The standard audit report includes the wording "These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits." As auditors are quick to claim, an audit is not a guarantee that no fraud has been committed. The cost of an audit that could make such a claim would be far more prohibitive than could be justified.
Nevertheless, many of the frauds that are committed are of a nature that will be detected by an audit that has been properly planned, performed, and supervised. The RSM US LLP (RSM) audits of Revolution Lighting Technologies Inc (Revolution) for 2014-2017 that led to SEC charges on September 30, 2022, are examples of cases where planning, performance, and supervision were found to be deficient.
Revolution, a maker of lighting products, employed the "bill and hold" method of revenue recognition which, when meeting certain criteria, records revenue before the product is shipped to the customer. The auditor is to perform tests to ascertain for the reported revenue that the criteria have been met. Since the "bill and hold" method can be readily used to manipulate revenue recognition, the auditor needs to take special care where the technique is encountered.
Though the wide-ranging Revenue Accounting standards, IFRS 15 and ASC 606, did not go into effect until 2018 for public companies, and 2020 for other entities, ASC 606 was initially issued in 2014, and so should have been carefully reviewed at that time. Also, detailed standards were in place for the 2014-2017 period that were organized generally by industry. While there was no clear-cut rule, the various revenue criteria in place were specific enough that when considered with adequate judgement, a correct accounting treatment was expected.
In fact, when the SEC investigated this case, they noted that RSM had applied the seven criteria that Staff Accounting Bulletin (SAB) 104 deemed appropriate for the "bill and hold" method at the time. SAB 104 had been issued back in 2003. In the listing of the following criteria, the SAB indicated that failure to meet any one of them would preclude recording of revenue:
- Risks of ownership must have passed to buyer.
- Buyer has a fixed commitment to purchase, preferably in writing.
- Buyer, not seller, requested the bill and hold transaction and there is a substantial business purpose for ordering the goods on a bill and hold basis.
- A fixed delivery schedule with reasonable delivery dates exists.
- Seller has not retained any specific performance obligations.
- Product is complete and ready for shipment.
- The ordered goods must have been segregated from the seller's inventory and not be subject to being used to fill other orders.
Revolution had failed to meet not only one, but the first four criteria. How could that many failures get by the auditors? First of all, the audit team members assigned to test the "bill and hold" sales were junior team members with no experience in this area, despite the audit plan stipulating that Revolution was at the "highest audit risk level" and that "bill and hold" posed a significant risk for fraud. On the whole audit team, only the engagement partner had experience in this area, and no training was provided beforehand.
Then the audit programs designed for testing did not call for the reviewers to look at underlying evidence other than the "bill and hold" agreements with customers. Even so, the agreements themselves were not even signed and dated until after the end of the period, and no cut-off testing was called for, nor procedures to ascertain that the customer initiated the "bill and hold" or had a "substantial" purpose for doing so. Finally, the auditors did not test evidence that would have revealed that there was no fixed delivery schedule, but that delivery generally only occurred when the customer requested it.
The auditors' justification for the above actions/inactions was that the impact on revenue in this area would be immaterial in any event. Unfortunately, that conclusion was based on faulty estimates provided by the client that were not initially questioned. The auditor's planning materiality had been set at 1% of revenue. The actual misstatement was between 5% and 10% of revenue. In one year, the undercounting of the misstatement of annual revenue was at least 44%.
Even when this discrepancy was uncovered, the RSM auditors determined that the misstatement was acceptable. Though "quantitatively" material, the misstatement was considered not "qualitatively" material. What that meant was that the trends in the company's revenue, profit/(loss), and other factors, were not substantially changed by the misstated revenue. Investors had been expecting a certain pattern of revenue growth and profit/loss for the years presented. So, since the misstatement of quantities did not materially change the expected trends, the auditors did not consider adjustments necessary.
There were various other shortfalls cited in the financial statement audit, as well as in the audit of internal control over financial reporting. Ultimately, the SEC found that RSM engaged in improper professional conduct, failed to properly conduct audits, failed to adhere to Public Company Accounting Oversight Board ("PCAOB") auditing and quality control standards, from planning and supervision of the audit through the evaluation of the audit results and review of Revolution's disclosures, and unreasonably failed to comply with professional standards by concluding that Revolution's accounting and financial statements conformed with GAAP, resulting in audit reports that were inaccurate. Without an appropriate level of skepticism, RSM displayed a lack of due professional care.
RSM was fined $3.75 million by the SEC and accepted various firm and individual sanctions without admitting or denying the SEC's findings. RSM also noted in a statement that "the SEC did not bring charges of intentional misconduct, and the SEC previously has publicly stated that the former client deliberately "misled" the RSM US audit team."
Though incompetence and lack of judgment are obvious factors in the above audit failure, other unstated conditions that auditors deal with may also have an impact. As noted in the SEC report, major issues were being dealt with right up to the filing deadline and beyond, creating time pressure. Also, the auditor does not want to lose an audit client or the significant fees that the client pays for the audit. Over the four years in question, RSM averaged over $600 thousand per year in audit fees. Though these factors should not cloud the auditor's judgment when performing an audit, the undue pressure that they can exert can lead to accusations that they do. The auditor must retain constant vigilance to avoid even the appearance of such contentions.
To reemphasize an earlier point, before taking on an audit, the staffing must be considered with special care. Those assigned to perform detail testing must have experience adequate to handle the level of complexity found in the client's accounting principles and processes. Likewise, the necessary training at all levels must be assured prior to moving forward.
Further details can be found at SEC Charges Audit Firm RSM and Three Senior-Level Employees with Failure to Properly Conduct Client Audits.