RETURN TO HAV EEL How Auditors Can Detect Financial Statement Misstatement BY HOWARD GROVEMAN id he most frequent causes of audit failure appear to be inappropriate au- dit team reactions to various warning signals, according to cases report- d to the American Institute of CPAs quality control inquiry committee (QCIC)—the group SEC practice section members must report to about liti- gution involving public companies These warning signal cll aention to >xoblem areas auditors have long ree~ ognized as sources of potential Gna cial statement difficulties. The experience of many young staff members and their lack of familiarity Sith these signal a recurring Heme, as are eepeated instances in which audies were not conducted in an atmosphere of appropriate p: fional see ‘More ao than any confusion cased by high-tech prod ucts or complex financial instruments, these problems ap- pear to be the primaty causes of audit failure. The sarpose ofthis article isto reemphasize che need for audit xepticism and to focus additional attention on potential arning signs ROFESSIONAL SKEPTICISM ‘When planning a financial statement audit, auditors de- sign procedures to provide reasonable assurance of detece- stg possible material misstatements, In perfarming such procedures, che audit team must always bear in mind that achough mose misstatements are the tesule of uninten- ‘ional mistakes (errors), they occasionally resule from em= ployee embezzlement or deliberate management manipulation (irregularities) or from the commission of a egal act. Accordingly. auditors must ensure tha audits are con= ducted with an attitude of skepticism While auditors should not assume client management personnel are dis- honest, they should not unquestioningly expect honesey > About one-third of cases reported to the AICPA quality control inquiry committee each year are deemed to be frivolous and are therefore closed by the committee following its analysis. Rather, an audic ceam must objective- ly evaluace observed conditions and audic evidence and follow up any po- ‘entially material negative indicators to determine whether or not financial stacements are free of material mis- sratement. ‘The Financial Executives Insticure hhas observed: “Audit teams must un- derstand not only accounting and au- diting issues, but also the risks and nature of the business and the eco- nomic reality of ies transactions. A is an audit team that is broadly trained key ingredient and has sufficient experience to relate seemingly unrelated items The overall realty check appears to be a missing text in some of the recent audie failures. One cannot develop. guidelines fora ‘smell est ‘OVERSTATEMENT OF INVENTORIES In recent years, the financial press has reported a rath of allegedly fraudulent financial statements atributed sig- nificant inventory misstatements, such as Leslie Fay, Phat- Mor and Crazy Eddie A December 1992 Hall Stret ourialaricle, “Inventory Chicanery: Tempts More Firms, Fools More Auditors” cited the “recent rise in inventory fraud” as “one of the biggest single reasons for the prolié eration of accounting scandals” Other abuses aso have been reported ' Auditors who showed up at plants were fresh out of college there was linle continuity of asigned salt 3 Partners or managers rarely atcended audit team ob- ‘servance of inventory coun coed page Occober 1985 JOURNAL 4f ACCOUNTANCY aBe alert for inventory that appears not to have been used for some time or that is stored in unusual locations or fashions. w Audicors were fooled because they checked only small samples of management’ tallies mAadicors permitted company off Gils to follow them and record where they made test counts, making i easy for officials to falsify counts for inven Cory not being tesed Audicors who identified a siua- Sion indicaring possible faud—such 2s a barrel filled with floor sweepings ‘whose contents management had val= uued at thousands of dollars—forced che company to subtract the amount from inventory but never recognized the possibility of intentional and per- vasive faud uuditors gave a client advance notice of specific locations where they would observe the inventory count Asa result, the client refrained from ‘making adjuscmencs ac locations where ie knew the inventories would be ob- served and instead made fraudulent adjustments at other locations 10 help prevent or detect such | abuses, the auditor’ inventory observation procedures should follow these guidelines: 1. The audit team assigned to ob- serve inventories