ACT341: Introduction to auditing

Section: 01
Course coordinator: AHU

Auditing and Accounting cases

Investigating issues of fraud and professional ethics.
Waste Management.

Group members
Md Faysal Ibn Idrish 1310608630
Mohammad Tanzil Hossain 1321010030
Mahin Zubair 1330385030
Faiyaz Alam Chowdhury 1330924630

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 Table of Contents

Table of Contents........................................................................................................................................ii
Introduction.................................................................................................................................................1
CASE 1.1-Waste Management: The Expense Recognition Principle............................................................2
CASE 1.5-Waste Management: The Definition of Asset...............................................................................5
CASE 2.2-Waste Management: Due Care....................................................................................................8
CASE 3.7-Waste Management: Understanding the client’s business and industry...................................12
CASE 4.2-Waste Management: General Computing Controls....................................................................16
CASE 4.5-Waste Management: Top-Side adjusting journal entries...........................................................20
CASE 5.6-Waste Management: Valuation of Fixed Assets.........................................................................22
References.................................................................................................................................................26

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 Introduction.
Waste Management Inc. was founded by Larry Beck and Dean L. Buntrock in 1894 that
provided waste and environmental service in North America. The company’s operation also
involved managing air and gas, environment and groundwater protection as well as
environmental engineering. The company offer environmental service in America, Canada and
Puerto Rico and known as “North America’s largest residential recycler”. The company was
able to handle more than 8.5 tons of materials which included plastic, metal, gas electronics and
paper at 128 different facilities.

During 1992-97 the company was found to have materially misstated their financial statement.
This was committed by six of the senior executives who played a role in this financial fraud. The
auditor repeatedly issued unqualified audit reports on the company’s materially false and
misleading annual financial statement. This allowed the managers to continuously commit fraud.

The security exchange commission penalized Arthur Anderson and partners with a fine of more
than $7 million. The investigation ended in the year 2002.

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CASE 1.1-Waste Management: The Expense Recognition
Principle.

1. Consider the principles, assumptions and constraints of Generally Accepted Accounting

Principles (GAAP). Define the matching principle and explain why it is important to
users of financial statements.

According to the matching principle, costs need to be matched to the revenues that they helped to
generate. A key point is that expenses should not necessarily be recognized when the work is
completed or a product is produced. Rather, the costs should be recognized when the costs can
be matched to revenue that has been recorded. If a connection cannot reasonably be made
between a cost and revenue that has been recognized, an accountant still has a responsibility to
try to determine whether there is some type of relationship between the cost and revenue
generated. The absolute goal is to try as hard as possible for an accountant to provide the best
measure of the profitability and performance of a company. As a result, accountants should
attempt to identify as best as possible, how much it cost to generate revenue. This is the basis of
the matching principle.

2. Based on the case information provided, describe specifically how Management violated
the expense recognition principle. In your description please identify a journal entry that
may have been used by Waste Management to commit the fraud.

GAAP requires that depreciation expense be determined by allocating the historical cost of assets
over the useful life of the asset less the salvage value. When the management team at Waste
Management made changes to the estimated useful life and salvage value of several assets, they
effectively reduced the depreciation expense, ultimately resulting in overstated income. The
reduction of depreciation expense in the current year essential defers depreciation expense to a
future year. The Matching Principle requires the depreciation expense of an asset to be
recognized over its useful life so that the associated expense is recorded in the year in which
related income is earned. The arbitrary changes made to the estimated useful lives and salvage
values directly violated the matching principle because the depreciation expense recognized in
future years would now be unrelated to the production of income in those related future years.
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In essence, increases to the useful life of assets have the effect of writing up the value of an asset
and reducing expenses. This change can have a material impact on the financial statements.
These types of changes, that affect the way a user of financial statements values Waste
Management, must be properly disclosed as required by GAAP under the Full Disclosure
Principle. This principle requires management to disclose sufficient information to allow the user
to make a judgment about the financial position of Waste Management.

3. Consult Paragraph 2 of PCAOB Auditing Standard No. 5. Do you believe that Waste
Management had established an effective system of internal control over financial
reporting related to the depreciation expense recorded in its financial statements? Why or
why not?

According to paragraph #2 of Auditing Standard #5, “effective internal control over financial
reporting provides reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statement for external purposes. If one or more material weaknesses
exist, the company's internal control over financial reporting cannot be considered effective.” In
the Appendix of Auditing Standard 5, paragraph A5 provides more specifics about the definition
of an internal control system.

According to that paragraph, such a system is “a process designed by, or under the supervision
of, the company's principal executive and principal financial officers, or persons performing
similar functions, and effected by the company's board of directors, management, and other
personnel, to provide reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with GAAP and includes
those policies and procedures that:

 Pertain to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company
 Provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company

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  Provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company's assets that could have a material effect
on the financial statements.”

