Reference no: EM133196946

Read the specific facts and circumstances of the case study, identify the key red flags that heighten professional skepticism, and provide your own evaluation for what you would do next for each red flag. 

I was the audit senior manager on the pursuit team and ultimately, the engagement team of a new client. My team was excited about the win, and because year-end was approaching fast, we started the audit within days of our appointment as the company's auditors. Initially, all went smoothly. We met our milestones and quickly developed an excellent working relationship with the company's CFO, who appreciated the quality of our work, our responsiveness, and the questions we asked about the business. Toward the end of the audit, a staff accountant drew my attention to a material reconciling item that lacked supporting documentation. The client contact responsible for providing the documentation had not responded to our requests for details, so I paid her a quick visit to find out what was causing the delay. She explained that the reconciling entry went back a number of years and was made up of mainly minor items, and it grew slightly year by year. Exact details would take several days, she said, because she'd have to go back years on some of the items. I explained that we would indeed need her help to explain these items even if it did take a few days for her to obtain the supporting documentation. When she still did not respond to our request, we knew we needed to elevate the matter although we were not yet overly concerned. That afternoon, I joined the partner in charge for a status meeting with the CFO since we were approaching the report date. He asked us what was still open to complete the audit. "We're waiting for detail on one reconciling item," I told him. "That's about it." He promised that his team would provide the information and said he'd get back to me. But he didn't get back to me. A few days before sign-off, the partner and I stopped by his office again. "Great job, guys," he said with a smile, leaning back in his chair. "But that one item - well, we don't want to make a mountain out of a mole hill, do we? It's been a regular reconciling item forever. Our prior auditors never flagged it even once, and it barely changes year to year."

"As you know, the audit report is due tomorrow," the CFO continued, "and frankly, I'd like us not to delay it by continuing to research that particular item. That OK with you guys?"

The following outcomes are examples of what could happen as a result of applying appropriate professional skepticism as an auditor of this case

After a long, uncomfortable silence, the audit partner cleared his throat and said to the CFO, "I respect you, and I completely understand your position. But equally, you need to understand ours. As your auditor, in our judgment, the amount is material. Comparing it to prior-year amounts simply is not sufficient under our professional obligations. We need to know what it's composed of, and we cannot sign off on our audit of your company's financial statements and internal controls over financial reporting without this information. If we can sit with your people and have them take us through the history of the amount, it would be very helpful." You could have heard a pin drop in the office. The CFO went pale, the smile gone from his usually jovial face. He was clearly surprised that this item had such importance to us. "Well," he said after a pause, "as our auditors, that is certainly your right. But you'll need to explain it to the audit committee." The next day, we did. The committee members were predictably cranky, but after some discussion, they agreed that the issuance of the financial statements and the audit report should wait for the research on this item. Two days passed. The targeted report date had been missed. The next day, the CFO's assistant called and asked us to come up to his office. When we arrived in his office, the CFO was with the head of Human Resources. Both looked serious. "Well," he said, looking the audit partner straight in the eye and reaching out to offer him a firm handshake, "I guess I owe you an apology. Both of you, in fact." He continued, "We've discovered an embezzlement. Been going on several years. That reconciling item was being used to cover it. Our control process broke down, and we did not catch it. Without you, our auditors, pushing us, we'd never have spotted it." My client contact - the woman who had ignored my original requests for documentation - had just been arrested for the embezzlement. She was escorted from the building in police custody.