'Significant Deficiencies' and 'Material Weaknesses'

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THE ACCOUNTING ANGLE
Interim Guidance from GAO on ‘Significant
Deficiencies’ and ‘Material Weaknesses’
By Stephen J. Gauthier
The GAO offers
interim guidance on
how the redefinition
of two terms will
affect auditors.
or more than a decade, independent auditors and their
clients used the terms material
weakness and reportable condition to
describe the deficiencies uncovered in
the course of a financial statement
audit. In 2006, the definition of the term
material
weakness
substantially
changed, while the notion of a
reportable condition gave way to the
related but different concept of a significant deficiency. Now, just two years later,
both terms have been redefined. In
response to this development, the U.S.
Government Accountability Office
(GAO) has offered interim guidance on
how this most recent change will affect
auditors performing engagements in
conformity with generally accepted government auditing standards (GAGAS).
F
BACKGROUND
In May 2006,the American Institute of
Certified Public Accountants (AICPA)
issued Statement on Auditing Standards
(SAS) No. 112, Communicating Internal
Control Related Matters Identified in an
Audit, which took effect for audits of
financial statements for periods ending
on or after December 15, 2006. A key
feature of SAS No. 112 was the introduction of a new terminological framework
to describe deficiencies uncovered in
the course of a financial statement
audit. SAS No. 112 redefined the term
material weakness as
a significant deficiency,or combination of significant deficiencies,
70 Government Finance Review | February 2009
that results in more than a
remote likelihood that a material
misstatement of the financial
statements will not be prevented
or detected.
SAS No. 12 also introduced the new
term significant deficiency, which it
defined as
a control deficiency, or combination of control deficiencies, that
adversely affects the entity’s ability to initiate, authorize, record,
process, or report financial data
reliably in accordance with generally accepted accounting principles such that there is more
than a remote likelihood that a
misstatement of the entity’s financial statements that is more than
inconsequential will not be prevented or detected.
The GAO incorporated both definitions into Section 5.11 of the most recent
(July 2007) version of Government
Auditing Standards, commonly known
simply as the “Yellow Book,” which establishes GAGAS. The use of GAGAS is
required for audits of federal funds (e.g.,
“Single Audit”).The use of GAGAS also is
sometimes mandated by law or regulation at the state level.
In October 2007, the AICPA issued
Statement on Auditing Standards No.
115, Communicating Internal Control
Related Matters Identified in an Audit,
which replaced the definitions of material weakness and significant deficien-
cy from SAS No. 112, with the following
new definitions:
■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.
not occur if AICPA guidance is “specifically excluded or modified” by the
Yellow Book itself.Thus, the issue arises
as to whether the incorporation of the
“old”definitions into Section 5.11 of the
2007 Yellow Book constitutes a “specific
exclusion or modification” that would
prevent the new AICPA definitions from
being implemented when SAS No. 115
takes effect (i.e., for audits of financial
statements for periods ending on or
after December 15, 2009).
■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
charged with governance.
As a general rule, such changes are
automatically incorporated into GAGAS.
However, automatic incorporation does
INTERIM GUIDANCE
To remove any potential ambiguity
regarding the implementation of SAS
No.115 in the context of a GAGAS audit,
the GAO has offered the following interim guidance,pending the next issuance
of Government Auditing Standards:
requirements of Government
Auditing Standards, Section
5.11; and
■ Auditors
following the new AICPA
guidance on material weaknesses
and significant deficiencies will
need to provide the new definitions and describe the scope of
their test work for internal control.
The GAO promises to fully deliberate
the new definitions as part of its preparation of the next version of Government Auditing Standards. The full text
of the GAO’s interim guidance is
available on the GAO’s Web site (at
http://www.gao.gov/govaud/icguidance0811.pdf). ❙
STEPHEN J. GAUTHIER is director of the
GFOA’s Technical Services Center in
Chicago, Illinois.
■ The
implementation of SAS
No. 115 is consistent with the
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