A material weakness is when one or more of a company's internal controls—activities, rules, and processes designed to prevent significant financial statement irregularities and improve operation efficiency—is ineffective. If a deficiency in internal control is a material weakness, it could result in a material misstatement in a company's financial statements. This would make the company's financial statement data unreliable and ineffective for assessing the company's financial health and determining a reasonable company stock price.
When an audit is conducted and a material weakness in the company's internal controls is detected, the auditors report the material weakness to the audit committee. Every publicly-traded company in the US must have a qualified audit committee. The audit committee, a part of the board of directors, requires that the company's management take steps to fix the controls and rectify the material weakness.
A material weakness, when reported by an auditor, simply suggests that a misstatement could occur. If a material weakness remains undetected and unresolved, a material misstatement could eventually occur in a company's financial statements. An error in the company's financial statements may have a tangible effect on a company's valuation.
In the US, companies must follow the Securities Exchange Committee (SEC) adopted Generally Accepted Accounting Principles (GAAP) when preparing financial statements. Most US firms subscribe to the 5% materiality rule, which states that misstated values 5% above bases (e.g., gross profit, net income, etc.) is material.
Sometimes, material weakness and significant deficiency are used interchangeably. They both identify deficiencies, but one carries more weight than the other. A significant deficiency, which is one or more weaknesses in a company's financial reporting, warrants attention but is less likely to have an impact on the financial statements as with material weaknesses.
GAAP does not safeguard against or provide guidance on what are material weaknesses.
For example, a $100 million overstatement in revenue would be a material misstatement for a company generating sales of $500 million annually. Incorrect company valuations, as a result of the material weaknesses, may affect the company's stock price. Due to their potential to hinder the integrity of the public, material weaknesses in a company's internal controls must be identified promptly.
In October 2018, Costco Wholesale (COST) reported a material weakness in its internal control. According to a press release, "The weakness relates to general information technology controls in the areas of user access and program change-management over certain information technology systems that support the Company's financial reporting processes." In simpler terms, unauthorized persons may have gained access to the company's financial reporting systems.
The company also reported that they did not identify any misstatements in the financial reports and that remediation efforts began immediately. Soon after their public announcement, their stock price fell by approximately 4%.
In 2019, Costco completed their remediation efforts, concluding that its internal controls over financial reporting was tested and operating effectively as of September 2019.
Material weaknesses can adversely affect a company's reputation and, subsequently, its value. A company's stock price may drop as some investors deem the company as a risky investment. Depending on the result of the weakness, the company may expend large sums to cover legal and additional external auditing fees. Also, employees, particularly management, may be heavily scrutinized and subject to disciplinary actions for their lack of oversight.
A material weakness, which is more severe than a significant deficiency, is an internal control deficiency or collection of deficiencies that create a material misstatement in a company's financial statements. A significant deficiency, according to the SEC, is one that negatively affects the "company's ability to record, process, summarize and report financial information, to the external auditor and the audit committee, with the intended result that these parties can more effectively carry out their respective responsibilities with regard to the company’s financial reporting."
There are several indicators of material weaknesses in internal controls. Some of the most notable include evidence of fraud by senior leaders, the identification of a financial misstatement in the company's financial statement missed by the company's internal controls but caught by an auditor, and poor management of a company's external and internal financial reporting.
Which of the following is responsible for establishing a private company’s internal control?
Which of the following is not one of the three primary objectives of effective internal control?
Assurance of elimination of business risk.
(Public) The Public Company Accounting Oversight Board states that reasonable assurance allows a:
remote likelihood that material misstatements will not be prevented or detected by internal control.
Two key concepts that underlie management’s design and implementation of internal control are:
inherent limitations and reasonable assurance.
Internal controls can never be considered as absolutely effective because:
their effectiveness is limited by the competency and dependability of employees.
A major control available in a small company, which might not be feasible in a big company, is:
the owner-manager’s personal interest and close relationship with personnel.
Public) Which of the following is responsible for establishing internal controls for a public company?
Which of the following parties provides an assessment of the effectiveness of internal control over financial reporting for public companies?Management Financial statement auditors
An act of two or more employees to steal assets or misstate records is frequently referred to as:
When the auditor attempts to understand the operation of the accounting system by tracing a few transactions through the accounting system, the auditor is said to be:
performing a walk-through.
