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RECOGNIZING THAT AN ACT IS ILLEGAL is difficult, even for lawyers and the courts. For auditors, who lack extensive legal training, it is even harder. As the Macdonald commission observed, "The most that can practically be expected is that the auditor be alert to the possibility of illegal acts and inquire carefully into any indications suggesting their existence."
The Auditing Standards Board has approved a new CICA Handbook section, 5136, to amplify guidance about misstatements arising from the consequences of illegal acts. While Section 5135, and the rest of the Handbook, continue to apply to all misstatements, including those arising from illegal acts, the new section elaborates on the special nature of illegal acts, and how this makes misstatements arising from the consequences of illegal acts hard to find. The section also provides guidance about applying the risk model, found in Section 5130, to illegal acts. (See "Drawing the line," in the Studies & Standards department, on page 68.)
Many laws and regulations are far removed from the events and transactions normally reflected in financial statements, and auditors may have little knowledge of such laws. Also, laws are complex -- one pattern of events may be legal while a similar string of events may not. Finally, the courts are continuously interpreting laws and regulations and sometimes the interpretations are surprising. A court's ruling can, for instance, result in a reversal of status from legal to illegal (or the opposite). All of these factors affect an auditor's ability to detect illegal acts, and to evaluate whether there ma be a material misstatement arising from the consequences of such an act.
A financial statement audit is not meant to check compliance with laws. The auditor's job is to look for misstatements in the financial statements.
While auditors clearly would like to find all misstatements, however caused, there remains a risk that they will not. To be cost-effective, auditors focus only on material misstatements. As a result, immaterial misstatements in financial statements may remain undetected. Also, the inherent limitations of an audit, described in Section 5000.04, and the possibility of collusion and concealment mean that absolute assurance is not possible.
The special nature of illegal acts makes it yet more difficult for auditors to find misstatements resulting...