Following is a portion of management's report on internal control by Milacron Inc. in 2004.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures (Interim Analysis)
Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed by the company is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission (SEC).... the company's chief executive officer and chief financial officer have concluded that the company's disclosure controls and procedures were not effective as of December 31, 2004, due to the material weakness in internal control over financial reporting described below.
Internal Control over Financial Reporting
While the company's assessment of the effectiveness of its internal control over financial reporting is not complete, a material weakness, as defined in standards established by the Public Company Accounting Oversight Board (United States), has been identified.... The identified material weakness consists of inadequate levels of review of complex and judgmental accounting issues. Various audit adjustments were needed to correct errors resulting from the internal control deficiency. This deficiency manifested itself in the determination of deferred tax valuation allowances as well as litigation reserves and recoverables from third-party insurers. These adjustments are reflected in the company's audited financial statements for the year ended December 31, 2004.... To address the identified material weakness, the company is in the process of implementing remediation plans, including the following:
● The company has increased its levels of review of complex and judgmental accounting issues.
● The company has initiated a plan to add personnel with technical accounting expertise.
● The company has made a commitment to increase professional development for finance and accounting personnel...
The indenture governing the company's 11 1/2% Senior Secured Notes due 2011 requires filing the Form 10-K in a timely manner. The failure to do so is a default under the indenture.
Updated Analysis Filed in Amended 10-K
The following is a description of the three material weaknesses in the company's internal control over financial reporting:
Review of Complex and Judgmental Accounting Issues-There are inadequate levels of review of complex and judgmental accounting issues. Various audit adjustments were needed to correct errors from this internal control deficiency... [remainder of paragraph describes these deficiencies in more detail].
Segregation of Duties-There is inadequate segregation of incompatible duties with respect to the company's manual and computerbased business processes at the corporate and operating levels. Such inadequacy in segregation of incompatible duties significantly reduced or eliminated the effectiveness of many of the company's internal controls over the accounts which comprise the consolidated financial statements. This material weakness has been caused primarily by two factors:
● Instances in which, as a result of the company's effort to stream-line business processes, individuals are in various conflicting roles; and
● The use of older computer systems which are not always capable of limiting user's access to certain transactions.
No audit adjustments to the company's audited financial statements for the year ended December 31, 2004 resulted from this material weakness.
To address this material weakness, the company will implement, based on specific circumstances, one or more measures, which will include:
● Reassignment of certain responsibilities in order to eliminate incompatible roles;
● Implementation of independent reviews of certain completed transactions; and
● Further restriction of access to certain sensitive, conflicting transactions.
Additionally, the company is in the process of implementing a company-wide [computer] system to upgrade its overall operating systems.
In addition to the many operating benefits, the new system will also be capable of adequate segregation of duties.
Inventory Valuation-There are insufficient controls with respect to the accounting for inventories primarily at one major North American manufacturing location. Specifically, the Company did not have effective controls to ensure inventory was properly valued and to ensure inventory was properly relieved at the time of sale.
Because of the material weaknesses described above, management has concluded that, as of December 31, 2004, the company did not maintain effective internal control over financial reporting.
Ernst & Young LLP , the registered public accounting firm that audited the company's financial statements included in the Form 10-K, has issued an attestation report on management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2004, which is included below.
Required
a. Identify the control deficiencies that management identified in its report on internal control.
b. For each control deficiency identified, answer the following:
(1) How would management identify the deficiency?
(2) How is management planning on remediating the deficiency?
(3) What evidence should the auditor gather to determine whether the control deficiency has been remediated?
c. Management indicates that the deficiencies may cause the company to violate its debt covenants.
(1) Explain why the deficiencies might violate debt covenants.
(2) What are the implications to the company if the debt covenants are violated?
(3) Why are lenders interested in the effectiveness of a company's internal control?
d. Management asserts that the control deficiencies did not lead to material misstatements in the financial statements:
(1) How would management know that there were no material misstatements?
(2) Is the auditor required to attest to this assertion by management? Explain why or why not.