Literature Review 5
Description on “Audit and Assurance Standard – 13”6
Misstatement or omission in the financial statements are considered material if they could influence the economic and financial decisions of the users of the information based on the provided statements. This research is an empirical research, which provides that a relevant expectation gap regarding materiality of misstatements exists between auditors and the users of the financial statements. This gap can be explained mainly by lack of communication between these two.
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WorldCom and other telecommunications firms faced reduced demand as the dot–com boom ended and the economy entered recession. Their revenues have fallen short of expectations, while the debt they took on to finance expansion remains high. As the stock market value of these firms has plunged, corporate management had a powerful incentive to engage in accounting practices that conceal bad news.
Accounting and Auditing Standard 13 states that the information is information is material if its omissions or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
As long as misstatement do not violate the fair and true view the financial statements give of the financial position of a company, they are considered immaterial. It is the responsibility of the auditor of the financial statements to be reasonably sure that the financial statements are free from material misstatement.
Because the user is the ne, who makes decisions based on the annual financial statements, in theory it should be the user of the financial statement, who decides what is material and what is not. However, users of the financial statements are not a homogeneous group. Shareholders, creditors and clients have different information needs and preferences and therefore consider other things as being material to their decisions.
Therefore, in practice the auditor decides on materiality baseline for the audit of the financial statements. The auditor is the confidant of the financial statement users who audits the financial statements of a company on behalf of the users.
Although the definition of the term explicitly addresses user’s economic decision-making, in practice, user are not involved in the concept at all. This gives reason to suspect that the implication of the concept of materiality are not known, or not fully known to users of the financial statements.
According to the research on WorldCom Inc. scandal we know that, the company began as a small Mississippi provider of long distance telephone service. During 1990s, the firm made a series of acquisitions of other telecommunication firms that boosted its reported revenue from $154 million in 1990 to $39.2 million in 2001, placing its 42nd among Fortune 500 companies. The acquisition of MCI in 1998 made the company second largest U.S. long distance carrier, and the acquisition of UUNet, America Online and CompuServe’s data network. Which made WorldCom among the leading operators of Internet infrastructure.
In its 25th statement, WorldCom admitted that the company had payments over $3.8 billion for line cost as capital expenditure rather than current expenses. Line costs are what WorldCom pays other companies for using their communication network; they consist principally of access fees and transportation charges for WorldCom customers. Reportedly, $3.05 billion was misclassified in 2001 and
$797 million in the first quarter of 2002. According to the company, another $14.7 billion in 2001 line costs in 2001 line costs was treated as a current expenses.
New York Times published news about WorldCom’s collapse on jully 22, 2002. WorldCom, plagued by the rapid erosion of its profits and an accounting scandal that created billions in illusory earnings which was the largest bankruptcy filing in U.S. history.
The WorldCom filing listed more than $107 billion in assets, surpassing those of Enron case, which was filed before this case. Thee WorldCom filing had been anticipated since the company disclosed in late June of that year that it had improperly accounted for more than $3.8 billion of expenses. WorldCom’s disclosure of possible new accounting problem came in a filing that the Securities and Exchange Commission had ordered to provide details of its 2011 and 2001 accounting irregularities, the S.E.C. filed civil fraud allegation against the company.
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In the disclosure by WorldCom, to the S.E.C, they disclosed that Mr. Sullivan, who was fired by WorldCom’s board then, to preserve documents and records related to his decisions to capitalize the cost of leasing space on competitors’ phone lines. Instead, those costs should have been recorded as current business expenses, reducing its cash flows and its profits. The Securities and Exchange Commission had charged WorldCom with fraud and the Justice Department had begun a criminal investigation of WorldCom’s entire business practices.
Description on “Auditing and Assurance Standard – 13”
This Standard on Auditing, explains the auditor’s responsibility to apply the concept of materiality in planning and performing an audit of financial statements.
Date of Effectiveness
This accounting standard is effective for audits of financial statements for periods beginning on or after April 1, 2010.
