Pipara & Co LLP

Communicating Deficiencies in Internal Control to Those Charged with Governance and Management

Introduction

Scope of this SA
  1. This Standard on Auditing (SA) deals with the auditor’s responsibility to communicate appropriately to those charged with governance and management deficiencies in internal control1 that the auditor has identified in an audit of financial statements. This SA does not impose additional responsibilities on the auditor regarding obtaining an understanding of internal control and designing and performing tests of controls over and above the requirements of SA 315 and SA 3302. SA 260(Revised)3 establishes further requirements and provides guidance regarding the auditor’s responsibility to communicate with those charged with governance in relation to the audit.
  2. The auditor is required to obtain an understanding of internal control relevant to the audit when identifying and assessing the risks of material misstatement4. In making those risk assessments, the auditor considers internal control in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of internal control. The auditor may identify deficiencies in internal control not only during this risk assessment process but also at any other stage of the audit. This SA specifies which identified deficiencies the auditor is required to communicate to those charged with governance and management.
  3. Nothing in this SA precludes the auditor from communicating to those charged with governance and management other internal control matters that the auditor has identified during the audit.
Effective Date
  1. This SA is effective for audits of financial statements for periods beginning on or after April 1, 2010.
Objective
  1. The objective of the auditor is to communicate appropriately to those charged with governance and management deficiencies in internal control that the auditor has identified during the audit and that, in the auditor’s professional judgment, are of sufficient importance to merit their respective attentions.

1 SA 315, “Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment”, paragraphs 4 and 12.

2 SA 330, “The Auditor’s Responses to Assessed Risks”.

3 SA 260(Revised), “Communication with Those Charged with Governance”.

4 SA 315, paragraph 12.

Definitions
  1. For purposes of the SAs, the following terms have the meanings attributed below:
  1. Deficiency in internal control – This exists when:
    1. A control is designed, implemented or operated in such a way that it is unable to prevent, or detect and correct, misstatements in the financial statements on a timely basis; or
    2. A control necessary to prevent, or detect and correct, misstatements in the financial statements on a timely basis is missing.

Significant deficiency in internal control – A deficiency or combination of deficiencies in internal control that, in the auditor’s professional judgment, is of sufficient importance to merit the attention of those charged with governance. (Ref: Para. A5)

Requirements
  1. The auditor shall determine whether, on the basis of the audit work performed, the auditor has identified one or more deficiencies in internal control. (Ref: Para. A1-A4)
  2. If the auditor has identified one or more deficiencies in internal control, the auditor shall determine, on the basis of the audit work performed, whether, individually or in combination, they constitute significant deficiencies. (Ref: Para. A5-A11)
  3. The auditor shall communicate in writing significant deficiencies in internal control identified during the audit to those charged with governance on a timely basis. (Ref: Para. A12- A18, A27)
  4. The auditor shall also communicate to management at an appropriate level of responsibility on a timely basis: (Ref: Para. A19, A27)
  1. In writing, significant deficiencies in internal control that the auditor has communicated or intends to communicate to those charged with governance, unless it would be inappropriate to communicate directly to management in the circumstances; and (Ref: Para. A14, A20-A21)
  2. Other deficiencies in internal control identified during the audit that have not been communicated to management by other parties and that, in the auditor’s professional judgment, are of sufficient importance to merit management’s attention. (Ref: Para. A22- A26)
  1. The auditor shall include in the written communication of significant deficiencies in internal control:
  1. A description of the deficiencies and an explanation of their potential effects; and (Ref: Para. A28)
  2. Sufficient information to enable those charged with governance and management to understand the context of the communication. In particular, the auditor shall explain that: (Ref: Para. A29-A30)
    1. The purpose of the audit was for the auditor to express an opinion on the financial statements;
    2. The audit included consideration of internal control relevant to the preparation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of internal control; and
    3. The matters being reported are limited to those deficiencies that the auditor has identified during the audit and that the auditor has concluded are of sufficient importance to merit being reported to those charged with governance.
Application and Other Explanatory Material
Determination of Whether Deficiencies in Internal Control Have Been Identified (Ref: Para. 7)

A1. In determining whether the auditor has identified one or more deficiencies in internal control, the auditor may discuss the relevant facts and circumstances of the auditor’s findings with the appropriate level of management. This discussion provides an opportunity for the auditor to alert management on a timely basis to the existence of deficiencies of which management may not have been previously aware. The level of management with whom it is appropriate to discuss the findings is one that is familiar with the internal control area concerned and that has the authority to take remedial action on any identified deficiencies in internal control. In some circumstances, it may not be appropriate for the auditor to discuss the auditor’s findings directly with management, for example, if the findings appear to call management’s integrity or competence into question (see paragraph A20).

A2. In discussing the facts and circumstances of the auditor’s findings with management, the auditor may obtain other relevant information for further consideration, such as:

  • Management’s understanding of the actual or suspected causes of the deficiencies.
  • Exceptions arising from the deficiencies that management may have noted, for example, misstatements that were not prevented by the relevant information technology (IT) controls.
  • A preliminary indication from management of its response to the findings.

