What an Auditor Does When Finding Fraud or Illegal Acts

While most auditors have encountered client errors, discovery of an irregularity or illegal act with a material effect on the financial statements is not an everday occurrence. Discovering an illegal act, particularly when senior management is involved, can raise other, even more difficult, issues, such as whether management's representations still can be relied on. As a result, auditors frequently have questions about how they should respond when they uncover an irregularity or illegal act. To provide auditors with some needed guidance, two hypothetical scenarios are presented below. In the first, the auditor uncovers fraud or an illegal act by the chief financial officer of a company that is a registrant with the Securities and Exchange Commission. In the second scenario, the auditor discovers an immaterial fraud by a bank teller. MATERIAL FRAUD OR ILLEGAL ACTS Mary Johnson, CPA, a member of the AICPA, is auditing the financial statements of ABC Company, a public company registered with the SEC. During the audit, Johnson discovers fraud or an illegal act material to ABC's financial statements. In fact, she believes Bob Smith, the company's chief financial officers, is involved in the fraud or illegal act. As a result of her discovery, Johnson must take several steps, as outlined below. She should 1. Report the fraud or illegal act directly to the audit committee of ABC's board of directors (or to the board itself if ABC does not have an audit committee). 2. Consider the implications of the fraud or illegal act for other aspects of the audit. Since Johnson believes ABC's CFO is involved in the fraud or illegal act, Johnson must consider whether she can still rely on management's representations. This will depend on the diligence and cooperation of other members of senior management and of the board of directors, including the audit committee, in investigating the matter and taking appropriate remedial action. If Johnson believes she cannot rely on management's representations, she should withdraw from the audit and proceed as described in step 4, below. 3. Insist the financial statements be revised and, if they are not, express a qualified or adverse opinion on the statements, disclosing all substantive reasons for the opinion. If Johnson is precluded by ABC from obtaining needed evidence, she should disclaim and opinion on the financial statements. 4. Withdraw from the engagement and communicate in writing the reasons for her withdrawal to ABC's audit committee, if she feels she cannot rely on management's representations or if ABC refuses to accept her audit report. Since Johson is a member of the SEC practice section of the AICPA division for CPA firms, she also must send a copy of he letter of resignation directly to the SEC within five business days. …