Monday April 18, 2022
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So as you're looking at your audit reports, there are going to be several pages. So we talked already about the audit opinion. That is where the auditor is telling you what they think about your financial statements. The financial statements, which are your responsibility, but the auditors will likely draft it for formatting purposes, not necessarily for the content. Again, the content is the responsibility of the organization being audited. And then there might be a management letter. So a management letter, though it says management, it is coming from the auditors and it is being presented to the management team of the organization.
This will include the board more than likely. And this letter is where they are pointing out things that they think are important. So they're like, hi, management team, I think you should know this thing. It's happening. This is what we observed and they want to make sure they put this in writing. More than likely this is going to be surrounded by any weaknesses or deficiencies that they noted in your internal control processes. So for example, they might say, "Okay. We notice that you're not using consecutive receipt numbers, and this is why it's important."
A great audit team is not simply going to tell you what you did wrong, they're also going to tell you why this is concerning. The so what, now what? So they are going to say, "We noticed that receipts are not kept in consecutive order. As a result, there is the possibility that cash could be received and unaccounted for because this is not something that's properly implemented. We recommend, therefore, that you use pre-numbered receipts. All the receipts are maintained at this place." This is what the management letter is going to contain.
It's going to contain things that talk about significant deficiencies. Like, y'all, this thing is not working. It is going to significantly hinder your operations. Material weakness. We've identified, okay, this thing is happening and could be detrimental. And I think it's going to be important then that I identify those two terms because even I still get confused when I think about it. So I'm going to include this link to this article in the show notes, but it is a CFS guide to significant deficiencies and material weakness.
So material weakness is a deficiency or combination of deficiencies in internal controls or financial reporting, such that there is a reasonable possibility that material misstatements of the company's annual or interim financial statements will not be prevented or detected on a timely basis. So again, it's a deficiency. So it's saying like, hey, this thing is such a big deal that it's going to affect the way that you read these reports. So, that is a high level material weakness. Below material weakness is the deficiency, like an individual thing.
So it's like, oh, this piece of things is not working correctly. So it's less severe. So a significant deficiency is less severe than a material weakness because it's not likely to affect the financial statements, but it's important enough to merit the attention of those responsible for oversight. So for example, a significant deficiency would be what I said about the receipts. So it's maybe it might not have a material effect, but this is a big deal. Maybe the auditor had other ways of verifying no, no money. We are not worried about the completion of your receipting, but they want you to know.
They want you to know this thing is a big deal and could really affect things. A material weakness is, hey, no one is reviewing these financial statements. They're being drafted. Journal entries are being done. No one is having any oversight. So, that is one of the reasons why sometimes auditors do a test of journal vouchers or journal entries. And they're looking for are there attachments, is someone approving. And when they see one or both of those are missing, those could be indications of material weaknesses, because now they're like people are making entries.
We can't verify if these entries are reasonable. No one's been looking to make sure. So even if at the time it might have been reasonable, nothing's happening on a timely basis, and so that could be a material weakness. The reason that this is important is because sometimes you can get an unmodified or unqualified AK the best type of opinion, and still have these types of things. And the reason why it's important that the auditors present this is, one, to cover their ass. They don't want it to come up later that, oh, these people weren't doing a thing and no one ever mentioned it.
And so that's one of the reasons that this is put into writing is so that the management team, including the board, can say, hi, the auditors can say, you are aware of this. We've been communicating this. Another thing the auditors will do is as they report on those things, the next year, they're probably going to look at it again. Because they're going to then say, as we reported last year, this thing is still happening. Again, they are making sure that they have covered their bases and said to management, we are continuing to report on this thing that we think is a big concern.
You have not addressed it yet. And there are cases where it might grow. So something may be a deficiency one year, and then because it's not taken care of, it might get escalated to a material weakness because again, maybe it was a new program and some things, they were just like, oh, it's not that much activity this first year. Cool. Not a big deal, but we do want you to notice. And now that program is a bigger portion of your organization's activity and now they're like, because this program is so big, this is more than just a deficiency. This is now a weakness.
And so that is why this letter is important. When I used to do audits, the company I worked for did two letters. So they did a management letter and they did an accounting letter. So, that management letter was what went to the board that said, hey, heads up. These things look wild and outrageous. And then they also did an accounting letter that went more just to the CFO or the bookkeeper that said, hey, here's some things we noticed. They're not huge red flags. We're not necessarily worried about communicating this to management, but here's some tips, some recommendations.
Again, almost any auditor who is going to tell you about your deficiencies or areas of improvement, they're going to tell you what is wrong. And I'm going to say, this is what I've seen from really what I would call to be good quality auditors. They're going to tell you what was wrong, what this creates a risk for and what their recommendations are for improving. You don't have to follow their recommendations, but that way they give you a more tangible idea of, okay, how would we fix this in the first place? The accounting letter is not mandatory.
Some auditors just say things verbally. So, I've definitely had instances where I've talked to auditors and been like, okay, thanks for telling me. Let's talk through how we could fix this so that it's not a bigger deal. Having that ability to talk through that with your auditor is something you should definitely look out for. If you are finding that your auditor is good to tell you what you did wrong but not able to tell you how to fix it or what the options are because ultimately it's your decision on how to fix it, you might want to look for another auditor.
So, that's what I wanted to tell you this week was just about the information in terms of what a management letter is, what's included. So, a management letter is going to tell the management team areas that they're like, this is big enough that is affecting your financial statements in areas that they're like this could grow to be big enough to affect your financial statements. We think it's enough that you should bring attention to. Depending on the scope of your audit, so the scope is like what the audit is covering, you might find your auditors will talk about some compliance issues.
Maybe they talk about IRS I-9s was something we commonly would report on, because we would say like, hey, you're not properly completing your I-9s. This could potentially lead to other issues down the line with the IRS. Not because that was part of the audit itself, but we recognize this is a concern and you can incur penalties. So we want you to be aware. Every audit firm is different. So if you're still looking for an auditor, really think about the areas that you're like, our organization is looking to grow and improve in these areas. Is that something we could brainstorm with you?
All right then. This has been another episode of The Nonprofit ACE Podcast. I'm your host, Chyla Graham. Be sure to leave us a review wherever you're listening and subscribe. You can follow me on social media at CNRG Accounting, C-N-R-G Accounting, and I'd love a review. So if you can give me some feedback, what do you love about the show, what would you like to see different, I would be open to that. We're looking at some two changes in the future, and so be sure to give me some info.
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CFO's Guide to Significant Deficiencies and Material Weaknesses