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Auditing Standard No. 2

An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements

APPENDIX D

Examples of Significant Deficiencies and Material Weaknesses
 

D1.            Paragraph 8 of this standard defines a control deficiency.  Paragraphs 9 and 10 go on to define a significant deficiency and a material weakness, respectively. 

Paragraphs 22 through 23 of this standard discuss materiality in an audit of internal control over financial reporting, and paragraphs 130 through 140 provide additional direction on evaluating deficiencies in internal control over financial reporting.  

The following examples illustrate how to evaluate the significance of internal control deficiencies in various situations.  These examples are for illustrative purposes only.

Example D-1- Reconciliations of Intercompany Accounts Are Not Performed on a Timely Basis

Scenario A - Significant Deficiency.  The company processes a significant number of routine intercompany transactions on a monthly basis.  Individual intercompany transactions are not material and primarily relate to balance sheet activity, for example, cash transfers between business units to finance normal operations.

A formal management policy requires monthly reconciliation of intercompany accounts and confirmation of balances between business units.  However, there is not a process in place to ensure performance of these procedures.  As a result, detailed reconciliations of intercompany accounts are not performed on a timely basis.   Management does perform monthly procedures to investigate selected large-dollar intercompany account differences.  In addition, management prepares a detailed monthly variance analysis of operating expenses to assess their reasonableness.
Based only on these facts, the auditor should determine that this deficiency represents a significant deficiency for the following reasons:  The magnitude of a financial statement misstatement resulting from this deficiency would reasonably be expected to be more than inconsequential, but less than material, because individual intercompany transactions are not material, and the compensating controls operating monthly should detect a material misstatement.  Furthermore, the transactions are primarily restricted to balance sheet accounts.  However, the compensating detective controls are designed only to detect material misstatements.  The controls do not address the detection of misstatements that are more than inconsequential but less than material.  Therefore, the likelihood that a misstatement that was more than inconsequential, but less than material, could occur is more than remote.

Scenario B - Material Weakness.  The company processes a significant number of intercompany transactions on a monthly basis.  Intercompany transactions relate to a wide range of activities, including transfers of inventory with intercompany profit between business units, allocation of research and development costs to business units and corporate charges.  Individual intercompany transactions are frequently material.

A formal management policy requires monthly reconciliation of intercompany accounts and confirmation of balances between business units.  However, there is not a process in place to ensure that these procedures are performed on a consistent basis.   As a result, reconciliations of intercompany accounts are not performed on a timely basis, and differences in intercompany accounts are frequent and significant.   Management does not perform any alternative controls to investigate significant intercompany account differences.
Based only on these facts, the auditor should determine that this deficiency represents a material weakness for the following reasons:  The magnitude of a financial statement misstatement resulting from this deficiency would reasonably be expected to be material, because individual intercompany transactions are frequently material and relate to a wide range of activities.  Additionally, actual unreconciled differences in intercompany accounts have been, and are, material.  The likelihood of such a misstatement is more than remote because such misstatements have frequently occurred and compensating controls are not effective, either because they are not properly designed or not operating effectively.  Taken together, the magnitude and likelihood of misstatement of the financial statements resulting from this internal control deficiency meet the definition of a material weakness.

Example D-2 - Modifications to Standard Sales Contract Terms Not Reviewed To Evaluate Impact on Timing and Amount of Revenue Recognition

Scenario A - Significant Deficiency.  The company uses a standard sales contract for most transactions.  Individual sales transactions are not material to the entity.  Sales personnel are allowed to modify sales contract terms.  The company's accounting function reviews significant or unusual modifications to the sales contract terms, but does not review changes in the standard shipping terms.  The changes in the standard shipping terms could require a delay in the timing of revenue recognition.   Management reviews gross margins on a monthly basis and investigates any significant or unusual relationships.  In addition, management reviews the reasonableness of inventory levels at the end of each accounting period.  The entity has experienced limited situations in which revenue has been inappropriately recorded in advance of shipment, but amounts have not been material. 
Based only on these facts, the auditor should determine that this deficiency represents a significant deficiency for the following reasons:  The magnitude of a financial statement misstatement resulting from this deficiency would reasonably be expected to be more than inconsequential, but less than material, because individual sales transactions are not material and the compensating detective controls operating monthly and at the end of each financial reporting period should reduce the likelihood of a material misstatement going undetected.  Furthermore, the risk of material misstatement is limited to revenue recognition errors related to shipping terms as opposed to broader sources of error in revenue recognition.  However, the compensating detective controls are only designed to detect material misstatements.   The controls do not effectively address the detection of misstatements that are more than inconsequential but less than material, as evidenced by situations in which transactions that were not material were improperly recorded.  Therefore, there is a more than remote likelihood that a misstatement that is more than inconsequential but less than material could occur.

