Proposal to Say the "F" Word in Auditing Standards

By Carmichael, Douglas R.; Craig, James L., Jr. | The CPA Journal, June 1996 | Go to article overview

Proposal to Say the "F" Word in Auditing Standards


Carmichael, Douglas R., Craig, James L., Jr., The CPA Journal


The ASB has decided it can no longer dance around fraud and the auditor's responsibility to detect it. Proposed new standards say the "' word loudly and clearly

The auditor's responsibility to plan an audit to uncover fraud has changed over the years. Those who entered the profession more than 20 years ago remember (and, apparently some have refused to forget) the guidance given by the committee on auditing procedures, which said "the issuance of an opinion respecting financial statements is not designed and cannot be relied upon to dis close defalcations and other similar irregularities, although their discovery frequently results." To drive the point home, many engagement letters contained that language. Those were the "good old days" when the auditor set his or her sights on catching unintentional errors only.

But the courts and the rest of the world didn't agree with this approach. The auditor's report made no mention about financial statements being free of only material unintentional errors. The world held the auditor to a higher standard. After the Equity Funding debacle, the SEC summoned leaders of the public accounting profession to Washington and demanded to know what they planned to do to ward off similar catastrophes in the future. Standard setters at the AICPA responded with SAS No. 16, The Independent Auditor's Responsibility for the Detection of Errors or Irregularities, which changed the standards to require the auditor to "plan the audit to search for errors or irregularities that would have a material effect on financial statements."

But problems continued to occur. Material fraud was being committed that misstated financial statements, and auditors in a number of well-publicized cases failed to detect frauds that audits in accordance with the standards should seemingly have detected.

The Auditing Standards Board (ASB) went back to the drawing board to see if standards needed to be changed to heighten the awareness and effectiveness of auditors in searching and detecting fraud. The result was SAS No. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities. SAS No. 53 requires auditors to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The statement was one of a series of nine statements that, as a group, became known as the expectation-gap standards. The statement indicated that responsibility to detect material misstatements existed whether the misstatement was a result of errors or irregularities. But the "F" word, fraud, was still studiously avoided except for a brief mention that management fraud was one form of irregularity. It was the intention of the standard setters, however, that auditors understand and perform audits so as to provide reasonable assurance that financial statements were free of material misstatement regardless of the cause, whether that be inadvertent error, employee dishonesty and concealment, or management fraud.

But in the years following the issuance of SAS No. 53, incidences of material misstatements in financial statements, principally because of management fraud, continued to be made public. The saw ings-and-loan crisis, with stories of mismanagement and fraud resounding throughout the land, brought the whole issue of auditor performance once again to the front pages.

The AICPA held a conference in 1992 to review the effectiveness of all the expectation-gap standards. Had they achieved the objective of better communication to users and improved the effectiveness of auditors, especially in the detection of errors and irregularities? One of the papers presented at the conference raised the issue of the effectiveness of SAS 53.

In 1993, the Public Oversight Board of the AICPA-feeling the pressure and need to improve auditor performance-issued a publication, In the Public Interest, that gave more than 20 recommendations to various players in the financial reporting process to restore public confidence. …

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