Internal Control Weakness Reporting

By Charles Hall | Auditing

Auditors often fail to capture and communicate internal control weaknesses, even though such communications are required by the audit standards.

But making our clients aware of control weaknesses can help them. How? It allows them to improve their accounting system. The result: prevention of future fraud and errors.

In this article, I’ll show you how to capture and communicate internal control deficiencies. By doing so, you’ll add value to your audit services and you’ll help your client protect their business.

At the end of the post, you’ll also see a video that summarizes this information.

A Common End-of-Audit Problem

You are concluding another audit, and it’s time to consider whether you will issue a letter communicating internal control deficiencies. A month ago you noticed some control issues in accounts payable, but presently you’re not sure how to describe them. You hesitate to call the client to rehash the now-cold walkthrough. After all, the client thinks you’re done. But you know that boiler-plate language will not clearly communicate the weakness or tell the client how to fix the problem. Now you’re kicking yourself for not taking more time to document the control weakness (back when you initially saw it).

Here’s a post to help you capture and document internal control issues as you audit.

Capture and Communicate Internal Control Deficiencies

Today, we’ll take a look at the following control weakness objectives:

1. How to discover them
2. How to capture them
3. How to communicate them

As we begin, let’s define three types of weaknesses:

• Material weaknesses – A deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis.
• Significant deficiencies – A deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness yet important enough to merit attention by those charged with governance.
• Other deficiencies – For purposes of this blog post, we’ll define other deficiencies as those less than material weaknesses or significant deficiencies.

As we look at these definitions, we see that categorizing control weaknesses is subjective. Notice the following terms:

• Reasonable possibility
• Material misstatement
• Less severe
• Merits attention by those charged with governance

Now let’s take a look at discovering, capturing, and communicating control weaknesses. 

1. Discover Control Weaknesses

Capture control weaknesses as you perform the audit. You might identify control weaknesses in the following audit stages:

1. Planning – Risk assessment and walkthroughs
2. Fieldwork – Transaction-level work
3. Conclusion – Wrapping up

A. Planning Stage

You will discover deficiencies as you perform walkthroughs which are carried out in the early stages of the engagement. Correctly performed walkthroughs allow you to see process shortcomings and where duties are overly concentrated (what auditors refer to as a lack of segregation of duties).

Segregation of Duties

Are accounting duties appropriately segregated with regard to:

• Custody of assets
• Reconciliations
• Authorization
• Bookkeeping

Notice the first letters of these words spell CRAB (I know it’s cheesy, but it helps me remember).

Auditors often make statements such as, “Segregation of duties is not possible due to the limited number of employees.”

I fear such statements are made only to protect the auditor (should fraud occur in the future). It is better that we be specific about the control weakness and what the potential impact might be. For example:

The accounts payable clerk can add new vendors to the vendor file. Since checks are signed electronically as they are printed, there is a possibility that fictitious vendors could be added and funds stolen. Such amounts could be material.

Such a statement tells the client what the problem is, where it is, and the potential damage. 

Fraud: A Cause of Misstatements

While I just described how a lack of segregation of duties can open the door to theft, the same idea applies to financial statement fraud (or cooking the books). When one person controls the reporting process, there is a higher risk of financial statement fraud. Appropriate segregation lessens the chance that someone will manipulate the numbers.

Within each transaction cycle, accounting duties need to be performed by different people. Doing so lessens the possibility of theft. If one person performs multiple duties, ask yourself, “Is there any way this person could steal funds?” If yes, then the client should add a control in the form of a second-person review.

If possible, the client should have a second person examine reports or other supporting documentation. How often should the review be performed? Daily, if possible. If not daily, as often as possible. Regardless, a company should not allow someone with the ability to steal to work alone without review. The fear of detection lessens fraud.

If a transaction cycle lacks segregation of duties, then consider the potential impact from the control weakness. Three possible impacts exist:

• Theft that is material (material weakness)
• Theft that is not material but which deserves the attention of management and the board anyway (significant deficiency)
• Theft of insignificant amounts (other deficiency)

My experience has been that if any potential theft area exists, the board wants to know about it. But this is a decision you will make as the auditor.

