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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.



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.

On Johnson's withdrawal, ABC must disclose within five business days the following information in a form 8-K, filed with the SEC, with a copy to Johnson on the same day:

* Johnson's resignation.

* Her conclusion the information coming to her attention has a material impact on the fairness or reliability of ABC's financial statements or audit reports and that this matter was not resolved to Johnson's satisfaction before her resignation.

5. Prepare a letter stating her agreement or disagreement with ABC's statements after reading ABC's form 8-K. If Johnson disagrees, she must disclose her differences of opinion in a letter to ABC as promptly as possible. ABC must then file the letter with the SEC within 10 business days after filing the form 8-K. Notwithstanding the 10-businessday requirement, ABC has two business days from the date of receipt to file the letter with the SEC.



Tom Doe, CPA, also a member of the AICPA, is conducting an audit of the financial statements of XYZ Bank. During the audit, he discovers a teller had stolen $1,000 from an account. this amount is not material to XYZ's financial statements.

As a result of his discovery, Doe must:

1. Discuss the matter with an appropriate level of bank management.

2. Consider the implications of the defalcation for other aspects of the audit or be satisfied that, in view of the perpetrator's position in the organization, there are no implications for other areas of the audit.

3. Make certain the audit committee of the bank's board of directors is adequately informed about the defalcation, unless in Doe's judgment it is clearly inconsequential.


Practitioners who have additional questions about how they should resond to discovery of an irregularity or illegal act can review the guidance contained in two articles: "Illegal Acts: What Are the Auditor's Responsibilities?," by Donanld L. Neebes, Dan M. Guy and O. Ray Whittington (JofA, Jan.91, page 82), and "The Auditor's New Guide to Errors, Irregularities and Illegal Acts," by D.R. Carmichael (JofA, Sept.88, page 40). They can also call the AICPA Technical Hotline at (800) 223-4158 (outside New York State) or (800) 522-5430 (New York State only).

Mr. Guy and Ms. Mancino are employees of the American Institute of CPAs and their views, as expressed in this article, do not necessarily reflects the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.
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Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:For the Practicing Auditor
Author:Mancino, Jane
Publication:Journal of Accountancy
Article Type:Column
Date:Jan 1, 1992
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