Management Override Of Internal Control

Question 1

Management override

Answer 1

Management override of controls refers to instances where management uses its authority to bypass or manipulate internal controls, leading to fraudulent financial reporting. This is a significant risk because management is in a unique position to perpetrate fraud by manipulating accounting records and preparing fraudulent financial statements.

Management can override controls using various techniques, including:

1. Recording Fictitious Journal Entries:
   
   • Example: Creating fake sales entries at the end of an accounting period to inflate revenue.
2. Inappropriately Adjusting Assumptions:
   
   • Example: Changing assumptions used to estimate bad debt provisions to reduce expenses artificially.
3. Omitting, Advancing, or Delaying Recognition:
   
   • Example: Delaying the recognition of expenses to the next period to improve current period results.
4. Concealing Facts:
   
   • Example: Not disclosing contingent liabilities that could affect the financial statements.
5. Engaging in Complex Transactions:
   
   • Example: Structuring transactions to hide debt or inflate revenue.
6. Altering Records and Terms:
   
   • Example: Changing the terms of a contract to recognize revenue prematurely.

Auditors must design and perform specific procedures to detect and address the risk of management override of controls:

1. Testing Journal Entries:
   
   • Inquiries: Ask individuals involved in financial reporting about unusual activity.
   • Selection: Focus on journal entries made at the end of the reporting period.
   • Testing Throughout the Period: Consider testing entries throughout the period, not just at the end.
2. Reviewing Accounting Estimates for Bias:
   
   • Evaluate Judgments: Assess whether management’s judgments indicate a bias that could lead to material misstatement.
   • Retrospective Review: Look back at prior year estimates to identify any patterns of bias.
3. Evaluating Significant Unusual Transactions:
   
   • Business Rationale: Assess whether unusual transactions have a legitimate business purpose or are designed to misrepresent financial performance.

Scenario: A company is under pressure to meet earnings targets. The CFO decides to record fictitious sales at the end of the year to inflate revenue.

Audit Procedures:
- Journal Entry Testing: The auditor selects and tests journal entries made at the end of the year, looking for unusual or unsupported entries.
- Inquiries: The auditor asks the accounting staff about any unusual transactions or adjustments.
- Review of Estimates: The auditor reviews the assumptions used in significant estimates, such as bad debt provisions, for any signs of bias.
- Evaluation of Transactions: The auditor examines significant transactions outside the normal course of business to ensure they have a legitimate business purpose.

By understanding these concepts and procedures, auditors can better identify and mitigate the risks associated with management override of controls. If you have any specific questions or need further examples, feel free to ask!