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During the assurance engagement, auditors should be aware of indicators which may lead to the disclosure that management can override financial reporting activities for the purpose of deceiving report users with fictitious profitability and financial stability.
For example, in the case of Cendant fraud, management utilized merger reserve to artificially inflate earnings in order to meet analyst's earning expectations. During this process, management of CUC would record a one-time merger and acquisition expense and establish a reserve for restructuring costs expected as a result of the merger. When the revenue is not strong enough to meet the expectations, management would reduce the merger reserve so as to increase net profit. According to the requirements of AAS18 (Australian Accounting Standards Board, 1996), accounting treatments such as recognizing purchased goodwill as an expense at the time of acquisition or writing it off against reserve at the time of acquisition were not acceptable as they could not reflect future benefits from such acquisition objectively.
Management override of the financial reporting activities may usually be reflected in the form of unusual journal entries. Auditors should use professional judgment, i.e. his or her understanding about the business and knowledge about relevant accounting requirements, when determining whether the journal entry is unusual or not. Thus, according to ASA 240 (Australian Accounting Standards Board, 2006), auditors should use professional judgment and testing to attain sufficient audit evidence to address management override of internal control:
Test the accuracy of journal entries recorded in the general ledger and other adjustments, particularly those made in month end and without supporting documents;
Obtain evidence and supporting for accounting estimates;
Get acquaintance with the business of the audit client and its operation environment, so as to detect unusual or significant business transactions;
When performing the above procedures, under the requirements of ASA 200, auditors should always maintain professional skepticism for the possibility that management could override the financial reporting activities which may lead to materially misstated financial reporting (Australian Accounting Standards Board, 2007).
Professional skepticism comes from auditors' professional knowledge about accounting and auditing, but more importantly, it comes from auditors' business sense. The financial reporting should go in line with the development trend in the industrial background and the company's overall performance. When obtaining such understanding, auditors should get acquaintance with previous audit working papers and documentations of the audit client; meanwhile, auditors should look up information concerning the development of the whole industry, overall performance of other competitors in the industry, and relevant government policies, etc, which may impose a great influence to the financial performance of the audit client. Moreover, auditors should carry out frequent interviews with employees of different levels and positions in the audit client's company, so as to get more information which may link to the detection of management override.
4.0 Management assertions and relevant audit procedures
When examining the reliability of the financial reports, auditors mainly show their concerns in the following aspects: the completeness, existence, accuracy, valuations, rights and obligations, and presentations of the financial assertion level (KPMG, 2010).
In the case of Cendant fraud, several misstatements were identified which had violated from the above management assertions.
4.1 Irregular charges against merger reserves
When the current year profit did not meet the expectation of external analysis, management would artificially reduce the merger reserve for restructuring costs expected as a result of the merger. The inappropriate written off merger reserve cause problems in light of the accuracy of goodwill and current year operating expenses.
In addressing the violation of accuracy assertion, auditors should perform analytical procedures and recalculate to cross reference the accuracy of the financial account. In the analytical procedures, auditors could compare the fluctuation of current year's figures with those of prior year, or set up an expectation of current year performance and compare it with the actual figures. When the fluctuations are of a significant level which cannot be explained with normal understanding in accordance with the business and company development, auditors should be aware of the possibility of management overrides and fraud.
4.2 False coding of service sold to customers
In order to increase revenue figures, management in CUC would falsely classify revenue from deferred revenue recognition program into immediate revenue for current period operation. In the deferred revenue recognition program, revenue should be recognized averagely over 12 to 15 months; however, when such revenue was recognized in a single month or in a single financial year, the revenue for that particular fiscal year would increase dramatically, which may give the illusion of strong financial performance. Such behavior of management override had violated from accuracy, existence, and obligation assertions.
In addressing risks such as the obligation assertion, auditors can carry out substantive procedures to examine the contract detail information with the revenue recognition. Based on the risk of significant misstatement and the total revenue amount of the audit fiscal year, auditors can select a number of sample contracts for examination. By checking the sales recognition clauses in the contracts and the actual sales recognition figures by the audit client, auditors can easily detect the existence of violations. By further examining the reason for such violation, auditors can make up a conclusion on whether management override exists in the financial reporting.
4.3 Delayed recognition of membership cancellations and bank rejection of charges made to member's credit card amounts
In order to deliver a strong annual revenue figure, CUC would delay recognition of customer's cancellations of membership benefit programs; meanwhile, as to the bank rejections of credit card charges made to member's credit card accounts, CUC would also delay such rejections. Such behaviors had violated from the accuracy, existence, rights and obligations, and presentations assertions.
In addressing risks such as the existence assertion, auditors can seek to obtain external audit evidence by sending confirmations to the third party. In the confirmations, auditors can check with the sales party with the balance, transactions amount, or even every specific transaction to check whether the figures provided by the audit client are correct or not. Such confirmations should be sent out and received by the auditors themselves, with no interference from the audit client, so as to avoid the risk that the figures sent out for confirmation or the replied figures be tampered by the client. When the replied amount could not match with that of the audit client, and the difference could not be reasonably explained, it may indicate the existence of management override or fraud. Furthermore, auditors could cross check detail transactions with the records from the bank statements.
Violations on management assertions could be detected in a number of ways. The best ways for fraud identification may be different in each audit case. However, when auditors can always maintain professional skepticism and be prepared with sufficient knowledge about the audit client's business, management overrides and other fraud commitments would be more easily detected during the audit engagement.