Evaluation of Materiality of Misstatements on Financial Statements - Assignment Example

Audit Case Requirement 3: Evaluation of materiality of mis ments on financial ments Part A The observation made by the junior auditor that 1.63% of the growers’ payable is immaterial is misleading. This is because the misstatement of the $20 million in the balance sheet statement has the potential of misleading a reasonable person relying on the financial statements approved by the independent auditing firm (Nguyen, 2008). Creditors relying on the balance sheet statement prepared by the organization will find the 1.63% of the current liabilities relevant since it will determine the ability of the firm in servicing it current financial liabilities when they fall due. Consequently, the assumption by the junior accountant that the $20 million payables are irrelevant is misleading since it will mislead creditors in assessing the liquidity position of the firm. Part B Rollover and iron curtain are the two methods that are employed in evaluating the material effect of misstating financial recording. The rollover method evaluation of the financial statement errors is undertaken by quantifying errors in the income statement using the amounts that were recorded in misstating the income statement. Thus, reversing effect is undertaken in the income financial statement to assess the carryover effects (Rezaee & Riley, 2011). Consequently, reversing the $20 million and $60 million of continuity and momentum entries that were made in wrong periods will reveal that each financial net income was either overstated or understated by $40 million. This is a significant amount that has the potential of misleading reasonable persons using the financial information to make optimal financial investment decision through stock buy or sell decisions. In contrast, the iron curtain approach quantifies errors in the income statement using accumulated amounts of errors if the erroneous amounts remain in the balance sheet statement (Whittington, 2012). Consequently, using the $40 million overstatement or understatement of the income statement for the last three years will yield a difference of $120 million on the income statement derived for financial year 2012. This is a significant amount that can mislead a reasonable person using the financial information prepared by firm. Consequently, the misstatement in the financial statements of Diamond has material effect due to the potential of misleading rational investors in making capital investment decision by buying or selling Diamond stock holding. Requirement 4: Understanding the Difference between Misstatement and Fraud The decision by Diamond Corporation to record “continuity” and “momentum” payments amounts to fraud. Identifying with a financial reporting decision is an error or fraud is determined by whether the decision is unintentional or intentional. An error is caused by unintentional financial statement misstatement while fraud is derived from intentional and deliberate cover up of the material facts (Kan, 2013). The senior management of Diamond was aware of the misstatements and deliberately concealed the financial misstatements to the lower managerial cadre and the independent auditing firm. Consequently, the financial misstatements experienced in the financial statements of Diamond Corporation were intentionally contributed by the senior management to influence the stock price of the firm shares that reflects it is a fraud action. Requirement 7 One of the generally accepted auditing standards that Deloitte auditing firm failed in auditing the financial results of Diamond in year 2011 and 2012 is exercising suitable professional care when undertaking the auditing procedure and preparing the financial report. Furthermore, the auditor has the obligation to diligently when undertaking the auditing exercise and report misleading financial information identified. The failure by the audit firm to detect misstatements in the financial report of Diamond Corporation implies that the firm failed in exercising it professional duty with care. Furthermore, the audit firm failed to inform the public of mysterious and misleading information reflected in the financial report prepared by Diamond internal accountant. Similarly, financial auditors are under obligation to gather sufficient information of an organization and it environment before undertaking an audit. The inability of Deloitte audit firm to identify misstatement due to the payment procedure Diamond Corporation applies in paying the growers reflects the auditing firm failed in observing the GAAS that auditing firm should have sufficient information surrounding an organization. In addition, the GAAS requires auditors to review its internal control in order to assess risks of material misstatement due to fraud or error and design timing, extent and nature of auditing procedures in future. Thus, the inadequacy capacity of Deloitte audit firm in auditing the financial statements of Diamond Corporation of material misstatement risk demonstrates the fieldwork standards of GAAS were not followed. Another