Assess each deficiency described below and determine whether it should be classified as a control deficiency, significant deficiency, or material weakness. Consider each deficiency separately.
Be able to support your answer. For scenario (c), specifically discuss the importance of professional skepticism.
a. The client's management was not diligent in systematically communicating company-wide policies and procedures and consistently emphasizing the importance of controls. Based on testing, the internal audit team felt that management did not promote the most appropriate level of control awareness.
b. While the internal audit function at your client, G-Tech, has a formal reporting relationship with the Audit Committee, top management (CEO and CFO) has been the one during the current year that has been calling the shots regarding the internal audit function. For example, top management is able to influence the internal audit plan; has a great deal of say with respect to hiring, firing, and compensating the internal audit director; and has primary responsibility for approving the internal audit budget. In actuality, the Audit Committee has only limited influence in these areas.
c. Your client, SEA, introduced a new product line this year. The total annual revenue for this product line is large enough that a misstatement in the account could be material. For this product line, the revenue is based on contracts that have complex multielement arrangements. SEA initiates a significant number of new contracts for this product line each week across multiple regions. When preparing these new contracts, a standard contract is used, and modifications to the standard contract are made based on the specific characteristics of the transaction.
When a new contract is entered into your client's computerized billing system, client accounting personnel at the regional office are to verify that revenue recognition conforms to the applicable financial reporting framework. As part of the control procedure, a revenue checklist is to be completed and signed off by the client accounting personnel who perform the verification.
Your audit team is satisfied that this primary control is effectively designed. However, a walkthrough and tests of the operating effectiveness of this control by your audit team revealed that these control procedures have not been consistently documented or performed for the new product line. The control has not been operating effectively. The deficiency only relates to this new product line and was not limited to a particular region. In performing internal control testing of this primary control, neither the audit team nor the client has identified a known dollar error related to the deficiency in this primary control. The audit team, based on appropriate consultation within the firm, agrees that this deficiency in operating effectiveness of this primary control represents a material weakness. However, the client wants to classify the deficiency as less than a material weakness because of a compensating control.
The compensating control is designed as follows. Specifically, a Revenue Accounting Manager at the company headquarters verifies the revenue recognition provisions of a random sample of new contracts on a weekly basis. This manager examines documents that indicate regional accounting personnel have verified the revenue recognition provisions. The manager also reperforms the verification procedure to ensure that revenue recognition provisions have been properly entered into the billing system. The client believes that these weekly verifications by a Revenue Accounting Manager constitute a compensating control that is likely to detect and prevent material misstatements in revenue recognition.
The audit team has indicated the following about the design of the compensating control:
● The compensating control is performed by headquarters personnel who the audit team believes to be appropriate, competent, and qualified to evaluate revenue recognition.
● The random sample examined by headquarters personnel is designed to verify 70% of the total revenue generated from these new product contracts with complex multi-element arrangements.
● Your audit team believes that the design of the compensating control is effective.
The audit team has tested a sample of contracts verified by a Revenue Accounting Manager at the company headquarters who performed the compensating control. The audit team's testing consisted of examining documentation that the control was performed and reperforming revenue recognition verification.
The sample size of contracts examined by the audit team was based on your audit firm's guidelines given the risk, the nature of the control, and the frequency with which it was performed.
During their tests, the audit team found one contract in the sample for which the compensating control was not properly performed. The audit team reported that there was not a dollar error associated with this control deficiency.