The financial services industry is particularly hazardous for auditors lacking relevant experience. Fifty-seven percent of audit claims involved banks and lending institutions, where 34 percent arose from insurance company audits and 9 percent from audits of securities dealers.
Unlike large insurance companies, which are subject to federal regulatory oversight, smaller insurers are subject only to state regulation. Since state laws vary from state to state, small insurers are more likely to fail due to mismanagement, resulting in claims against external auditors. Of the insurance company audit claims in Florida, 42 percent alleged the financial statements were materially misstated or management fraud went undetected. In other cases some 33 percent alleged failure to detect a defalcation and 25 percent said claim reserves were misstated.
Common themes in these types of claims included allegations that the insurance company had set aside inadequate reserves by improperly classifying claims or making inaccurate actuarial estimates. When regulators liquidate an insurance company, they typically seek recovery from the company's directors/officers, the actuarial firm, and the external auditors.
The shareholders of small community banks and credit unions increasingly look to external auditors to alert them of fiscal mismanagement and fraud. Thirty-three percent of financial institution audit claims in Florida, alleged inadequate reporting or disclosures, 33 percent involved errors reviewing loan files or testing loans, 20 percent were material misstatements in financial statements, and 14 percent failed to detect defalcations.
In audit claims of manufacturers, 60 percent applied to overvaluation of assets in the financial statements, 17 percent failed to detect defalcations, 17 percent had inadequate disclosures, and 6 percent involved withdrawing from the engagement without issuing a report.
A Florida CPA firm audited the financial statements of a manufacturer that relocated to a municipality, which provided low-interest loans to finance the move. Within six months, the company went bankrupt, causing it to liquidate its remaining inventory to pay creditors for less than 32 percent of the value reflected in the financial statements.
The bankruptcy trustee sued the CPA firm, alleging that the statements materially overstated the inventory due to the auditor's failure to consider obsolescence and the inventory's physical condition. The investigation further revealed the firm had not done sufficient testing to determine inventory value and did not validate the cost of component parts included in work-in-process calculations. These problems led to a settlement before trial.
Claims for NPOs tend to be less severe than those involving other industries, because the entities being audited themselves are smaller. With poorly organized accounting records and weak internal controls, these clients sometimes rely on their auditor to make sure accounting records are accurate. Because NPOs frequently have deadlines for submitting audit reports to obtain grants and other funding, the CPA should complete this evaluation well in advance of the audit start date. In such cases, auditors should identify weaknesses in internal controls and make written recommendations for correction in management letters supplied to both management and the board of directors.
A Florida CPA firm audited a charity's annual financial statements. Like many small charities, the client had weak internal controls. The auditor alerted the board of directors that controls for handling cash and vendor payments were weak and recommended that the client institute a second signature procedure for large vendor payments. The client followed the recommendation, but also received substantial non-cash contributions.
The CPA firm issued unqualified opinions each year. After an audit report was issued, the charity's local director resigned and moved out of the region. The client informed the CPA that the former director had embezzled substantial funds by selling contributed goods. The charity sued, alleging that inventory was materially misstated and that had the firm planned the audit correctly it would have discovered the ongoing sale of assets. This case was tried by a jury, which was sympathetic to the client's situation and awarded substantial damages. The key issue was the auditor's non-compliance with SAS no. 82, which deals with consideration of fraud in a financial statement audit.
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