Scenario B - Material Weakness.  The company has a standard sales contract, but sales personnel frequently modify the terms of the contract.  The nature of the modifications can affect the timing and amount of revenue recognized.  Individual sales transactions are frequently material to the entity, and the gross margin can vary significantly for each transaction.

The company does not have procedures in place for the accounting function to regularly review modifications to sales contract terms.  Although management reviews gross margins on a monthly basis, the significant differences in gross margins on individual transactions make it difficult for management to identify potential misstatements.  Improper revenue recognition has occurred, and the amounts have been material. 
Based only on these facts, the auditor should determine that this deficiency represents a material weakness for the following reasons:  The magnitude of a financial statement misstatement resulting from this deficiency would reasonably be expected to be material, because individual sales transactions are frequently material, and gross margin can vary significantly with each transaction (which would make compensating detective controls based on a reasonableness review ineffective).  Additionally, improper revenue recognition has occurred, and the amounts have been material.   Therefore, the likelihood of material misstatements occurring is more than remote.   Taken together, the magnitude and likelihood of misstatement of the financial statements resulting from this internal control deficiency meet the definition of a material weakness.

Scenario C - Material Weakness.  The company has a standard sales contract, but sales personnel frequently modify the terms of the contract.  Sales personnel frequently grant unauthorized and unrecorded sales discounts to customers without the knowledge of the accounting department.  These amounts are deducted by customers in paying their invoices and are recorded as outstanding balances on the accounts receivable aging.  Although these amounts are individually insignificant, they are material in the aggregate and have occurred consistently over the past few years.

Based on only these facts, the auditor should determine that this deficiency represents a material weakness for the following reasons:  The magnitude of a financial statement misstatement resulting from this deficiency would reasonably be expected to be material, because the frequency of occurrence allows insignificant amounts to become material in the aggregate.  The likelihood of material misstatement of the financial statements resulting from this internal control deficiency is more than remote (even assuming that the amounts were fully reserved for in the company's allowance for uncollectible accounts) due to the likelihood of material misstatement of the gross accounts receivable balance.  Therefore, this internal control deficiency meets the definition of a material weakness.

Example D-3- Identification of Several Deficiencies

Scenario A - Material Weakness.  During its assessment of internal control over financial reporting, management identified the following deficiencies.  Based on the context in which the deficiencies occur, management and the auditor agree that these deficiencies individually represent significant deficiencies: 

  • Inadequate segregation of duties over certain information system access controls.
  • Several instances of transactions that were not properly recorded in subsidiary ledgers; transactions were not material, either individually or in the aggregate.
  • A lack of timely reconciliations of the account balances affected by the improperly recorded transactions.

Based only on these facts, the auditor should determine that the combination of these significant deficiencies represents a material weakness for the following reasons: Individually, these deficiencies were evaluated as representing a more than remote likelihood that a misstatement that is more than inconsequential, but less than material, could occur.  However, each of these significant deficiencies affects the same set of accounts.  Taken together, these significant deficiencies represent a more than remote likelihood that a material misstatement could occur and not be prevented or detected.   Therefore, in combination, these significant deficiencies represent a material weakness.

Scenario B - Material Weakness.  During its assessment of internal control over financial reporting, management of a financial institution identifies deficiencies in: the design of controls over the estimation of credit losses (a critical accounting estimate); the operating effectiveness of controls for initiating, processing, and reviewing adjustments to the allowance for credit losses; and the operating effectiveness of controls designed to prevent and detect the improper recognition of interest income.   Management and the auditor agree that, in their overall context, each of these deficiencies individually represent a significant deficiency.

In addition, during the past year, the company experienced a significant level of growth in the loan balances that were subjected to the controls governing credit loss estimation and revenue recognition, and further growth is expected in the upcoming year.

Based only on these facts, the auditor should determine that the combination of these significant deficiencies represents a material weakness for the following reasons:

  • The balances of the loan accounts affected by these significant deficiencies have increased over the past year and are expected to increase in the future.
  • This growth in loan balances, coupled with the combined effect of the significant deficiencies described, results in a more than remote likelihood that a material misstatement of the allowance for credit losses or interest income could occur.

Therefore, in combination, these deficiencies meet the definition of a material weakness.