Misstatements and Internal Control Deficiencies Flashcards
Which is the correct order of severity, from least severe to most severe, for the terms for deficiencies in internal control that an auditor has identified during an audit of financial statements that should be communicated to management and those charged with governance?
A. Other deficiencies in internal control, significant weaknesses, material deficiencies
B. Other deficiencies in internal control, significant deficiencies, material weaknesses
C. Operational deficiencies, material weaknesses, significant deficiencies
D. Other deficiencies in internal control, material weaknesses, significant deficiencies
B.
In order of severity, from least severe to most severe, the correct terms are:
Other deficiencies in internal control
Significant deficiency
Material weakness
Editor notes:
One way to remember their relative order is to keep in mind that the term material is one of the key terms in auditing. It is the material weakness that is most severe and it is worse to be weak than deficient (merely lacking). Once you have that in mind, obviously a significant deficiency is more severe that a “plain” deficiency.
Only significant deficiencies and material weaknesses are included in the written communication to management and those charged with governance. The auditor should communicate orally or in writing the other deficiencies in internal control (those that are not judged to be significant deficiencies or material weaknesses and have not been communicated by other parties to management) to management.
The terms internal control deficiencies or deficiencies in internal control are often used to encompass all three types. For example,
If the auditor has identified one or more deficiencies in internal control, the auditor should evaluate each deficiency to determine, on the basis of the audit work performed, whether, individually or in combination, they constitute significant deficiencies or material weaknesses.
Or put another way, material weaknesses are a subset of both significant deficiencies and deficiencies in internal control. Significant deficiencies are a subset of deficiencies in internal control. All material weaknesses are deficiencies in internal control, but not all deficiencies in internal control are material weaknesses; and so on. The editors realize this may seem obvious; however, it is likely that the examiners will ask you to relate these levels of internal control deficiencies in some way to each other. As you need to work at a pace of about 1½ minutes per multiple-choice question during the exam (first, focus on the concepts; begin to work on speed as your exam date draws nearer) to leave yourself 15 minutes per task-basked simulation (and less than half that for the research question), it’s best to have already thought about the different ways these terms could be presented in relation to one another on the exam.
Which of the following statements is correct concerning deficiencies in internal control identified in an audit of financial statements?
A. An auditor is required to search for deficiencies in internal control during an audit.
B. All significant deficiencies are also considered to be material weaknesses.
C. An auditor may communicate some deficiencies during an audit in addition to after the audit’s completion.
D. An auditor may report that no significant deficiencies were noted during an audit.
C.
Answer c., an auditor may communicate some deficiencies in internal control during an audit of financial statements (in addition to after the audit’s completion) due to their significance and the need for timely corrective action. Such early communication is not required to be in writing. However, all significant deficiencies and material weaknesses should ultimately be reported in the required written communication to management and those charged with governance even if they were communicated earlier or remediated during the audit. For a nonissuer, the required written communication is best made by the audit report release date, but should be made no later than 60 days following this date. For a public company (an issuer), it is required to be made prior to the issuance of the audit report.
Regarding incorrect answer a., in an audit of financial statements, the auditor is not required to search for deficiencies in internal control. The objective of the auditor is to appropriately communicate to those charged with governance and management deficiencies in internal control that the auditor has identified during the audit—on the basis of the audit work performed—and that, in the auditor’s professional judgment, are of sufficient importance to merit their respective attentions.
Regarding incorrect answer b., all material weaknesses are significant deficiencies, but not all significant deficiencies are material weaknesses.
Regarding incorrect answer d., an auditor should not issue a written communication stating that no significant deficiencies were identified during the audit. However, management or those charged with governance may request that the auditor issue a communication indicating that no material weaknesses were identified (this may be required by a governmental authority). This is allowable. Such a communication should include all the same elements as the written communication of significant deficiencies and material weaknesses, except it should omit the description of significant deficiencies and an explanation of their potential effects.
When should the auditor make the written communication of significant deficiencies and material weaknesses to management and those charged with governance and the communication of other internal control deficiencies to management?
A. No later than 60 days following the audit report release date
B. No later than 30 days following the audit report release date
C. No later than 60 days following the audit report date
D. No later than 30 days following the audit report date
A.
The communications should be made no later than 60 days following the report release date.
