Fraud and Auditor Negligence

I received an interesting Google alert yesterday.  The Supreme Court of Canada ruled that Deloitte should be held responsible for damages related to its audit work performed almost 20 years earlier.

The case centered on whether an auditor is responsible for catching fraud – and what happens when it is missed.  In this case Deloitte was engaged to audit the financial statements of a theater production company.  The audit was required by both its lending arrangement and because it had sufficient investors who demanded it.  The financial statements understated certain expenses (see yesterday’s blog) and recording certain pre-sales as revenue – debt recorded as income.

There are two questions in these situations – the significance of the fraud and reliance upon the statements.  In some trials it was proven that there was significant fraud but no one relied upon the financial statements.  Without reliance, the auditor is not really responsible – after all, the purpose of the audit is to provide relevant information to stakeholders and if they choose to ignore it, that is their choice.

In this particular case there was substantial fraud.  Deloitte’s procedures did not identify the activity, or if it did, the fraud was not brought to the attention of the appropriate level of management.  Now, this case is interesting because the chairman and vice chairmen were the perpetrators of the fraud so really, who would have been the appropriate level of management?  Technically the auditor should withdraw at that stage – which surprisingly was one of Deloitte’s defenses – that they were being punished for not withdrawing as the auditor.

But I digress as the court did not find that Deloitte discovered the fraudulent activity. Which, by the way, went on for 5 years.

Needless to say, the lenders and investors were decidedly unhappy to know their money disappeared with no likelihood of recovery.  The Company, Livent, filed for bankruptcy and it was the bankruptcy trustee that sued.  Their position is that the auditors’ failure to identify and report the fraud led to the 5 years of borrowing and additional investor funding which essentially went straight to the two chairmen charged with fraud.

The Supreme Court agreed that the auditor was responsible for not identifying the fraudulent activity and taking steps to correct it earlier.

As an auditor, this is one of those rulings that give us pause.  If we perform the audit and gather, what we believe to be sufficient, audit evidence to support the conclusion, then there really shouldn’t be an audit failure.  But actually, even if we gather lots of evidence, the reality is we ask questions of management.  Sometimes, management lies.  Or in this case, were probably instructed by their senior leadership to provide certain answers which proved to be incorrect in the end.

Or, in other words, the audit partner meets with the president and CEO.  She has a list of questions that have filtered up from the audit team through various levels of audit management.  One of those questions was probably, “We discovered certain transactions that were authorized by you, are you comfortable with how those transactions are recorded?”  The answer was no doubt yes.

The auditors may have felt uncomfortable but what can they do?  This type of activity probably doesn’t lead to issuing a qualified, adverse, or disclaimed opinion.  The auditor’s only option is to withdraw because the reporting of fraud is not something you will find in the auditors’ report.  Why? you may ask.  Because fraud is a legal claim that would have to be adjudicated and proven and what the auditor discovers might be evidence of such activity but it hasn’t been proven in a court of law.

It is a terrible position for the auditor.  It is also the risk of performing audits.  I would like to tell you that, in that situation, we would resign.  But because we have withdrawn from engagement before doesn’t mean that the evidence in every case is sufficient to draw that conclusion.  Honestly, there were engagements that we completed that made us uncomfortable but that discomfort never rose to the level of us wanting to withdraw.  This is ultimately what audit leadership is required to made the decision upon.  It isn’t easy and sometimes auditors are wrong.  But if we withdrew from every engagement that caused us to be nervous there would never be another audit performed.

An interesting story that I will still be thinking about for a few days.

Have an awesome day.

Using accounting to deceive

I have received a few google alerts recently about companies that are being accused of using their accounting and financial statements to deceive readers.   It is sadly a far too common occurrence.  For readers of financial statements – like those who are owners in a homeowners or condominium association – knowing what to look for can help you determine if the information could be incorrect and maybe even fictitious.

First up on the balance sheet is cash.  While it is difficult to determine if the amount of cash is bogus there are things to look for, especially in associations.  If the financial statements show lots of cash but you are receiving messages from the board saying that they are worried about having to increase assessments – ask how that can possibly be.   There could be a logical explanation but every once in a while something is just flat our wrong.

Accounts receivable is one of the places where potential problems may really lurk.  Accounts receivable are sales that have not been collected – i.e. an IOU from the buyer.  For most businesses, one month’s sales in receivable would be expected, but watch out.  I once worked on an engagement for a hotel chain where the accounts receivable kept increasing and was approaching almost 10 days of revenue.  The a/r was used to hide the theft of cash sales and the controller didn’t catch it.  Ask yourself, if you owned a business like that, would you let someone promise to pay you later?

Inventory is another big area where accounting irregularities can show up.  Ask yourself, does the inventory seem excessive?  An easy way to tell is to divide the cost of goods sold by 12 and then compare that number to the amount reported as inventory.  Is it close to or less than 1:1?  That would mean that inventory is turning every 30 days.  If it is over 1.5:1, or more than 45 days, be careful.  Inventory goes obsolete quickly these days so lots of inventory may mean lots of write-offs coming soon.

Fixed assets, or property, plant and equipment can be gimmicked as well.  WorldCom tried to pull off this method of lying to their investors.  This is one of those areas that is harder to tell if something is wrong but the best thing to do is look at how fast the investment in fixed assets grow.  If sales have grown on average 3% over the last 5 years and fixed assets grew 12% this year, it may be worth questioning.  It is definitely worth looking at when fixed assets grows consistently at 12% year over year and sales isn’t going anywhere.  That is a sign of trouble.  We performed a review this past year where we required management to write down their asset value because we felt that the fixed assets were overstated.

Keep in mind that most entities that want to fool you will want you to focus on their profits – which means that revenues exceed expenses.  The easiest way to do that is to move expenses to the balance sheet; the receivables, the inventory, the fixed assets.  Look at expense trends and if you see an expense, like cost of goods sold, drop as a percentage, and then check if inventory went down that same percentage.  If it went up, it could be a sign something is wrong.

The vast majority of financial statement issuers are above board and honest.  To help keep them that way, remember to read the statement critically and be willing to ask questions, especially if you have a financial interest in the issuer.

Have a great day.