<<

. 63
( 82 .)



>>




Contingencies
In the normal course of business, the Company is subject to contingencies, such as legal
proceedings and claims arising out of its business, that cover a wide range of matters, in-
cluding, among others, product liability, environmental liability and tax matters. In accor-
dance with SFAS No. 5, Accounting for Contingencies, the Company records accruals for
such contingencies when it is probable that a liability will be incurred and the amount of
loss can be reasonably estimated. For a discussion of contingencies, reference is made to
Note 8, Income Taxes, and Note 22, Litigation Matters, to these consolidated financial
statements.




Source: Bristol-Myers Squibb, 2002 Annual Report, p. 39.




process.”24 Thus while each member of the committee may not possess the requi-
site accounting knowledge, they should approach their review task with imagina-
tion, perceptiveness, and resourcefulness in order to assure themselves that the
policies are reasonable and consistent with the financial reporting requirements of
the FASB, AICPA, SEC, and other regulatory agencies. Furthermore, the commit-
tee should exercise judgment regarding the need for the use of specialists in areas
of complex accounting, tax, and legal matters. For example, several independent
consultants, who are retired partners of CPA firms, sit on the corporate audit
committee to assist the committee with complex accounting issues.25 In short, the
primary objective of the committee™s review should be to scrutinize management™s
judgment in selecting the accounting principles and methods used in the prepara-
tion of the financial statements and to recommend the statements for the approval
of the board of directors.




24
Russell E. Palmer, “Audit Committees”Are They Effective? An Auditor™s View,” Journal of Ac-
countancy 144, No. 3 (September 1977), p. 78.
25
Obviously, a retired partner would not sit on the audit committee of a corporation that is a client of
his or her former firm. As two commentators point out: “[A]nalysts, stakeholders, the press, juries and
jurists, and the public would not be persuaded that a retired partner of an audit firm could perform ef-
fectively as a member of the audit committee of a client of the partner™s firm.” Dan M. Guy and
Stephen A. Zeff, “Independence and Objectivity: Retired Partners on Audit Committees,” CPA Jour-
nal 72, No. 7 (July 2002), p. 34.
318 Reviewing Accounting Policy Disclosures



Exhibit 10.7 Accounting Policy Disclosures: A Checklist

Yes No Remarks

1. Summary of the significant accounting
policies reviewed by the external auditor,
chief financial officer, and internal auditor.
Summaries obtained. ________ ________
2. Accounting policies are consistent in
relationship to the industry practices
(conservative or liberal). ________ ________
3. Current reporting requirements are
reflected in the accounting policies. ________ ________
4. Accounting changes reviewed and the
external auditor™s concurrence obtained. ________ ________
5. Disclosure of significant accounting
policies is adequate to support the
auditor™s unqualified opinion. ________ ________
6. Major financial reporting problems
resolved satisfactorily. ________ ________
7. Unresolved differences between the
auditor and management reviewed. ________ ________
8. Additional disclosures reviewed. ________ ________
9. Unusual occurrences during the year,
such as a disposal of a segment of the
business properly disclosed in the
financial statements. ________ ________
10. Accounting policies are consistent with
a fair presentation of the financial
statement in conformity with generally
accepted accounting principles. ________ ________
11. Accounting policies reflect the board™s
authorization regarding financial and
accounting matters. ________ ________

Signed by: _______________________________________________ Date ________
(Should be signed by the chairman of the audit committee)*


*See Chapter 4 with respect to procedures to document audit committee activities.
Sources and Suggested Readings 319