Waste Management did not have an effective system of internal control over financial reporting
related to the depreciation expense recorded in its financial statements. Stated simply, Waste
Management’s internal control system did not provide reasonable assurance that the transactions
are recorded fairly, accurately, and in accordance with GAAP.

4. Consult Paragraphs 5-6 of PCAOB Auditing Standard No. 15.As an auditor, what type of
evidence would you want to examine to determine whether Waste Management’s
decision to change the useful life and salvage value of its assets was appropriate under
GAAP?

A company is allowed to change the useful life and/or the salvage value of its fixed assets under
GAAP if events or circumstances reveal additional information that indicates that a change to the
useful life and/or salvage value will more accurately depict the current market situation. Stated
simply, there should be a legitimate basis to make any changes to these variables. In addition,
according to the SEC, changes to the variables used in estimating depreciation and the resulting
impact to investors should be disclosed in the financial statements to be in accordance with
GAAP.

For evidence, an auditor should examine relevant information about comparable useful lives
used in the industry and monitor the company’s actual experience for similar assets in the past to
determine if the firm’s decision to change the useful life and salvage value of its assets was
appropriate under GAAP. Overall, the rationale for changes must be well supported and
reasonable. In making this determination, interviews with managers and other relevant personnel
would be essential, as each of these estimates are subjective. Ultimately, the events or
circumstances resulting in the need for the changes would need to be critically evaluated and
corroborated with sufficient and competent evidence by the auditors. After considering all of the
available evidence, if the auditors are still unsure about the decision, they could use an
independent third party to evaluate the changes to the useful life and/or salvage value that are
proposed.

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 CASE 1.5-Waste Management: The Definition of Asset.
1. Consider the principles, assumptions and constraints of Generally Accepted Accounting
Principles (GAAP). What is the definition of an asset?

According to GAAP, an asset must provide an organization with a right to enjoy future benefits
(e.g., by providing future cash flows for the organization). The organization must have control
of this future benefit and the transaction that allowed this future benefit to exist for the
organization must have occurred for an asset to exist.

2. Consider the practices of “basketing” and “bundling”. Briefly explain why each practice
is not appropriate under GAAP.

According to GAAP, costs related to impaired or abandoned assets that were previously being
amortized must be written off or expensed immediately in the period where the impairment or
abandonment became known. Waste Management capitalized the costs related to obtaining
landfill permits and interest on landfill construction costs. In some instances, the company
invested significant resources and the required permit was not obtained, resulting in material
impairment or abandonment of the landfill. At this point, Waste Management should write off
the expenses related to the impaired or abandoned projects and disclose the impact in the
financial statements in accordance with GAAP. However, in reality, the company transferred
these costs to other active landfill sites, a practice known as basketing. Basketing is not
appropriate as Waste Management was continuing to carry the deferred permitting costs on its
balance sheet, when they should have been written off to the income statement. According to the
SEC, Waste Management regularly mixed the impaired or abandoned project costs with the
assets of permitted landfills and amortized the costs over the life of that site. Essentially, the
company was basketing these costs with permitted landfills in order to avoid expensing the costs
immediately.

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Bundling, which is very similar to basketing, refers to the practice Waste Management used to
transfer unamortized costs of landfills that closed early to another actively operating landfill.
Bundling is also not in compliance with GAAP as the company is required to recognize and
disclose the unamortized costs related to the closed landfill in the period that the landfill closed.
Transferring the costs to an operating landfill is not appropriate under GAAP.

3. Consult Paragraphs 6-7 of PCAOB Auditing for Waste why netting write-offs against
other gains would be effective fraudulent Management's management team in trying to
cover up their fraudulent behavior.

Netting involves the use of one-time gains on the sale or exchange of assets to offset unrelated
expenses to avoid showing the impact of such expenses in the financial statements. Essentially,
Waste Management was able to “net” the impact of these expenses against the one-time gains on
the sale or exchange of assets. Netting was thus effective for the management team to help cover
up their fraudulent activity as auditors were not necessarily expecting the nonrecurring or one-
time gains that were not incurred in the normal course of business.

4. Consult Paragraph 10 of PCAOB Auditing Standard No15.As an auditor, what type of

evidence would allow you to detect whether your client was engaging in behaviors that
are designed to mask fraudulent behavior (i.e., “basketing”, “bundling” or “netting”)?

As an auditor, it may be difficult to determine if a client is engaging in basketing or

bundling as management is aware that they are not acting in accordance with GAAP and is likely
to be trying to conceal their activity. In conducting the audit, the auditor would first need to
obtain an understanding of the company’s industry environment. An investigation of the
pertinent factors affecting the industry should lead to the realization that landfill permits were
becoming difficult to obtain. From this fact, an auditor should take the next step and ask
management and other key personnel if any landfills were materially impaired or abandoned
during the year.