Editor notes:
Although the auditor is required to make both these communications no later than 60 days following the report release date, the written communication is best made by the report release date because it will enable those charged with governance to discharge their oversight responsibilities.
For public companies, the written communication of significant deficiencies and material weaknesses should be made prior to the issuance of the audit report on the financial statements. (There is no requirement for auditors of public companies to report other control deficiencies identified in an audit of financial statements to management; however, of course, the auditor may report such matters to management, the audit committee, or others, as appropriate.)
Which of the following is true regarding deficiencies in internal control identified in an audit of financial statements?
A. Auditors should search for them.
B. Auditors should communicate them to management and those charged with governance.
C. Auditors may communicate that no material weaknesses or significant deficiencies were identified.
D. They should be disclosed in the notes to the financial statements.
C.
Answer b., if the auditor finds deficiencies in internal control as a consequence of performing audit procedures in an audit of financial statements, the auditor is required to communicate them to management and those charged with governance.
Editor note: Significant deficiencies and material weaknesses should be communicated in writing to both management and those charged with governance; other deficiencies in internal control that are of sufficient importance to merit management’s attention and have not been communicated to management by other parties should be communicated orally or in writing to management. If the latter is communicated orally, the auditor should document it.
Regarding incorrect answer a., the auditor is not required to search for them. Further, the required communication explicitly states:…we considered the Company’s internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances for the purpose of expressing our opinion on the financial statements, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control. Accordingly, we do not express an opinion on the effectiveness of the Company’s internal control.
Regarding incorrect answer c., the auditor should not issue a written communication stating that no significant deficiencies were identified during the audit because such a communication has the potential to be misunderstood or misused. However, the auditor may issue a written communication stating that no material weaknesses were identified during the audit. (Although such a written communication does not provide any assurance about the effectiveness of an entity’s internal control over financial reporting.)
Regarding incorrect answer d., they are not required to be disclosed in the notes to the financial statements.
An auditor has determined a materiality threshold of $100,000 for a client. The auditor has accumulated audit evidence that supports an allowance for bad debts in the range of $1.5 million to $1.8 million. The client recorded $800,000, as the allowance for bad debts and declines to record any additional allowance. What proposed adjustment will the auditor include in the summary of unadjusted differences?
A. Debit bad debt expense $1,100,000; credit allowance for bad debts $1,100,000
B. Debit bad debt expense $700,000; credit allowance for bad debts $700,000
C. Debit bad debt expense $850,000; credit allowance for bad debts $850,000
D. Debit bad debt expense $750,000; credit allowance for bad debts $750,000
The correct answer is (B).
The Summary of Unadjusted Misstatements is a record of all of the misstatements identified during the course of your audit. If a range of reasonable allowance for bad debt is supported by sufficient appropriate audit evidence and the recorded allowance of bad debt is outside of the range of reasonable estimates, the auditor should treat the difference between the recorded amount and closest reasonable amount in range as a misstatement and a proposed adjustment for the same will be included in summary of unadjusted differences.
The recorded amount for allowance of bad debts is $800,000 and the closest reasonable amount in the range as per audit evidence is $1,500,000, hence an adjustment of $700,000 ($1,500,000 - $800,000) will be a proposed adjustment:
Debit bad debt expense $700,000
Credit allowance for bad debts $700,000
When determining whether uncorrected misstatements are material, individually or in the aggregate, an auditor of a non-issuer would consider each of the following, except
A. The particular circumstances of each misstatement.
B. The cost of correcting the misstatements.
C. The effect of uncorrected misstatements related to prior periods.
D. The size and nature of the misstatements.
The correct answer is (B).
The auditor should determine whether uncorrected misstatements are material, individually or in the aggregate. In making this determination, the auditor should consider:
Size & nature of misstatements: both in relation to particular classes of transactions/ balances/disclosures and Financial Statements as a whole, and particular circumstances of their occurrence.
Effect of uncorrected misstatements related to prior periods on the relevant classes of transactions/balances/disclosures and Financial Statements as a whole
The cost-benefit analysis of correcting a misstatement would never be considered by the auditor.
Which of the following statements should not be included in a written communication regarding significant deficiencies and material weaknesses identified in an audit of financial statements?
