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.
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.
Now that we have defined material weaknesses and significant deficiencies, we can discuss how to distinguish between the two.
First, ask these two questions:
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.)
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.
The following deficiencies must be communicated in writing to management and to those charged with governance:
The written communication (according to AU-C section 265) must include:
Next, I explain how to communicate other deficiencies (those that are less than a material weakness or a significant deficiency).
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.
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.
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.
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Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
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