SOURCES AND SUGGESTED READINGS
American Institute of Certified Public Accountants, Audit Committees, Answers to Typical
Questions about Their Organization and Operations (New York: AICPA, 1978).
American Institute of Certified Public Accountants, Meeting the Financial Reporting Needs
of the Future: A Public Commitment from the Public Accounting Profession (New York:
AICPA, 1993).
American Institute of Certified Public Accountants, Practice Alert 2000-2 “Quality of
Accounting Principles-Guidelines for Discussions with Audit Committees,” www.aicpa
.org/members/div/secps/index.htm.
Bristol-Myers Squibb Company, 2002 Annual Report.
Exxon Corporation, 1992 Annual Report.
Ford Motor Company, 1990 Annual Report.
Gerson, James S., J. Robert Mooney, Donald F. Moran, and Robert K. Waters, “Oversight
of the Financial Reporting Process”Part I.” CPA Journal 59, No. 7 (July 1989), pp. 22“28.
Gerson, James S., J. Robert Mooney, Donald F. Moran, and Robert K. Waters, “Oversight
of the Financial Reporting Process”Part II.” CPA Journal 59, No. 8 (August 1989), pp. 40,
42“47.
Guy, Dan M., and Stephen A. Zeff, “Independence and Objectivity: Retired Partners on
Audit Committees.” CPA Journal 72, No. 7 (July 2002), pp. 30“34.
McKesson Corporation, 1998 Annual Report.
Opinions of the Accounting Principles Board, No. 20. “Accounting Changes” (New York:
American Institute of Certified Public Accountants, 1971).
Opinions of the Accounting Principles Board, No. 22, “Disclosure of Accounting Policies”
(New York: American Institute of Certified Public Accountants, 1972).
Palmer, Russell, E., “Audit Committees”Are They Effective? An Auditor™s View,” Journal
of Accountancy 144, No. 3 (September 1977), pp. 76“79.
Public Oversight Board, A Special Report by the Public Oversight Board of the SEC Prac-
tice Section, AICPA (Stamford, Conn.: Public Oversight Board, 1993).
Schornack, John J., “The Audit Committee”A Public Accountant™s View,” Journal of Ac-
countancy 147, No. 4 (April 1979), pp. 73“77.
Securities and Exchange Commission, Release No. 33-8183, “Strengthening the Commis-
sion™s Requirements Regarding Auditor Independence,” January 28, 2003, www.sec.gov/
rules/final/33-8183.htm.
Wal-Mart Stores, Inc., 2003 Annual Report.
Chapter 11
A Perspective on Fraud
and the Auditor
In view of the general misconception concerning the auditor™s responsibility for
the detection of fraud, the purpose of this chapter is to examine the implications
of management fraud as it relates to the external auditor and the audit committee.
Moreover, audit committee members will not only examine the meaning and ra-
tionale for management fraud but also explore ways to safeguard the entity against
such fraud. The committee™s monitoring of certain general business practices, such
as conflicts of interest, will be discussed in Chapter 12.


MEANING OF FRAUD IN A FINANCIAL STATEMENT AUDIT
According to the Auditing Standards Board of the AICPA, fraud and its charac-
teristics are described in this way:

Fraud is a broad legal concept and auditors do not make legal determinations of
whether fraud has occurred. Rather, the auditor™s interest specifically relates to acts
that result in a material misstatement of the financial statements. The primary factor
that distinguishes fraud from error is whether the underlying action that results in the
misstatement of the financial statements is intentional or unintentional. For purposes
of the Statement, fraud is an intentional act that results in a material misstatement in
financial statements that are the subject of an audit.1

The Board describes the types of misstatements as follows:
• Misstatements arising from fraudulent financial reporting are intentional mis-
statements or omissions of amounts or disclosures in financial statements de-
signed to deceive financial statement users where the effect causes the financial
statements not to be presented, in all material respects, in conformity with gen-
erally accepted accounting principles (GAAP). Fraudulent financial reporting
may be accomplished by the following:
” Manipulation, falsification, or alteration of accounting records or supporting
documents from which financial statements are prepared
” Misrepresentation in or intentional omission from the financial statements of
events, transactions, or other significant information
” Intentional misapplication of accounting principles relating to amounts, clas-
sification, manner of presentation, or disclosure

1
Statement on Auditing Standards No. 99, “Consideration of Fraud in a Financial Statement Audit”
(New York: AICPA, 2002), par. 5.


