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Auditing for violations of environmental laws.

Environmental laws are becoming increasingly complex with considerable governmental emphasis on compliance. Noncompliance can result in costly cleanups, fines and penalties to a client company. Financial statements must reflect actual and potential liabilities that arise as a result of noncompliance with environmental laws and regulations. Auditors should design their audits to consider the financial statement impact of environmental cleanups and other costs of noncompliance. Proper procedures and documentation should minimize liability exposure in an environment where harmed parties are quick to sue the auditor.

Two primary issues are of concern when auditing clients involved with hazardous materials or toxic waste or who own property that may be environmentally contaminated. These issues include unrecorded loss contingencies and going concern questions. Clients may fail to record the costs of rectifying environmental problems for several reasons, such as management's lack of awareness of a problem. Management may choose to ignore environmental problems due to the magnitude of the costs of cleanup. The Environmental Protection Agency (EPA) has identified more than 27,000 hazardous waste sites in the United States with an estimated cleanup cost of $25 million. cost of environmental cleanup and decontamination could bankrupt a company that otherwise may be solvent. Thus, failure to accrue cleanup costs and the effect on a client's solvency must be addressed by the auditor.

This article examines the issue of auditing clients that are involved with hazardous waste materials. Audit procedures that should be employed in this situation are discussed along with how the auditor should handle a situation in which environmental problems are encountered. A summary of Statements on Auditing Standards that affect the audit of environmental issues is presented in Table 1. Each is discussed in the following sections.

Audit Procedures for the External Auditor

Statement on Auditing Standards (SAS) No. 12(1), Inquiry of a Client's Lawyer Concerning Litigation, Claims and Assessments, provides guidance on how the auditor should obtain evidential matter regarding uncertainties due to litigation, claims and assessments. The audit procedures discussed in SAS No. 12 should be employed to detect the presence of environmental issues as of the client's balance sheet date. These procedures include discussions with management, review of documentation supporting litigation, obtaining management representations and obtaining attorney letters. Additional audit procedures for clients exposed to environmental problems that are not considered in SAS No. 12 include an evaluation of internal controls and employing specialists perform an environmental audit of the company.

Discussions with Management

SAS No. 12 states that the auditor should ascertain management's policies and procedures for identifying, evaluating and accounting for litigation. This discussion is broad in nature and determines management's assessment of general litigation against the company. The auditor should expand the discussion to specifically address environmental issues. Inquiries about the presence of environmental litigation should also include questions about the client's involvement with hazardous materials or toxic waste and of ownership of property that may be environmentally contaminated (as well as liens thereon). If any involvement is indicated, the auditor should obtain from management a description of the items and an evaluation of present or potential litigation stemming therefrom.

Review of Documentation

Discussions with management should be followed up with a review of supporting documentation. This documentation could include correspondence with the client's legal counsel, legal documents and reports from environmental auditors (if any). Additionally, minutes of meetings of stockholders, directors and appropriate management committees should be reviewed with an eye toward discussion of environmental issues.

Management's Letter of Representations

SAS No.19(2) establishes the requirement for written representations from management. Failure to obtain written representations could yield a modified opinion due to a scope limitation. Matters included in those representations are "violations or possible violations of laws or regulations whose effects should be considered for disclosure in the financial statements or as a basis for recording a loss contingency.

SAS No. 63(3) expands the scope of this statement for audits of governmental entities (or entities receiving governmental financial assistance) by requiring that auditors consider obtaining representations about the following:

* Management is responsible for the entity's compliance with laws and regulations applicable to it; and

* Management has identified and disclosed to the auditor all laws and regulations that have a direct and material effect on the determination of financial statement amounts.

The SAS No. 63 recommendations are seemingly applicable to clients involved with hazardous waste materials. The auditor should consider obtaining management representations that the company is in compliance with environmental laws and regulations and has adequate controls over the handling of hazardous materials. Obtaining such representations should serve to heighten management's awareness of its responsibilities.

This is also suggested in SAS No. 54(4) Illegal Acts by Clients, in which the auditor is charged with making inquiries of management concerning:

* The client's policies relative to the prevention of illegal acts; and

* The use of directives issued by the client and periodic representations obtained by the client from management at appropriate levels of authority concerning compliance with laws and regulations.