Errors: Another Cause of Misstatements

While auditors should consider control weaknesses that allow fraud, we should also consider whether errors can lead to potential misstatements. So, ask questions such as:

• Do the monthly financial statements ever contain errors?
• Are invoices mistakenly omitted from the payable system?
• Do employees forget to obtain purchase order numbers prior to buying goods?
• Do bookkeepers fail to reconcile the bank statements on a timely basis? 

B. Fieldwork Stage

While it is more likely you will discover process control weaknesses in the planning stage of an audit, the results of control deficiencies sometimes surface during fieldwork. How? Audit journal entries. What are audit entries but corrections? And corrections imply a weakness in the accounting system.

When an auditor makes a material journal entry, it’s difficult to argue that a material weakness does not exist. We know the error is “reasonably possible” (it happened). We also know that prevention did not occur on a timely basis.

C. Conclusion Stage

When concluding the audit, review all of the audit entries to see if any are indicators of control weaknesses. Also, review your internal control deficiency work papers (more on this in a moment). If you have not already done so, discuss the noted control weaknesses with management. 

Your firm may desire to have a policy that only managers or partners make these communications. Why? Management can see the auditor’s comments as a criticism of their own work. After all, they designed the accounting system (or at least they oversee it). So, these discussions can be a little challenging.

Now let’s discuss how to capture control weaknesses.

2. Capture Internal Control Weaknesses

So, how do you capture the control deficiencies?

First, and most importantly, document internal control deficiencies as you see them.

Why should you document control weaknesses when you initially see them?

1. You may not be on the engagement when it concludes (because you are working elsewhere) or
2. You may not remember the issue (weeks later).

Second, create a standard form (if you don’t already have one) to capture control weaknesses. 

Internal Control Capture Form

What should be in the internal control form? At a minimum include the following:

1.  Check-mark boxes for:
   • Significant deficiency
   • Material weakness
   • Other control deficiency
   • Other issues (e.g., violations of laws or regulations) 
2. Whether the probability of occurrence is at least reasonably possible and whether the magnitude of the potential misstatement is material
3. Description of the deficiency and the verbal or written communications to the client; also the client’s response
4. The cause of the condition
5. The potential effect of the condition
6. Recommendation to correct the issue
7. Person identifying the issue and the date of discovery
8. Whether the issue is a repeat from the prior year
9. An area for the partner to sign off that he or she agrees with the description of the deficiency and the category assigned to it (e.g., material weakness)
10. Reference to related documentation in the audit file

After capturing the weaknesses, it’s time to communicate them. 

3. Communicate Control Weaknesses

Material weaknesses and significant deficiencies must be communicated in writing to management and those charged with governance. Other deficiencies can be given verbally to management, but you must document those discussions in your work papers.

Provide a draft of any written communications to management before issuing your final letter. That way if something is incorrect (your client will let you know), you can make it right–before it’s too late. Additionally, discuss the control weakness with relevant personnel when you initially discover it. You don’t want to surprise the client with adverse communications in the written internal control letter. 

Internal Control Video Summary

Here’s a video that summarizes the information above.

Summary

The main points in capturing and communicating internal control deficiencies are:

1. Capture control weaknesses as soon as you see them
2. Develop a form to document the control weaknesses
3. Communicate significant deficiencies and material weaknesses in writing

These communications can be somewhat challenging since you’re telling management they need to make improvements. So make sure all information is correct and let your senior personnel do the communicating.

How Do You Capture and Report Control Deficiencies?

Whew! We’ve covered a lot of ground today. How do you capture and report control deficiencies? I’m always looking for new ideas: Please share.

Payment Fraud Tests: Five Powerful Ideas

By Charles Hall | Auditing , Fraud

Are you looking for payment fraud tests? Ways to detect fraudulent payments and create unpredictable tests. Here’s your article.

You are leading the audit team discussion concerning disbursements, and a staff member asks, “Why don’t we ever perform fraud tests? It seems like we never introduce elements of unpredictability.”

You respond by saying, “Yes, I know the audit standards require unpredictable tests, but I’m not sure what else to do. Any fresh ideas?”

The staff member sheepishly responds, “I’m not sure.”

And you are thinking, “What can we do?”

Five Payment Fraud Tests

Here are five payment fraud tests that you can perform in most any audit.

1. Test for duplicate payments

Why test for duplicate payments?

