What an auditor does when finding

fraud or illegal acts.

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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.

MATERIAL FRAUD OR

ILLEGAL ACTS

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.
IMMATERIAL FRAUD

OR ILLEGAL ACTS

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.

ADDITIONAL GUIDANCE

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).