A. The auditor’s consideration of internal control was not designed to identify all deficiencies in internal control that might be significant deficiencies or material weaknesses.
B. There were no significant deficiencies identified during the audit.
C. A material weakness is a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis.
D. The purpose of the auditor’s consideration of internal control was to express an opinion on the finan¬cial statements, but not to express an opinion on the effectiveness of the entity’s internal control.
B.
The auditor should not issue an written communication stating that no significant deficiencies were identified during an audit.
The other answer alternatives are all examples of items that should be included in the written communication regarding significant deficiencies and material weaknesses identified during an audit of financial statements.
The auditor should
A. Accumulate misstatements identified during the audit, other than those that are clearly trivial
B. Accumulate uncorrected misstatements identified during the audit, other than those that are clearly trivial
C. Communicate on a timely basis with the appropriate level of management all uncorrected misstatements accumulated during the audit
D. Include in the audit documentation all uncorrected misstatements accumulated during the audit
A.
The auditor should accumulate all (not just uncorrected) misstatements identified during the audit, other than those that are clearly trivial.
The auditor should communicate on a timely basis with the appropriate level of management all (not just uncorrected) misstatements accumulated during the audit. The auditor should request management to correct those misstatements.
The auditor should include in the audit documentation all (not just uncorrected) misstatements accumulated during the audit and whether they have been corrected. The auditor should also include in the audit documentation related to evaluation of misstatements identified:
- The amount below which misstatements would be regarded as clearly trivial
- The auditor’s conclusion about whether uncorrected misstatements are material, individually or in the aggregate, and the basis for that conclusion
Regarding the evaluation of misstatements, the overall objective of the auditor is to evaluate the effect of
A. Corrected misstatements on the financial statements
B. Uncorrected misstatements on the audit
C. Identified misstatements on the financial statements
D. Identified misstatements on the audit
D.
The auditor evaluates the effect of identified misstatements on the audit because the auditor should determine whether the overall audit strategy and audit plan need to be revised if: (1) the nature of identified misstatements and the circumstances of their occurrence indicate that other misstatements may exist that, when aggregated with misstatements accumulated during the audit, could be material or (2) the aggregate of misstatements accumulated during the audit approaches materiality.
Regarding incorrect answer A., misstatements that are corrected, of course, do not have an effect on the financial statements.
Regarding incorrect answer B., the auditor is concerned with the effect of all identified misstatements on the audit per the explanation for the correct answer; not just uncorrected misstatements.
Regarding incorrect answer C., only uncorrected misstatements, if any, affect the financial statements.
Which of the following factors should an auditor consider in evaluating the severity a deficiency in internal control to determine if it should be communicated to management and those charged with governance, i.e., that it is a significant deficiency or a material weakness?
I. Magnitude of the potential misstatement
II. Likelihood of the misstatement
A. I only
B. II only
C. Both I and II
D. Neither I nor II
C.
The severity of a deficiency in internal control is dependent on the magnitude of the potential misstatement that could result from the deficiency or deficiencies and whether there is a reasonable possibility (the likelihood) that the entity’s controls will fail to prevent, or detect and correct, a misstatement of an account balance or disclosure. It’s also important to note that whether a misstatement actually occurred is not relevant to the determination of a control deficiency’s severity.
A deficiency in internal control
A. Is a deficiency that is less severe than a significant deficiency yet important enough to merit attention by those charged with governance
B. May be due to a deficiency in either the design of the control or a failure of its adaptation to a particular entity’s control environment
C. Exists when a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis
D. Is a deficiency such that there is a reasonable possibility that a misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis
C.
A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis.
Regarding incorrect answer a., a significant deficiency (not a deficiency in internal control) is 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. Also, deficiencies in internal control (that are neither significant deficiencies nor material weaknesses and have not been communicated to management by other parties) are important enough to merit the attention of management, but not the attention of those charged with governance.
Regarding incorrect answer b., a deficiency in internal control may be due to either a deficiency in the design or operation (not the failure of its adaptation to…) of a control:
A deficiency in design exists when:
A control necessary to meet the control objective is missing; or
An existing control is not properly designed so that, even if the control operates as designed, the control objective would not be met
A deficiency in operation exists when:
A properly designed control does not operate as designed; or
The person performing the control does not possess the necessary authority or competence to perform the control effectively
Regarding incorrect answer d., a material weakness (not a deficiency in internal control) is a deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis.