SOX) Which section of the Sarbanes-Oxley Act requires management to issue an internal control report?
Sarbanes-Oxley requires management to issue an internal control report that includes two specific items. Which of the following is one of these two requirements?
A statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
Internal control reports issued by public companies must identify the framework used to evaluate the effectiveness of internal control. Which of the following is the most common framework in the U.S.?
Internal Control - Integrated Framework - COSO
To obtain an understanding of an entity’s control environment, an auditor should concentrate on the substance of management’s policies and procedures rather than their form because:
management may establish appropriate policies and procedures but not act on them.
After considering a client’s internal controls, an auditor has concluded that it is well designed and is functioning as intended. Under these circumstances the auditor would most likely:
not increase the extent of predetermined substantive tests.
When a compensating control exists, the absence of a key control:
is no longer a concern because there is no longer a significant deficiency or material weakness.
When planning an audit, the auditor’s assessed level of control risk is:
an economic issue, trading off the costs of testing controls against the cost of testing balances.
External financial statement auditors must obtain evidence regarding what attributes of an internal audit (IA) department if the external auditors intend to rely on IA’s work?
Hanlon Corp. maintains a large internal audit staff that reports directly to the chief financial officer. Audit reports prepared by the internal auditors indicate that the system is functioning as it should and that the accounting records are reliable. An independent auditor will probably:
place limited reliance on the work performed by the internal audit staff.
To be effective, an internal audit department must be independent of:
operating departments.the accounting department.
The independent auditor should acquire an understanding of the internal audit function as it relates to the independent auditor’s study and evaluation of internal control because the:
work performed by internal auditors may be a factor in determining the nature, timing, and extent of the independent auditor’s procedures.
An auditor should consider two key issues when obtaining an understanding of a client’s internal controls. These issues are:
the design and utilization of the controls.
Compared to a public company, the most important difference in a nonpublic company in assessing control risk is the ability to assess control risk at _______ for any or all control-related objectives.
The primary emphasis by auditors is on controls over:
The financial statements are not likely to correctly reflect GAAP if the:
controls affecting the reliability of financial reporting are inadequate.
When considering internal control, an auditor should be aware of the concept of reasonable assurance, which recognizes that the:
costs of internal control should not exceed the benefits expected to be derived from internal control.
The Sarbanes-Oxley Act requires:
all public companies to issue reports on internal controls.
How must significant deficiencies and material weaknesses be communicated to those charged with governance?
Written communication is required.
Significant deficiencies are matters that come to an auditor’s attention and should be communicated to an entity’s audit committee because they represent:
internal control deficiencies that could adversely affect a company’s ability to initiate, record, process, or report external financial statements reliably.
Which of the following statements about auditor documentation of the client’s internal controls is correct?
No one particular form of documentation is necessary.
Internal controls are not designed to provide reasonable assurance that:
all frauds will be eliminated.
(Public) When one material weakness is present at the end of the year, management of a public company must conclude that internal control over financial reporting is:
(Public) The auditor’s tests to understand the client’s internal controls might include which of the following types of procedures?
Which of management’s concerns with respect to implementing internal controls is the auditor primarily concerned?
Reliability of financial reporting.
Which of the following activities would be least likely to strengthen a company’s internal control?
Maintaining insurance for fire and theft.
(Public) Management must disclose material weaknesses in internal control:
if the weakness exists at the end of the year.
When auditing a private company, the auditor should obtain an understanding of internal control sufficient to:
(Public) The initial presumption in the audit of a public company is that control risk is:
In the audit of a private company, the auditor will test controls when control risk is initially assessed at:
Public) The auditor’s study of a public company’s internal control is:
required by the Sarbanes-Oxley Act.
The auditor’s consideration of a private company’s internal control is:
Internal controls can never be regarded as completely effective. Even if company personnel could design an ideal system, its effectiveness depends on the:
competency and dependability of the people using it.
Even with the most effectively designed internal control, the auditor must obtain audit evidence, beyond testing the controls, for every:
material financial statement account.
The essence of an effectively controlled organization lies in the:
attitude of its management.