should be led by ca- pable, experienced personnel who are WTHE MOST FREQUENT AUDIT FAILURES ap- ‘pear co result from inappropriate audit team reactions to familiar with che client and its opera- tions: che greater the risk, the greater the experience needed When less-ex- perienced personnel participate, they should be adequately supervised and encouraged to bring anything out of the ordinary to the attention of the partner manager or other auditor in charge 2 chat location 2, If neither the partner nor man- ager can be present, one should be reachable in case problems arise A. preobservation planning mecting can help ensure an inexperienced staf will pay appropriate atention to potential Jy significant matters. 3: When observing the count: mf using a substantive cest ap- proach, make certain audie test counts focus on high value items and will, in the aggregate, encompass a sufficient proportion ofthe invencory being If not all locations will be visited, or if counts are made cyclically, make certain the locations and cyeles do not follow an easily predictable pat- tecn and advise the client as late as, possible about locations or cycles to be observed Be skeptical of large or unusual tese count differences or of client per~ sonnel taking notes or displaying par- detect seul incre in aude procedures oF test coun If there are move chan oct CGsional diferences, ensure that they ging ot none mie oto have been used for some time or tat word in unusullcatons or ahions Ifnoc ated 30 dentibed, such condidons may indicate damage obsolescence or excess quantities. bf Ensure that incereornpany and ine serplane ovement i kaprto en abe solute minimum, Esablits control of the inventory before you lesve atl fy yourselfany items added vo ic air the coune is completed ae proper and reasonable. Inventory overstatement ao can be decected through other auditing pro~ cedures Exhibit 1, page 85, lists indi- ators that should dutcee the audi teams atetion eo potble overtates tmene and provides peranens detecdion procedures CPAS might appl OVERLY AGGRESSIVE ACCOUNTING A key indicator, indeed an alarm bell, is an entity’s use of very aggres- sive accounting principles or prac tices in audit areas such as income recognition, capitalization and defer- ral of costs, depreciation and amorti~ zation The use of such principles tory abuses, the inventory observation team ‘warning signals. In cases reported to the American Insticute of CPAs quality control inquiry committee, problems aso include inexperienced sail ssigned to at- dts and a lack of professional skepticism. §TO MAINTAIN THE APPROPRIATE DEGREE of skepeicism, auditors should noe assume client manage- ‘ment is dishonest but alo should not unquestioningly expect honesty. The audic team should evaluate evi- dence objectively to determine whether financial state- ‘ments ae fee of material misstacement INVENTORY MISSTATEMENTS HAVE caused numerous financial statement problems. To prevent or should include experienced personnel; 2 partner or manager should be present or easily reached. MAN ENTITY'S USE OF AGGRESSIVE accounting practices may indicate management is more concerned with the portrayal of favorable financial results chan with the reality All practices should be acceptable under gen- erally acceptable accounting principles and the Gnancial seatements should make overall busines sense MOTHER POTENTIAL PROBLEM AREAS audi- tors may encounter include inappropriate revenue recognition, inadequate loss reserves, understated costs and expenses and unusual or related party transactions oF balances HOWARD GROVEMAN. CPA CFE recently cetived fom Grane Thornton LLP in New York City He previously was the firm’ national ditector of accounting and auditing A member of che Financial Accounting Scandards Advisory Council, he has served on several American Insite of CPAs committees including he precursor of che auditing standards board and the SEC practice section executive committee JOURNAL + ACCOLNTANCY Ovcober 2995es If the audit team concludes it is likely management is not acting in good faith, the auditors usually should resign Indicator =. Warning S/an5 | Qersuay ge games ot geen tone ne ra nase 9 set Rene inclearo¢ ineffective cute procedures or indications of possible inclusion in ientoy oF merchandise sold or for when purchases are not recorded (DFew or no writedowns to market or provisions for leseence when there have been changes in product fines or technology or rapid declines in sales or markets 4. Questionable proceaures