Theft may occur as the accounts payable clerk generates the same check twice, stealing and converting the second check to cash. The second check may be created in a separate check batch, a week or two later. This threat increases if (1) checks are signed electronically or (2) the check-signer does not normally examine supporting documentation and the payee name.

How can you test for duplicate payments?

Obtain a download of the full check register in Excel. Sort by dollar amount and vendor name. Then investigate same-dollar payments with same-vendor names above a certain threshold (e.g., $25,000).

2. Review the accounts payable vendor file for similar names

Why test for similar vendor names?

Fictitious vendor names may mimic real vendor names (e.g., ABC Company is the real vendor name while the fictitious name is ABC Co.). Additionally, the home address of the accounts payable clerk is assigned to the fake vendor (alternatively, P.O. boxes might be used).

The check-signer will probably not recognize the payee name as fictitious.

How can you test for similar vendor names?

Obtain a download of all vendor names in Excel. Sort by name and visually compare any vendors with similar names. Investigate any near-matches.

3. Check for fictitious vendors

Why test for fictitious vendors?

The accounts payable clerk may add a fictitious vendor. What address will be entered for the fictitious vendor? You guessed it: the payable clerk’s home address (or P.O. Box).

Pay particular attention to new vendors that provide services (e.g., consulting) rather than physical products (e.g., inventory). Physical products leave audit trails; services, less so.

How can you test for fictitious vendors?

Obtain a download in Excel of new vendors and their addresses for a period of time (e.g., month or quarter). Google the business addresses to check for validity. If necessary, call the vendor. Or ask someone familiar with vendors to review the list (preferably someone without vendor set-up capabilities).

4. Compare vendor and payroll addresses

Why compare vendor and payroll addresses?

Those with vendor-setup ability can create fictitious vendors associated with their own home address. If you compare all addresses in the vendor file with addresses in the payroll file, you may find a match. (Careful – sometimes the match is legitimate, such as travel checks being processed through accounts payable.) Investigate any suspicious matches.

How can you test for the same vendor and payroll addresses?

Obtain a download in Excel of (1) vendor names and addresses and (2) payroll names and addresses. Merge the two files; sort the addresses and visually inspect for matches.

5. Scan all checks for proper signatures and payees

Why test checks for proper signatures and payees?

Fraudsters will forge signatures or complete checks with improper payees such as themselves.

How can you test for proper signatures and payees?

Pick a period of time (e.g., two months), obtain the related bank statements, and scan the checks for appropriate signatures and payees. Also, consider scanning endorsements (if available).

Your Payment Fraud Tests

Those are a few of my payment fraud tests. Please share yours.

Need additional ideas regarding how fraud might occur. Check out my post: 25 Ways Fraud Happens.

My fraud book provides more insights into why fraud occurs, how to detect it, and–most importantly–how to prevent it. Check it out on Amazon by clicking here. The book focuses on local government fraud, but most of the information is equally applicable to small businesses.

Governmental Internal Controls

By Charles Hall | Fraud , Local Governments

Below I provide useful summary of governmental internal controls.

Why am I providing this list of useful controls? Most small governments struggle with establishing sound internal controls. So, the list provides a beginning point for preventing theft in your government. While not a comprehensive list, it will help. 

Many of the internal controls listed below are also pertinent to nonprofits and small businesses as well. You will find this same checklist in The Little Book of Local Government Fraud Prevention (available on Amazon) which provides many more fraud prevention ideas.

I am providing general fraud prevention controls and then transaction-level controls for:

• Cash receipts and billing
• Cash payments and purchasing
• Payroll

General Governmental Internal Controls

Here are some general governmental internal controls.

1. Have bank statements mailed directly to someone outside of accounting; recipient should peruse bank statement activity before providing it to accounting
2. Perform surprise audits (use outside CPA if possible)
3. Elected officials and management should review the monthly budget to actual reports (and other pertinent financial reports)
4. Map internal control processes by transaction cycle (preferably done by a seasoned CPA); once complete, provide the map to all employees involved in the cycle; when control weaknesses exist, institute additional controls (see 11. below)
5. Use a whistleblower program (preferably use an outside whistleblower company)
6. Reconcile bank statements monthly (have a second person review and initial the reconciliation)
7. Purchase fidelity bond coverage (based on risk exposure)
8. Periodically request from the government’s bank a list of all bank accounts in the name of the government or with the government’s federal tax I.D. number; compare the list to bank accounts set up in the general ledger
9. Secure computer access physically (e.g., locked doors) and electronically (e.g., passwords)
10. Do not allow the electronic transmission (e.g., email) of sensitive data (e.g., social security numbers) without the use of protected transmission technology (e.g. Sharefile); create policy and train staff
11. Where possible, segregate who (1) authorizes transactions, (2) records transactions, (3) reconciles records, and (4) has custody of assets; when segregation of duties is not possible, require documented second-person review and/or surprise audits

Transaction Governmental Internal Controls

Here are transaction level governmental internal controls.

