Does Management Need to Perform Retrospective Review Procedures of Accounting Estimates

Direction tin override internal controls, resulting in fraudulent fiscal reporting. Below I provide examples of management override of internal controls and how you can inspect for these potential threats.

Controls can exist overridden, even when properly designed and operating. Accounting personnel normally comply with the wishes of management either out of loyalty or fearfulness. So if a trusted C.E.O. asks the accounting staff to perform questionable deportment, they will sometimes comply because they trust the leader. Alternatively, management can threaten bookkeeping personnel with the loss of their jobs if they don't comply. Either way, direction gets what it wants by overriding internal controls.

Examples of Management Override of Internal Controls

Here are examples of management override of internal controls:

1. Booking journal entries to inflate profits or cover upward theft
2. Using significant transactions outside the normal course of business to dress upward the financial statements
3. Manipulating estimates
4. Transferring company cash to their personal accounts

Auditors consider management override in all audits (or at to the lowest degree, they should). Why? Because it'south ever possible. That's why audit standards require that we respond to the risk of management override in all audits.

Beginning, permit's consider how management overrides controls with periodical entries.

1. Journal Entry Fraud

Think about the WorldCom fraud . Expenses were capitalized to inflate profits. Income statement amounts were moved to the balance sheet with questionable entries. One time the fraud was discovered, the internal auditors were told the billion-dollar entries were based on what direction wanted. The entries were non in accord with generally accustomed accounting principles. And why was this washed? To increase stock prices. Direction endemic shares of WorldCom, so they profited from the climbing stock values. The fraud led to prison house sentences and the demise of the company, all because of management override.

Journal entries are an like shooting fish in a barrel manner to override controls. Consider this scenario: Management meets at year-end, and they accept not met their goals; so they manipulate earnings by recording nonexistent receivables and revenues, or they tape revenues before they are earned. For example, direction accrues $10 million in fake revenue, or they book January revenues in December.

Periodical Entry Testing

Auditors should test journal entries for potential fraud, merely how? Starting time, understand the normal process for making journal entries: who makes them, when are they made, and how. Also, inquire nearly journal entry controls and consider any fraud incentives, such as bonuses related to profits. Then retrieve about where fraudulent entries might be made and test those areas. Fraudulent periodical entries are frequently made at twelvemonth-stop, so brand sure yous examination those. Here are some boosted journal entry examination ideas:

• Examine entries made to seldom-used accounts
• Review consolidating entries (also known as top-side entries)
• Test entries made at unusual hours (eastward.g., during the dark)
• Vet entries made by persons that don't commonly brand journal entries
• Look at suspense account entries
• Review round-dollar entries (e.thou., $100,000)
• Test entries made to unusual accounts

You don't demand to perform all of the above tests, but the ones that are higher risk in light of journal entry controls and fraud incentives. Data mining software can be helpful in vetting journal entries. For example, y'all tin search for journal entries made by unauthorized persons. But excerpt all periodical entries from the full general ledger and group them by persons making the entries; thereafter, scan the listing for unauthorized persons.

Fraudulent journal entries are not the simply fashion to override controls. The books tin can be cooked with related party transactions.

2. Funny Business organization

Sometimes, equally an accountant, you'll see funny transactions. No, I don't mean they are amusing. I mean they are unusual. Management tin can alter profits with transactions outside the normal form of business, and these are ofttimes related party transactions.

For example, Burning Fire, an inspect client, is owned by Don Jackson. Mr. Jackson too owns another business organisation, Placid Lake. Equally y'all are auditing Burning Fire, you lot come across information technology received a check for $ten million dollars from Placid Lake. So y'all ask for transaction support, but at that place is little. The CFO says the payment was made for "prior services rendered," merely information technology doesn't ring truthful. This could be fraud and is an case of a transaction outside the normal form of business organization. Why would a company record such an entry? Possibly to bolster Burning Fire'south financial statements. When you encounter such a transaction, consider whether a fraud incentive is present. For example, do loan covenants require sure financial ratios and does this transaction bring them into compliance?

Next, we wait at how management tin can juice upward profits by manipulating estimates.

3. Manipulating Estimates

Auditing standards require a retrospective review of estimates equally a risk assessment process. Why? Considering direction can manipulate estimates to inflate earnings and assets. Auditing standards call such tendencies bias, a sign that fraudulent financial reporting might exist. That's why auditors review prior estimates and related results.

For example, suppose a company has a policy of reserving xc% of receivables that are xc days or older. If at year-end the greater-than-ninety-days bucket contains $ane,000,000, management can increase earnings $400,000 by lowering the reserve to 50%. What an easy way to increase cyberspace income!

Retrospective Review of Estimates

So, how does an accountant perform a retrospective review of an allowance for uncollectible accounts? Compare the twelvemonth-end reserve with that of the last ii or 3 years. If the reserve decreases, ask why. At that place might be legitimate reasons for the refuse. But if at that place is no reasonable basis for the smaller allowance, bias could be present. Note such changes in your risk assessment summary. For instance, in the accounts receivable section, you might say: The allowance for uncollectible accounts appears to accept decreased without a reasonable ground. Why? Considering you've identified a fraud take a chance that deserves attention.

Complex estimates are easier to manipulate without detection than simple ones. Why? Because intricate estimates are harder to sympathize, and complication creates a smokescreen, making bias more difficult to spot. As an example, consider pension program assumptions and estimates. Very circuitous. And changes in the assumptions tin dramatically touch the balance sheet and net income.

Now, let'south expect at how to document your retrospective review.

Documenting Your Retrospective Review

Document your retrospective review. How? List the current and prior twelvemonth estimates and explicate the ground for each. As well, examine the results of the prior yr estimates. For instance, compare the electric current year bad debts with the prior year uncollectible allowance. Additionally, consider including incentives for manipulating profits such equally bonuses.

Label the workpaper Retrospective Review of Estimates to communicate its purpose. Also, consider calculation purpose and determination statements such as:

• Purpose of workpaper: To perform a retrospective review of estimates to run across if bias is present.
• Conclusion: While the assart estimate is higher in the current year, the judgments and assumptions are the aforementioned. It does non appear that bias is present. All other prior year estimates announced reasonable.

Other determination examples follow:

• Conclusion: The rate of return used in computing the alimony liability increased by 1%. The increase does non appear to be warranted given the mix of investments and past history. Bias appears to be present and is noted in the risk assessment summary course (in the payroll and benefits department).
• Conclusion: Based on our review of the economic lives of assets in the prior year depreciation schedule, no bias is noted.
• Conclusion: We reviewed bad debt write-offs in the current twelvemonth and compared them to the uncollectible allowance in the prior year. No management bias is noted.

Is in that location some other fashion that management might override controls? Yes, sometimes management requires accounting personnel to transfer company cash to personal bank accounts.

4. Transferring Visitor Cash to Personal Accounts

Years ago I audited a hospital in Alabama. The C.E.O. would sometimes go to Panama City Beach, and while in that location, direct his accounting staff to wire funds to his personal account—and they did. Why? The threat of losing their jobs. Some management personnel, especially those with muscle, can intimidate the accounting employees into doing the unbelievable. I've seen this happen and once the C.E.O. is called out, he pretends to know nothing about the prior conversations with accounting.

Management Override of Internal Controls

In your future audits, consider that management override of internal controls is always a possibility.

So don't allow yourself to believe that management is too honest to commit fraud. (A personal friend of mine just went to jail for stealing $3.v meg; he was part of the company's management team. I've known him for twenty years, so I was stunned to hear this.) Conduct your audits to detect material misstatements, including fraud--even if you've known the management team for many years.

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