Considerations Specific to Smaller Entities

A3. While the concepts underlying control activities in smaller entities are likely to be similar to those in larger entities, the formality with which they operate will vary. Further, smaller entities may find that certain types of control activities are not necessary because of controls applied by management. For example, management’s sole authority for granting credit to customers and approving significant purchases can provide effective control over important account balances and transactions, lessening or removing the need for more detailed control activities.

A4. Also, smaller entities often have fewer employees which may limit the extent to which segregation of duties is practicable. However, in a small owner- managed entity, the owner-manager may be able to exercise more effective oversight than in a larger entity. This higher level of management oversight needs to be balanced against the greater potential for management override of controls.

Significant Deficiencies in Internal Control (Ref: Para. 6(b), 8)

A5. The significance of a deficiency or a combination of deficiencies in internal control depends not only on whether a misstatement has actually occurred, but also on the likelihood that a misstatement could occur and the potential magnitude of the misstatement. Significant deficiencies may therefore exist even though the auditor has not identified misstatements during the audit.

A6. Examples of matters that the auditor may consider in determining whether a deficiency or combination of deficiencies in internal control constitutes a significant deficiency include:

  • The likelihood of the deficiencies leading to material misstatements in the financial statements in the future.
  • The susceptibility to loss or fraud of the related asset or liability.
  • The subjectivity and complexity of determining estimated amounts, such as fair value accounting estimates.
  • The financial statement amounts exposed to the deficiencies.
  • The volume of activity that has occurred or could occur in the account balance or class of transactions exposed to the deficiency or deficiencies.
  • The importance of the controls to the financial reporting process; for example:
    • General monitoring controls (such as oversight of management).
    • Controls over the prevention and detection of fraud.
    • Controls over the selection and application of significant accounting policies.
    • Controls over significant transactions with related parties.
    • Controls over significant transactions outside the entity’s normal course of business.
    • Controls over the period-end financial reporting process (such as controls over non-recurring journal entries).
  • The cause and frequency of the exceptions detected as a result of the deficiencies in the controls.
  • The interaction of the deficiency with other deficiencies in internal control. A7. Indicators of significant deficiencies in internal control include, for example:
  • Evidence of ineffective aspects of the control environment, such as:
    • Indications that significant transactions in which management is financially interested are not being appropriately scrutinised by those charged with governance.
    • Identification of management fraud, whether or not material, that was not prevented by the entity’s internal control.
    • Management’s failure to implement appropriate remedial action on significant deficiencies previously communicated.
  • Absence of a risk assessment process within the entity where such a process would ordinarily be expected to have been established.
  • Evidence of an ineffective entity risk assessment process, such as management’s failure to identify a risk of material misstatement that the auditor would expect the entity’s risk assessment process to have identified.
  • Evidence of an ineffective response to identified significant risks (e.g., absence of controls over such a risk).
  • Misstatements detected by the auditor’s procedures that were not prevented, or detected and corrected, by the entity’s internal control.
  • Disclosure of a material misstatement due to error or fraud as prior period items in the current year’s Statement of Profit and Loss5.
  • Evidence of management’s inability to oversee the preparation of the financial statements.

A8. Controls may be designed to operate individually or in combination to effectively prevent, or detect and correct, misstatements6. For example, controls over accounts receivable may consist of both automated and manual controls designed to operate together to prevent, or detect and correct, misstatements in the account balance. A deficiency in internal control on its own may not be sufficiently important to constitute a significant deficiency. However, a combination of deficiencies affecting the same account balance or disclosure, relevant assertion, or component of internal control may increase the risks of misstatement to such an extent as to give rise to a significant deficiency.

A9. Law or regulation in some jurisdictions may establish a requirement (particularly for audits of listed entities) for the auditor to communicate to those charged with governance or to other relevant parties (such as regulators) one or more specific types of deficiency in internal control that the auditor has identified during the audit. Where law or regulation has established specific terms and definitions for these types of deficiency and requires the auditor to use these terms and definitions for the purpose of the communication, the auditor uses such terms and definitions when communicating in accordance with the legal or regulatory requirement.

A10. Where the jurisdiction has established specific terms for the types of deficiency in internal control to be communicated but has not defined such terms, it may be necessary for the auditor to use judgment to determine the matters to be communicated further to the legal or regulatory requirement. In doing so, the auditor may consider it appropriate to have regard to the requirements and guidance in this SA. For example, if the purpose of the legal or regulatory requirement is to bring to the attention of those charged with governance certain internal control matters of which they should be aware, it may be appropriate to regard such matters as being generally equivalent to the significant deficiencies required by this SA to be communicated to those charged with governance.

A11. The requirements of this SA remain applicable notwithstanding that law or regulation may require the auditor to use specific terms or definitions.

5 Accounting Standard (AS) 5, “Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies” requires that prior period items should be separately disclosed in the Statement of Profit and Loss in a manner that their impact on the current profit or loss can be perceived.

6 SA 315, paragraph A72.

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