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 It would also be relevant to review Board of Director’s minutes. For example, the auditor
could then vouch that amounts included in deferred asset accounts on the balance sheet
corresponded to interest capitalization of landfills that were not abandoned or impaired. If the
auditor learns that a landfill was impaired or abandoned, he/she would trace the unamortized
costs of that landfill to inclusion as an immediate expense. The auditor would also look for
appropriate disclosure in the financial statements. As an auditor, netting can be detected with a
careful audit of asset dispositions. In conducting such an audit, the auditor needs to first test the
asset disposal list for completeness. Once the completeness of the list has been audited, the
auditor can then sample from the list of asset dispositions for detail testing. For each disposition
selected, the auditor would then need to corroborate the sale price for the asset. Once the sale
price was corroborated, the auditor would then have to calculate whether a gain or loss was
realized from the sale of the asset. Next, the auditor would have to trace any gain or loss into its
proper recording in the income statement. This set of audit procedures would detect whether any
gain was actually used to offset expenses, as opposed to being properly recorded on the income
statement as a gain on sale of assets.

5. Consider the decision by CFO James Koenig and Corporate Controller Thomas Hau to
phase in the new GAAP method to capitalize interest expense over three years. Do you
believe that this decision was in the best interests of the shareholders in the long run?
Why or why not?

No, I do not believe that the decision to phase in the new GAAP method to capitalize interest
expense over three years was in the best interest of the company’s shareholders. Stated simply,
the use of accounting methods that are not in accordance with GAAP provide a false and
misleading picture of the company’s true financial position and results of operations. As a result,
the use of these accounting methods was ultimately going to have a severe negative impact on
shareholders, which of course they did.

6.

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 CASE 2.2-Waste Management: Due Care.
1. What is auditor independence and what is its significance to the audit profession? In
what ways was Arthur Andersen’s independence potentially impacted on the Waste
Management audit?

According to the second general standard of Generally Accepted Auditing Standards, “In all
matters relating to the assignment, an independence in mental attitude is to be maintained by the
auditor or auditors.” Unfortunately, the facts of the case reveal numerous issues that suggest that
Andersen's independence may have been compromised on the Waste Management audit.

For example, at Andersen, the compensation of partners depended on their ability to cross-sell
other services to its audit clients. More than half of the fees for Waste Management were
charged for non-audit services. The size of the non-audit fees would likely have made it hard for
the Andersen partners to challenge Waste Management's team on the difficult accounting issues.

In addition, more than fourteen former Arthur Andersen accountants were working at Waste
Management. Several were in senior executive positions, including Thomas Hau, the chief
accounting officer. Another concern is how Robert Allgyer was chosen for the engagement. He
was chosen based on his personal style that fit well with the Waste Management officers.

Article IV of the AICPA Code of Conduct (Objectivity and Independence) states: “A member in
public practice should be independent in fact and appearance when providing auditing and other
attestation services.” Close relationships might affect independence in appearance, even if
independence in fact is maintained. Clearly there was cause for concern at Waste Management.

2. Consult Paragraphs 3 6 of Quality Control Standard No. 20 (QC 20).Considering the

example in the Waste Management case, please explain why a review by the Practice
Director and Audit Division Head is important in the operations of a CPA firm. In your
opinion, was this review effective in the present context? Why or why not?

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A review by the Practice Director and Audit Division Head serves as a quality control
mechanism for the audit as the work of the engagement partner and concurring partner are
reviewed. Since the practice director and audit division head are not directly involved with the
engagement, each professional is in a position to provide an unbiased opinion on all work
completed.

This type of review is important because of the specialized knowledge possessed by each
professional. Thus, this review, if conducted effectively, can reduce the exposure of the firm to
financial loss resulting from litigation, customer complaints and loss of reputation due to
intentional or unintentional errors in an individual engagement. Indeed, an effective control of
this type helps to ensure that individual partners conform to a firm’s “best practices” and that
GAAP was properly and consistently applied on the engagement.

In this case, the review does not appear to have been effective as Andersen issued an unqualified
opinion on Waste Management when misstatements of $128 million or 12% of net income were
not deemed material by Andersen.

3. Consult Paragraph 7 of PCAOB Auditing Standard No. 13. Do you believe that
Andersen’s final decision regarding the PAJE’s was appropriate, under the
circumstances? Would your opinion change if you knew that all of the adjustments were
based on subjective differences (e.g., a difference in the estimate of the allowance for
doubtful accounts), as compared to objective differences (e.g., a difference in the account
receivable balance of their biggest customer)?

