The Potential Impact of Statement on Auditing Standard Number 112 (SAS 112)

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By Scott A. Clelland, CPA, PSA, RMA

The American Institute of Certified Public Accountants (AICPA) recently issued Statement on Auditing Standards Number 112 (SAS 112), “Communicating Internal Control Related Matters Identified in an Audit,” causing much discussion amongst practitioners who audit and opine on financial statements of commercial entities. If an auditor identifies control deficiencies and determines that these meets the definition of a significant deficiency or a material weakness (see sidebar), the auditor is required to communicate these findings in writing to management and those charged with governance (i.e., Board or Council). SAS 112 was issued to establish standards and provide guidance on communicating matters related to an entity’s internal control.

Although SAS 112 pertains directly to auditors who express opinions on financial statements, its impact will be felt by commercial entities if the audit firm prepares the financial statements as part of the audit process. Much of the discussion surrounding SAS 112 concerns whether or not this practice can continue.

Potential Impact

One concern is the volume and aggregate amount of journal entries that an auditor proposes during the course of an audit. SAS 112 states that if the auditor has made a “significant” number of journal entries or proposed journal entries that are material to the financial statements, it is assumed that the entity does not have adequate controls in place over the processing and recording of transactions. What exactly is a “significant” number of audit adjustments is not defined and left to the judgment of the auditor. If the auditor determines that the audit adjustments are considerable, the auditor would be required to report at least a significant deficiency and potentially a material weakness in internal controls.

The other area of concern is whether or not the auditor can prepare the financial statements of the entity. SAS 112 states that it is a strong indication of a material weakness if an entity has ineffective controls over the preparation of their financial statements such that controls are absent or not effective in preventing or detecting material misstatements in the preparation of financial statements, including the related footnotes. According to SAS 112, an auditor can still propose adjustments and assist in the assembling or drafting of the financial statements, but cannot establish or maintain the entity’s controls, since doing so could impair their independence.

AICPA Offers Some Clarity

In response to the debate, the AICPA recently issued an Audit Risk Alert, in which they address “Lack of Client Expertise in Financial Accounting and Reporting.” In the example presented, it is assumed that the auditor provides assistance in the drafting of the financial statements yet is able to remain independent. That is, the auditor records client-approved adjusting entries and assists in the drafting of financial statements and notes from a client-prepared trial balance. (The auditor cannot be responsible for preparing the trial balance or preparing and approving the adjusting entries.)

Prior to signing the final client representation letter, management obtains the drafted financial statements and the related footnotes and support, and reviews and approves them. Management also reviews and answers the current disclosure checklist from AICPA to ensure propriety and completeness of the footnotes. The financial statements are read, revised, and approved by appropriate members of management.

Under this scenario, SAS 112 does not believe there is an observed control deficiency. Despite management asking the auditor to assist in the drafting of the financial statements and footnotes, they do possess the necessary accounting expertise to prevent, detect, and correct a potential misstatement in the financial statement or notes. There would not be a control deficiency that would be required to be reported.

The auditor is, however, expected to gain a further understanding of the entity’s controls to ensure they are designed appropriately and operating effectively. This is also dependent upon the competence and expertise of management. If during the course of this evaluation, the auditor determines that management lacks the necessary accounting expertise to detect a material misstatement, then that control deficiency would have to be evaluated by the auditor.

Options for Preparation of Financial Statements

SAS 112 leaves three options for preparation of financial statements:

  • The entity should prepare the financial statements and have them available for audit. It is the responsibility of management, not the auditor, to implement and ensure that controls are in place over financial reporting and that the financial statements are those of the entity, not the auditor.
  • If an entity does not have the personnel on staff that can prepare the financial statements, potentially resulting in a material weakness, the entity should consider hiring someone that can perform the function. Alternatively, the entity could contract with a third party that has the ability to prepare the financial statements, but would not issue an opinion.
  • The last option (although not recommended) is to have the auditor prepare the financial statements and live with a material weakness being communicated in writing.

Conclusion

The auditor can still assist in the drafting of the financial statements and related footnotes as long as the following questions can be answered in the affirmative:

  • Does your entity have management skilled and knowledgeable enough to prepare and understand the financial statements?
  • Is management current with standards applicable to your entity and able to complete the applicable AICPA disclosure checklist?

SAS 112 was issued to provide guidance mainly for auditors for communicating internal control related matters identified in an audit and placed much more emphasis on reporting control deficiencies as part of the audit process. However, as noted in this article, it does indeed impact some commercial entities and how they handle the financial statement process. Remember, the auditor cannot serve as a prevent or detect control over the financial reporting process. Therefore, each entity must consider and determine whether they believe they have the ability to prepare the financial statements and footnotes and prepare them without the auditor proposing significant audit adjustments. Since SAS 112 is effective for the upcoming December 31, 2006 audits, it is important to assess your current status and address this situation now or risk dealing with a surprise material weakness comment communicated at the end of the audit process.

Scott A. Clelland, CPA, PSA, RMA is Partner-in-Charge of Public Sector Services for WISS & Company, LLP, an accounting and consulting firm in Livingston, NJ. Scott can be reached at 973-994-9400 or sclelland@wiss.com.

Deficiencies Explained

SAS 112 defines three important terms:

  • A control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.
  • A significant deficiency is a control deficiency(ies) that adversely affects the entity’s ability to initiate, authorize, record, process or report financial data reliably such that there is a remote likelihood that a misstatement of the entity’s financial statements will not be prevented from being detected.
  • A material weakness is a significant deficiency(ies) that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. An important example of a material weakness is employees or management who lack the qualifications and training to fulfill their assigned functions; for example, the Chief Financial Officer lacks the knowledge and skill to apply New Jersey Accounting Principles or GAAP in recording the entity’s financial transactions or preparing its financial statements.

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