Objective of the Standard
The objective of the auditor is to apply the concept of materiality appropriately in planning and performing the audit.
AAS 13 lays down standard on concept of materiality and its relationship with audit risk. Information is material if its misstatement could influence the economic decisions of tis users taken on the basis of the financial information. Materiality is the cut off limit with reference to which the misstatements are considered, it may be the amount, nature of the item, size or frequency.
For example, the remuneration to director may have to be specifically disclosed. The amount of which judged from total salary of the staff may be negligible. But the nature of the item would make it material for misstatement.
The materiality is observed with the reference to the individual items or aggregate of them. Some items which are not by themselves material may cumulatively result in material significance. Some items though by size not material, may relate to legal or statutory matters the non0compliance of which make the financial statements materially misleading. Other particular items may qualitatively present material misstatements. For example, inappropriate application of accounting policy may result in material misstatements either in current period or may effect material misstatements in financial statement that follow the period.
The relationship between Materiality and Audit Risk
The auditor plans to keep the audit risk at a minimum level while planning the audit. While planning, he decides the materiality level of specific account balances or class of transactions, which helps him in deciding the items to be selected, the sample to be chosen and which audit procedures to be applied on them.
There is an inverse relationship between audit risk and audit materiality. If the materiality is high, the audit risk is low. If the auditor chooses to keep the materiality limit of few hundred rupees for the truth and correctness of profit, the chances that that audit carried out may fail to detect the errors within which such a narrow range may be higher. In such case, the auditor reduces the audit risk by more appropriate checking of control systems, balances and transactions. The auditor lays strictly a lower control risk and carry out additional tests to control. Similarly he puts a lower detection risk and carry out additional procedures. These two in combination would help the auditor in reducing the total audit risk to level he wanted, in spite of his fixing tolerable materiality level at a lower level.
Materiality and audit risk in evaluating audit evidences
At the planning stage, the auditor may lay for himself a materiality level, which however, may change as he proceed along the audit. The knowledge gained or change in the circumstances in the audit may alert the auditor to revise the materiality level to lower or higher side.
In forming an opinion about the financial statement, the auditor should consider whether the effect of aggregate uncorrected misstatement on the financial information is material. The aggregate of uncorrected misstatement comprise of specific misstatement identified by auditor during his audit, the net misstatement brought down form previous period without correction, the projected misstatement where misstatements are projected from a sampling test of balances and transactions. The management should correct and adjust the financial information in reference to misstatement showed to them. The adjustment should involve application of appropriate accounting policy, providing disclosure where it was conspicuous by absence, complying with the statue for matters affecting financial statements, rectification of errors, undoing , suitability, by disclosure or otherwise, the effect of fraud, ect. If the auditor could not find the effect of material misstatements within materiality level fixed for the financial statement as a whole, he may decide to express a qualified or adverse opinion about the financial statement appropriately.
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The method which I am using is Case Study Analysis for my study. The case study methodology helps to understand the circumstances in which the data can be collected through various research techniques, such as case observation or articles. In order to explain the AAS-13 in details, I have taken real case study in this paper regarding the WorldCom Inc. scandal in 2002 in which the management and such as document observation or articles. In order to explain the AAS – 2 in details, I have taken real example in this paper regarding the WorldCom scandal in which the management and internal auditors were equally at fault.
WorldCom was not the only telecommunications firm in financial trouble. The difficulties of Qwest Communications, Global Crossing, Adelphia, Lucent Technologies, and Enron (which had major investments in internet ventures) have been widely reported at the same time. As in these other firms, investors in WorldCom have suffered major losses: the market value of the company’s common stock plunged from about $150 billion in January 2000 to less than $150 million as of July 1, 2002. The desire to avoid or postpone stock market losses of this magnitude creates a powerful incentive for corporate management to engage in accounting practices that conceal bad news.