Cash Receipts and Billing Controls

1. Use a centralized receipting location (when possible)
2. Assign each cash drawer to a separate person; require daily reconciliation to receipts; require second person review
3. Deposit cash timely (preferably daily); require the composition of cash and checks to be listed on each deposit ticket (to help prevent check-for-cash substitution)
4. Immediately issue a receipt for each payment received; a duplicate of the receipt or electronic record of the receipt is to be retained by the government
5. A supervisor should review receipting-personnel adjustments made to accounts receivable
6. Do not allow the cashing of personal checks (e.g., from cash drawers)

Cash Payments and Purchasing Controls

1. Guard all check stock (as though it were cash)
2. Do not allow hand-drawn checks; only issue checks through the computerized system; if hand-drawn checks are issued, have a second person create and post the related journal entry
3. Do not allow the signing of blank checks
4. Limit check signing authorization to as few people as possible
5. Require two employees to effectuate each wire transfer
6. Persons who authorize wire transfers should not make related accounting entries
7. Require a documented bidding process for larger purchases (and sealed bids for significant purchases or contracts); specify procedures for evaluating and awarding contracts.
8. Limit the number of credit cards and the chargeable maximum amount on each card
9. Allow only one person to use an individual credit card; require receipts for all purchases
10. Require a street address and social security or tax I.D. numbers for each vendor added to accounts payable vendor list (P.O. box numbers without a street address should not be accepted)
11. Signed vendor checks should not be returned to those who authorized the payment; mail checks directly to vendors
12. Compare payroll addresses with vendor addresses for potential fictitious vendors (usually done with electronic audit tools such as IDEA or ACL)

Payroll Controls

1. Provide a departmental overtime budget/expense report to governing body or relevant committee
2. Use direct deposit for payroll checks
3. Payroll rates keyed into the payroll system must be supported by proper authorization in the employee personnel file
4. Immediately remove terminated employees from the payroll system
5. Use biometric time clocks to eliminate buddy-punching
6. Check for duplicate direct-deposit bank account numbers
7. A department head should provide written authorization for overtime prior to payment

Your Recommendations

What additional controls do you recommend? Share your thoughts below.

Splitting Payments to Circumvent Approval Requirements

By Charles Hall | Asset Misappropriation

Some fraudsters split payments to circumvent approval requirements. In this article, I show you how this type of theft works and what you can do to prevent it.

The Theft

The maintenance supervisor, Billy, wants to make a fraudulent payment to ABC Hardware for $9,900. (ABC Hardware is owned by his cousin.) So, Billy wants to avoid his company’s review process. He knows that all checks over $5,000 require the physical signature of the finance director. All checks below $5,000 are signed by the computer. What’s a boy to do? Well, Billy can split the transaction–two checks for $4,950 each. That will work.

Billy asks his cousin for two ABC Hardware invoices of $4,950 rather than the one for $9,900. Afterwards, Billy approves each invoice, and the payments are made.

So, Billy tries the scheme again, and it works. Then, he does so repeatedly. His cousin rewards him with free trips to South Dakota, his favorite hunting destination.

The Weakness

No one is querying the check register for payments just below the threshold. Also, bids were not obtained.

The Fix

Download the check register into Excel (or any database package). Then, sort the payments and look for repeated payments–just below the threshold of $5,000–to the same vendor.

Require bids for significant expenses, and retain the bids as support for the payments.

Difference in Bribes and Gratuities

Learning tip: The hunting trip is referred to as a gratuity rather than a bribe. Why? Bribes are inducement payments made before the purchase decision. Gratuities–free trips in this example–are given after the vendor payments. The purpose of the gratuity is to reward the complicit person (Billy). Then, in the future, Billy knows the drill and expects more of the same.

