence affects
the integrity of
financial
statements.
Discuss Internal Auditors
Role
Who are internal auditors?
An independent group of experts in
control, accounting, and operations.
What do they do?
Monitor operating results
and financial records.
Evaluate internal controls.
Assist with increasing efficiency
and effectiveness of operations.
Detect fraud.
What is the Role of External
Auditors?
Who are external auditors?
Employees of CPA firms.
What do they do?
Perform SEC-required audits.
Examine financial statements in
accordance with GAAP to be
certain they are free from
material (significant)
misstatement.
Provide reasonable assurance that
financial statements are “presented
fairly.”
What Do Auditors Do?

Provide an independent assessment of a firm’s


internal control system.
Study the control system to determine if they can
rely upon it as they audit.
Interview employees
to see if procedures are understood.
to see if proper documentation is being
made.
to see if proper authorization is being
obtained.
to identify potential weaknesses in the
system.
(continued)
What Do Auditors Do?

Observe operations
to verify compliance with procedures.
to verify inventory.
Sample a set of transactions for analysis
to conclude if procedures are complied with.
to determine if system is reliable.
Confirmation
of records to verify existence of accounts.
with customers to verify account balances.
Perform analytical procedures involving
comparative ratio analysis.
Are Auditors Independent?
AUDITORS MANAGEMENT

Responsible to financial Pays the auditors.


statement users to Wants to use the
ensure they are least conservative
represented fairly. estimates.
Avoid litigation Desires to present
and damages by the most favorable
providing unbiased position.
and fair information.
Have a reputation to
protect.
It is this tension that provides users with information
that fairly represents the business’s performance.