Question

REVIEW QUESTIONS

2. Generally, how is the problem of management override and collusion addressed?

4. What is the role of the external auditor in the financial reporting process?

5. How is materiality determined?

Answer 1

2)The term “management override” refers to the ability of management and/or those charged with governance to manipulate accounting records and prepare fraudulent financial statements by overriding these controls, even where the controls might otherwise appear to be operating effectively.Collusion involves people or companies that would typically compete, conspiring or working together that result in an unfair market advantage. ... Competition among auditors and mandatory audit both increase the probability of collusion.Depending on the individuals involved, internal controls cannot prevent management override or collusive behavior by and among senior management. Since prevention (segregation of duties, approvals and authorizations) is not possible in a collusive environment, the principal internal control procedures will be centered on detection. The fear of detection may be an effective deterrence mechanism, but that does not eliminate the concern that traditionally designed internal control systems centered on prevention will not be effective when management override or collusion is present. Thus, internal and external auditors, fraud examiners, and forensic accounting professionals must design procedures to detect such activity.

4)External auditors are responsible for auditing the company's financial statements and providing reasonable assurance that they are presented fairly and in conformity with GAAP and that they reflect true representation of the company's financial position and results of operations.Potential lenders and investors often require externally audited financial statements before extending credit or providing funds for your business. If it is discovered that an auditor failed to detect material misstatements, it reflects poorly on the firm and the profession in general. For that reason, various accounting bodies release auditing standards and expectations to define the role of external audit firms.

5)Unfortunately, there’s no specific definition of materiality under U.S. Generally Accepted Accounting Principles (GAAP). But the Conceptual Framework for Financial Reporting under International Financial Reporting Standards (IFRS) says:

Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.

To establish a level of materiality, auditors rely on rules of thumb and professional judgment. They also consider the amount and type of misstatement.

The materiality threshold is typically stated as a general percentage of a specific financial statement line item. For example, let’s suppose Joe Auditor sets a materiality threshold of 1% of revenue for ABC Company. For 2017, the company reports annual revenue of $190 million, so its materiality threshold is $1.9 million.

During fieldwork, Joe unearths a clerical error that caused ABC to understate revenue by $1 million. Is this error material? Although a $1 million error may seem significant, it’s less than 1% of the company’s annual revenue. So, it’s immaterial to ABC’s overall financial performance.

On the other hand, if the company had overstated its revenue by $1 million due to a fraud scheme involving a senior executive, Joe may deem the misstatement as material because it involved a member of the senior leadership team and potential criminal activity.

Regardless of whether a misstatement of revenue is considered material, it may trigger a material misstatement in accounts receivable. In other words, the balances recorded as due from customers may be materially different from the actual amounts due.