Thursday, May 28, 2015

Weak Link in the Chain: Material Weaknesses in Financial Reporting




In accounting, moving from posting a transaction to generating financial statements is a long and winding road. There are many steps along the way. You can think of the process as a chain. If there is a weakness in the chain, the company may end up with financial statements that are incorrect. An external auditor has a duty to audit the internal controls over financial reporting.

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Public companies and PCAOB
The importance of internal controls has been ramped up with the passage of Sarbares-Oxley (SOX) legislation. SOX has a large impact on public-traded companies. To understand how internal controls are addressed, consider these players:

·      PCAOB: The Public Company Oversight Board has oversight over the accounting and financial statements for public companies. Part of that oversight means that PCAOB inspects the work performed by auditors of public companies.

·      Auditors: External auditors have an obligation to assess the effectiveness of internal controls. If the auditor finds internal control weaknesses, they must discuss those weaknesses to company management. If management does not take action to correct the weaknesses, that situation may affect the type of audit opinion issued.

·      Audit Committee: A company’s audit committee hires the auditor and receives the audit report. The audit committee is obligated to perform a due diligence investigation into the auditor’s work. Essentially, and audit committee asks questions to ensure that the audit is performed correctly.


Audit Committee Dialogue- New Guidance
The National Law Review recently explained that PCAOB is publishing guidance to Audit Committees. The guidance is referred to as the Audit Committee Dialogue. The Dialogue is based on the results of the PCAOB’s inspections of public company auditors. The communication provides the Audit Committee with specific questions they should be asking their auditors.

The Audit Committee Dialogue discusses three types of material weaknesses that currently need to be addressed. This post discusses one of those weaknesses: Internal controls over financial reporting.

ICFR: Internal Controls over Financial Reporting
The PCAOB performed a review of 2012 and 2013 audit reports. They found that 77% of the material weaknesses in internal controls were not disclosed until after financial statements were issued with reporting errors. In other words, the auditor was not able to identify a weakness before the weakness cause an error.

An example
To clarify, let’s use an example. Assume that Acme Clothing manufactures and sells clothing to retailers. The contracts with the retailers allows for certain sales returns and allowances. These transactions require some complex journal entries.

Acme Clothing does not require the Controller to review these complex journal entries on a timely basis. This control weakness means that incorrect journal entries generate errors in the financial statements.

The weak link in the chain is the journal entry review process.

Questions to find the weakness
Audit Committee Dialogue recommends that Audit Committees ask the auditor these questions:

·      What component of the internal controls over financial reporting has the highest risk for a material weakness? Have you planned your audit test work to address these potential weaknesses?

·      What would you do if you found a weakness?

·      Are these steps in your audit plan?


Issuing financial statements that must be restated is a huge issue for investors, lenders and other stakeholders. After all, the stakeholders all make decisions based on the original set of financial statements. These questions can help prevent material misstatement of the financials.

What types of internal control weaknesses have you seen? What problems did they cause? I’d love to hear from you.

Ken Boyd
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
Co-Founder: accountinged.com

Image: Chain by Pratanit

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