GAAS that Deloitte failed to observe in auditing the financial reports of Diamond is determining informative disclosures that are not reasonably satisfactory and state the findings in the audit report. Diamond Corporation provided inadequate information on its payment schedule utilized in acquiring the inventory from the farmers. This inadequate disclosure by Diamond was not captured by the auditor that demonstrates the auditing failed in fulfilling its GAAS obligation. Requirement 8 One of the assertions under auditing standards number 15 that Deloitte audit firm should investigate in evaluating the financial statements of Diamond Corporation is occurrence or existence. Occurrence or existing financial statement assertion involves investigating the existence of liabilities or assets of an organization at specific financial date and the transactions occurring have been recorded during that specific period (Whittington, 2012). This assertion is essential in auditing the financial statements of the organization due to it tendency of reporting the payables due to growers using different prices to achieve profitability target. Thus, the cost of the inventories incurred during the different periods kept on been changed to reflect the analysts profitability expectation. This meant that the payable liabilities in different specific dates was deliberately misstated and wrongly recorded in different specific financial years. Another financial statement that Deloitte audit firm should investigate deeply is completeness. Completeness financial statement assertion holds that all accounts and transactions that are presented under the financial statement are included (Rezaee & Riley, 2011). This assertion is essential since it will ensure the financial statements presented by Diamond are not intended to influence the opinion of the analysts in determining the stock price of Diamond. The stock price of Diamond dropped from $90 in September of 2012 to $20 in December of the same year due to previous misleading financial statement released. Thus, undertaking an investigation on completeness of the financial statements presented by Diamond Corporation will ensure the presented financial statements are accurately and reliably recorded. Allocation or valuation is another financial statement assertion that Deloitte audit firm should deeply investigate in auditing the financial statements of Diamond Corporation. Allocation or valuation financial statement assertion implies that liability, asset, expense, revenue and equity components that are reflected under the financial statements presented should have amounts that are appropriate (Nguyen, 2008). The financial statement misstatements identified in the financial statements of Diamond was due to incorrect recording of assets, expenses and liabilities. Consequently, Deloitte needs to undertake deep investigation on the allocation assertion of Diamond financial statements to ensure they reflect the real financial performance and position to the external users of financial information (Whittington, 2012). Obligation and rights is another financial statement assertion that Deloitte should deeply investigate in auditing the financial statements of Diamond Corporation. Obligation and obligation financial statement assertion holds that company rights control or holding the assets and financial obligations of the liabilities should be within a specific date (PCAOB, 2010). One of the attribute of the financial statement of Diamond in misleading the external users of the financial information was reporting of continuity financial information. The allocation of the information was deliberately twisted to fit the interest of the senior management. Thus, Deloitte audit firm should pay deeper attention on financial statement assertion towards allocation or valuation of the financial statements components. This will ensure the auditing process is able to detect misleading valuation and allocation of the financial statements components. Requirement 9: Relevance of Professional Skepticism and impediments in exercising it Purpose of issuing Staff Audit Practice Alerts Issuing audit practices alerts plays a vital role in allowing auditors to undertake auditing exercise optimally. This is because audit practices alerts issued enables auditors to identify matters that are related to present economic environment and are likely affect material misstatement risk that will require additional attention by the auditor. This is because the alert practice highlights key issues contributed by the present economic environment such as economic conditions impact on audit, fair value estimates and measurements auditing, financial statement submission auditing and ability of the company to continue as going concern consideration by the auditor. Thus audit practices alerts issued is essential in enabling auditors to identify issues that are likely to contribute financial statement misstatement risk in undertaking auditing. Professional Skepticism Professional skepticism in auditing practice is defined as auditor’s attitude of questioning and assessing