Attorney Letters

The client's attorney represents the auditor's primary source of corroborating evidence for the information provided by management. The external auditor is required by SAS No. 12 to send a letter of audit inquiry to the client's general counsel. The letter details litigations that are pending or threatened as well as unasserted claims and assessments against the client. The attorney is asked to provide information on the listed items, describing their nature and the likelihood of an unfavorable outcome. Further, the attorney also should detail any additional litigation or claims not included by management on the list. Auditors should consider expanding the scope of the letter to specifically address environmental issues. This notion is supported by SAS No. 54, which states that the auditor generally does not have the expertise to make a determination about whether or not an act is illegal.

Evaluation of Internal Control Structure

Statement of Auditing Standards No. 55(5) Consideration of the Internal Control Structure in a Financial Statement Audit, describes the internal control structure as consisting of three components - the accounting system, the control environment and control procedures. An effectively designed and implemented internal control structure should provide reasonable assurance that specific organizational objectives will be achieved. It also reduces the risk that transactions will occur without proper authorization. As such, an effective internal control structure should reduce the risk of environmental problems arising without management's knowledge. The review of a client's internal control structure should be expanded to consider the controls over the generation, transfer, elimination and cleanup of toxic substances.

Environmental Audit

An environmental audit is a systematic examination of a client's operations and properties, both past and present, to identify potential 11-abilities arising from environmental causes. It is performed by a third party and consists of a review of permits, plant visits or actual site sampling and analysis. An audit can be a useful tool to verify compliance with regulations, evaluate the effectiveness of environmental management systems in place, verify the progress of a client's waste minimization initiatives and assess risks from regulated and unregulated materials and practices.

Audits can be classified into three levels by the degree of analysis(6). The first level consists of a preliminary or screening audit based on available documents, management representations, discussion with appropriate government parties and a walk-through of the facility. The first level does not involve gathering primary data by sampling and testing procedures and is the least expensive and least extensive of the three levels.

The second level consists of limited-testing such as bulk and air sample tests for asbestos; ambient air tests; wastewater samples; and magnetometer, acoustic or electric field tests. The amount of testing is generally based on the data gathered from a first level audit. The third level consists of a second level audit plus intrusive testing such as water well analysis, test borings or excavations of soil and wipe or scrape samples of suspected toxic materials. The third level is the most extensive of the three and is designed to provide the greatest amount of information on the extent of environmental damage present at the site or in the client's operations.

SAS No. 11(7), Using the Work of a Specialist, establishes guidance regarding an auditor's use of a specialist. A specialist in this case is the party conducting the environmental audit. The auditor is required to be satisfied with the professional qualifications and reputation of the specialist. The specialist should but is not required to be independent of the client. The auditor, client and specialist should all be fully aware of the nature of the work to be performed, including the objectives and scope of the work and the assumptions upon which it will be based. The auditor is required to obtain a sufficient understanding of the methods and assumptions used by the specialist in order to make a determination of whether the specialist's report is suitable for the auditor's purposes.

The auditor should not refer to the work performed by the specialist if the specialist's findings support the representations in the financial statements. This practice eliminates confusion as to the amount of work performed by the auditor and as to the responsibility for that work. The situation in which the findings of the specialist do not support the representations in the financial statements is discussed in a subsequent section.

Environmental issues When Auditing Banks

At first glance, it would seem that the auditor of a bank would not be concerned with environmental issues within the audit. A closer examination reveals that banks may indeed have environmental issues that affect its financial statements and solvency. Banks may become liable for environmental cleanup costs if they have loans secured by contaminated properties. it has been suggested by recent court decisions that lending institutions may be required to pay the cost of environmental cleanups and decontamination for property and facilities that they hold as loan collateral.(8)

Given this situation bank auditors should look closely at the client bank's loan portfolio. Where loans are secured by property, the auditor should ascertain the business of the property holder to determine whether environmental problems could exist on the property. In those cases where problems might exist, the auditor should employ means to determine whether or not such problems actually do exist. These procedures involve employing a specialist to perform an environmental audit. Additionally, the lender may avoid liability through the innocent party" defense created by the Superfund Amendment and Reauthorization Act of 1986 (SARA).(9) Regardless of the results of the review of the loan portfolio, bank management and its audit committee should be aware of the possible liabilities related to the environmental issues.

