You are auditing a company whose management has intentionally made adjustments to various financial statement items that are not in accordance with generally accepted accounting principles. This behavior has occurred over a number of accounting periods
None of the individual adjustments by itself is material and the aggregate effect on the financial statements taken as a whole is immaterial. Top management of the client are aware of these misstatements and consider them part of their strategic management of earnings. Explain how you as the independent auditor should respond to this situation.
The fact that the client's records contain intentional errors may be indicative that the client (if a public company) has violated securities laws by failing to maintain accounting records that accurately and fairly reflect in reasonable detail the transactions of the company. This would be considered an illegal act and would require, among other things, that the auditor communicate with the audit committee of the client board of directors.
The following represent important considerations in formulating a response to this situation:
-An inconsequential misstatement should be viewed differently than those that are more significant.
-The clarity of authoritative accounting guidance with respect to the misstatement (i.e., if clear and authoritative guidance exists, the misstatement should be corrected).
-The manner in which the misstatement arose; in this case, a misstatement, even though immaterial, that is part of an ongoing earnings management initiative sanctioned by management likely is not acceptable
-Intentional misstatements are more important than unintentional misstatements (such as clerical error) since an intentional error reflects on the integrity and reliability of management and employees of the client company.
-Immaterial misstatements may be material if they allow the client to avoid violation of a contractual agreement such as a debt covenant.
-Does an immaterial misstatement affect the trend in earnings?
-Does the immaterial misstatement allow the company to meet financial analysts' expectations for the company?
-Does the immaterial misstatement result in meeting the threshold for management bonuses where the bonus compensation is based on earnings?
The fact that the departure from GAAP in this case is intentional should alert the auditor to look for motivations for the client to make such a departure. The honesty and integrity of the client must be considered. Although immaterial, the misstatements should be closely reviewed to see if they are motivated by any of the above mentioned factors or other factors that the auditor might identify.
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