critically to derive audit evidence. Thus auditor’s professional skepticism is the ability of the auditor to possess questioning attitude and assessing the financial statements presented critically to derive optimal audit evidence. Professional skepticism plays an essential role when undertaking audit of a firm’s financial statement. One of the importances of professional skepticism is that it helps an auditor to undertake investigation on financial transactions that are highly driven by management decision or are outside normal business activities. Thus, an auditor is able to effectively derive audit evidence appropriately when dissimilar evidence is present and significant review of any evidence is available. Similarly, professional skepticism is essential since it helps in detecting fraud perpetuated management of an organization. Management of companies has the potential of manipulating financial information through manipulated account records. Consequently, employing professional skepticism will allow an auditor to identify financial statement misstatements perpetuated by management or employees of a company. Deloitte Professional Skepticism Deloitte audit firm failed to employ professional skepticism appropriately in detecting the financial fraud perpetuated by the senior management. One of the aspects misleading financial information on 2012 expenses derived from payment paid to walnut growers. The costs of the walnuts reflected in 2012 financial year financial statement indicated the payments were for the current year when there were payments for previous years inventory supplied. If Deloitte auditors had employed appropriate professional skepticism they would have detected past cost of inventories paid under the current year were treated as the current year cost of goods. This is because the auditors would have questioned why suppliers who did not supply walnuts in 2012 but received payments in 2012 qualified in 2012 financial year cost of goods sold. In addition, the auditors of Deloitte would have questioned the connection of physical units sold in 2012 financial year with the units reflected to be the cost of goods sold. If the auditors of the firm had questioned the validity of these financial information and conducted rigorous assessment on the financial statements presented by the company, it would have detected the manipulation of financial data undertaken by the senior management of the organization. Consequently, the failures by the auditors of Deloitte in auditing the financial statements of Diamond to detect misstatements indicate Deloitte did not employ the appropriate degree of professional skepticism. Requirement 12: Auditors’ Report on Internal Control over Financial Reporting Identification of incorrect recording of continuity payments for the 2010 financial year and inadequate control system would have derived a different opinion on internal control of the report in 2010. Deloitte had indicated that Diamond had maintained an effective internal control in making financial reports in financial year of 2010. Consequently, the realization of the inadequate control system would have motivated the audit firm to indicate that the internal control of Diamond is ineffective in capturing financial information accurately. Requirement 14: Application of AICPA Rules of Conduct In undertaking the auditing exercise on Diamond Company financial statements, Deloitte seems to have violated a number of AICPA rules. One of the AICPA rules that have been violated in undertaking the audit exercise is general standards rule number 201. One of the requirements under general standards rule is due professional care. Auditors are expected to undertake their professional services with due professional care when serving their clients (Rittenberg, Johnstone, & Gramling, Auditing: A business risk approach, 2012). The manner under which Deloitte undertook Diamond financial statements audit reflects it did not employ due professional care. This is because Deloitte would have been able to detect fraud perpetuated by the senior management in manipulating the financial statements to achieve predetermined financial outcome. In addition, Deloitte audit firm would have been able to identify inadequacies of internal control system of the organization in recording financial transaction in 2010 financial year continuity financial recordings. Similarly, general standard rule provides that members should collect sufficient and relevant data in conducting in making reasonable recommendations and conclusions towards the services undertaken. The unqualified opinion that Deloitte made after auditing the financial statements of Diamond was derived without investigating sufficient and relevant financial transactions leading to the financial statements presented. This is because if Deloitte had reviewed the transaction figures adequately, it would have revealed the manipulation of data by the senior management and internal accountants of Diamond Corporation. Consequently, Deloitte audit firm violated rule 201 due to it incompetent in collecting sufficient data to audit the financial