White-Collar Crime

Splitting payments is a form of white-collar crime. There are many ways that professionals steal. Click here for more fraud-related examples (some of which are hard to believe).

Material Weaknesses and Significant Deficiencies

By Charles Hall | Auditing

In today’s post, I tell you how to understand and communicate material weaknesses and significant deficiencies.

How do you categorize a control weakness? Is the weakness a material weakness, a significant deficiency or something less? This seems to be the most significant struggle in addressing internal control issues.

And if you’ve been in the business for any time at all, you know that management can take offense regarding control weakness communications. For instance, a CFO may believe that a material weakness reflects poorly upon him. After all, he controls the design of the accounting system. So, communicating control weaknesses can result in disagreements. Therefore, it’s even more important that these communications be correct.

Before telling you how to distinguish material weaknesses from significant deficiencies, let’s review control weakness definitions.

Definitions of Control Weaknesses

A deficiency in internal control is defined as follows: A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis. A deficiency in design exists when (a) a control necessary to meet the control objective is missing, or (b) an existing control is not properly designed so that, even if the control operates as designed, the control objective would not be met. A deficiency in operation exists when a properly designed control does not operate as designed or when the person performing the control does not possess the necessary authority or competence to perform the control effectively.

Now let’s define (1) material weaknesses, (2) significant deficiencies, and (3) other deficiencies.

1. Material weakness. A deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis.
2. Significant deficiency. A deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness yet important enough to merit attention by those charged with governance.
3. Other deficiencies. For the purposes of this blog post, an other deficiency is a control weakness that is less than a material weakness or a significant deficiency.

How to Categorize a Control Weaknesses

Now that we have defined material weaknesses and significant deficiencies, we can discuss how to distinguish between the two.

Material Weakness

First, ask these two questions:

1. Is there a reasonable possibility that a misstatement could occur?
2. Could the misstatement be material?

If your answer to both questions is yes, then the client has a material weakness. (By the way, if you propose a material audit adjustment, it’s difficult to argue that there is no material weakness. As you write your control letter, examine your proposed audit entries.)

Significant Deficiency

If your answer to either of the questions is no, then ask the following:

Is the weakness important enough to merit the attention of those charged with governance? In other words, are there board members who would see the weakness as important.

If the answer is yes, then it is a significant deficiency.

If no, then it is not a significant deficiency or a material weakness.

How to Communicate Material Weaknesses and Significant Deficiencies

The following deficiencies must be communicated in writing to management and to those charged with governance:

• Material weaknesses
• Significant deficiencies

The written communication (according to AU-C section 265) must include:

• the definition of the term material weakness and, when relevant, the definition of the term significant deficiency
• a description of the significant deficiencies and material weaknesses and an explanation of their potential effects
• sufficient information to enable those charged with governance and management to understand the context of the communication
• the fact that the audit included consideration of internal control over financial reporting in order to design audit procedures that are appropriate in the circumstances and that the audit was not for the purpose of expressing an opinion on the effectiveness of internal control
• the fact that the auditor is not expressing an opinion on the effectiveness of internal control
• that the auditor’s consideration of internal control was not designed to identify all deficiencies in internal control that might be material weaknesses or significant deficiencies, and therefore, material weaknesses or significant deficiencies may exist that were not identified
• an appropriate alert, in accordance with section 905, Alert That Restricts the Use of the Auditor’s Written Communication

Next, I explain how to communicate other deficiencies (those that are less than a material weakness or a significant deficiency).

How to Communicate Other Deficiencies

Other deficiencies can be communicated in writing or orally and need only be communicated to management (and not to those charged with governance). The communication must be documented in the audit file. So if you communicate orally, then follow up with a memo to the file addressing who you spoke with, what you discussed, and the date of the discussion.

Stand-alone management letters are often used to communicate other deficiencies. Since there is no authoritative guidance for management letters, you may word them as you wish. Alternatively, you can, if you like, include other deficiencies in your written communication of significant deficiencies or material weaknesses.

A Key Word of Warning

Always provide a draft of any written communications to management before final issuance. It is much better to provide a draft and find out (before issuance) that it contains an error or a miscommunication. Then, corrections can be made.

Additional Information

Writing your internal control letter is a part of the wrap-up process for audits. Click here for additional information concerning wrapping up an audit.