United States: SEC Accounting Fellows Address Evaluation Of Internal Control Over Financial Reporting

Last Updated: December 11 2018
Article by Cydney Posner

A number of members of the SEC accounting staff addressed the 2018 AICPA Conference on Current SEC and PCAOB Developments. Some of the remarks provided helpful guidance for evaluating internal control over financial reporting.

Operating effectiveness. An accounting fellow, Emily Fitts, addressed internal control over financial reporting, focusing on the evaluation of operating effectiveness of controls and preparation of material weakness disclosures. Each year, she noted, management is required to evaluate the effectiveness of these controls, i.e., whether they "have been implemented and actually operate in a manner consistent with their design," an exercise that is especially important this year in light of the implementation of new accounting standards. The first step is "to determine if the control is operating as designed." To that end, she suggests the following questions:

  • "Did the operating effectiveness assessment include an evaluation of how the operation of the control mitigated the identified risks?
  • When a control is designed to address multiple financial reporting risks or if the control is multi-faceted, does the assessment include an evaluation of the operating effectiveness of each aspect of the control?
  • For controls that operate more than once per annual period, was the consistency of the execution of the control considered?
  • When the control was designed with a threshold, was the threshold applied consistently to identify items and was further evaluation conducted when necessary?
  • Was the competency and authority of the personnel who performed the control, or monitored its performance, evaluated and considered?
  • In considering the competency and authority of the personnel, did the evaluation of the control's operating effectiveness consider whether there had been any changes in the personnel who either perform the control or monitor its performance?"

Second, the nature, timing and extent of the evaluation procedures should be risk-based; as the risks of control failure and material misstatement increase, generally more persuasive evidence is needed for the evaluation. Again, to gauge the adequacy of the evaluation procedures, she suggests the following questions:

  • "Is the sample size to evaluate the effectiveness of the control sufficient in considering the number of instances in which the control operated during the assessment period?
  • Were the risks considered in determining the appropriate level of persuasiveness needed for the evidence to be obtained?
  • For controls related to financial reporting elements with a higher risk of material misstatement (resulting from the susceptibility to fraud, the significance of judgment, or the control's complexity), did the nature, timing, and extent of the evaluation procedures appropriately reflect the level of risk?
  • Was the type of control (whether it is, manual or automated) considered in determining the nature, timing, and extent of the evaluation procedures?
  • Did the control rely on the completeness and accuracy of the information produced by the company? If so, were the controls over that information evaluated and found to be effective?"

Material weakness disclosures. Finally, when disclosing a material weakness, management's goal should be to allow "investors to understand the cause of the control deficiency and to assess its potential impact on the company's financial reporting." To assess the adequacy of the disclosure, she suggests the following questions:

  • "Does the disclosure allow an investor to understand what went wrong in the control that resulted in a material weakness?
  • Is it sufficiently clear from the disclosure what the impact of each material weakness is on the company's financial statements? For example, is the material weakness pervasive or isolated to specific accounts or disclosures?
  • Are management's plans to remediate the material weakness sufficiently clear? For example, does disclosure of the remediation plans provide sufficient detail that an investor would understand what management's plans are and how the remediation plans would address the identified material weakness?"

Evaluating severity of control deficiencies. Another accounting fellow, Tom Collens, addressed issues related to the evaluation of control deficiencies. According to Collens, when evaluating whether the severity of a control deficiency rises to the level of a material weakness, "management should evaluate the level of detail and assurance needed to support their conclusions by considering what the views of a 'prudent official' would be in conducting their own affairs. Specifically, management should consider the level of detail and degree of assurance that would satisfy a prudent official looking to obtain reasonable assurance that the financial statements are in conformity with GAAP."

This analysis should be a "holistic" one; management should avoid narrow evaluations "focused solely on the actual misstatements caused by a deficiency," but rather should conduct a more "holistic" evaluation, considering whether "there was a reasonable possibility that a material misstatement would not have been prevented or detected on a timely basis due to the identified deficiency." In some instances, he suggests, management has limited its assessment of the effect of a control deficiency "to the specific area in which a misstatement occurred without considering whether it is reasonably possible that other financial statement areas could be impacted based upon the root cause of the control deficiency. For example, if a deficiency is identified related to the sufficiency or competence of a registrant's accounting personnel due to a misstatement identified in a complex area of GAAP, management should consider whether it is reasonably possible that similar misstatements could occur in other areas of GAAP for the same reason."

Noting that an accurate definition of the control deficiency is a prerequisite to effective treatment, Collens advises that problems can arise when management "attempts to estimate the potential magnitude of a misstatement that could result from a control deficiency without considering what might be reasonably possible based upon the information known." For example, offsetting misstatements within a financial statement line item might require evaluation from an absolute value perspective.

Finally, compensating controls "should be designed to achieve the same objective as the control identified as deficient." For example, the staff have objected when management has contended that "compensating controls reduced the severity of a control deficiency below the level of a material weakness despite the fact that a material misstatement did exist. This might occur because either the control intended to be a compensating control was not designed or operating at a sufficient level of precision to prevent or detect a material misstatement, or because the intended compensating control was not designed to achieve the same objective as the control identified as deficient."

Other speakers addressed—surprise—revenue recognition, specifically, observations on the identification of performance obligations and evaluating the existence of a significant financing component (see these remarks), and application of the principal versus agent guidance and the guidance on the identification of performance obligations (see these remarks). Additional speakers addressed the new lease standard (see these remarks), the new credit losses standard (see these remarks), and consultations (see these remarks). SEC Chief Accountant Wes Bricker provided an overview.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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