fr determining or aggregating Inventory cots or inaications thet lewroneous or insuppertable costs have been applied ieee ectiperes ne te wanes ie ae es in aioe, Solar ivi anda Se sry ata PIRSA’ Tce items back fo applicable test counts or notations of such counts, ‘available, (it ot covered by invertor test counts, consider why) Hf the {quantities ae derive feom other sources, scratinize the vnderying, eeurents and obtain explanations as to the Business reasons, In some sstuations, test the quantities by coasiering sales (in addition to ‘examining purchasing or manufectring ecards in eanjunction with Bricing tests) or by current abservation coupled with examination of subsequent period sales. Perform procedures such as expanding cutoff tests and reviewing subse. ‘quent peed enries and cbtaining confirmation om major supplies Products believed to be affeced by such changes should be compared with recent and subsequent period sales activity, explanations should be ‘biained trom management and available cocumentation (such a8 otrespondence and sales returns) should be examined Adeitiona pricing tests should be pertored. Management should be sekad fo sly any quesensle determinations that oul hare 3 Significant effect Perform anal comparisons and felon upon vaiancs: these ae Key Drocedures for detecting laventor misstatements tis essential such Drocedures be performed by personne! with requisite Beckground and nay indiease management is overly concerned with che portrayal, rather athe realty of forable Roanctal ls Auditors should ensure that any such practice is acceptable under gen- erally accepted accounting principles and that they have appropriately doc~ amented the encity’s rationale for its use and the basis for the audicors" conclusion. In addition, auditors should be aware that management’ aggressiveness may affect other audic teas, such as those involving the use of estimates. Particular skepticism is salled for if aggressive principles or practices are being applied in more than one area. These matcers should be viewed from 2 business perspec tive In other wards, the financial statements should make overall busi- In addition—and this applies equally to all indicators—if the mem- bers of the audit team conclude itis ely management is not acting in good faith, the auditors usually should resign. Generally accepted auditing standards were not designed to uncov= sperience ex che machinations of a dishonest management OTHER LIKELY AREAS OF MISSTATEMENT Among other Bnancial statement areas shat could give rise to material mis- statement, the ones audicors should fo- cus on include ‘Inappropriate revenue recogni= tion Inadequate collecibilicy (os) re serves wUnderstated cost and expenses Unusual or related party eransic- tions or balances Exhibit 2, page 86, liss indicators ‘of problems in the above areas a5 well as the procedures customarily applied in such circumstances IMPROVING DETECTION This article doesn't provide a com- plete list bue ic does include the most common situations chat may give rise to material misseatements Senior au~ dit personnel should not only direct appropriate attention to these matters themselves but also should ensure that Occober 1995, less-experienced scaffare familiar with chem Mans, perhaps most, er~ rors and irregularities (incloding frauds) can be dececced only by ex- amining the underlying dezailed records (such as invoices, correspa dence and shipping documents) This work usually s performed by staff as- sistants, and it is essential that they appreciate the importance of the du- ties they are assigned and have an in- formed understanding of the potential significance of all matters discovered. All audit personnel should bear in mind thatthe indicators discussed here should be called co the attention of others in the firm with the back- ground and authority to help deal swith them, such 2s more senior mem- bers of the audie team Business realcies and human nature being what they are, ics unlikely un- intentional or deliberate financial | statement misstatements can be elimi} nated emtirely However, skepticism, coupled with a chorough understand ing of the indicators. will improve the likelihood of auditor detection. JOURNAL «1 \ccoUNTaNeY 85|Cipinanorpnate revenue reogn i | Cpeiaer vous! wensetons cearing shety fre th end of an important peried such as the Dalonce sheet date or quatary reporting periods Cpriesine products belore a sale is consummated or ications trat cusiomers ae rot obligated to pay for shipments