A Dishonest Client Will Get The Best Of

The Auditor Almost Every Time

Able Construction Company entered into long-term construction contracts,
recognizing income using the percentage of completion method of
accounting. To finance its operations, Able borrowed funds from the bank
and agreed to comply with restrictive loan covenants dependent on
reported income from the long-term contracts. The percentage of
completion method of accounting requires, among other things, an
agreement with well-defined, enforceable terms, a reliable method of
estimating costs to complete the contracts, and recognition of losses at the
time they become known. As part of the audit of Able, its auditors read the
contracts for all projects in progress, tested costs incurred to date, and
assessed the ultimate profitability of the contracts, including discussing
them with management. A significant part of verifying income under
percentage of completion is auditing costs incurred.
In the current year, managements records and schedules of projects indicate that all
projects will result in a profit. For
each project, there is a separate schedule showing estimated total revenue from the
project, costs incurred in the
current period, costs incurred to date, estimated total costs, percentage of completion,
and profit recognized in the
current period. The auditor discussed each project with management, performed audit
tests to support the schedule,
and concluded that the revenue, expenses, and profit were reasonably stated. Reported
income allowed Able to meet
several of the restrictive covenants in its loan agreement with the bank.
In fact, Able had incurred a significant loss on one of its major projects. Able engaged a
subcontractor to do
reconstructive work not anticipated in the original contract bid. In awarding the
subcontract, Able entered into an
agreement with the subcontractor that the work would not be paid for until after its
audit was completed in an effort
to defer recording losses associated with the additional work. Management hid the
subcontractors invoices from the
auditors as they were received. During the next year, management recognized this loss
but doctored the invoices so
that it appeared the unexpected additional cost was incurred during that year, and
that the previous years
statements were correct and that all loan covenants with the bank were satisfied.
The fraudulent misstatement was discovered several years later when Able went
bankrupt and the CPA firm was sued
by the bank for performing inadequate audits. The firm was ultimately found not
responsible, but only after spending
extensive time and large amounts of money defending its audit.