320
Meaning of Fraud in a Financial Statement Audit 321


Fraudulent financial reporting need not be the result of a grand plan or conspir-
acy. It may be that management representatives rationalize the appropriateness of
a material misstatement, for example, as an aggressive rather than indefensible
interpretation of complex accounting rules, or as a temporary misstatement of fi-
nancial statements, including interim statements, expected to be corrected later
when operational results improve.
• Misstatements arising from misappropriation of assets (sometimes referred to as
theft or defalcation) involve the theft of an entity™s assets where the effect of the
theft causes the financial statements not to be presented, in all material respects,
in conformity with GAAP. Misappropriation of assets can be accomplished in
various ways, including embezzling receipts, stealing assets, or causing an entity
to pay for goods or services that have not been received. Misappropriation of as-
sets may be accompanied by false or misleading records or documents, possibly
created by circumventing controls. The scope of this Statement includes only
those misappropriations of assets for which the effect of the misappropriation
causes the financial statements not to be fairly presented, in all material respects,
in conformity with GAAP.2
In addition, the Institute of Internal Auditors defines fraud as:

Any illegal acts characterized by deceit, concealment or violation of trust. These acts
are not dependent upon the application of threat of violence or of physical force.
Frauds are perpetrated by individuals and organizations to obtain money, property or
services; to avoid payment or loss of services; or to secure personal or business ad-
vantages.3

With respect to the identification of fraud, the Institute™s Standards for the
Professional Practice of Internal Auditing indicate:

The internal auditor should have sufficient knowledge to identify the indicators of
fraud but is not expected to have the expertise of a person whose primary responsi-
bility is detecting and investigating fraud.4

With respect to fraudulent financial reporting, the National Commission on
Fraudulent Financial Reporting defined such reporting as:

intentional or reckless conduct, whether act or omission, that results in materially
misleading financial statements. Fraudulent financial reporting can involve many
factors and take many forms. It may entail gross and deliberate distortion of corpo-
rate records, such as inventory count tags, or falsified transactions, such as fictitious
sales or orders. It may entail the misapplication of accounting principles. Company
employees at any level may be involved, from top to middle management to lower-
level personnel. If the conduct is intentional, or so reckless that it is the legal equiv-
alent of intentional conduct, and results in fraudulent financial statements, it comes

2
Ibid., par. 6.
3
Institute of Internal Auditors, The Professional Practices Framework (Altamonte Springs, FL: IIA,
2002), p. 26.
4
Ibid., section 1210. A2., p. 9 For further information regarding the identification of fraud and the in-
ternal auditor™s responsibility for detection, see Practice Advisory 1210. A2-1 and 1210.A2-2.
322 A Perspective on Fraud and the Auditor


within the Commission™s operating definition of the term fraudulent financial
reporting.
Fraudulent financial reporting differs from other causes of materially misleading fi-
nancial statements, such as unintentional errors. The Commission also distinguished
fraudulent financial reporting from other corporate improprieties, such as employee
embezzlements, violations of environmental or product safety regulations, and
tax fraud, which do not necessarily cause the financial statements to be materially
inaccurate.5

Although there is a distinction between fraudulent financial reporting and mis-
appropriation of assets, this chapter addresses both types of fraud.
Although both the private sector and public sector have initiated action, partic-
ularly the Foreign Corrupt Practices Act of 1977 and Sections 301 and 302 of the
Sarbanes-Oxley Act of 2002 (discussed in Chapter 1), to protect the business com-
munity against management fraud, it is apparent that such positive actions will not
completely eliminate this corporate problem. Since the passage of the acts, man-
agement fraud cases continue to be discussed in the news media. The cost of man-
agement fraud to the business community is indeterminable, primarily because
many cases are not revealed or not discovered. Furthermore, the cost of compliance
to safeguard the entity from management fraud is increasing. For example, see the
reports by the Association of Certified Fraud Examiners in Exhibits 11.1 and 11.2.6
Consequently, the cost in money and time to businesses and consumers to re-
form corporate behavior, as well as the cost of liability insurance, is constantly in-
creasing.
In October 1997, Ernst & Young™s Fraud Investigative Group in the United
Kingdom surveyed senior executives in 11,000 major organizations in 32 coun-
tries. Based on 1,205 responses, Ernst & Young reported these findings:

• The experience of organisations participating in our surveys shows that the curse
of fraud continues. More than half had been defrauded in the last 12 months. 30%
had suffered more than five frauds in the last five years.
• 84% of the worst frauds were committed by employees, nearly half of whom had
been with the organisation for over 5 years.
• Most of the worst frauds were committed by management.
• 87% of respondents thought the incidence of fraud would increase, or at best re-
main static, over the next 5 years. Yet less than half of these organisations had
done as much as they cost effectively could to protect their business against fraud.
• Only 13% of fraud losses had been recovered”including insurance recoveries.

<<

. 63
( 82 .)



>>