Billy Muldoon, CPA and CFO, just finished reading a preliminary draft of his companys annual audit report from PwC. He was pleased that they had given the company a clean audit opinion, but dismayed to learn that they had concluded and were planning to disclose that the company had a material weakness in their internal controls over financial reporting. Billy was concerned that such a disclosure might result in a large drop in the market price of the companys stock. Included with the draft of the report was the following note of explanation from the partner in charge of the engagement as to how PwC had reached this conclusion:

Dear Billy, As you know, we perform an integrated audit which combines our testing of the adequacy of internal controls with our performance of our normal audit procedures. This process starts during our audit planning process with the review of managements assertions surrounding the adequacy of internal controls, including those surrounding financial reporting. Unfortunately, as we conducted our work we discovered a series of deficiencies, which individually are immaterial. Taken together, we believe these significant deficiencies represent a more than remote likelihood that a material misstatement could occur and not be prevented or detected. Therefore, in accordance with Section 404 of SOX and PCAOB AS 2201, the deficiencies need to be disclosed as material in the audit report. We are also concerned that other internal control weaknesses could provide indirect evidence of managerial ability because the design and implementation of internal controls is a primary management responsibility.

Once you have had a chance to review, please feel free to reach out to me to discuss.

Identified Weaknesses:

We found inadequate segregation of duties over access to your sales information system controls.

We found several instances of transactions on the general ledger which were not also recorded in the appropriate subsidiary ledger: these transactions were not material individually or in aggregate.

We found that timely reconciliations of certain intercompany transaction accounts were not being performed: the individual transactions were material on an individual basis and only impacted balance sheet accounts.

We found insufficient procedures to qualitatively assess whether the fair value of a reporting unit is less than its carrying value in order to assess goodwill impairment. Billy immediately shot off an email to the partner requesting a meeting stating he vehemently disagreed with his analysis. He further stated that he thought PwC was intentionally misclassifying these items as material weaknesses over fear of potential legal liability.

Questions

1. What are the main arguments that the partner from PwC will need to counter when he meets with Billy? That is, what are the reasons and rationalizations he should expect to hear from Billy as to why a material weakness in the ICFR does not exist?

2. What is at stake for both Billy and PwC should the partner be unable to convince Billy to accept the material weakness disclosure? Consider the requirements of certification under SOX 302 in your response in addition to those of SOX 404. Address the potential liability to both PwC and Billys company for failure to follow AS 2201.

3. What levers does the partner have? Where can he go to for support?

4. Assume Billy suggests the opinion on ICFR be changed from material to significant? Should the PwCpartner go along? What is at stake for PwC, Billy, and the company of characterizing the deficiency as significant if it is, in fact, material?