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 experience ideas 10 top Work face-to-face with a Top 10 CPA and advisory firm and experience round-the-clock commitment to ideas from nearly 200 professionals trained in the not-for-profit and government industry. Learn more at www.bkd.com. experience February 2009 | Government Finance Review 71