statements of Diamond. General standards AICPA rule also, provides that members should to plan and supervise performance of their professional services adequately. In undertaking the audit exercise of Diamond financial statements, Deloitte failed to detect financial misstatements due deliberate manipulation of cost of goods by the management. This demonstrates that the management of the audit firm did not prepare adequately and supervise the junior auditors undertaking the auditing exercise adequately to detect the financial fraud perpetuated by the senior management of Diamond Company. Thus, Deloitte violated AICPA rule 201 in undertaking it professional services. Another rule that Deloitte audit firm violated in auditing the financial statements of Diamond financial statements is rule 203 on accounting principles. Rule 203 provides that a member should not make an opinion that affirmatively declare the financial statements of an entity presented conform to generally accepted accounting principles (Rittenberg, Johnstone, & Gramling, Auditing: A business risk approach, 2012). In addition, members are not allowed to make an opinion illustrating that he is not attentive to material alteration that can be made to financial statements to ensure they conform to generally accepted accounting principles and if any of the financial statements presented deviate from accounting principles developed by the council that can cause material effect of the financial statements entirely (Gilbertson, Lehman, & Debra, 2012). However, the audit report that Deloitte prepared affirmatively declare the financial data and statements of Diamond to be fully in conformity in all material respect to generally accepted accounting principles. This is in contrast with rule 203 that prohibits making an opinion that affirmatively declares financial statements to be in line with generally accepted accounting principles. In addition, the audit reports that Deloitte was preparing for Diamond financial statements did not indicate that reporting of current liabilities on continuity provision deviated from generally accepted principles provided by accounting council by 1.63% that had potential to cause material effect on the financial statements of Diamond Company as a whole. Consequently, Deloitte violated rule 203 in providing the auditing services on Diamond financial statements. Requirement 15: Understanding auditors’ liability and the concept of Scienter under the Securities Exchange Act, 1934 Violation of rule 10b-5 implies that one has indirectly or directly engaged in acts that deceive, exclude relevant information, and make false statements or conduct business operations deceive other persons when undertaking business or professional transactions (Cross, Miller, Cross, & Cross, 2012). The concept of Scienter and gross negligence under the context of rule 10b-5 means that individuals or entities should be found guilty for fraud when they act indirectly or directly and knowingly in a manner likely to cause financial losses of investors. Thus, the Scienter and gross negligence intended to balance unfair acquisition of defrauding investors unintentionally and ensuring investors are protected from financial losses due to deliberate fraudulent actions by business entities or consultants (Gilbertson, Lehman, & Debra, 2012). This illustrates why Court allowed Deloitte to submit a motion dismissing the allegation brought against it. The reason behind the decision of the court derives from previous court observation that one can only be accused violating rule of 10b-5 if the plaintiff proves he acted in Scienter (Bolger, 1980). Consequently, allowed Deloitte to dismiss the allegation by demonstrating it did not violate rule 10b-5 intentionally as provided under Scienter and gross negligence concept. Reference Bolger, J. P. (1980). Recklessness and the Rule 10b-5 Scienter Standard after Hochfelder. Fordham Law Review , 49 (5), 817-836. Cross, F. B., Miller, R. L., Cross, F. B., & Cross, F. B. (2012). The legal environment of business: Text and cases : ethical, regulatory, global, and corporate issues. Mason, OH: South-Western Cengage Learning. Gilbertson, C., Lehman, M. ,., & Debra, H.-G. (2012). Fundamentals of Accounting: Course 1. Boston: Cengage Learning. Kan, E. (2013). Audit and Assurance - Principles and Practices in Singapore (3rd Edition). Singapore: CCH Asia Pte Ltd. Nguyen, K. (2008). Financial Statement Fraud: Motives, Methods, Cases and Detection. Florida: Universal-Publishers. PCAOB. (2010, December 5). Auditing Standard No. 15 . Retrieved 2014, from http://pcaobus.org/standards/auditing/pages/auditing_standard_15.aspx Rezaee, Z., & Riley, R. (2011). Financial Statement Fraud Defined. Hoboken: John Wiley & Sons, Inc. Rittenberg, L. E., Johnstone, K. M., & Gramling, A. A. (2012). Auditing: A business risk approach. Melbourne, Vic: South-Western Cengage Learning. Rittenberg, L. E., Johnstone, K. M., & Gramling, A. (2011). Auditing. Mason, Ohio: South-Western. Whittington, R. (2012). Wiley Cpa Exam Review 2013, Auditing and Attestation. New York: John Wiley & Sons Inc. Read More