How Financial Statements Can Be Erroneously Prepared

The misuse or misunderstanding of the properCPAs to perform additional procedures to help
application of materiality can lead to manipulatingdetect potentially fraudulent actions. SAS No. 82,
reported income through "earnings management"Consideration of Fraud in a Financial Statement
techniques. This type of fraudulent financialAudit, meets the public's expectations of
reporting receives ample attention in the financialassurance that financial statements are devoid of
press. This is a subject relevant to thematerial misstatement caused by error or fraud.
preparation and audit of all financial statements.SAS no. 82 is designed to help define the
SEC Staff Accounting Bulletin (SAB) no. 99,responsibilities of the auditor in detecting fraud.
Materiality, helps advise preparers and independentErrors that are unintentional can occur at any time
auditors how to evaluate materialityor place causing unpredictable financial statement
misstatements in the financial reporting andeffects. A thorough internal control system can
auditing processes considering certain GAAP andreduce the risk of material errors. Fraud,
the federal securities laws that relate tohowever, is intentional and is usually accomplished
materiality.by avoiding internal controls. Fraud is difficult to
Materiality is defined by the FASB as, "Thedetect using internal controls and requires the
magnitude of an omission or misstatement ofexpertise of the auditor.
accounting information that, in the light ofSAS No. 82 provides auditors with guidelines on
surrounding circumstances, makes it probable thathow to address potential fraudulent situations in a
the judgment of a reasonable person relying onfinancial statement audit. It describes the different
the information would have been changed ortypes of fraud and advises the auditor of how to
influenced by the omission or misstatement." Thedifferentiate between the risk of material fraud,
criteria for determining materiality by the FASB isfraudulent financial reporting, and misappropriation
that if the presentations of financial informationof assets. SAS also requires auditors to record
are to be prepared economically on a timely basisthe risk factors identified and their response to
and presented formally, then the concept ofthem in both employee and management fraud.
materiality is crucial. Misstatements occurring fromEmployee fraud usually involves the
clerical error or adjustments for missed invoicesmisappropriation of assets or improper record
are not required to always be corrected as longkeeping. Employees are known to commit fraud
as the error is identified in the audit process anddue to or in combination with various factors:
management is notified.1) Emotional duress
Reliance on quantitative benchmarks to determine2) A perceived opportunity to get away with
whether items are material to the financialsomething
statements is not acceptable. Qualitative, as well3) Resentment due to perceived pay inequity.
as quantitative factors, must be considered inManagement fraud usually involves manipulative
determining the materiality of differences and/orfinancial reporting. There are several incentives for
omissions. Abuse of materiality, errors that aremanagement fraud. They include:
intentionally recorded within a defined percentage1) Incentive to affect stock price
ceiling, and then dismissed as not enough to2) Expectations of investors
affect the bottom line, is not tolerated as well.3) To avoid debt
The SAB describes several qualitative factors that4) To avoid tax liability
management and auditors can refer to when5) To meet budget
determining the materiality of misstatements. In a6) To influence creditors
financial statement, a quantitatively small7) To achieve bonuses
misstatement may become material if:8) To avoid punishment.
1) The misstatement came from an item thatTo avoid the fraudulent activities of employees
can be precisely measured.and management several things need to be
2) It is from an estimate.implemented. Internal controls must be maintained
3) It disguises a change in earnings.to insure ethical practices are maintained. Top
4) It covers up a failure to meet analysts'management's support of internal control must be
expectations of the endeavor.assured so as to not lose its effectiveness.
5) It changes a loss into income.Unusual or difficult transactions should be
6) It involves a portion of the business that hasmonitored thoroughly. Top management sets the
been classified as a significant business segmenttone for financial activity, if the ethical code is
regarding profitability.weak, a third party must become involved.
7) It affects the business's ability to adhere toSAS No. 82 provides that the auditor accepts
regulations.responsibility for detecting fraudulent practices and
8) It affects the business's ability to comply withcommunicating with managers. It also contains
contractual obligations.performance guidelines to assess the risk of
9) It effects the management's incentivematerial misstatement due to fraud and how to
compensation.respond to the risks involved. This standard raises
10) It involves the covering up of illegal activity.public expectations and gives auditors greater
The appropriate use of materiality shouldresponsibility in assuring that fraudulent practices
strengthen the effectiveness of financialno longer go undetected.2.
reporting.1.1. C. Terry Grant, "Earnings Management And The
The American Institute of Certified PublicAbuse Of Materiality." Journal of Accountancy
Accountants' (AICPA) Auditing Standards Board(September, 2000)
recently issued a new standard that requires2. Alan Reinstein; Gregory A.