Drafting a Memo over a Material Misstatement

Analyzing a Personal Accounting Ethical Situation

Material Misstatements

This memo is to address the fact that what appear to be material misstatements have appeared in our company’s financial statements.

As a publicly traded company, we have a legal and ethical duty to inform investors and stakeholders of potential fraud.

While our external auditor is unaware of these material misstatements, they have come to my attention and it as a legal accountant that it is my responsibility to inform you of them so that you may take the necessary steps of rectifying the matter.

In this memo, I will lay out the issues as they appear to me under PCOAB and AICPA rules and regulations as well as the State of Texas’ CPA rules, which I am bound by law to observe.

Following this overview, I will provide a brief list of recommendations of the actions that I believe the company would do well to consider as it takes its next steps in addressing this issue.

Legal Responsibilities

The PCAOB states under Auditing Standard No. 12:

“In an integrated audit, the risks of material misstatement of the financial statements are the same for both the audit of internal control over financial reporting and the audit of financial statements. The auditor's risk assessment procedures should apply to both the audit of internal control over financial reporting and the audit of financial statements.”

The AICPA under section 315.21 states:

“If during the audit or reaudit, the successor auditor becomes aware of information that leads him or her to believe that financial statements reported on by the predecessor auditor may require revision, the successor auditor should request that the client inform the predecessor auditor of the situation and arrange for the three parties to discuss this information and attempt to resolve the matter.” (AU 315.21)

An internal audit has been conducted and a material misstatement has been identified. According to the AICPA, it is therefore the legal responsibility of all parties to convene and resolve the issue.

Additionally, section 316.79 through 316.82 provides instructions on communicating potential fraud in material misstatements to management and those in charge of overseeing governance:

“Whenever the auditor has determined that there is evidence that fraud may exist, that matter should be brought to the attention of an appropriate level of management. This is appropriate even if the matter might be considered inconsequential, such as a minor defalcation by an employee at a low level in the entity's organization.” (AU 316.79)

And:

“The auditor also may wish to communicate other risks of fraud identified as a result of the assessment of the risks of material misstatements due to fraud. Such a communication may be a part of an overall communication with those charged with governance of business and financial statement risks affecting the entity and/or in conjunction with the auditor communication about the quality of the entity's accounting principles.” (AU 316.81)

It is not my intention at this time to report these findings to a third party; however, it may be that in spite of this warning, I may be obliged to report these findings to a third party, according to AICPA rules:

“The disclosure of possible fraud to parties other than the client's senior management and those charged with governance ordinarily is not part of the auditor's responsibility and ordinarily would be precluded by the auditor's ethical or legal obligations of confidentiality unless the matter is reflected in the auditor's report. The auditor should recognize, however, that in the following circumstances a duty to disclose to parties outside the entity may exist:

a. To comply with certain legal and regulatory requirements

b. To a successor auditor when the successor makes inquiries in accordance with section 315, Communications Between Predecessor and Successor Auditors

c. In response to a subpoena” (AU 316.82)

And from a personal point of view, I must bring attention to this issue because of the State of Texas CPA rules, under which I am bound, and which state that you and I both would be held accountable should this material misstatement proceed unchecked. I bring your attention to Sarbanes Oxley Act Provision 304:

“If a material misstatement occurs as a result of their misconduct, CEO and CFO must reimburse bonuses and incentive pay from prior 12 months.” (The Texas State Board of Public Accountancy)

Recommendations

I recommend that we meet to go over the material misstatements with the accounting team.

If it can be discerned with certainty that these statements are in fact inaccurate, the next step would be to determine if they are the result of error or fraud.

If the latter, certain steps will need to be taken to identify the root of the fraud; if the former, certain steps will need to be taken to ensure the error in processing has been adequately and appropriately addressed.

As the statements have already been released to the public, our internal investigation may result in the need for further publication so as to clarify the previous release.

This would be necessary out of respect for the law and stakeholder opinion.

However, let us first conclude our investigation into this matter with your assistance that we may be sure of the facts and nature of the statements as they currently stand.