PAJEs or Proposed Adjusting Journal Entries refer to the adjustments recommended by the
auditors for the client’s financial statements to comply with GAAP. These entries are used as a
mechanism to correct an account balance that is not recorded in accordance with GAAP. The
decision made by Andersen regarding the PAJEs was inappropriate under the circumstances
because the differences would likely have mattered to financial statement users. Andersen
partners had a high level of professional training and experience in adhering to professional
standards. As a result, it is surprising that they did not require the adjustments to be recorded.
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Because of the magnitude of the adjustments, taken together, it probably would not have
mattered if the adjustments were based on subjective as compared to objective differences
discovered by Andersen. It is important to point out that the PAJE’s resulted in an overstatement
of net income by 12 percent. So, regardless of subjective differences or objective differences,
the proposed adjustments were material in nature and would have resulted in a change in
earnings per share. It is however important to point out that the subjective differences often lead
to negotiation between the auditors and the client, where the objective difference typically do
not. And, it is during these negotiations where an auditor’s independence is truly put to the test.
This is a terrific opportunity to bring up this tension in class and illustrate the difficulties of
maintaining an independent and objective mind as an auditor.

4. Refer to Section 203 and Section 206 of SARBOX. How would these sections of the law
have impacted the Waste Management audit? Do you believe that these sections were
needed? Why or why not?

Section 203 of the Sarbanes-Oxley Act requires audit partners to rotate off an audit engagement
after five years. Section 206 says that the CEO, Controller, CFO, Chief Accounting Officer or
person in an equivalent position cannot have been employed by the company’s audit firm during
the 1-year period (“the cooling off period”) proceeding the audit.

Many believe that this law goes far enough, and that the audit firm itself should not have to
rotate off an audit engagement every five years. Arguments against the rotation of the audit firm
argue that forcing audit firm rotation every five years would be too chaotic and the costs for both
audit firms and clients would be significant. Audit firms incur substantial costs in the first
couple years of an audit engagement as they are acquiring information about the firm, its
industry and its internal control system for the first time. Requiring audit firms to switch every
five years would inflate audit costs as firms would constantly be in the process of performing due
diligence and researching their clients. The inflated costs of performing the audit would
undoubtedly be passed onto clients. Another argument against audit firm rotation is that
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requiring firms to switch may be counterproductive in that fraud may actually be harder to find
as the new audit firm is not as familiar with the client’s business processes, risks, and attitude of
management.

Waste Management had several employees who were formed employees of Arthur Andersen. In
addition, every chief financial officer and chief accounting officer at Waste Management until
1997 was a former auditor of Andersen. Section 206 of SOX would have affected Waste
Management’s chief officers since the former Andersen employees would have had to wait at
least one year before stepping into the position.

Arguments supporting section 203 and 206 believe these sections are needed in order to keep a
respectable distance between the client and audit firm. Rotating partners every 5 years will make
it harder for employees of the audit firm to create close relationships with employees at the client
company. This distance helps create an image of independence. Section 206 also supports the
argument of independence. By requiring former audit employees to wait one year before
stepping into a “C” position it creates an image of independence. The former employee can take
time off the engagement and employees still on the engagement have time to make changes to
procedures and such; this way the former employee does not know every procedure being done
and is at a far enough distance to be “out of the loop.” If the former employee stepped into the
position right away he would know all of the audit procedures being used and could inform other
members of management of how to hide fraud and other scandals from the auditors.

The key arguments against section 203 and 206 support the overarching belief that rotating
partners is too costly. A student may argue that if partners are rotated every 5 years there will
always be a learning curve which will slow down the audit, creating higher costs for clients and
audit firms. A student may also argue that making a former employee wait at least one year
before stepping into an influential position at the former client is costly to the client. In addition,
a student may argue that it is better for the former audit employee to be in the position right away
this way no current knowledge of the company is lost.

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 CASE 3.7-Waste Management: Understanding the
client’s business and industry.
1. Consult Paragraphs 5-8 of PCAOB Auditing Standard No. 8 and Paragraphs 7-10 of
PCAOB Auditing Standard No. 12. Based on your understanding of inherent risk
assessment and the case information, identify three specific factors about Waste
Management that might cause you to elevate inherent risk. When identifying each factor,
indicate the financial statement account that is likely to be most affected (and briefly
discuss why it is most affected)

PCAOB AS No. 8, paragraphs 5-8 discuss risk of material misstatement. They indicate that
“inherent risk, which refers to the susceptibility of an assertion to a misstatement, due to error or
fraud, that could be material, individually or in combination with other misstatements, before
consideration of any related controls”. Risks of material misstatements at the financial statements
level may be especially high due to fraud if management of a company is under pressure to meet
deadlines and represents the company financial statements in the best light possible. Inherent risk
relates to company’s environment and its internal controls.

