Trends in Material Weakness – May, 2014

Over the past two years, we have analyzed Management’s Annual Report on Internal Control Over financial Reporting and the Report of the Independent Registered Public Accounting Firm for instances where a material weakness in a company’s internal controls over financial reporting is identified. Our research indicates certain trends in the nature of identified material weaknesses and allows us to work with our clients to ensure risk is addressed when designing and testing their control environments.

Material weaknesses identified in our research indicates companies continue to struggle with controls around financial reporting, tax provisions and entity level controls as these areas are the most frequently identified material weaknesses. These areas are consistently noted in our continuous research that stretches back to the beginning of 2013. In the current period reviewed, weaknesses in companies’ controls over accounting estimates are an area of increasing occurrence. We examined filings from July 1, 2013 to February 28, 2014, and, combined with our prior research, have identified the following trends in material weaknesses disclosed since the beginning of 2013.

Financial reporting controls continue to be the vast majority of identified material weaknesses, which is consistent with findings over the past year. Disclosures not prepared by employees with the requisite knowledge, companies lacking formalized controls around the review of financial statement disclosures, or companies unaware of the impact of new promulgated regulatory requirements and the impact on financial reporting are the most common control weaknesses.

The number of material weaknesses associated with entity level controls, or the control environment, continues to be one of the top areas identified by company management and their auditors. On May 14, 2013, The Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) released an updated version of its Internal Control – Integrated Framework. While the core definition of internal control and the five components remain largely unchanged, the revised framework reflects considerations of many changes in the business and operating environments including:

  • Expectations for governance oversight,
  • Globalization of markets and operations,
  • Changes and greater complexities of business,
  • Demands and complexities in laws, rules, regulations, and standards,
  • Expectations for competencies and accountabilities,
  • Use of, and reliance on, evolving technologies, and
  • Expectations relating to preventing and detecting fraud.

The newly revised Integrated Framework refocuses companies and their auditors to evaluate the robustness of the entity level controls. The application of the revised Integrated Framework to non-financial reporting aspects of an organization led to many newly identified material weaknesses in a company’s entity level controls. Companies should revisit their risk assessment and consider control improvements.

Material weaknesses relating to accounting estimates are an area of increasing occurrence, most notably due to the expertise and professional judgment required to support certain accounting estimates. We note the most common types of accounting estimates receiving material weaknesses pertained to allowances (doubtful accounts, loan losses), valuation of financial instruments and valuation of postretirement benefit obligations. The PCAOB and SEC have continued to focus on the reasonableness of companies’ estimates. Auditors are challenging companies’ estimates and it’s become increasingly important to ensure adequate and competent resources are in place to develop and support the various estimates within the financial reporting process.

Material weaknesses with the design and operation of controls covering the completeness and accuracy of the tax provision are common. Companies recognize they have a deficiency of technical expertise in place to ensure that the process was properly controlled and misstatements would be identified. Companies found they needed more people involved in the process, as well as people with technical expertise in the area.

Our significant experience assisting companies in addressing control deficiencies through process remediation and process improvement allows us to support companies with the development of a robust, yet cost-effective approach in order to enhance their control environments. Streamlined, efficient control structures generate savings as control environments operate and are tested for compliance. Additionally, companies are better prepared to address risk and prevent the occurrence of a material weakness.

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