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Defense against litigation for deficiency in audit of AR

In confirming accounts receivable on December 31, 2007 the auditor found 15 discrepancies between the customers' records and the recorded amounts in the accounts receivable master file. A copy of all confirmations that had exceptions was turned over to the company controller to investigate the reason for the difference. He, in turn, had the bookkeeper perform the analysis. The bookkeeper analyzed each exception, determined its cause, and prepared an elaborate spreadsheet explaining each difference.

Most of the differences in the bookkeeper's report indicated that the exceptions were caused by timing differences in the client's and customer's records. The auditor reviewed the spreadsheet and concluded that there were no material exceptions in accounts receivable.

Two years subsequent to the audit, it was determined that the bookkeeper had stolen thousands of dollars in the past year by taking cash and overstating accounts receivable. Ina lawsuit by the client against the CPA, an examination of the auditor's December 31, 2007, accounts receivable working papers, which were subpoenaed by the court, indicated that one of the explanations in the bookkeeper's analysis of the exceptions was fictitious. The analysis stated the exception was caused by a sales allowance granted to the customer for defective merchandise the day before the end of the year. The difference was actually caused by the bookkeeper's theft.

a. What are the legal issues involved in this situation? What should the auditor use as a defense in the event that he is sued?
b. What was the CPA's deficiency in conducting the audit of accounts receivable?

Solution Preview

The legal issue is whether the CPA firm (and its insurance carrier) are responsible for reimbursing the dollar amount of the theft to the audit client. The first line of defense is that it cannot be assumed that a CPA will discover all fraud. The only sure way to find fraud is with a 100% test of every transaction; in other words, to completely redo the accounting records. That is not practical or affordable and therefore CPAs use testing procedures to determine the validity of the system of internal control. This very situation is not an uncommon; it happens much more than is reported.

The defense to be used relates to the ...

Solution Summary

The solution explains which section of the generally accepted auditing standards (GAAS) will be used to attack the CPA firm's procedures. Following that are two paragraphs explaining how it could have been done much better and what the weaknesses in the procedures were.