Question

Lucas Edgerton is a staff auditor at Jansen, Smith, and Bryan, LLP. During the audit of a regional pizza franchise, Lucas discovers several deficiencies in internal controls. Explain how Lucas should determine whether or not these deficiencies are significant and/or material weaknesses. B 1 TE T? TE = 9 a O Word(s)

Answer 1

Misstatements in financial statements are material when they can reasonably be expected to influence the decisions taken based on those financial statements. Misstatement can be material either by magnitude or due the nature of the item. For example, an asset would typically be considered material if it is 1% or more of the total assets. Some misstatements are not significant by magnitude but are material by their nature. For example, a loan advanced to a director of a company, however small, is material because the users of financial statements will value such information for decision making purposes.

In this problem if these deficiency are influence the decision taken based on financial statement then it is significant and material if not infulance then it is not significant.

The 5 steps to understanding how to analyze deficiencies below are detailed at a very high level and do not cover all possible ways to analyze a deficiency, but, this should provide some guidance with understanding the overall process.

Step 1: Define the overall materiality threshold for your company.

Determine a dollar value that will be used to calculate materiality based on management’s consideration and where possible, recommendations from your auditors. This determination will allow you to define the dollar amounts and where to focus your internal audit and review efforts on. Officially, this step should occur prior to undertaking any controls documentation effort as it determines the areas of your company that should have internal controls

Step 2: Assign dollar values to the 3 available levels of deficiencies based on your materiality threshold.

There are three possible levels of deficiency for any error found:

Material Weakness (requires an 8K and disclosure in your 10Q/K)

Significant Deficiency (requires escalation to the Board of Directors / Audit Committee)

Deficiency (should be disclosed to your Board of Directors / Audit Committee)

Step 3: Determine the value of the deficiency.

The absolute value of a deficiency can sometimes be difficult to determine. A general example of a deficiency value is if you find that a payment was made incorrectly. Let’s say for the sake of this blog post that the error found was valued at $42,500.

Step 4: Assess the value of the deficiency against your materiality threshold.

Using the values assigned in the above examples, the $42,500 deficiency would constitute a significant deficiency. I.e.:

A deficiency with a value between $35,217.60 - $117,293.00 is a significant deficiency.

The assessment process doesn’t stop with just looking at the dollar value. You can also argue that perhaps you have other controls in place that would lessen the impact of the deficiency found or that would perhaps have caught the error entirely at some point in the process and before the financials were reported to the SEC. Formalizing these types of arguments can be especially important if you are looking at a potential material weakness.

Step 5: Review your work with your auditors.

Your auditors will need to review your analysis and assessment to determine if they agree and share your perspective. As you can imagine, it is better to agree with your auditors on your materiality thresholds prior to finding an issue so start the process of assessing your materiality, material weakness, significant deficiency, and deficiency values as soon as possible. Taking the time to determine these amounts and gaining external audit agreement may save you time, money, and perhaps an unwanted deficiency assessment.