Preventing Relevant Document Destruction

In a recent fraud case, we were requested to help identify whether or not a court order to produce all "accounting books and records" was met by the opposing party. Electronic general ledger files produced by the defendant lacked certain accounts, including the bank accounts. Additionally, by viewing the accounting software's auditing function, we were able to determine that all transactions for each calendar year were electronically imported to the accounting software the January following each year; i.e., somehow all the entries were stored up for a whole year and then entered - an unlikely process.

Eventually, the defendant produced a computer said to contain the entire accounting system. Using forensic computer tools and asking the appropriate questions, we were able to determine that the computer's operating system software was loaded the day before the computer was provided to counsel and that file manipulation continued early into the morning of delivery. The computer's hard drive was shipped to the retailer only weeks before delivery of the machine to counsel. These points, among others, provide circumstantial evidence that the computer could not have been used for accounting functions as claimed.

The "Expectation Gap"

As described in an article in the July/August issue of Today’s CPA, a perceived "expectation gap" has existed for at least three decades and perhaps even longer between what users of financial statements believe the responsibilities of independent auditors to be and what auditors have been able to deliver in terms of performance. The Sarbanes-Oxley Act of 2002 (SOX) raised the bar for minimum standards of disclosure for public companies, as well as minimum standards of performance for the auditors of those companies. The passage of SOX represents a major opportunity to narrow the gap.

According to the article, to understand the expectation gap, the origins and elements of audit expectations must be examined. In 1993, academics analyzed the audit expectation gap by separating it into three main components. The first component consists of the deficient performance on the part of the auditors, represented by a failure to comply with promulgated standards. Although few civil cases have emerged from the scandals of the late 1990’s and 2000’s, early anecdotal evidence implies a lack of perceived independence and due professional care on the part of many Big Four auditing firms. Two of the top ten deficiencies in SEC enforcement actions from 1987 to 1997 were failure to gather sufficient audit evidence (80% of cases), followed closely by failure to exercise due professional care (71% of cases). These failures represent violations of the general standards applicable to all CPA work and, we note, often arise with respect to expert witness work by a CPA.

The next component of the expectation gap relates to standards that fail to meet the expectations of the public. For example, current generally accepted accounting principles (GAAS) require independent auditors to plan and perform the audit to provide reasonable assurance that the financial statements are free of material misstatements caused by error or fraud. At first glance, these stated responsibilities seem straightforward. However, there has been considerable miscommunication and misunderstanding about the limitations of the independent audit and its shared boundaries with management’s responsibilities, with auditors believing management to have responsibility for financial statements while the public expects auditors to have that responsibility.

The third component is the public’s unreasonable expectation of the auditor. The public appears to require auditors to play the part of "watchdog," protecting against fraud. In fact, the professional skepticism of auditors, or lack of such skepticism, has been noted in cases of audit failure. The scope of the audit process has typically been limited to determining whether management has correctly recorded and reported in the company’s financial statements the economic consequences of business decisions; yet financial statement users often believe the audit scope includes assessing the company’s business model and adequacy of management’s financial decisions.

The purpose of Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is to provide readers with information necessary to understanding a company’s financial condition, changes in financial condition and results of operations. As reporting requirements have increased, MD&A for many companies has become unnecessarily long, redundant and ineffective. In December 2003, the SEC issued an interpretive release providing guidelines as to how companies can present more relevant and concise disclosure information in their MD&A. According to the SEC release, the MD&A has three primary objectives:

In addition to traditional information such as lines of business, principal products and services, location of operations, revenue, earnings and cash generation, and economic or industry-wide factors and/or trends affecting the company’s results, this executive summary should also discuss risks and challenges faced by the company and management’s actions or plans to address these issues. The MD&A should be the first place someone, especially a non-accountant, starts to understand a public company's financial statements.

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