When Environmental Problems Are Discovered

The auditor may discover environmental problems as a result of audit procedures performed. In this case the auditor should determine if the client has accrued for estimated loss contingencies for the cleanup and remediation. If an accrual exists, the auditor should determine if the accrual is adequate. Procedures may involve the use of an environmental specialist since the auditor probably will not possess the expertise required to make such a determination. Alternatively, the client's internal audit staff may possess some expertise to assist in this process.

If the client has not accrued for the cleanup costs, the auditor must make a determination of their impact on audit. A first step should be the determination of the estimated costs involved. Again, a specialist would probably be required to make this determination. Once the amount of the environmental damage has been assessed, the auditor should consider the impact on the financial statements of the client and the audit report. Regardless of the auditor's conclusions, the client's audit committee should be notified of the findings.

Communications With the Audit Committee

Auditing standards require certain events to be communicated to the audit committee. SAS No. 54 requires that illegal acts be reported to the audit committee unless clearly inconsequential. The communication should describe the act and the circumstances surrounding it as well as the financial statement impact. SAS No. 60(10), Communications of Internal Control Structure Related Matters Noted in an Audit, requires that certain deficiencies in the internal control structure reportable conditions) be reported to the audit committee. Reportable conditions are those that could result in a material misstatement or omission in the financial statements. Inadequate controls over compliance with environmental laws and regulations could yield materially misstated financial statements. The presence of reportable conditions such as those summarized in Table 2 should arouse concern in the auditor that exposure due to noncompliance with environmental laws and regulations may exist. Management's control over the handling, recording and reporting of environmental issues may result in a reportable condition which should be reported to the audit committee.

Communications with the audit committee are typically in writing and may take place during the audit or at its conclusion. The report should indicate that the information is intended solely for use by the audit committee. The communication should include a description of the environmental problems and management's lack of adequate control over its handling.

Going Concern Issue

The auditor may have doubts about the ability of the client to continue as a going concern if severe and costly environmental problems are found. For instance, the estimated cost of the environmental cleanup may exceed the client's financing arrangements. Alternatively, the client may be unable to efficiently alter production methods or the handling of hazardous waste in order to avoid violation of environmental laws. SAS No. 59(11), The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, provides guidance to the auditor in such cases. SAS No. 59 requires the auditor to determine if there is substantial doubt about the entity s ability to continue as a going concern for a period of one year beyond the balance sheet date. If the auditor has such doubts, he or she is required to:

* Obtain information about management's plans that are intended to mitigate the effect of such conditions or events; and

* Assess the likelihood that such plans can be effectively implemented.

The auditor is required to determine the adequacy of the client's disclosure of its environmental problems and ability to continue as a going concern if he or she concludes that management's plans do not remove substantial doubt over the issue.

Audit Report

The auditor also must alter the audit report if substantial doubt exists over the client's ability to continue as a going concern. An explanatory paragraph must be added to the audit report to reflect this conclusion. Additionally, it would be a departure from generally accepted accounting principles if the disclosures with respect to going concern issues are inadequate. If this is the case, either a qualified or an adverse opinion is appropriate, depending on materiality of the effect.(12)

The audit report also may be modified if the environmental problems resulted from illegal acts performed by client personnel. A qualified or adverse opinion should be issued if the auditor concludes that the effect of the environmental problems resulting from an illegal act has a direct and material effect on line items in the financial statements and the matter was not corrected by the client. The auditor should disclaim an opinion (or withdraw from the engagement) if precluded by the client from obtaining sufficient competent evidential matter to evaluate the effect of the illegal act of the financial statements.

