Question

You are the senior manager or audit engagement partner on Care For Kids Inc., a not-for- profit organization that has a December 31 year-end.

While performing year-end substantive procedures, the engagement team identified an error in the entity’s year-end adjusting entries. Care For Kids Inc. had inadvertently not recorded an unrealized gain of $5 million in one of its many investment portfolios. The investments total approximately $200 million. Through inquiry of client management, the engagement team learned that the accounting department had not reviewed the broker’s statement for this particular portfolio. The portfolio, which consisted of traded securities, had increased in market value by $5 million. Materiality for the audit was $10 million.

As part of the audit, you must assess the operating effectiveness of controls related to the misstatement under audit standards established by the AICPA.

Required:

What factors would you consider to determine if a deficiency, significant deficiency, or material weakness exists? Be specific to this situation.

What, if any, communications would you be required to make to those charged with governance?

What effect would the materiality of this oversight have on your assessment of this control weakness?

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Answer 1

Materiality

In planning and performing the examination of internal control, the
auditor should use the same materiality used in planning and performing the audit of the entity's financial statements.

Indicators of Material Weaknesses
Indicators of material weaknesses in internal control include
• identification of fraud, whether or not material, on the part of senior
management;
• restatement of previously issued financial statements to reflect the correction of a material misstatement due to error or fraud;
• identification by the auditor of a material misstatement of financial
statements under audit in circumstances that indicate that the mis-
statement would not have been detected and corrected by the entity's
internal control; and
• ineffective oversight of the entity's financial reporting and internal
control by those charged with governance.

If the auditor determines that a deficiency, or a combination of deficiencies, is not a material weakness, he or she should consider whether prudent officials, having knowledge of the same facts and circumstances, would likely reach the same conclusion.

Significant deficiency
A deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance.

Evaluating Identified Deficiencies
The auditor should evaluate the severity of each deficiency to deter-
mine whether the deficiency, individually or in combination, is a material weakness as of the date of management's assertion. The severity of a deficiency depends on
• the magnitude of the potential misstatement resulting from the defi-
ciency or deficiencies; and• whether there is a reasonable possibility that the entity's controls will
fail to prevent, or detect and correct a misstatement of an account bal-
ance or disclosure.
The severity of a deficiency does not depend on whether a misstatement actually occurred.
Factors that affect the magnitude of the misstatement that might result from a deficiency or deficiencies include, but are not limited to, the following:
• The financial statement amounts or total of transactions exposed to
the deficiency
• The volume of activity (in the current period or expected in future pe-
riods) in the account or class of transactions exposed to the deficiency

In evaluating the magnitude of the potential misstatement, the maximum amount by which an account balance or total of transactions can be overstated is generally the recorded amount, whereas understatements could be larger.
Risk factors affect whether there is a reasonable possibility that a deficiency, or a combination of deficiencies, will result in a misstatement of an account balance or disclosure. The factors include, but are not limited to, the following:
• The nature of the financial statement accounts, classes of transactions,
disclosures, and assertions involved
• The susceptibility of the related asset or liability to loss or fraud
• The subjectivity, complexity, or extent of judgment required to determine the amount involved
• The interaction or relationship of the control with other controls
• The interaction among the deficiencies
• The possible future consequences of the deficiency

The evaluation of whether a deficiency presents a reasonable possibility of misstatement may be made without quantifying the probability of occurrence as a specific percentage or range. Also, in many cases, the probability of a small misstatement will be greater than the probability of a large misstatement.
Multiple deficiencies that affect the same significant account or disclosure, relevant assertion, or component of internal control increase the likelihood of material misstatement and may, in combination, constitute a material weakness, even though such deficiencies individually may be less severe. Therefore, the auditor should determine whether deficiencies that affect the same significant account or disclosure, relevant assertion, or component of internal control collectively result in a material weakness.
Multiple deficiencies that affect the same significant account or disclosure, relevant assertion, or component of internal control also may collectively result in a significant deficiency.
A compensating control can limit the severity of a deficiency and prevent it from being a material weakness. Although compensating controls can mitigate the effects of a deficiency, they do not eliminate the deficiency. The auditor should evaluate the effect of compensating controls when determining whether a deficiency or combination of deficiencies is a material weakness.

Effect of Substantive Procedures on Conclusions About the Operating
Effectiveness of Controls.

This evaluation should include, at a minimum
• the risk assessments in connection with the selection and application
of substantive procedures, especially those related to fraud.
• findings with respect to illegal acts and related party transactions.
• indications of management bias in making accounting estimates and
in selecting accounting principles.
• misstatements detected by substantive procedures. The extent of such misstatements might alter the auditor's judgment about the effectiveness of controls.

To obtain evidence about whether a selected control is effective, the control should be tested directly; the operating effectiveness of a control cannot be inferred from the absence of misstatements detected by substantive procedures. The absence of misstatements detected by substantive procedures, however, may affect the auditor's risk assessments in determining the testing necessary to conclude on the operating effectiveness of a control.

Communicating Certain Matters
- Deficiencies identified during the integrated audit that, upon evalu-
ation, are considered significant deficiencies or material weaknesses should be communicated, in writing, to management and those charged with governance.

- If the auditor concludes that the oversight of the entity's financial
reporting and internal control by the audit committee (or similar subgroups with different names) is ineffective, the auditor should communicate that conclusion, in writing, to the board of directors or other similar governing body if one exists.

- The written communications should be made by the report release date, 26 which is the date the auditor grants the entity permission to use the auditor's report. For a governmental entity, the auditor is not required to make the written communications by the report release date, if such written communications would be publicly available prior to management's report on internal control, the entity's financial statements, and the auditor's report thereon. In that circumstance, the written communications should be made as soon as practicable, but no later than 60 days

- The auditor also should communicate to management, in writing, all deficiencies (those deficiencies that are not material weaknesses or significant deficiencies) identified during the integrated audit on a timely basis, but no later than 60 days following the report release date, and inform those charged with governance when such a communication was made. In making the written communication referred to in this paragraph, the auditor is not required to communicate those deficiencies that are not material weaknesses or significant deficiencies that were included in previous written communications, whether those communications were made by the auditor, internal auditors, or others within the organization.

-  The auditor is not required to perform procedures that are sufficient to identify all deficiencies; rather, the auditor communicates deficiencies of which he or she is aware.

- Because the integrated audit does not provide the auditor with assurance that he or she has identified all deficiencies less severe than a material Weakness, the auditor should not issue a report stating that no such deficiencies were identified during the integrated audit.