Aernatwely: Bil-ang-holé tansactons or ‘other indications that sales ae Pacognzed in advance of shipment Percentage o-completin accounting when there sre uncertainties about the tora fides (or binging ature of the underying contractor questions sBout the reliability of the pertinent cost records, Jnvacorded sales returns and sllowances, of sions Mar appear ew i relation to bast experience (or the auiter's knowledge of the business (Bpradensne cacy eres ‘2. Curent provisions or aggregate reserves that seem low in relation to past experience or current business ceneitions past due receivable balances or targe DIES TrOM TELUS parties or unfamiliar sources, | | c.»circutar wansactions'—ectietibilty depends on funds or continued patronage tobe provided by the entity G3 ncersated cons and peraee Efren aes ». Improper or insutficenty supported capitalization of || costs ordeteral of satup, agministatve or advertising «Unusually slow depreciation of fixed assets or lengthy amortization periecs. (Fer examale a comouter Feasing company using a 15.year lite for operating leases } Casas ox ‘Significant wansaction or amounts that apcear unusust ‘or whose purpose is unclear ar that inclve related entities the audior does not a0 86 JOURNAL «1 ACCOUNTANCY October 1995 Procedures All such transactions shouldbe examined and the audit team satisfied that they are procery accounted for Be alert to conditions such at those iscussed inthe following incieater Contiger the need ta perform prove. ‘dures to search fer agaiora! unusual vansactions_A pattern af such tuarsactiors nay nave a sare negative management imoicalions os the use af very aggressive accourting princpie® ‘Such transactions may come ts the audit team attention 35a result of utott procedures, accounts raceivabe confirmaticns or Inventory cbse vation, fr exampe. (Assistants shouldbe alerted to such powsbltes} ‘The ait team shoul satisyiealf 2s tothe aporopriate accounting leeatment after scrutinizing the underlying documentation and contacting the customers crectly if mecessary. The eam also should inguire about any adcitional transactions ofthis nature and conser procedures fo &k- tend the earch. Here foo the team should consider the implications af 2 vossicle oa Deoenctng 20 the “are othe auestions the auciter should consider ‘the propity ofthe income recognized er of the use ofthis acczunting method and should document such considerations In some insances, 3 legel opinion should be obtained. If its determined tne methor is 0c: ‘ceptable, consideration should be given to the income recognized for the articular eontrect(s) in question, ensuring that tne judgments are rea sonable and supported by appropriate audit evidence These may come to attention in conjunction with accounts receivable Confirmations eto! testing or other procedures. The aucitr shoud obtain an explanation ang consider exoansion of confirmation niaetng customers by phone) and (or additional traneactions Management shouldbe asked to explain this, preferably in writing. and to provide supporting evidence. Auaiters should examine this evidence ‘2nd apply procedures such a intensive analytical comparisons and re iew of subsequent pried payments, exercising particular skepticism when the entity empleys aggresive accounting principles or practices, ‘The workpepers shouid document an understanding ofthe debter anc the rasons for nonpayment In adéilion, the auditor sould ebtain approptt ate evidential mater relating tothe callectibily of such recenables All such transactions shouldbe serutiized Consieration should be gv- en to whether classification a5 a receivable is appropiate (and a8 to the Propriety of recognizing any profits based on sch transsctions) Gutott or analytical procedures may rigger tis Indicator. Auditors would ‘then usvally perform proceaures such ae extending out-o-perieg tests or ‘obtaining accounts payable confirmations ‘tient polices concerning such capitalization and deferrals shovid be deeumented and ctent records supporting such amounts should be au: ited Allocations of lavor and ater costs between amounte to Be capi talized and amunts tobe expensed should be supperted by contempors: ‘neous records Auditors should examine the clients support fer these po sitions with an understanding thatthe burden of proot rests withthe lent ‘The auctor shovld obtain explanations for such policies preferably in lritng 0d be satisfied they are reasonable in the cxcumstances All such transactions ana balances should be serutinited. In some in- stances the aucitor may wish to verfrm procecures with rezoect tthe ‘elated party's ecorcs Calecitility of any uen receivables fet be Sup Dorted by aPprcprite audited encence ee SeeCPAs Pree ee Ce Perey a ae THE PROCESS HAS BEEN SIMPLIFIED & MADE AFFORDABLE. A system created by an accountant for accountants, Single keystroke 00S operation or point & click in Windows Software is compatible with any of the popular tax preparation packages Investment of only $120 00 includes fling ton Federal and State returns. 