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Significant deficiency

What Is Significant Deficiency?

A significant deficiency is a control weakness that is less severe than a material weakness but is still important enough to warrant the attention of those responsible for oversight of a company's financial reporting. It falls within the broader category of auditing standards and internal control practices, specifically concerning a company's system of internal controls over financial reporting (ICFR). While a significant deficiency does not necessarily mean that a material misstatement of the financial statements will occur, it indicates a flaw in the design or operation of controls that could lead to such a misstatement.

History and Origin

The concept of a significant deficiency gained prominence in the United States following the passage of the Sarbanes-Oxley Act of 2002 (SOX). This landmark legislation was enacted in response to major corporate accounting scandals, aiming to improve corporate governance, accountability, and the reliability of financial statements. Section 404 of SOX specifically mandates that management and external auditors assess and report on the effectiveness of a company's internal control over financial reporting.5, 6

To provide clear definitions for terms used in this context, the U.S. Securities and Exchange Commission (SEC) adopted a formal definition of "significant deficiency" on August 3, 2007. The SEC defined it as "a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the registrant's financial reporting."4 This definition was designed to help companies and their auditors differentiate between control issues of varying severity. The Committee of Sponsoring Organizations of the Treadway Commission (COSO), formed in 1985 to combat fraudulent financial reporting, also plays a foundational role by providing frameworks for internal control that companies often adopt.3

Key Takeaways

  • A significant deficiency is a flaw in internal control that is less severe than a material weakness.
  • It is serious enough to be brought to the attention of a company's audit committee and management.
  • Unlike a material weakness, a significant deficiency does not, by itself, indicate a reasonable possibility of a material misstatement in the financial statements.
  • Identification of a significant deficiency requires evaluation and potential remediation to strengthen the control environment.
  • These deficiencies are primarily identified through the internal audit process or external financial statement audits.

Interpreting the Significant Deficiency

When an auditor identifies a significant deficiency, it signals that there are weaknesses in a company's internal control system that, while not immediately indicative of a material misstatement, could still lead to problems in financial reporting. The Public Company Accounting Oversight Board (PCAOB) Auditing Standard AS 2201 requires auditors to communicate such deficiencies in writing to management and the audit committee.2

The interpretation involves professional judgment by the auditor and management. It requires an understanding of the potential impact of the deficiency on the reliability of financial data and the company's ability to prevent or detect misstatements. For example, a control that is occasionally bypassed might be a significant deficiency if it could lead to a significant but non-material error, whereas a regularly bypassed control over a critical process might escalate to a material weakness. The severity of the deficiency is not measured by the actual amount of misstatement but by the "reasonable possibility" of a significant misstatement occurring.

Hypothetical Example

Imagine "Green Solutions Inc.," a publicly traded company that processes numerous small customer refunds daily. Their standard procedure for refunds requires an accounting clerk to initiate the refund and a separate supervisor to approve it.

A recent internal audit reveals a control weakness: on several occasions over the past quarter, the supervisor was on vacation, and another accounting clerk, rather than a designated backup supervisor, approved refunds. This occurred due to an oversight in the company's vacation coverage policy for segregation of duties within the accounting department.

While no material misstatements occurred, and the amounts involved were individually small, the auditor identified this as a significant deficiency. Why? Because the control designed to ensure proper authorization and prevent unauthorized or erroneous refunds (the supervisor approval) was sometimes performed by someone without the appropriate authority or independence. If this practice were to continue, or if the refund amounts were larger, there would be a reasonable possibility that a significant, though not necessarily material, misstatement could occur and not be detected. The auditor would communicate this significant deficiency to Green Solutions' management and its audit committee, recommending a formal backup approval process be established and enforced.

Practical Applications

Significant deficiencies arise in various facets of a company's operations, particularly those related to compliance and accounting standards. They are a key focus for external auditors during their annual audit of financial statements and internal controls.

  • Auditing: Auditors are required to identify and communicate significant deficiencies to a company's audit committee. This informs the committee about less severe, but still important, control weaknesses that could impact financial reporting reliability.
  • Regulatory Scrutiny: Regulatory bodies, such as the SEC and PCAOB, monitor audit quality and internal control effectiveness. Consistent identification of significant deficiencies, especially if unresolved, can draw regulatory attention, potentially leading to further investigations or enforcement actions. The PCAOB has, at times, expressed concern over the high rate of audit failures related to internal controls.1
  • Internal Control Improvement: Companies use the identification of significant deficiencies as an opportunity to improve their control environment. Addressing these issues proactively can prevent them from escalating into more serious material weaknesses.
  • Risk Management: Part of effective risk assessment involves understanding all control weaknesses, regardless of their immediate severity. Significant deficiencies contribute to a company's overall risk profile.

Limitations and Criticisms

Despite their importance, the identification and reporting of significant deficiencies come with certain limitations and criticisms:

  • Subjectivity: The distinction between a control deficiency, a significant deficiency, and a material weakness often relies on the auditor's professional judgment. This can introduce subjectivity into the classification process, potentially leading to inconsistencies across different audit firms or even different engagements by the same firm.
  • Cost of Remediation: While less severe, addressing significant deficiencies still requires resources and time from a company's management and internal audit teams. Companies may find themselves investing considerable effort in remediating issues that do not directly translate into material misstatements.
  • Focus on Documentation vs. Effectiveness: Sometimes, the emphasis on documenting controls to identify deficiencies can lead to a compliance-driven approach, where companies focus more on creating paperwork rather than truly enhancing the operating effectiveness of their internal controls.
  • Investor Confusion: For external stakeholders, particularly investors, the precise distinctions between control deficiencies, significant deficiencies, and material weaknesses can be confusing. While material weaknesses must be publicly disclosed, significant deficiencies are typically communicated only to the audit committee and management, potentially creating a perception of a lack of transparency if internal control issues persist without public disclosure.

Significant Deficiency vs. Material Weakness

The terms "significant deficiency" and "material weakness" are often confused but represent different levels of severity in internal control deficiencies. Both indicate a shortfall in a company's internal control over financial reporting, but their potential impact on financial statements differs significantly.

A significant deficiency is a weakness in internal control that is important enough to merit attention by those responsible for oversight of a company's financial reporting. It suggests a problem that could lead to a significant, though not necessarily material, misstatement of the financial statements, but the likelihood is not as high as with a material weakness. For example, if a company's fraud risk assessment process is not consistently applied across all departments, it might be a significant deficiency.

A material weakness, by contrast, is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. The key difference lies in the "reasonable possibility" of a "material misstatement." If an auditor identifies a material weakness, they cannot issue an unqualified opinion on the effectiveness of a company's ICFR. Companies are also required to publicly disclose material weaknesses in their SEC filings. An example might be an inadequate segregation of duties where one person can both record and authorize significant transactions without independent review.

FAQs

What causes a significant deficiency?

A significant deficiency can stem from various issues, including inadequate design of an internal control, failure of a control to operate as intended, insufficient training for employees performing control activities, or a lack of oversight by management.

Is a significant deficiency publicly disclosed?

No, typically a significant deficiency is not publicly disclosed. It is communicated by the external auditor in writing directly to the company's audit committee and management. Only a more severe "material weakness" requires public disclosure in a company's SEC filings.

How does a company address a significant deficiency?

Once a significant deficiency is identified, the company's management is responsible for developing and implementing a remediation plan. This plan might involve redesigning the control, providing additional training, improving documentation, or enhancing supervision. The auditor will then monitor the remediation efforts in subsequent periods.

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