Question

Conduct a web search for some examples of companies/organisations where internal controls have Failed to operate effectively. You can also look at some of the corporate collapses including failures of Any banking institutions. Examples can also be a non-profit organisation such as football club or Hospital etc. Your selected case would have received media publicity or there would have been some Government investigation. For the cases you have identified, answer the following questions: (a) What factors led to the failure of these controls? (b) Could the failure have been avoided? If so, how

Answer 1

Company Name - Magnum Hunter Resources Corporation

(a) The Securities and Exchange Commission took action against Texas-based energy company Magnum Hunter Resources Corporation, including its chief financial officer and chief accounting officer, as well as an external auditor and a consultant, for improperly concluding that a serious staffing problem in the accounting department did not rise to the level of a material weakness in internal control. The action does not include any allegations of accounting anomalies that arose during the reporting periods in question, although the company eventually went on to restate its financial results and declare bankruptcy. The SEC fined Magnum Hunter Resources Corp. $250,000 and two members of management a combined $40,00 for the internal control violations, and it suspended from practice an auditor and an internal audit consultant from separate regional firms in Texas. The SEC says the company undertook rapid growth through acquisition in 2010 and 2011, straining the accounting staff to keep up. Both the external auditor and the consultant identified the staffing problem as a deficiency in control, but the SEC says both concluded and advised management that the severity of the deficiency did not rise to the level of a material weakness, which would need to be disclosed to investors.

Below is a summary from the SEC of how controls broke down at MHR.

• The company’s rapid growth by acquisition strained its accounting resources, making the company unable to complete its standard monthly close process on time.
• The CFO and CAO knew of the accounting stress, but failed to apply appropriate standards when determining the severity of the internal control deficiency.
• The lead partner from a PCAOB-registered firm on an internal audit consulting engagement identified problems in the accounting department that exhibited “inadequate and inappropriately aligned staffing,” causing delays in testing. The partner concluded the staffing deficiency did not constitute a material weakness despite his belief that “[t]he potential for error in such a compressed work environment presents substantial risk.”
• The engagement partner on the external audit recognized the company lacked “adequate internal control over financial reporting due to inadequate and inappropriately aligned staffing” which “increases the possibility of a material error occurring and being undetected,” yet concluded the weakness did not rise to the level of material weakness and failed to adequately document the basis for his conclusion.

Source: Securities and Exchange Commission

(b) Yes the failure could have been avoided.

Had the external auditor reported the internal control failure in his audit report, the failure could have been avoided.

Had the CEO and CAO been concluded correctly that the serious staffing problem in the accounting department did rise to the level of a material weakness in internal control.