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
https://creativecommons.org/licenses/by/2.0/
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