PCAOB AS No. 12, paragraphs 7-10 talk about the importance of an auditor to obtain an
understanding of a company and its environment in order to conduct thorough audit and assess
effects of different events on the company and how these events influence the risks of material
misstatement. It is also important to obtain an understanding on the industry, regulatory and
other external factors such as the competitive environment, the regulatory environment, legal &
political environments and other external conditions.

Based on the above information and our analysis of the case, we came to a conclusion that the
management of the Waste Management Company had elevated inherent risks due to the
following three factors:

 During recession, the executives of Waste Management set aggressive goals for revenue
and net income growth. This factor would elevate the inherent risk of misrepresentation
of accounts receivables/cash and bad debt accounts.

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  New government regulations made the process of obtaining landfills more costly and
lengthy. This factor can influence company’s revenue and therefore increase the risk of
misstatement of revenue accounts.
 International expansion factor increases the risk of currency exchange misrepresentation.

2. Consult Paragraphs 29 and 32 of PCAOB Auditing Standard No. 5. Identify the types of
revenue earned (a brief description will do) by Waste Management. Do you believe that
any of the different types of revenue earned by Waste Management might be subject to
significantly differing levels inherent risk? Why or why not?

PCAOB AS No. 5, paragraph 29 discusses the importance of identification of significant account

in a company and lists out nine specific risk factors: 1) Size and composition of the account; 2)
Susceptibility to misstatement due to errors or fraud; 3) Volume of activity, complexity, and
homogeneity of the individual transactions processed through the account or reflected in the
disclosure; 4) Nature of the account or disclosure; 5) Accounting and reporting complexities
associated with the account or disclosure; 6) Exposure to losses in the account; 7) Possibility of
significant contingent liabilities arising from the activities reflected in the account or disclosure;
8) Existence of related party transactions in the account; and 9) Changes from the prior period in
account or disclosure characteristics. PCAOB AS No. 5, paragraph 32 indicated the possibility
that the components of significant accounts or disclosures might be subject to significantly
different risks. Therefore, different controls might be necessary to identify these risks.

Waste Management earns revenue from its four lines of newly reorganized business: waste
services, clean energy, clean water, environmental and infrastructure engineering and consulting.
Waste Management also provides these services internationally. These revenue types are very
likely to have different inherent risks. Waste Management will have higher inherent risks with
waste services due to the intense competition and excess landfill capacity in some of its markets.
Elevated inherent risk also exists with the services provided abroad. The exchange of foreign
currency to the U.S. dollars could potentially increase risk of misstatements.

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 3. Consult Paragraphs 8-10 of PCAOB Auditing Standard No. 13. Comment on how your
understanding of the different types of revenue earned (in Question 2) would influence
the nature, timing, and extent of your audit work at Waste Management.

PCAOB AS No. 13 paragraphs 8-10 discuss the importance of attention that should be devoted
to any particular area where a material weakness could appear. The nature, timing and extent of
auditor’s work should change depending on the risk assessment as “the auditor should design and
perform audit procedures in a manner that addresses the assessed risks of material misstatement
for each relevant assertion of each significant account and disclosure.” Designing his/her
procedures, the auditor should take into account the type of misstatement that could occur and
adjust his/her procedures according to the risk assessment. Depending of the nature of the risk,
the auditor should adjust the tests of controls and substantive tests.

Based on our review of the different types of revenues earned it is clear that each type of revenue
is likely highly likely to have different inherent risks. Therefore, the auditor should increase the
nature, timing and extent of his work for the waste services and the international services. This
means performing extensive tests of controls that should be carried several times a year with an
interim and an audit at the close of the financial year.

4. Consult Paragraphs 52-53 of PCAOB Auditing Standard No. 12. For one of Waste
Management's revenue sources (please choose one), brainstorm about how a fraud might
occur. Next identify an internal control procedure that would prevent, detect, or deter
such a fraudulent scheme.

PCAOB AS No. 12 paragraph 52 talks about how the engagement team members should conduct
their discussions regarding “the potential for material misstatement due to fraud should occur
with an attitude that includes questioning mind, and the key engagement team members should
set aside any prior beliefs they might have that managements is honest and has integrity”.

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PCAOB AS No. 12 paragraph 53 indicates that auditors need to have a “questioning mind” and
exercise “professional skepticism” throughout the audit process, including gathering and
evaluating evidence.

One of the Waste Management’s revenue sources that have a high potential for fraud is the waste
services and especially the solid waste collection from commercial and industrial customers. The
complexity of solid waste collection contracts “under one to three-year service agreements” may
lead to fraud. Waste Management could record revenue from an inexistent contract or a former
client that has not renewed its contract. The firm could also proceed in early revenue recognition
for contracts overlapping several financial periods. That would lead to a material misstatement
on revenue recognition.

