Audit Standards and Fraud Discovery

• Publication year: 1998
• Pages: 29
• Citation: Vol. 27 No. 3 Pg. 29

27 Colo.Law. 29 Colorado Lawyer 1998.

1998, April, Pg. 29. Audit Standards and Fraud Discovery

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29

Vol. 27, No. 3, Pg. 29

The Colorado Lawyer
April 1998
Vol. 27, No. 4 [Page 29]

Specialty Law Columns
Business Law Newsletter
Audit Standards and Fraud Discovery
by Gordon Yale

The issue of fraud and auditor responsibility for its discovery has troubled the accounting profession and its counsel for years. Until 1989, the profession attempted to insulate auditors from liability in this area. These attempts included both lowering client expectations concerning audited financial statements and promulgating standards that explicitly disclaimed audit responsibility for the discovery of fraud

Despite these efforts, courts and regulators increasingly held auditors accountable for the discovery of fraud in the course of an ordinary audit examination. In many of those instances, regulators or plaintiffs successfully argued that the proper application of existing generally accepted auditing standards ("GAAS") would have uncovered fraudulent transactions or accounting treatments

With the February 1997 release of Statement on Auditing Standards No. 82, entitled "Consideration of Fraud in a Financial Statement Audit" ("SAS No. 82"), the accounting profession has more formally responded to an auditor's responsibility for the discovery of fraud. The profession has done so not only by acknowledging that the detection of errors and fraud is a primary purpose of audit examinations, but also by providing a highly detailed list of risk factors that may indicate the existence of fraud. These risk factors, coupled with a set of procedures that an auditor must employ to provide "reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud,"1 provide practical and detailed guidance for auditors and their counsel

The Way It Was

Up to 1977, the position of the American Institute of Certified Public Accountants ("AICPA"), the author of statements on auditing standards, was that an "ordinary examination directed to the expression of an opinion on financial statements is not primarily or specifically designed, and cannot be relied upon, to disclose defalcations. . . . Similarly, although the discovery of deliberate misrepresentations by management is usually more closely associated with the objective of an ordinary examination, such examination cannot be relied upon to assure its discovery."2 Similar cautionary language also was used in letters to clients reporting on the adequacy of client internal controls.

Subsequent to the Equity Funding scandal in 1975, an AICPA committee was formed to evaluate whether failure of auditors to uncover fraud indicated a need to revise existing GAAS. While the committee concluded that no specific changes were needed, the AICPA issued Statement on Auditing Standards No. 16, entitled "The Independent Auditor's Responsibility for the Detection of Errors and Irregularities" ("SAS No. 16"), in 1977.

In part, SAS No. 16 stated: "Under generally accepted auditing standards the independent auditor has the responsibility, within the inherent limitations of the auditing process . . . to plan his examination to search for errors or irregularities that would have a material effect on the financial statements."3 Despite this subtle movement toward auditor responsibility, engagement and...