Deck 3: WorldCom: The Revenue Recognition Principle

Question 1

Consider the principles, assumptions and constraints of Generally Accepted Accounting Principles (GAAP). Define the conservatism constraint and explain why it is important to users of financial statements.

Answer 1

GAAP:
GAAP is a generally accepted accounting principle. It is the set of accounting principles and standards. It was issued in 1973 for US public and private companies by the financial accounting standard board for issuing a public statement.
It is the set of accounting guidelines lines and rules used by the companies for financial reporting.
Conservatism constraint:
Conservatism constraints use by an accountant when all other accounting theories and principles failed to provide guidance to an accountant. It is a principle that guides how to record uncertain events and estimates. It is a financial reporting approach outlined by the FASB.
This principle applies to estimates like an allowance for doubtful accounts, other unknown future events. Most of the companies minimized profit by recording uncertain losses and not recording estimated gains. The GAAP and accounting standards concerned the usefulness of financial data to the users of financial statements.
This state when there is a doubt to report information that does not overstate or understate income, assets, liability, and expenses. The financial accounting standard board does not want the error or overestimation in the financial information. It can sway the decision of the users.

Question 2

Consider the significant year-end transactions consummated by BFA. Do you believe that the accounting for these transactions violated the conservatism constraint? Why or why not? Please be specific when answering the question.

Answer 2

Generally Accepted Accounting Principles (GAAP):
It is a set of generally accepted rules that are followed in the field of accounting for reporting financial statements. They are applied so as to establish relevance, understandability, comparability and reliability amongst the financial statements that are produced around the world in different countries. These principles help in standardising the basic rules of accounting for an entity.
The year end large transactions made through the years is a violation of the concept of conservatism. BFA had invested in a lot of properties as down payments indirectly, but it can be tracked back to company and that is against GAAP's rule of being considered as a gain. To be considered as a gain in this transaction, the seller cannot be a part of lending or contributor to the purchase of the house. Here in this case, BFA is forming to be a part of the buyer's contribution. By paying the down payments, the firm is investing in future prospective income, which is against the conservatism concept. Not being able to sell the houses, the firm faces a huge loss. If the law of conservatism was followed, then the firm would not have invested in so many houses consecutively.

Question 3

Consult Paragraph 2 and Paragraph A5 (in Appendix A) of PCAOB Auditing Standard No. 5. Do you believe that BFA had established an effective system of internal control over financial reporting related to its significant year-end transactions? Why or why not?

Answer 3

Internal Financial Controls include:
1. Operational Controls.
2. Fraud Prevention Controls.
3. Internal Controls over Financial Reporting
Internal Controls over Financial Reporting are the controls that ensure that, transactions recorded in the books of accounts, shall be -
1. Authorized by the appropriate level of management for example - Some transactions would require authorization from the management, whereas some transactions would require approval from the Director/CEO
2. Recorded accurately in monetary terms.
3. Processed properly in accordance with the standard operating procedures of the organization
Essentially, they are controls relating to books of accounts and financial reporting. They include within their wide scope, safeguarding of assets, and authorization of transactions, maintenance of records and preparation of financial statements.
In the current case, BFA has entered into significant year end transactions with its related parties leading into significant decrease in the valuation of its net assets.
This approach results into fraudulent financial reporting.
The auditor needs to ensure the following:
1. Understanding the terms of the transactions, ensuring that the agreements do not result into misappropriation of assets.
2. The transactions have been recorded in accordance with GAAP.
3. The transactions have been disclosed appropriately.
4. In depth verification should be done for transactions which are not entered into in the normal course of business.
5. The transaction with related parties should not be biased.
6. All the relevant documents and contracts shall be inspected.
7. The auditor needs to verify whether anys transactions have been entered into which would impact the valuation of the assets and liabilities which results into window dressing.

Question 4

Consult Paragraphs.21-.22 of AU Section 326. Consider the sale of the Santa Fe Trails Ranch II stock by Foundation Investments to Friend. Do you believe that the auditor should have completed any additional testing beyond vouching the payment received from Friend? Provide the rationale for your decision.

Question 5

Consider the role of president at BFA. Next, assume that as president, you are representing the upper management team at the Foundation's annual meeting. During the question-and-answer session, an investor asks you to justify the creation of ALO and whether the real estate transactions between BFA and ALO were legitimate. Develop a response that could potentially satisfy the investor's curiosity. Next, state the type of documentary evidence you would request if you were the investor.