The
detection and reporting of illegal acts by management or other employees is a
difficult task. To fulfill their responsibilities, auditors must have a good
knowledge of the client’s business, including an understanding of the laws and
regulations that govern the business and activities of their clients. In
addition, accountants and auditors must be sensitive to factors in the company
that may indicate an abnormally high risk of illegal acts by the company or its
employees.
Instructions
(a)
Identify some examples of illegal acts that may be committed by a company or
its employees that, if violated, could reasonably be expected to result in a
material misstatement in the financial statements.
(b)
Explain how, if at all, an undetected illegal act by a client (for example,
paying bribes to secure business, or violating pollution control laws and
regulations) could affect the company’s financial statements.
(c)
Identify some factors that could indicate that the risk of violation of laws
and regulations is greater than normal and that evaluation of note disclosure,
or possibly recognition, of an illegal act may be required.
(a) Some
examples of illegal acts (the violation of laws and regulations) may include:
·
Paying bribes
or “kickbacks” to secure business for the entity
·
criminal
activities committed by the company or its employees on behalf of the company
·
Violations
of laws and regulations that enter into the determination of financial
statement amounts or disclosures, such as the tax laws
·
Violations
of laws and regulations that have a fundamental effect on the entity’s industry
and its operations, such as violating pollution control and environmental laws
for a chemical company.
(b) Generally, illegal acts, if detected by authorities, are likely to give
rise to criminal penalties often including some form of financial liability. As
a result, when an illegal act occurs and an accountant or auditor fails to
detect it, a material liability may be omitted from the financial statements
(as, arguably, all illegal acts are material). Another possibility is that the
potential liability fails to satisfy the requirements of accrual, in which case
note disclosure of the contingency will incorrectly be omitted from the
financial statements. In addition, revenues and expenses derived from an
illegal act, if material in relation to the financial statements, should be
disclosed.
(c) Factors that could indicate that the inherent risk of violation of
laws and regulations is greater than normal include the following:
·
violations
of laws and regulations by the entity in the current or previous years
·
recent,
well-publicized violations of laws and regulations by other companies in the
industry
·
laws and
regulations that are new or unusually complex
·
lack of
experience on the part of management in interpreting or applying specific laws
and regulations
·
active
monitoring by regulators or other groups
