You are engaged to audit a manufacturer of specialized steel. During the audit, you review correspondence with regulatory agencies and discuss with management and employees any knowledge of compliance issues. The CFO informed you that the IRS indicated the company would receive penalties for tax filings of $200,000. This amount was material, and an audit adjustment was made to reflect the penalties. You reviewed Board minutes and tax returns to gain sufficient evidence. You performed the audit in accordance with GAAS and you issued an unmodified opinion.

After the audit report was issued, an inspection for emissions was performed by the EPA representative. These inspections are randomly performed with each company being inspected at least once every three years. The EPA inspector found the company was illegally emitting harmful waste into the atmosphere. The company was told they needed to book a remediation liability, which caused them to violate their debt covenants.

The bank and the client sued your firm for negligence because you failed to detect the violation and bring it managements and the banks attention.

1. What is your responsibility as an auditor for detecting noncompliance with laws and regulations?
2. What category or categories of noncompliance are described in the scenario?
3. Did you follow the appropriate procedures for detecting noncompliance with laws and regulations?
4. If so, why? If not, what should you have done differently?
5. Based on your explanation, would you conclude the firm is liable to the client? the bank?