WorldCom increased both its net income and its assets by transferring part of a current expense to a capital account. Had it not been detected, the maneuver would have resulted in lower net income in subsequent years as the capitalized asset was depreciated. Essentially, capitalizing line costs would have enabled the company to spread its current expenses into the future, perhaps for 10 years or even longer.
the SEC requested data from the firm about a range of financial reporting topics, including (1) disputed bills and sales commissions, (2) a 2000 charge against earnings related to wholesale customers, (3) accounting policies for mergers, (4) loans to the CEO, (5) integration of WorldCom’s computer systems with those of MCI, and (6) WorldCom’s tracking of Wall Street analysts’ earnings expectations.
According to initial accounts, the treatment of line costs as capital expenditures was discovered by WorldCom’s internal auditor, Cynthia Cooper, in May, 2002. Ms. Cooper reported the matter to the head of the audit committee of WorldCom’s board of directors, Max Bobbitt, on or about June 12th, who in turn asked the company’s current outside auditor, KPMG, to investigate.
On July 15th, however, Representative Tauzin, Chairman of the House Energy and Commerce Committee, said that internal WorldCom documents and e-mail messages indicated that the Company’s executives knew as early as the summer of 2000 that the accounting treatment was improper.
After intense research on the topic, I discovered that the internal auditors were an early line of defence against accounting errors (e.g., mistaken classifications with no intention to deceive) and accounting fraud (e.g., knowingly false classifications with intention to deceive). I observed one thing about the case that it took more than a year for the company’s internal auditors to discover the misclassification; according to AAS-13 it was auditor’s duty to take into consideration the incorrectness of the misstatement. But it did not happened in the due course of time, considering the amount of costs being capitalized about, $750 million each quarter and the impact on net income and assets. This might have been caught earlier if the company had followed the accounting standard of audit materiality. When I observed closely, I noticed the fact that Andersen was not notified that line costs were being capitalized was irrelevant; according to me, Andersen should have designed their audit to detect misclassifications of this magnitude. We can also note that Andersen should have taken into account the financial condition of WorldCom and paid more attention to the possibility of aggressive accounting practices.
An internal auditor has an immense role for the good corporate governance. The fraud has happened outside India, but the effects were tremendous. Now we know the possible flaws in the corporate activities and we can work to make our regulations even stricter. Since the compulsion of the audit from 1996 under Company’s Act in India, the role of internal and external auditor has brought down transparency and reliability of financial statements in many organizations. All the stakeholders rely on the financial statements for their economic decisions because of the role and responsibility of the auditor. But in this case study we have observed that the auditors and the management were at fault. Though the actions were taken by the authorities but the effects were irreversible.
I would like to recommend:
- All the auditing standards should be conveyed to all the corporate entities.
- Information about the standards and the rules should be followed by the management.
- Though in theory, all the rules and regulations are followed by the company, but in practical world we should adhere to the ICAI guidelines and focus more on internal management.
- The Indian Government and ICAI must prevent large firms to manipulate the internal auditing standards by continuous check on the companies.
- Severe actions must be taken in case of such frauds other than financial penalties.
A HANDBOOK OF PRACTICAL AUDITING BY B.N. TANDAN, S. SUDHARSHAM, S. SUNDHARABAHU
- Nytimes.com. 2014.WORLDCOM'S COLLAPSE: THE OVERVIEW; WORLDCOM FILES FOR BANKRUPTCY; LARGEST U.S. CASE. [online] Available at: http://www.nytimes.com/2002/07/22/us/WorldCom-s-collapse-the-overview-WorldCom-files-for-bankruptcy-largest-us-case.html [Accessed: 16 Feb 2014].
- Ifrs.org. 2014.IFRS - Home. [online] Available at: http://ifrs.org [Accessed: 16 Feb 2014].
- Markham, J. W. 2006.A financial history of modern U.S. corporate scandals. Armonk, N.Y.: M.E. Sharpe.
- Rooij, D. D. 2009.Materiality of misstatements from the perspective of the users of the financial statements - Narrowing the expectation gap between users and auditors. Rotterdam: Erasmus University.