Inadequate testing and verification of accounts receivable are very common problems in audit claims. Too often auditors except management representations about the collectibility of a particular receivable or class of receivables without adequately examining past collection experience or the reasonableness of management representations in light of market/industry conditions. Expert review often finds that bad debt reserves were inadequate and the company failed to write off portions of accounts receivable in prior periods. This failure results in material errors in past and current financial statements.
A Florida CPA firm audited the annual financial statements of a Florida based wholesale distributor. The business was eventually sold to another party. During the audit fieldwork the following year, the successor auditor discovered evidence that the company's CFO had orchestrated an embezzlement scheme. Drawing on his prior experience as an auditor, the CFO had created fictitious vendor accounts to cover up theft. The vendor addresses in Florida were post office boxes that an accomplice had rented. When auditors sent out accounts receivable confirmations, the confirmations verified the fictitious receivables. The buyer of the company stated that he had relied on financial statements that were materially misstated and sued the CPA firm, as he overpaid for the business. The case was settled before trial.
Of all the nonpublic audit claims in Florida, 20 percent alleged failure to detect defalcation. Most of these instances arose from audits of not-for-profit organizations and government entities. Despite the fact that the auditors' duty is limited to "a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud" (AICPA Professional Standards), the public at large, as well as clients, expect auditors to detect embezzlements.
Businesses with a high volume of cash receipts or those with poor internal controls are particularly susceptible to embezzlement schemes. They most often involve long term employees stealing inventory or cash in increasing amounts over a long period of time. The client often seeks recovery from the auditor once it discovers its bonding coverage is inadequate to meet the loss, as well as, the expense of pursuing the embezzler. Losses typically range from $100,000 to several million dollars. In 35 percent of these cases, the amounts stolen are material to the company's financial statements in one or more years.
A Florida CPA firm audited a manufacturer's annual financial statements. During one of the audits the CEO informed the auditors that the company had discovered the CFO had been embezzling funds over a number of years. The client sued the CPA firm for failing to detect the embezzlement.
The CFO committed the theft by diverting mail containing customer payments and debiting an inventory account to cover the theft. The company did not maintain a perpetual inventory and the discrepancy went undiscovered for three years because production costs only fell within the expected range. While the CPA firm could not have detected the theft during the audit, the absence of effective inventory and cost accounting controls constituted a reportable condition. The key issue was whether the CPA firm adequately reported these problems and made recommendations to management about instituting proper controls.
Despite management's failure to introduce proper controls, the auditor did not document this need in a management letter to the client. The CPA's counsel advised the case would not be defensible at trial and recommended it be settled.
Over half of all audit related claims arise out of improper inventory valuation. Professional judgment involving CPAs and auditors is a significant factor is valuing inventory and other assets. Practitioners who lack experience with a client's specific industry are more likely to make mistakes valuing partially completed products and projects, raw materials and intangible assets, such as, goodwill or R&D. Errors valuing obsolete inventory also are quite common. Most times the auditors rely on management representations and fail to verify the accuracy of them.
A Florida CPA firm issued unqualified audit reports for five years to a client whose asset-based lending agreement was secured by unsold and pre-sold inventory. Comments in the paperwork indicated that the auditor had ongoing concerns about inventory being obsolete and late booking of returns. At the end of the fifth year, the client's lender initiated foreclosure proceedings to liquidate the business' assets when it no longer could service its debt.
After recovering about one-third of the outstanding debt in liquidation, the lender sued the directors, the officers, and the CPA firm. The lender alleged that the third year financial statements were materially misstated, causing it to further extend the line of credit, despite the fact that the client was in violation of the loan covenants. The auditor in his deposition stated that the inventory was overstated for all five years and returns were improperly booked. The client's inventory control system did not track unit costs or date of purchase, which the auditor failed to disclose as an internal control weakness in either management letters or audit reports. The CPA was responsible for 15 percent of the damages.
Failure to include appropriate disclosures on the face of the financial statements or in the footnotes is another type of audit claim. Almost 13 percent of audit claims in Florida alleged that this was the principal error leading to a loss. In most cases, the dispute concerned classification and disclosure of the nature of a security that a client held, such as derivatives or loans to related parties. An auditor has explicit duties in auditing investments. It is difficult for CPAs to defend such claims, especially when the investments are material to the financial statements.
A Florida CPA firm audited the annual financial statements of a government entity. The client had made substantial investments in derivatives, which eventually led to significant portfolio losses. The client sued the audit firm, alleging it had failed to sufficiently describe the nature of the investments in the footnotes. The suit also argued the firm knew of the risks associated with these types of investments and that the client was relying on the income stream to fund ongoing operations. Despite this, the CPA firm failed to alert the entity's governing board of the risks.
The investigation indicated that the footnotes did not sufficiently describe the securities. The client's governing board had directed the auditor to work though the entity's financial manager and in-house counsel, both whom lacked any expertise on derivatives. Although the auditor identified the risks of derivatives to these parties, this information did not reach the governing board.
CPAs issued engagement letters in approximately 85 percent of all audit engagements resulting in claims. In cases where the CPA had no engagement letter, the client typically was a closely held business, an employee benefit plan, or a non profit organization. Engagement letters describe the scope of service to the client and when service begins. For example, audit claims by lenders sometimes allege that their bank would not have extended the line of credit if the auditors had issued their report in a timely manner. In this case, the CPA firm uses the engagement letter to establish when audit work began and the scope of their services. For the 85 percent of audit claims that had engagement letters, one-third were not signed.
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