Failure to Competently Evaluate Evidence Obtained by the Confirmation Process
In general, it is presumed that audit evidence is more reliable when it is obtained from knowledgeable
independent sources outside the entity. During the 2005 year-end audit, L&H failed to competently evaluate
the reliability of the audit evidence obtained by the confirmation process. Exhibit 1 elaborates on the
inadequacies.
Failure to Assess the Risk of Material Misstatement Due to the Omni Data Transaction
Although L&H became aware of the informant’s allegations prior to and during the course of the 2005
year-end audit, it took few steps to investigate the informant’s allegations during the audit. Moreover, to
the extent to which L&H developed any evidence regarding the informant’s allegations, the evidence
corroborated many of the informant’s claims.
For example, L&H searched Connecticut and Massachusetts corporate records, but found no evidence
that Omni Data was incorporated. Howley attempted to contact the alleged President of Omni Data, but
was initially unable to reach her as the first confirmation sent to Omni Data was returned as undeliverable.
L&H discovered additional red flags regarding the Omni Data transaction during the 2005 interim
reviews and year-end audit. For example, L&H discovered that:
The Omni Data receivable comprised approximately 76 percent of the overall accounts
receivable, but LocatePlus had collected only $250,000 in payments in 2005 from Omni Data
out of approximately $3.6 million in revenue recognized.
Payments totaling approximately $10,000 from LocatePlus to the alleged President of Omni
Data.
Payments totaling approximately $325,000 to the CEO.
Although L&H’s work papers document the informant’s allegations, they do not document the
procedures specifically designed to assess these risks. In fact, L&H’s “Fraud Risk Assessment Form,” for
the 2005 year-end audit, which lays out procedures intended to facilitate compliance with auditing
standards is blank.
Moreover, an item on L&H’s audit program (completed at the conclusion of the audit) specifically
instructs “[i]f you believe that fraud or an illegal act may have occurred, document the circumstances
identified and apply the procedures for potential fraud or illegal acts in additional procedures section of
this audit program.”
The work paper states, “none noted” next to the proposed procedure indicating that L&H never applied
the additional procedures in its own audit program. Howley testified that he reviewed this work paper.
L&H’s 2005 year-end work papers do not document that L&H came to any conclusion about the
merits of the informant’s allegations. L&H’s 2006 year-end work papers document that the very
existence of Omni Data was still an open question through the 2006 year-end audit and that L&H did
not come to a final conclusion about the informant’s allegations until, at the earliest, April 2007.
Despite the numerous red flags and lingering questions about the existence of the Omni Data
receivable, L&H’s 2006 year-end work papers also do not document an assessment of the risks of
material misstatement due to fraud.
Despite being aware of the informant’s allegations of fraud (and thus the risks of material
misstatement), Howley did not undertake adequate audit procedures during the 2005 or 2006 year-end
audits to assess these risks.
L&H’s 2005 year-end audit work papers document that L&H accepted management’s explanations for
the red flags. For example, with regard to the Omni Data receivable, Howley accepted LocatePlus’s
management’s representation that it was collectable despite L&H’s difficulties verifying its existence and
Omni Data’s failure to make payments under the terms of the purported contact.
With regard to the CEO payments, Howley accepted the explanation that the payments were “bonuses”
approved by the Board even though the bonuses did not go through LocatePlus’s payroll system. In
addition, L&H did not obtain LocatePlus’s Board minutes to attempt to verify the explanation. Finally,
with regard to the payments to the alleged President of Omni Data, Howley accepted LocatePlus’s
explanation that they were “referral fees” despite allegations that the alleged President was a figurehead
installed by the CEO.
Alleged Professional Violations
The SEC charged that L&H, Howley and Wood engaged in improper professional conduct that violated
Section 4C(a)(2) of the Exchange Act and Rule 102(e)(1)(ii) of the Commission’s Rules of Practice.
Under Rule 4C(b)(2) and Rule 102(e)(1)(iv)(B) the term “improper professional conduct” means, in part,
“a single instance of highly unreasonable conduct that results in a violation of applicable professional
standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is
warranted.”
In light of the specific allegations that the Omni Data transaction was fictitious, L&H’s and Howley’s
failure to adequately design testing procedures to address that very risk, and Wood’s concurrence in the
approval of the issuance of L&H’s 2005 and 2006 audit reports when he knew that significant matters
were unresolved, constituted highly unreasonable conduct that resulted in a violation of applicable
professional standards in circumstances in which each knew, or should have known, that heightened
scrutiny was warranted.
The failure of L&H and Howley to plan the audits properly, test the Omni Data revenue adequately,
obtain sufficient competent evidence to serve as a basis for L&H’s audit reports, and assess properly the
risks of material misstatement due to fraud, and the failure of Wood to address these deficiencies also
constituted highly unreasonable conduct that resulted in a violation of applicable professional standards in
circumstances in which each knew, or should have known, that heightened scrutiny was warranted.
