Accountant Misses $3.4M Embezzlement in Audit

Cuyahoga Heights Local School District – a school district located in Cleveland, OH – has sued a former accountant for missing an embezzlement which eventually led to the theft of over $3M.  The embezzlement was discovered by the state during an oversight audit in 2011.

Joe Palazzo worked for the District and was in charge of technology services.  It was discovered that from 2007 to 2011, Palazzo would create fake invoices for work or products that were never done.  Ther invoices were paid to shell companies and Palazzo would then receive kick-backs from the people who owned these shell companies.  Joe Palazzo was sentenced in 2013 to 11 years in prison for the embezzlement.  While the accounting firm of Rea & Associates was only the auditor for the school during the 2008 fiscal year, the school is bringing suit against them.  They claim that if Rea had done their audit correctly, it would have discovered the early embezzlement and prevented it from going on for another 3 years.  The school district explains that the accounting firm’s malpractice stemmed from the fact that they “failed to obtain a sufficient understanding of the School District and its environment, including its internal controls, in order to assess the risk of material misstatements due to error or fraud and to design further audit procedures.”

The school is trying to place the blame for the entire embezzlement on the auditors, despite the fact that they only audited the books for one year.

This scenario highlights a few important accounting firm risk management and insurance practices:

  • Claims Made – Accountant’s professional liability insurance is written on a claims made basis.  This means that the insurance must be active and currently in place in order for coverage to be afforded for past actions.  Many firms are tempted to drop their insurance once they feel their risks have diminished or their practice is winding down.  However, in the case noted above, a firm was sued for work done nearly 6 years ago.  Firms need to be careful before they drop insurance coverage for this very reason – lawsuits often take years before filed.
  • Retro Date – Accountant’s malpractice insurance policies also contain a “prior acts” date.  Any work done prior to that date is not covered under the insurance.  Before engaging with a high-risk client or before beginning a firm’s practice, accountants need to secure this type of insurance.  Waiting until the firm is more established or has more revenue simply means that the firm’s early work has no coverage once insurance is purchased.
  • High Risk Engagements – Audits are historically the highest risk work an accountant can perform.  It is important to have robust procedures for handling audits and for following up on any red flags in the engagements.  A second partner review of the work is also prudent to catch anything previously overlooked.

Contact us to discuss ways to further protect your accounting practice.