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Sarbanes Oxley Act -
Auditing Standards |
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Public
Company Accounting Oversight
Board
Bylaws
and Rules – Standards – AS2
Auditing
Standard No. 2: An Audit of Internal Control
Over Financial Reporting Performed in
Conjunction With an Audit of Financial
Statements
Example
D-2—Modifications to
Standard Sales Contract Terms Not Reviewed
To
Evaluate Impact on
Timing and Amount of Revenue
Recognition
Scenario A –
Significant Deficiency. The company uses a
standard sales contract for
most
transactions. Individual sales transactions are
not material to the entity.
Sales
personnel
are allowed to modify sales contract terms. The
company's accounting
function
reviews significant or unusual modifications to
the sales contract terms, but
does
not review changes in the standard shipping
terms. The changes in the
standard
shipping
terms could require a delay in the timing of
revenue recognition. Management
reviews
gross margins on a monthly basis and
investigates any significant or
unusual
relationships.
In addition, management reviews the
reasonableness of inventory
levels
at
the end of each accounting period. The entity
has experienced limited situations
in
which
revenue has been inappropriately recorded in
advance of shipment, but
amounts
have
not been material.
Based
only on these facts, the auditor should
determine that this deficiency
represents
a
significant deficiency for the following
reasons: The magnitude of a
financial
statement
misstatement resulting from this deficiency
would reasonably be expected to
be
more than inconsequential, but less than
material, because individual
sales
transactions
are not material and the compensating detective
controls operating
monthly
and at the end of each financial reporting
period should reduce the likelihood
of
a
material misstatement going undetected.
Furthermore, the risk of
material
misstatement
is limited to revenue recognition errors related
to shipping terms as
opposed
to broader sources of error in revenue
recognition. However, the
compensating
detective controls are only designed to detect
material misstatements.
The
controls do not effectively address the
detection of misstatements that are
more
than
inconsequential but less than material, as
evidenced by situations in
which
transactions
that were not material were improperly recorded.
Therefore, there is a
more
than remote likelihood that a misstatement that
is more than inconsequential
but
less
than material could occur.
Scenario B - Material
Weakness.
The
company has a standard sales contract,
but
sales
personnel frequently modify the terms of the
contract. The nature of the
modifications
can affect the timing and amount of revenue
recognized. Individual sales
transactions
are frequently material to the entity, and the
gross margin can vary
significantly
for each transaction.
The
company does not have procedures in place for
the accounting function to
regularly
review
modifications to sales contract terms. Although
management reviews gross
margins
on a monthly basis, the significant differences
in gross margins on individual
transactions
make it difficult for management to identify
potential misstatements.
Improper
revenue recognition has occurred, and the
amounts have been material.
Based
only on these facts, the auditor should
determine that this deficiency
represents
a
material weakness for the following reasons: The
magnitude of a financial
statement
misstatement
resulting from this deficiency would reasonably
be expected to be
material,
because individual sales transactions are
frequently material, and gross
margin
can vary significantly with each transaction
(which would make compensating
detective
controls based on a reasonableness review
ineffective). Additionally,
improper
revenue recognition has occurred, and the
amounts have been material.
Therefore,
the likelihood of material misstatements
occurring is more than remote.
Taken
together, the magnitude and likelihood of
misstatement of the financial
statements
resulting from this internal control deficiency
meet the definition of a
material
weakness.
Scenario C – Material
Weakness.
The
company has a standard sales contract,
but
sales
personnel frequently modify the terms of the
contract. Sales personnel
frequently
grant
unauthorized and unrecorded sales discounts to
customers without the knowledge
of
the accounting department. These amounts are
deducted by customers in paying
their
invoices and are recorded as outstanding
balances on the accounts
receivable
aging.
Although these amounts are individually
insignificant, they are material in
the
aggregate
and have occurred consistently over the past few
years.
Based
on only these facts, the auditor should
determine that this deficiency
represents
a
material weakness for the following reasons: The
magnitude of a financial
statement
misstatement
resulting from this deficiency would reasonably
be expected to be
material,
because the frequency of occurrence allows
insignificant amounts to become
material
in the aggregate. The likelihood of material
misstatement of the financial
statements
resulting from this internal control deficiency
is more than remote (even
assuming
that the amounts were fully reserved for in the
company's allowance for
uncollectible
accounts) due to the likelihood of material
misstatement of the gross
accounts
receivable balance. Therefore, this internal
control deficiency meets the
definition
of a material weakness.
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