Case 1.1-Waste Management: The Expense Recognition Principle

Case 1.1-Waste Management: The Expense Recognition Principle

1 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Case #1.1–Waste Management: The Expense Recognition Principle

I.Technical Guidance To maximize a student’s knowledge acquisition of this material, this book has been designed to be read in conjunction with the post–Sarbanes-Oxley technical audit guidance. All of the PCAOB Auditing Standards that are referenced in this book are availablefor free at http://pcaobus.org/STANDARDS/Pages/default.aspx. In addition, a summary of the provisions of the Sarbanes-Oxley Act of 2002 is available for free on the book’s website at

www.mhhe.com/thibodeau4eor athttp://www.aicpa.org/Pages/Default.aspx.

II.Recommended Technical Knowledge Conceptual Framework The Expense RecognitionPrinciple (sometimes referred to as the Matching Principle) PCAOB Auditing Standard No. 5 Paragraph #2 PCAOB Auditing Standard No. 15 Paragraphs #5-6 III.Classroom Hints This case provides students with an opportunity to appreciate the difficulty that can be associated with auditing the application of depreciation rules to different types of assets at an audit client. Since the computation of depreciation expense requires management to estimate the salvage value and the estimated useful life for each asset depreciated, an auditor is often forced to evaluate a number of subjective factors when completing his/her procedures. To properly do so, students are able to see that an auditor must first understand the true economic substance of management's estimates for both salvage value and the estimated useful life. After gaining this understanding, the auditor must then determine whether the client has properly calculated and recorded depreciation expense in accordance with the economically appropriate estimates. Of course, each of these judgments must be made based on sufficient and competent evidence. In Auditing and Accounting Cases Investigating Issues of Fraud and Professional Ethics 4th Edition Thibodeau Solutions Manual Visit TestBankDeal.com to get complete for all chapters

Case 1.1-Waste Management: The Expense Recognition Principle

2 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.addition, the case provides a mechanism to illustrate the importance of identifying relevant financial statement assertions and identifying the related control activities that are designed to prevent and/or detect fraud in the post-Sarbanes audit environment. Finally, the case provides an opportunity for instructors to highlight the responsibility of management and the board of directors for an effective internal control system in the post-Sarbanes audit environment.We believe it is essential for students to carefully read over the recommended technical knowledge, along with this case reading. The educational psychology literature suggests that the acquisition of technical/factual type knowledge increases dramatically when such knowledge can be applied in a realistic context.This case assignment will work best ifitis used at the time when instructors cover the purchasing process, the fixed asset process or the audit of depreciation expense. Alternatively, the case can be used when instructors cover the audit evidence topic or when instructors discuss the ways in which a management team can perpetrate a fraud. Indeed, because of the subjectivity associated with the estimate of an asset’s useful life and salvage value, the account can be used by management as a mechanism to help smooth earnings and/or perpetrate fraudulent activity. As a result, we recommend that instructors spend time in class reviewing the impact that an increase in salvage value and/or an increase in depreciable life can have on reported earnings. This discussion should help students conceptualize how the application of depreciation rules can be used as a mechanism to perpetrate fraudulent activity.Importantly, the goal of the previous discussion is not necessarily to make sure that students are experts in auditing recorded depreciation expense at an audit client with significant investments in fixed assets. Rather, we believe that it is important to point out to students that they willencounter difficult financial statement accounts to audit in their role as an auditor.

Case 1.1-Waste Management: The Expense Recognition Principle

3 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Therefore, when such an account is encountered, students must take the time to fully understand the nature and economic substance of the account. The professional judgment that is involved in auditing a difficult financial statement account also provides an opportunity for instructors to remind students of the importance of being unbiased and objective when making their audit judgments. Indeed, we believe that it is helpful to consistently remind students of their responsibility to maintain an attitude of professional skepticism throughout the audit process.Indeed, one of the primary goals of the Sarbanes-Oxley Act of 2002 was to take steps to improve the independenceand objectivity of the audit process (e.g., Section 201). As such, we encourage instructors to take this opportunity to remind students of their responsibility.This case also provides an opportunity for instructors to highlight the increased responsibility that management now has for effective internal controls under the Sarbanes-Oxley Act of 2002 (SARBOX). Under Section 404 ofSARBOX, management is responsible for establishing and maintaining an effective internal control system that is designed to support reliable financial statement reporting. In addition, management must undertake a process whereby they assess the effectiveness of their own internal control system each year. Given this increased responsibility, it is amazing for students to see that the management team and Board of Directors at Waste Management actually ignored the recommendation made by Arthur Andersen to conduct a site by site analysis of their landfills. In the post-Sarbanes environment, this is clearly a process that would haveto be in place to insure reliable financial reporting.Finally, this case provides an opportunity to highlight the importance of identifying the relevant financial statement assertions about a significant financial statement account, a critically important task in the post-Sarbanes environment. The discussion of student responses to question #3 provides instructors with an opportunity to discuss this point. In addition, the

Case 1.1-Waste Management: The Expense Recognition Principle

4 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.discussion of student responses to question #3 provides an opportunity for instructors to highlight the importance of being able to identify an internal control activity that is explicitly designed to support reliable financial statement reporting for a particular financial statement assertion. Once again, the knowledge required to link an internal control activity to the financial statement assertion is essential in the post-Sarbanes audit environment. Thus, we encourage instructors to take the time to make this linkage explicit for students in the present context.IV.Assignment Questions & Suggested Answers 1.Consider the principles, assumptions and constraints of Generally Accepted Accounting Principles (GAAP). Define theexpense recognition principle (sometimes referred to as matching principle)and explain why it isimportant to users of financial statements.According to the expense recognition 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 hasa 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 measureof the profitability and performance of acompany. 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 expense recognition principle.

2.Based on the case information provided, describe specifically howWaste 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 costof assets over the useful life of the asset less the salvage value. When the management team at