To issue a report on internal control over financial reporting for a public company, an auditor must:
evaluate management’s assessment process and independently assess the design and operating effectiveness of internal control
Public)medium Which of the stock exchanges require listed companies to have an audit committee composed entirely of independent directors?NYSE NASDAQ
Which of the following factors may increase risks to an organization?Geographic dispersion of company operations Presence of new information technologies
Which of the following statements is correct with respect to separation of duties?
Employees who authorize transactions should not have custody of related assets.
Authorizations can be either general or specific. Which of the following is not an example of a general authorization?
A sales manager’s authorization for a sales return.
The most important type of protective measure for safeguarding assets is:
the use of physical precautions.
Which of the following is correct with respect to the design and use of business documents?
Not all documents used for internal purposes need to be prenumbered.
Public PCAOB Standard 2 requires auditors to evaluate the effectiveness of the audit committee’s oversight of the company’s
Which of the following is correct?
Authorization is a policy decision for either a general class of transactions or specific transactions.
Which of the following principles is not necessary for the proper design and use of documents and records?
Designed for a single use to increase efficiency of operations.
Narratives, flowcharts, and internal control questionnaires are three common methods of:
documenting the auditor’s understanding of internal controls.
_____ deal with ongoing or periodic assessment of the quality of internal control by management.
Public Smaller public companies face challenges implementing effective internal control due to ______.
Which of the following is not one of the levels of an absence of internal controls?
Which of the following is the correct definition of “control deficiency?”
A control deficiency exists if the design or operation of controls does not permit company personnel to prevent or detect misstatements on a timely basis.
A(n) _______ deficiency exists if a necessary control is missing or not properly formulated.
To determine if significant internal control deficiencies are material weaknesses, they must be evaluated on their:Likelihood Significance
The purpose of an entity’s accounting information and communication system is to ______.Monitor transactions Record and process transactions Initiate transactions
A procedure that would most likely be used by an auditor in performing tests of control procedures that involve segregation of functions and that leave no transaction trail is:
If the results of tests of controls support the design and operations of controls as expected, the auditor uses ____ control risk as the preliminary assessment.
Internal controls normally include procedures designed to provide reasonable assurance that:
transactions are executed in accordance with management’s authorization.
Which of the following is correct?
A material weakness is always a significant deficiency.
Which of the following is not a likely procedure to support the operating effectiveness of internal controls?
Completing an internal control questionnaire.
Public)medium Before making the final assessment of internal control at the end of an integrated audit, the auditor must:
Test controls Perform substantive tests of details
Significant deficiencies and material weaknesses in internal control of a public company must be reported to which of the following?
Audit committee of the company’s board of directors.
Of the following statements about internal controls, which one is not valid?medium
Control procedures reasonably ensure that collusion among employees cannot occur
Proper segregation of functional responsibilities calls for separation of:
authorization, recording, and custody.
Audit evidence concerning proper segregation of duties normally is best obtained by:
direct personal observation of the employee who applies control procedures.
It is important for the CPA to consider the competence of the clients’ personnel because their competence bears directly and importantly upon the:
achievement of the objectives of internal control.
Which of the following is not one of the subcomponents of the control environment?
Adequate separation of duties.
Which of the following best describes the inherent limitations that should be recognized by an auditor when considering the potential effectiveness of internal control?
Procedures that depend on segregation of duties can be circumvented by collusion
Management’s ongoing and periodic assessment of the quality of internal control performance to determine that controls are operating as intended and modified when needed.
Company-wide policies for the approval of all transactions within stated limits.
The actions, policies, and procedures that reflect the overall attitudes of top management, directors, and owners of an entity about control and its importance to the entity.
Segregation of the following activities in an organization: custody of assets, accounting, authorization, and operational responsibility.
Management’s identification and analysis of risks relevant to the preparation of financial statements in accordance with generally accepted accounting principles
Policies and procedures that help ensure necessary actions are taken to address risks in the achievement of the entity’s objectives.
A process designed to provide reasonable assurance regarding the achievement of management’s objectives in the following categories: (1) reliability of financial reporting, (2) effectiveness and efficiency of operations, and (3) compliance with applicable laws and regulations.