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

St. Louis Test Preparation

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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Accounting-Related Class Action Cases: 2014 Analysis

A class action lawsuit can be devastating to the future prospects of a company. In some cases, the class action case is brought due to an accounting issue. This fascinating study reviews the 2014 class action lawsuits related to accounting. It’s a cautionary tale for all accounting managers.

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Cornerstone Research is a firm that provides economic and financial analysis for commercial litigation and regulatory cases. Here are the highlights of the firm’s 2014 summary of Securities Class Action filings that included Accounting Allegations.

Defining a class action

A class actions lawsuit allows a large number of people with a common interest in a matter to sue (or be sued) as a group. In many of these cases, the common interest is that each person involved in filing the suit owns the firm’s common stock. Generally, the class action suit claims that an accounting irregularity caused as sharp decrease in the price of the stock.

The impact of restating the financials

The report explains that a number of stock price declines occurred after a firm’s financial statements were restated. This article explains some of the circumstances that require restatement of the financials. Here are two that apply to this discussion:

·            Correction of an error

·            Change in GAAP accounting method: If a change in an accounting policy would have changed the prior year financial statements, that change needs to be disclosed.

Explaining the impact of an accounting change allows the statement reader to make a “apples-to-apples” comparison. Assume that the company changed from the FIFO to the LIFO inventory value method. That change would generate a different cost of sales amount- which would also change net income.

GAAP requires that the prior year financial statements must be restated to reflect the new inventory valuation method. Restating the prior year financials allows the statement reader to see the prior year and the current year results using the same inventory valuation method. Using the same method means that the financials are comparable.

Class action accounting cases

The firm explains that cases considered as accounting cases are those that involve GAAP violations, auditing violations or weaknesses in internal controls.

Again, the main reason for the accounting-related suits is a price decline after a restatement. Essentially, the stockholders believe they have been harmed by management’s mistakes- the resulting stock price decline after the restatement. Figure 9 in the 2014 report shows a mean return of a 5% stock price decline after a restatement.

Weakness in internal controls

60% of the accounting cases in the 2014 study alleged an internal control weakness. Internal controls are put in place for two reasons. First, these controls help to segregate duties and prevent theft of assets. Internal controls also ensure that the financial statements are materially correct.

Keep in mind that Sarbanes Oxley (SOX) has raised the bar on management’s responsibility for internal controls. Company management must now review internal controls and report on any internal control weaknesses.

Write-downs

If an asset’s value has been permanently reduced, the asset is impaired. The impaired asset’s value should be adjusted- so that the value of the asset is not overstated. The reduction is value is called a write-down.

A write-down occurs when an asset’s value is posted to an expense. The write-down reduces the asset balance and increases expenses. A number of cases in the study involved write-downs, as well as adjustments to reserve account balances. 

A reserve posts an expense and a liability for contingencies (losses). A good example is a reserve for loan loss at a bank or financial institution that provides loans. If a portion of the entry is reserved, expenses are reduced. Since reserve accounts require judgment, there is some risk for manipulation of expenses.

A cautionary tale

Consider this issues as you manage your business. Staying on top of internal controls is critical. These controls can help you avoid correcting mistakes- and avoid the added challenge of restating your financials.

Ken Boyd

St. Louis Test Preparation

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies (2015)

Co-Founder: accountinged.com

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