Accounting Second Four Weeks Indiana University A100 Internal Controls Auditing To conduct a nancial audit means to carry out a thorough examination of an entity s books and records nancial accounts and policies and procedures Financial audits are performed by external independent auditors who are certi ed public accounts CPA s In conducting an audit the auditors must rely on the company s internal controls Internal controls Procedures or systems which are designed to Promote Ef ciency Safeguard Assets Avoid Fraud and Errors Keep Accounting Data Accurate Owner Manager A sole proprietor managing his or her own business Owner s business nancing investing operating Stockholders Board of directors managers employees The corporation Financing investing operating Stockholders elect the board of directors they represent stockholder s interest to management SEC Securities and Exchange commission The purpose is to make sure that publicly traded companies report the truth when they prepare their nancial statements Before this no one was checking what companies reported and management often embellished them FDR and Joseph Kennedy created the SEC Added External Auditors to nancial statements The External Auditors Opinion make sure that the procedures manual is being followed 1 Internal Auditors work for the company goes around to all departments of the company and samples and tries to determine if the procedures manual is being followed before External Auditors come in ENRON Pipeline company run by Ken Ley He continued to buy other companies in the industry andersen they were also pro table He would give his managers big bonuses and then they would go to another country They would create sham businesses and borrow money He had ENRON own 49 and his top managers own the other 51 so that Enron did not own a majority of the new business and have to consolidate their nancial statements External Auditors David Duncan from Arthur Andersen kept signing their nancial statements for two years after they knew something was up The whole company was brought down as a result of few people from their Houston of ce Sarbanes Oxley SARBOX Law to make sure there will never be another ENRON Established Public Company Accounting Oversight Board PCAOB Under SEC to oversee the auditing of publicly held companies Implications for Companies Audit committee Oversight of internal audit Independent and one must have nancial expertise Hires and receives report from independent auditors Limits on loans made to executives Section 404 internal control audit required Section 302 holds management responsible Section 404 When External Auditors come in they have to give their opinion of the strength of the company s internal controls along with their nancial statements Implications For Auditors 7 year work paper retention Second partner review Quality review by PCAOB every year of the auditors 2 Can t provide consulting services to audit clients in the same year Report to the audit committee Lead auditor has to rotate every 5 years One year wait before auditor can go to work for the client Internal Controls Control environment or the Tone at the top Management must set an ethical tone for its employees control the risks assets Risk Assessment The company must realize the risks it faces and take steps to Control Actives The company must establish procedures policies to protect its Information Communication The policies procedures must be communicated to employees Monitoring There must be continual follow up to see how the procedures are working and to make any necessary modi cations Auditing Terms Sampling Using a random subset of the population in order to form an opinion on the population as a whole Audit Evidence Information gathered by the auditors for their analysis sand evaluation Materiality Refers to the size of an error in the nancial statements An error omission in the nancial statements is considered material if it is signi cant enough as to make it probable that the decision of a reasonable person would be impacted by the error or omission Overstating revenue or overstating expenses External Auditors don t are about errors that are not material Auditors must stay skeptical and maintain a professional distance Fraud Triangle Financial need Perceived opportunity 3 Rationalization Public accounting rms provide Account Assurance Services Independent professional services that improve Non Assurance Services Independent professional services that improve Information technology consulting information quality Ex Audits of nancial statements Audits of internal controls information quality Ex Tax preparation planning Fraud investigations Auditors Compilation review or audit With an audit an option is given Unmodi ed opinion Quali ed opinion Adverse opinion Disclaimer of an opinion Tax Business Taxes Taxable Entities Corporations Flow through Entities Limited liability companies LLC s S Corporations Partnerships 4 Proprietorships Proprietorships Owned by one individual the business is not incorporated not considered a separate entity from the owner All net income ows through to the owner to pay taxes on his her individual return Owner pays tax on the taxable income of the business NOT the amount of cash withdrawal Advantage easy to establish Disadvantage all liabilities of the business re considered liabilities of the owner Business Taxes Proprietorships Owned by one individual and the business is not incorporated Not considered a separate entity from the owner All net income ows through to the owner to pay taxes on their individual return Advantage easy to establish Disadvantage all liabilities of the business are liabilities of the owner Partnership Owned by two or more parties and the business is not incorporated Considered a separate entity from the owners Files a tax return but does not pay tax Income ows through to the owners to pay taxes on their ind returns Advantage easy to establish Disadvantage all liabilities of the business are liabilities of the owner Regular Corporation A business which is incorporated Separate entity from its owners The corporation les a tax return and is required to pay corporate tax The income is subject to double taxation Tax is paid on taxable income at the corporate level 5 When the corporation pays dividends these are not deductible to the corporation but are taxable income to the stockholders Advantage potential loss to the stockholders is limited to the amount invested usually