Follow the Leader: There Are Five Business-Building Hats Managing Partners Need to Wear. Here's How to Make Them Fit Better

Despite the high-profile lawsuits filed against auditors for revenue manipulation by company management, data on audit malpractice claims for the 22,000 CPA firms insured with Continental Casualty Co. (CNA), underwriters of the AICPA professional liability insurance program, show only 5% of all audit claims involved this type of financial statement fraud. An examination of CNA's overall audit claims data provides CPAs with some insight into what prompts most audit claims and what steps accounting firms can take to protect themselves against liability. While tax practice generated almost 60% of AICPA program claims, audit claims--which occurred far less frequently--tended to be "severe" (high cost). And, although claims from public company audits generally were costly, they made up only 2% of all program claims; those from audits of nonpublic entities accounted for 14%. This article focuses on audit claims involving nonpublic entities. AUDIT CLAIMS BY CAUSE OF LOSS As shown in exhibit 1, page 61, nonpublic audit claims arose primarily from technical standards violations, failure to detect defalcations or failure to include appropriate disclosures on the face of the financial statements or in the footnotes. Inventory errors. Of the 63% of audit claims from technical standards violations, almost half involved improper inventory valuation. This figure was much higher for manufacturing industries. Professional judgment is a significant factor in valuing inventory and other assets. Practitioners who lack experience with a client's specific industry are more likely to make mistakes valuing partially completed products and projects, raw materials and intangible assets such as goodwill or technology in the research and development stage. Errors valuing obsolete inventory also are common. Many times the auditor relies too much on management representations and fails to verify their reasonableness. Example. A CPA firm issued unqualified audit reports for three years to a client whose asset-based lending agreement was secured by unsold and presold inventory. Comments in the workpapers indicated the auditor had ongoing concerns about inventory obsolescence and late booking of returns. At the end of the third year, the client's lender initiated foreclosure proceedings to liquidate the business's assets when it no longer could service its debt. After recovering about half of the outstanding debt in liquidation, the lender sued the directors, the officers and the CPA firm. The lender alleged the second-year financial statements were materially misstated, causing it to further extend the line of credit despite the fact the client was in violation of the loan covenants. An expert the insurance company retained on the auditor's behalf concluded inventory was overstated in all three years and returns were, in fact, improperly booked. The client's inventory control system did not track unit costs or date of purchase, and the auditor failed to disclose this internal control weakness in either management letters or the audit reports. The parties settled the claim before trial for approximately 10% of the damages. Accounts-receivable errors. Inadequate testing and verification of accounts receivable were also common problems. Of the 63% of nonpublic entity audit claims that arose from technical standards violations, more than one-third involved accounts-receivable errors. Too often the auditors accepted management representations about the collectibility of a particular receivable or class of receivables without adequately examining past collection experience or the reasonableness of management representations in light of market and industry conditions. Expert review often revealed bad debt reserves were inadequate and the company failed to write off a significant portion of accounts receivable in prior periods. This failure resulted in material errors in past and current financial statements. …