The firm’s managements should implement a preventive control that will check and validate the
contracts’ status and verify their occurrence. In order to prevent a potential fraud, a detective
control between the sales journal and the original contracts could be done in order to detect any
fraud linked with contracts complexity.

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 CASE 4.2-Waste Management: General Computing
Controls.

1. What is the difference between an information technology general control and an automated
application control? Provide an example of each in your response.

ITGC represent the foundation of the IT control structure. They help ensure the reliability of data
generated by IT systems and support the assertion that systems operate as intended and that output is
reliable. ITGC usually include the following types of controls:
 Control environment, or those controls designed to shape the corporate culture or "tone at the
top."
 Change management procedures - controls designed to ensure the changes meet business
requirements and are authorized.
 Source code/document version control procedures - controls designed to protect the integrity of
program code
 Software development life cycle standards - controls designed to ensure IT projects are
effectively managed.
 Logical access policies, standards and processes - controls designed to manage access based on
business need.
 Incident management policies and procedures - controls designed to address operational
processing errors.
 Problem management policies and procedures - controls designed to identify and address the
root cause of incidents.
 Technical support policies and procedures - policies to help users perform more efficiently and
report problems.
 Hardware/software configuration, installation, testing, management standards, policies and
procedures.
 Disaster recovery/backup and recovery procedures, to enable continued processing despite
adverse conditions.

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  Physical security - controls to ensure the physical security of information technology from
individuals and from environmental risks.

Automated application control

Application controls refers to the transactions and data relating to each computer-based application
system and are, therefore, specific to each such application. The objectives of application controls,
which may be manual or programmed, are to ensure the completeness and accuracy of the records and
the validity of the entries made therein.
Application controls are controls over the input, processing, and output functions. From the 30,000 foot
view they include things like:
 Ensure the input data is complete, accurate and valid
 Ensure the internal processing produces the expected results
 Ensure the processing accomplishes the desired tasks
 Ensure output reports are protected from disclosure

From the close inspection view they include such things as:
 Edit tests
 Control totals/batch balancing
 Reconciliation of accounts
 Exception handling
Both automated controls and manual procedures should be used to ensure proper coverage. These
controls help ensure data accuracy, completeness, validity, verifiability, and consistency, and thus
ensure the confidentiality, integrity and availability of the application and its associated data.

2. Consult Paragraphs 36-37 of PCAOB Auditing Standard No. 5. Do you believe that information
technology general controls have a pervasive effect on the reliability of financial reporting at an
audit client like WMI? Why or why not? Please be specific.

Information technology general controls do have a pervasive effect on the reliability of financial
reporting because it impacts so many automated application controls and manual controls that are

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dependent on information generated by the technological infrastructure. For example, information
technology general controls over program development, program changes, computer operations, and
access to programs and data help ensure that specific automated application controls over the
processing of transactions are operating effectively. Stated simply, the proper functioning of automated
application controls is dependent on effective ITGCs to provide a secure environment for functioning.
Information technology general controls also have a pervasive effect on the reliability of financial
reporting as such controls directly impact computerized accounting calculations, and any other control
procedures that depend at least in part on information generated from the computerized system. As
such, information technology controls would definitely have a pervasive impact on the reliability of
financial reporting at WMI. In the case, the successful integration of the billing systems between Waste
Management and USA Waste Service is shown to be important to the success of the merger. Several
additional information systems were created in order to provide more timely financial statements as
well as increase the efficiency and effectiveness of the flow of transactions between information
systems. When these systems were not operating effectively, management was unable to access timely
financial information to make effective decisions and monitor business operations

3. Consult Paragraphs B28-B31 (in Appendix B) of PCAOB Auditing Standard No. 5. Define what is
meant by a benchmarking strategy. Based on the case information, do you believe that a
benchmarking strategy would have been appropriate during the first year audit at WMI? Why or
why not?

According to paragraph B28, “Entirely automated application controls are generally not subject to
breakdowns due to human failure. This feature allows the auditor to use a "benchmarking" strategy.” A
benchmarking strategy allows the auditor to rely upon the results of testing in a prior year to provide
evidence about the effectiveness of an automated application control in the current year. According to
paragraph B29, “If general controls over program changes, access to programs, and computer
operations are effective and continue to be tested, and if the auditor verifies that the automated
application control has not changed since the auditor established a baseline (i.e., last tested the
application control), the auditor may conclude that the automated application control continues to be
effective without repeating the prior year's specific tests of the operation of the automated application
control.”

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 4. Consult paragraph A4 (in Appendix A) of PCAOB auditing standard No.5. Given the PCAOB’s
views, do you believe that the audit firm should be providing assurance on the information
contained in public company press releases? Why or why not?