As a result of the conduct alleged in the SEC filing, L&H, Howley and Wood violated Section
10A(a)(1) of the Exchange Act, which requires each audit to include procedures designed to provide
reasonable assurance of detecting illegal acts that would have a direct and material effect on the
determination of financial statement amounts.
Exhibit 1
Evaluation of Audit Evidence
First, L&H initially sent its confirmation to the president of Omni Data – a person alleged by the informant to
be a “stooge” of the CEO – at the address that LocatePlus had provided. Moreover, the confirmation was
initially returned to L&H by the U.S. Postal Service as “undeliverable.” Ultimately, a confirmation was
received, signed by a person purporting to be president of Omni Data.
During the 2006 year-end audit, the confirmation sent to the Omni Data address that LocatePlus had
provided was again returned as “undeliverable.” When Howley questioned LocatePlus about the confirmation,
he was told that Omni Data had a new president, and that it was doing business under a completely different
name: Economics Data Solutions. Howley researched the new president but was unable to confirm that he was
related to Omni Data. In fact, the only research contained in L&H’s 2006 work papers regarding the alleged
new president was a December 8, 2005, newspaper article describing an individual by the same name as an
attendee at tryouts for the reality television show Ultimate Fighting. L&H ultimately received a confirmation
signed by a person purporting to be the new president of Omni Data.
Questions
1. Do you think L&H’s actions with respect to LocatePlus and its alleged relationship with Omni
Data illustrates a case of moral blindness? Explain with respect to the ethics of actions by
LocatePlus and its effect on audit decisions by L&H.
Moral blindness is a term used to describe someone who can’t tell right from wrong – a person who is
oblivious to moral issues — rather than just choosing to ignore doing “the right thing.” In the case of
LocatePlus, L&H and Howley wanted to believe that LocatePlus was an honest client so the firm
ignored all the red flags that raised issues about the accounting and financial reporting and reflected
A lack of integrity by a client typically means that the information provided by the client and the
financial statements cannot be trusted. L&H had determined to use extensive care in the audit and treat
2. A critical element of the due care requirement is to approach an audit with professional
skepticism. Evaluate the audit procedures and decisions made by L&H with respect to this
ethical standard.
L&H should have been highly skeptical of LocatePlus after being warned by the predecessor auditors and
tips about the fraud from the information. Professional skepticism is an attitude that includes a questioning
mind and a critical assessment of audit evidence. For example, with regard to the Omni Data receivable,
Howley accepted LocatePlus’ management’s representation that it was collectible despite L&H’s
difficulties verifying its existence and Omni Data’s failure to make payments under the terms of the
purported contact. L&H should have required not just confirmation but subsequent procedures to ensure that
the receivable from Omni Data was paid. L&H should have been more skeptical when they could not find
3. Evaluate the legal liability of L&H, Howley and Wood using the legal concepts discussed in
this chapter. Support your analysis with reasoning as to whether the auditors failed to exercise
ordinary care, were grossly negligent, or committed fraud.
L&H failed to exercise due professional care in the planning and performance of the audit and the
preparation of the audit report, which is failure to exercise ordinary care. In exercising professional
skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that
management is honest. L&H and Howley are legally culpable for failing to conduct an audit in accordance
What Happened to LocatePlus?
The former chief financial officer and, later, CEO of LocatePlus, a publicly-traded tech business in Beverly,
Mass. that sold access to personal data and other information, has been sentenced to five years in prison,
three years of supervised release and was ordered to pay restitution to his victims.
James T. Fields, former CFO of LocatePlus, was convicted by a federal jury of conspiracy, money
laundering, securities fraud, aggravated identity, theft and other charges. Fields and LocatePlus former
CEO, Jon Latorella, were also charged with using the identity of an Andover man who drowned in
Marlebead Harbor in 1985 as the head of a fictitious company that he created. The sentencing comes nearly
one year after Latorella was sentenced to five years in prison, followed by three years of supervised release.
Beginning in 2002, Fields participated in several schemes to inflate LocatePlus’ assets and revenues. Along
with using a dead man’s identity as the head of a fake company (named Andover Secure Resources), he
also fabricated a loan transaction between the fake company and LocatePlus under which the fake business
borrowed more than $1 million from LocatePlus at a “favorable interest rate.” Working with Latorella,
Fields also created a second fake company, called Omni Data Services, and falsified revenue streams to
make it look like the fake business was paying LocatePlus millions of dollars.
In addition to the fake companies, the two also deceived the SEC by fabricating investors using the
identities of Fields’ girlfriend, skydiving instructors and two dead men.
LocatePlus did not admit or deny the SEC’s claim but it did agree not to sell its securities in the public
markets. In the midst of Chapter 11 bankruptcy proceedings, the firm sold its assets in January 2012 to the
Everest Group.