3 plus a full money-back quarantee maT when you elena ee aT ba Pc Gea hee sf Value Added Network Services ELECTRONIC FILING IS OUR QNLY BUSINESS, pe ERS os 1-800-479-7614 here are clues chit should I alert CPAs co the possibili- —though of course nor the cersainty—of misstatement or fraud, according co Robert E Fleming. director of audit and a counting and a shareholder of bach Kahn & Werlin. Albans: New York. “At our firm he sid. we pit. particular atention co them ‘The firm is especially aleze co ssatning signals in new auditing en gogements For example Fleming said. “When we replace another CPA firm, we consider che change ‘auditors 3s one possible indicator of potential mis~ statements or itreg~ ularities, Before we aecept a replacement engagement. we want ro learn as much as posible about che cr- cumstances suround= ing the replacemenc The rm conacts the previous auditor and reviews i esionship with the client, "We sk about the clients integeity ind discuss in deta any problem areas.” During the first year ofthe audic engagement, che au inerease the tisk of fraudulent timin- cial reporting, Fleming suid. inelud~ ing an overly complex oxganizitionil seruequre with many subsidiaries. une usually structured prctnerships ind numerous joing ventures In such ex es, he suid, "We pay particular ten | tion to the magninide and frequency of rebated parry mansactions Instilling skepticism Of che Hens 25 parmners mn 130 profesiontls. about 31 pmmers ind Lin professionsls do wuts wad che am hires 8 co 12 new auditors every year, The firm has a diverse ange of clients including finincial [etcetera EEE "We try to emphasize to our new auditors that thelr role is ‘oe skeptical and to ask ‘questions ofthe client,” said Robert E. Fleming, a sharehold+ CASE STUDY Pay Attention to Warning Signals sisutions: manufacturers. real es te developers, not-for-profit orga~ izations and government entices. Tn our raining program, for each audie level we have a module ‘on professional skepticism.” Fleming said “Using ease studies the mod= ules give examples of auditor reac~ ton to particular situations and show how a skeptical atinude might have ferreced our misstacemencs made by the client We ery co emphasize £0, our younger of les-experienced auditors that they should not be embarrased sbout their role 2s independent 2udi- tors." he said. "We steess that one of their fanctions is co bbe skeptical and to get independent evi- dence regarding the client's assertions That’ necessary be- cause it is easy for new auditors fo be intimidated by older, more experienced Gnancial personnel at a client company. nd they have not yet heard enough Fecories’ chat clients often tell auditors about the reasons ddicstalE watches for er of Urbaeh Kahn & Werin. behind transactions. ssarning signals Such experience will ‘There are many faccorsthac might come with time, but we ery to mah them ware of potential problems The fitins new audicors are closely supervised by a senior ac- countane for at least che first six snowehat afeer ehat they may work slone on occasion with more indi- tect supervision, Fleming said. Au- dice sre conducced by ceams of 2 0 0 profesional with an expe= enced Reld auditor in charge, a5 cells with audic management that relies experienced audit part= nner He added an example of special iuulit procedures [fit i possible, the ‘uicors often make unannounced sist 0 a cient inventory site Sela Friedman | | {|CASE STUDY Strong Internal Controls Are Vital 6“ 'etely heavily on the state of che clients \ X [tera conta in auesiog he poren= tial for fraud,” said Ellen MG. Long CPA, president of Long & Edmunds, CPAs. Warrens- burg. Missouri. “If we see 2 weakness in those controls then we do much mote testing” Longs frm of ewo partners plus one experienced sta? soon-to-be CPA and one accounting student audits mainly government entities, long with 2 number of noc for-profit organizations, “We deal with numerous com pliance issues and state regulations,” she said. We