Paragraph A4 sets the boundaries for the auditor's evaluation and testing of the internal control system.
Specifically, the answer states that the audit of internal control does outside a company’s GAAP-basis
financial statements and notes.” It is clear that the technical guidance does not require auditors to audit
this type of information. According to the SEC, the pro forma information would be considered outside a
company’s GAAP-basis financial statements and notes and would not be subject to auditor evaluation
and testing. 1 However, the situation does give rise for an interesting class discussion. Arguments for
positive assurance on information contained in public company press releases:

 Companies are providing information about future earning which would greatly influence a
stock holder’s financial decision to keep or sell their shares. Thus, assurance should be provided.
The bottom line is that press releases are utilized by companies to provide information to
financial statement users and the public (just like financial statements), therefore assurance
should be provided on them.
 Press releases have a direct effect on a company’s future reputation and forecasts.
 Press releases have an impact on financial analysts' recommendations to the marketplace,
which influence investors. So, assurance should be provided.

Arguments against providing assurance on information contained in public company press releases:

 Press releases typically only contain information in piecemeal fashion and thus do not provide
an overall view of the company’s financial position. Thus, assurance is not necessary.
 Press releases on future earnings and future transactions cannot be assured due to
unpredictable future events. This would open the door for substantial litigation.
 Investors and analysts should not be relying on the information provided in the press release
because they should know that the information has not been audited.

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 CASE 4.5-Waste Management: Top-Side adjusting
journal entries.
1. Consult paragraph 14-15 of PCAOB auditing standard No. 13. If you were auditing
Waste Management, what type of documentary evidence would you require to evaluate
the propriety of such a top-side adjusting journal entry?

Because top-side journal entries and typically made by senior management at the end of
reporting period, I would first want to schedule the audit at the end of the period because these
types of journal entries are a chance of fraud. The case clearly shows the lack of control over the
journal entries.

2. Consult paragraph 14 of PCAOB auditing standard NO. 5. Based on the case information,
do you think this paragraph relates to the use of top-side adjusting journal entries at an
audit client like Waste Management? Why or why not?

Yes. The policy suggests that the auditor should take into account the result of his or her fraud
risk assessment. The fraud risk assessment should address the risk of management overrides and
other controls

3. Consult paragraph 26-27 of PCAOB auditing standard No. 5 and paragraph 41 of

PCAOB auditing standard No. 13. Do you believe that the period end financial reporting
process should always be evaluated by auditor as a significant and material process and
during an audit of internal control? Why or why not?

Paragraphs 26-27 of Standard No. 5 highlight the importance for auditors to understand and
evaluate the period-end financial reporting process at a detailed level. Indeed, according to
paragraph 26, because of its importance to financial reporting and to the auditor's opinions on
internal control over financial reporting and the financial statements, the auditor must evaluate
the period-end financial reporting process. The period-end financial reporting process includes
the following:
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• Procedures used to enter transaction totals into the general ledger;

• Procedures related to the selection and application of accounting policies;

• Procedures used to initiate, authorize, record, and process journal entries in the general ledger;

• Procedures used to record recurring and nonrecurring adjustments to the annual and quarterly
financial statements;

• Procedures for preparing annual and quarterly financial statements and related disclosures.”

4. Consult paragraph 71--72 of PCAOB auditing standard No. 12. Identify one specific
control procedure that could prevent or detect a misstatement related to a top-side
adjusting journal entry.

One specific control procedure that could be designed to prevent a misstatement related to a top-
side adjusting entry from occurring would be to involve management from the operating units in
the decisions to make all top-side adjusting entries related to their own operating units. For
example, the company can implement a policy that both the top corporate executives and the
management from the operating units must sign off on the entries. Another specific control
procedure that could be designed to detect a misstatement that originated from a top-side
adjusting entry would be to require that all significant top-side entries be reviewed by the audit
committee.

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 CASE 5.6-Waste Management: Valuation of Fixed
Assets.
1. Consult paragraph 65 69 of PCAOB auditing standard no. 12. Based on your
understanding of fraud risk assessment, what three conditions are likely to be presented
when a fraud occurs (i.e., the fraud triangle)? Based on the information provided in the
case, which of these three condition was most prevalent at waste management and why?

The three conditions which comprise the “fraud triangle” are as follows:

 The first condition recognizes that an employee or a manager of a company is likely to

either have incentives in place or be under significant pressure to achieve specific
estimates, forecasts, or expectations.
 The second condition recognizes that in order for a fraud to be carried out, the internal
control environment must provide an opportunity for an employee or a manager of a
company to commit a fraudulent act. In order to have an opportunity to commit fraud,
there must be a weakness in the operating effectiveness of a control or a non- existent
control.
 The third condition recognizes that for an employee or a manager of a company to
perpetrate a fraud, the individual must possess an “attitude” that allows them to
rationalize that they are knowingly committing a crime.

