What is the formal definition of a “material weakness” in internal control? How do material weaknesses in internal control differ from “significant deficiencies” in internal control? Identify the three material weaknesses in Exhibit 1 that you believe were most critical. Defend your choices. Can an organization’s internal controls be so inadequate that it is not possible for the entity to be audited? Defend your answer.

Exhibit: 1
1. Control Environment: As of October 31, 2005, management was unsuccessful in establishing an adequately strong consciousness regarding the consistent application of ethics across all areas of the company and the importance of internal controls over financial reporting, including adherence to GAAP.
2. Accounting Personnel: We did not have a sufficient number of accounting personnel with an appropriate level of accounting knowledge, experience and training in the application of GAAP.
3. Accounting Policies: We did not have a formalized process for monitoring, updating, disseminating, and implementing GAAP-compliant accounting policies and procedures.
4. Internal Audit: Our internal audit department was not an effective monitoring control over financial reporting.
5. Segregation of Duties: We did not maintain effective controls to ensure adequate segregation of duties.
6. Information Technology (“IT”): Our IT general controls over computer program development, computer program changes, computer operations and system user access to programs and data were ineffectively designed.
7. Journal Entries: We did not maintain effective controls over the preparation, support, review and approval of journal entries.
8. Account Reconciliations: We did not maintain effective controls over account reconciliations and financial analysis and review.
9. Period End Close: We did not maintain effective controls over the period end close process.
10. Pension Accounting: We did not maintain effective controls to accurately estimate our pension and OPEB obligations.
11. Warranty Accounting: We did not have appropriate warranty cost accounting models and methodologies in place to adequately estimate warranty accruals and we did not perform appropriate financial analyses of the warranty cost estimates on a periodic basis.
12. Income Tax Accounting: We did not have sufficient modeling tools in place or a process to validate the positive and negative evidence necessary to determine whether valuation allowances were required to reduce the carrying values of deferred tax assets.
13. Inventory Accounting: We did not maintain effective controls over our inventory accounting process.
14. Revenue Accounting: We did not maintain effective controls over the revenue accounting process.
15. Contracts and Agreements: We did not perform effective reviews of contracts and agreements, including customer agreements, supplier agreements, agreements related to variable interest entities, derivatives, debt, and leases to assess the accounting implications related to the contracts and agreements.