The auditor should also qualify or disclaim an opinion if unable to become satisfied as to the reasonableness of the work performed or conclusions reached by a specialist hired to perform an environmental audit. Generally, the auditor should apply additional procedures, perhaps the employment of an additional specialist, to resolve the issue. If this does not result in a convergence of opinions, the auditor should qualify or disclaim an opinion due to the inability to obtain sufficient competent evidential matter in regard to an issue of material significance to the financial statements. If the auditor decides to modify the opinion under these circumstances, the specialist may be referenced in the auditor's report. This would be done to provide information about the reason for the modification. However, as mentioned earlier, the specialist should not be referenced in the report containing an unqualified opinion.

Withdrawal From Audit

If the client refuses to accept an opinion modified as outlined above, the auditor should withdraw from the audit without issuing a report. The auditor should indicate the reasons for withdrawal in writing to the audit committee or board of directors. Further, the auditor may be asked to respond to a client's filing of SEC Form 8-K regarding change in auditors.


Environmental laws are complex and the instances as well as costs of violating those laws are increasing. Given these conditions, it is essential that external auditors evaluate the impact of these laws on their clients during their audits. Without such an awareness, auditors may find themselves involved in undesired and costly litigation defending unqualified opinions given to client companies responsible for environmental damage. Secured lenders may also initiate litigation if the underlying property must be cleaned up and the client is insolvent. This article has discussed a variety of auditing standards implicitly providing guidance to the auditors in conducting an audit with potential environmental concerns.


1. American Institute of Certified Public Accountants (AICPA). 1976. SAS No. 12, Inquir) of a Client's Lauyer Concerning Litigation. Claims and Assessments (New York).

2. AICPA. 1977. SAS No. 19, Client Representations (New York).

3. AICPA. 1989. SAS No. 63, Compliance Auditing Applicable to Governmental Entities and Other Recipients of Governmental Financial Assistance (New York).

4. IAICPA. 1988. SAS NO. 54, illegal Acts by Clients (New York).

5. AICPA. 1988. SAS No. 5 5, Consideration of the Internal Control Structure in a Financial Statement Audit (New York).

6. Commins, James A. 1990. "Environmental Audits Revisited," The Journal of Commercial Bank Lending (May:13-17).

7. AICPA. 197 5. SAS No. 11, Using the Work of a Specialist (New York).

8. Scangnelli, John M. and B. Charles Malloy. 1987. "Should Lenders Require Environmental Audits?" The Journal of Commercial Bank Lending (July:14-19).

9. Leighton-Smith, Susan. 1987. Issues in Lending ... The New Innocent Party Defense Under SARA," The Journal of Commercial Bank Lending (July:20-25).

10. AICPA. 1988. SAS No. 60, Communication of internal Control Structure Related Matters Noted in an Audit (New York).

11. AICPA. 1988. SAS No. 59, The Auditor's Consideration of an Entity's Ability to Continue a.1 a Going Concern (New York).

12.AICPA. 1988. SAS No. 58, Reports on Audited Financial Statements (New York).
 Table 1
 Sources of Guidance When Auditing for Environmental Issues
Statement on Auditing
Standards (SAS) Title
 No. 11 Using the work of a Specialist
 No. 12 Inquiry of a Client's Lawyer Concerning
 Litigation, Claims, and Assessments
 No. 19 Client Representations
 No. 54 Illegal Acts by Clients
 No. 55 Consideration of the Internal Control Structure
 in a Financial Statement Audit
 No. 58 Reports on Audited Financial Statements
 No. 59 The Auditor's Consideration of an Entity's
 Ability to Continue as a Going Concern
 No. 60 Communication of Intertial Control Structure
 Related Matters Noted in an Audit
 No. 63 Compliance Auditing Applicable to
 Governmental Financial Assistance
 Governmental Entities and Other Recipients of

Table 2

Examples of Reportable Conditions that Impact Environmental Issues

* Inadequate provisions for the safeguarding of assets

* Absence of appropriate reviews and approvals of transactions

* Evidence of failure of identified controls in preventing or detecting misstatements of accounting information

* Evidence of failure to safeguard assets from loss, damage, or misappropriation

* Evidence of misrepresentation by client personnel to answer the auditor

* Evidence that employees or management lack the qualifications to fulfill their assigned function

Source: SAS No. 60 (AU 325.21)
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Author:Cornell, David W.; Apostolou, Barbara
Publication:The National Public Accountant
Date:Jul 1, 1991
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