2. Consult paragraph 26-27 of PCAOB auditing standard No. 5 and paragraph 41 of

PCAOB standard 13. Do you believe that the period-end financial reporting process
deserves special attention from auditors? Why or why not?

Paragraphs 26-27 of Standard No. 5 points the importance for auditors to understand and
evaluate the period end financial reporting process at a detailed level. According to paragraph 26,
“because of its importance to financial reporting and to the auditor's opinions on internal control
P a g e 22 | 32
over financial reporting and the financial statements, the auditor must evaluate the period end
financial reporting process. The period end financial reporting process includes the following:

 Procedures used to enter transaction totals into the general ledger.

 Procedures related to the selection and application of accounting policies
 Procedures used to initiate, authorize, record, and process journal entries in the general
ledger
 Procedures used to record recurring and nonrecurring adjustments to the annual and
quarterly financial statements
 Procedures for preparing annual and quarterly financial statements and related
disclosures.

Paragraph 27 describes what the auditor should evaluate when obtaining an understanding and
evaluating the period end process. As part of evaluating the period end financial reporting
process, the auditor should assess:

 Inputs, procedures performed, and outputs of the processes the company uses to produce
its annual and quarterly financial statements
 The extent of information technology ("IT") involvement in the period end financial
reporting process
 Who participates from management
 The locations involved in the period end financial reporting process
 The types of adjusting and consolidating entries

The nature and extent of the oversight of the process by management, the board of directors, and
the audit committee. This process absolutely deserves special attention from auditors. It is
absolutely critical, that students recognize the importance of this process.

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 3. Consult sections 204 and 301 of SARBOX. What is the role of the audit committee in the
financial reporting process? Do you believe that an audit committee can be effective in
providing oversight of the management team at waste management?

It is important to note that paragraph 69 of Auditing Standard No. 5 explicitly notes that
ineffective oversight of the company's external financial reporting and internal control over
financial reporting by the company’s audit committee is an indicator of a material weakness in
internal control over financial reporting. This of course has elevated the importance of the audit
committee. In addition, the audit committee plays an important role as a liaison with a
company’s auditor. According to Section 301 of SOX, the audit committee of an issuer shall be
directly responsible for the appointment, compensation, and oversight of the work of any
registered public accounting firm employed by that issuer. Moreover, according to Section 204,
the auditing firm must report all critical accounting policies and practices and all alternative
treatments of financial information within GAAP that have been discussed with management as
well as the ramifications of the use of such alternative disclosures and treatments, and the
treatment preferred by the auditing firm. This is an important component of the oversight role
played by the audit committee. For Waste Management, the audit committee can absolutely be
effective in helping to insure fair and accurate financial reporting. Organization’s tone at the top
is properly established. In addition, an audit committee can take great care to review all top-side
adjusting journal entries made by management at the end of the financial reporting process. In
addition, an audit committee can have important input into the compensation policies at an audit
client. That is, the audit committee can help insure that an organization is not providing extra
incentives to managers

4. Consult sections 302 and 305 and title IX of SARBOX. Do you believe that these will
help deter fraudulent financial reporting by a top management group such as the waste
management? Why or why not?

According to section 302 of SORBOX, in the post-Sarbanes audit environment, the CEO and
CFO of each issuer must now prepare a statement to accompany the audit report to certify the

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appropriateness of the financial statements and disclosures contained in the periodic report, and
that those financial statements and disclosures fairly present, in all material respects, the
operations and financial condition of the issuer. If a CEO or CFO violates this section, he/she can
be held criminally liable. Essentially this statement holds the CEO and the CFO personally liable
for the assertions that they have made within the financial statements. And, under Title IX of
SARBOX, the maximum penalty for filing false financial statements with the SEC for willful
and knowing violations are a fine of not more than $5,000,000 and/or imprisonment of up to 20
years. This is an absolutely critical point that must be made to answer this question. The bottom
line is that crime does not pay. Imprisonment and financial penalties have been established to
deter an upper management group from committing fraudulent activity. A further illustration of
the point that crime really does not pay can be found in Section 305 of SARBOX. According to
Section 305, if a company is ultimately required to restate their financial statement with the SEC
due to material noncompliance with financial reporting rule, the CEO and CFO are now required
to reimburse the issuer for any bonus or other incentive-based or equity-based compensation
received during the twelve months following the issuance or filing of the noncompliant
document and any profits realized from the sale of securities of the issuer during that period.
Given the changes brought upon by SARBOX, these new provisions are likely to deter
fraudulent behavior. Stated simply, the penalties are severe and if it is found that such an upper
manager did profit from a fraudulent act, the law now provides a clear mechanism to get the
money back, not only to repay the financial benefit but also to incur punitive penalties as well,
amounting to financial penalty and jail time.

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References

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