If an individual uncorrected misstatement is judged to be material, other offsetting misstatements
A. Should not be considered by the auditor
B. May be considered by the auditor as appropriate if, for example, an overstatement of revenue is completely offset by an overstatement of expense
C. May be considered by the auditor as appropriate if the offsetting misstatements are within the same account balance or class of transactions
D. May be considered by the auditor as appropriate if the offsetting misstatements are within the same account balance or class of transactions if the risk that further undetected misstatements may exist is considered
D.
It may be appropriate to offset misstatements within the same account balance or class of transactions; however, the risk that further undetected misstatements may exist should be considered before concluding that offsetting even immaterial misstatements is appropriate. (The auditor may need to reassess the risks of material misstatement for a specific account balance or class of transactions upon identification of a number of immaterial misstatements within that account balance or class of transactions.)
Regarding incorrect answer B., if revenue has been materially overstated, the financial statements as a whole will be materially misstated, even if the effect of the misstatement on earnings is completely offset by an equivalent overstatement of expenses.
An auditor’s written communication regarding significant deficiencies and material weaknesses identified during a financial statement audit should
A. Include a brief description of the tests of controls performed in searching for significant deficiencies and material weaknesses
B. Indicate that the purpose of the auditor’s consideration of internal control was to express an opinion on the financial statements but not to express an opinion on the effectiveness of the entity’s internal control
C. Include a paragraph describing management’s assertion concerning the effectiveness of internal control
D. Indicate that the deficiencies should be disclosed in the annual report to the entity’s shareholders
B.
The written communication regarding significant deficiencies and material weaknesses identified during a financial statement audit should include sufficient information to enable those charged with governance and management to understand the context of the communication. The communication should:
(1) include a statement that indicates that the purpose of the audit was for the auditor to express an opinion on the financial statements;
(2) state that the audit included consideration of internal control over financial reporting in order to design audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of internal control;
(3) state that the auditor is not expressing an opinion on the effectiveness of internal control;
(4) state that the auditor’s consideration of internal control was not designed to identify all deficiencies in internal control that might be material weaknesses or significant deficiencies, and therefore, material weaknesses or significant deficiencies may exist that were not identified;
(5) include the definition of the term material weakness and, when relevant, the definition of the term significant deficiency;
(6) include a description of the significant deficiencies and material weaknesses and an explanation of their potential effects; and
(7) include an appropriate alert that restricts its use. (If an entity is required to furnish the auditor’s written communication to a governmental authority, a specific reference to the governmental authority may be included in the paragraph that restricts its use.)
What is the term for an internal control deficiency such that there is a reasonable possibility that a material misstatement of the company’s financial statements will not be prevented or detected on a timely basis?
A. Deficiency in internal control
B. Material deficiency
C. Material weakness
D. Significant deficiency
C.
A material weakness is a deficiency or combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the company’s financial statements will not be prevented or detected on a timely basis.
A significant deficiency is 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 responsible for oversight of the company’s financial reporting.
A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis. The various standards don’t use the term material deficiency.
The auditor should determine whether uncorrected misstatements are material, individually or in the aggregate. In making this determination, one of the aspects the auditor should consider is the size and nature of the misstatements, in relation to all except which of the following?
A. Particular classes of transactions, account balances, or disclosures
B. The financial statements as a whole
C. The particular circumstances of their occurrence
D. Prior period uncorrected misstatements
D.
The size and nature of misstatements in relation to prior period uncorrected misstatements is not relevant.
The size and nature of the misstatements are considered in relation to all of the other answer alternatives.
Regarding answer A., each individual misstatement is considered to evaluate its effect on the relevant classes of transactions, account balances, or disclosures, including whether the particular materiality level for that particular class of transactions, account balance, or disclosure, if any, has been exceeded.
Editor Note: When determining whether uncorrected misstatements are material, individually or in the aggregate, the auditor should also consider the effect of uncorrected misstatements related to prior periods on the relevant classes of transactions, account balances, or disclosures and the financial statements as a whole. The cumulative effect of immaterial uncorrected misstatements related to prior periods may have a material effect on the current period’s financial statements.