find ‘when we Gtse work with them, many small government units aren't as well informed 3s they should be about seaucory requirements. If something isnt right, ie may not be that che clients don t ‘want co comply; they may not be aware of what chey should be doing. I see part of our cole as making sure they under- stand what is expected of them * What the firm looks at ‘There are several things Long's frm considers during an audit that might warn of misstatements or faud, includ- ing the “the way the client's financial staff responds to questions,” she said “For example, iff ask about internal controls and get an unusual or ambigu- ous response that may be a clue that something is wrong If our suspicions are aroused, I start asking around in more depth. I've found chat if we ask around discreetly, there is usually someone who ‘can give us information we need ‘Other signals that raise her suspi are improper segregation of duces, with individuals who are related working closely in the same area; poor recordkeeping: a lor of cash activity and transactions using petty ca chan checks: and the lack of a bidding process for the purchase of goods or services. While these ate not guat~ antees something is amiss, itis important ¢o look closely acall cransactions, she said. “Ir often is very haed to tell the difference berween incompetence and fraud “We tell our new auditors to ake nothing tor granted, when they are on an audit, but also not to assunie peo ple are doing anything wrong " Long stid "The new auditors are usually recent graduates. snd thes re very conscious of what a proper audit should be like and what an ideal financial report should look like They tend to notice everything We are 1 small firm and we don t have » formal tniining program,” she added. The rm sends wditors co 2 continuing professional education css on trad spon- sored by the Missouri Society of CPAs: there ire sec eather "Our new auditors are usualy re- ‘cent graduates, and they're very conscious of what a proper ‘shouldbe fke and what an ides financial report should look lke, ions said Elen M. . Long, CPA, of Long & Edmunds, CPAs ‘ions tor individ ac varying levels of experience, “We ako send them for CPE to learn more about sulting cals wll a government audiing ‘The rst of ee ting b on-theoo™ The audit re going to the client, he auditor in charge runs che Sgures from the client’ general ledger chrough a software program (che American Institute of CPAs Accountant’ ‘Teal Balance) o do a variey of tess. “We look at things such as the changes between the prior and current years Sgures in all rial balance aecounss and the difference be- ‘seen the amount budgeted and actual revenues and ex- penditures,” she said “For example, 1 take the range of figures from the soft ‘ware program, using the materiality level to decide which accounts and which transactions to examine” Acthe client’ offices, the CPA in charge looks at the internal contzols, asks questions of the client's financial staff and prepares alist of criteria to be used to test whether the necessary con- trols are in place—including how many people sign checks and what the over- sight procedures are The firm's new staff members work under direct supervision and don't speak directly with che clients financial staff concerning significant audit issues, Long said During the audit they follow the td instructions of the senior CPA and, in accordance with the list of criteria, ex: amine the checks, invoices and other Papers for the accounts selected and uke the necessary calculations to see if the controls are functioning, [f there are discrepancies that cannot be resolved, the auditor in charge will discuss these with ehe client For example Long explained, “IF wanted che staf member with me 10 do some expense testing, I'd decide how anich he or she should test for a particular account, such a8 office supplies—a routine expendicure. Depend- ing on the materiality level, I might decide to examine © invoices for 80% of the fora office supply costs. Our seaff' member would do that, checking and listing the cows shown agains che general ledger Bgures to be sure there was no dispariny the invoices were approved at the appropriate level of authority and che goods were actual- Iv received” Pairing the junior and senior auditors at an audie ies the newer sta member an opportunity to see how che clients internal controls work and what che firm considers clues co possible misstatement, Long added. “Selina Friedman 80 JOURNAL ACCOUNTANCY Oceuder 5