on those financial statements is material. Although there are rare cases in which GAAP need not be followed (e.g., new forms of business transaction), see 2 AICPA PROFESSIONAL STANDARDS, Code of Professional Conduct ET Section 203.02 (Am. Inst. Certified Pub. Accountants (CCH) 1990), in the usual circumstance, GAAP is to be followed. When it is not and the auditor fails to discover it, an unqualified audit opinion rendered on the related financial statements is incorrect. See ALVIN A. ARENS & JAMES K. LOEBBECKE, AUDITING: AN INTEGRATED APPROACH 110 (5th ed. 1991). GAAP also requires the disclosure of all material related party transactions. See 1 ACCOUNTING STANDARDS, FASB Statements of Standards 553 (Fin. Accounting Standards Bd. 1990). If the auditor does not discover, and is therefore unable to require disclosure of a transaction of this type, the related financial statements are not fairly presented. In United States v. Simon, 425 F.2d 796 (2d Cir. 1969) (the "Continental Vending" case), the auditors failed to discover the magnitude of a related party transaction because of the client's practice of netting receivables and payables from the same company. As a result, the net impact to the audited company appeared insignificant even though the receivable could not be repaid by the related party. See WALLACE, supra note 57, at 260. GAAP requires this disclosure because transactions consummated between related parties (i.e., officers, directors, subsidiaries, affiliates, etc.), are not at arms' length. Therefore, there is the likelihood that the transfer price may not be at fair market value. If the transfer price is below fair market value, the stockholders and/or creditors will be financing the differential and should know it.
Another area of potential litigation is when there is inadequate disclosure of a "probable" material uncertainty in which "there is a reasonable possibility that the outcome will be unfavorable," see Kieso and Weygandt, supra, at 604, such as litigation between the client and another party (e.g., customer, vendor, or competitor). Such a contingency could certainly affect an investor's or creditor's assessment of the quality of his investment or loan. Improper deferral of costs is another problem. As a general rule, for the financial statements to be reflected in accordance with GAAP, costs need to be expensed when incurred. However, it is sometimes difficult to determine this date, especially when one is dealing with estimates. Id. at 38. Expense and revenue recognition are complex issues. Typically, the "expense recognition is tied to revenue recognition.... This practice is referred to as the matching principle because it dictates that efforts (expenses) be matched with accomplishment (revenues) whenever it is reasonable and practicable to do so." Because deferring expenses is equivalent to reflecting costs that have already been incurred as an asset, expense deferral has been used by some clients to manipulate or "smooth" income.
Other Irregularities: Lapping is an irregularity committed by the client's management or employees, which is intended to hide a theft of cash by manipulating the application of cash receipts to accounts receivable. See, e.g., WALLACE, supra note 57, at 267 (discussing settlement of lawsuit brought against Arthur Andersen & Co., involving their client Frigitemp, in which various collusive fraudulent practices, including lapping, went undetected by the auditors). Another client irregularity is kiting. Kiting occurs when the cash balance is overstated, typically by means of bank transfers and float. Still another irregularity involves the embezzlement of company funds by management or an employee, see, e.g., LARRY F. KONRATH, AUDITING CONCEPTS AND APPLICATIONS: A RISK-ANALYSIS APPROACH 61 (1989) (discussing an instance when Touche Ross & Co. successfully defended itself in 1982 for failing to detect an