Auditors want to help their clients succeed. Throughout the audit process, they typically compile a list of internal control weaknesses and operating inefficiencies that may warrant management’s attention. These may be formally communicated through a ‘management letter.’ This letter can provide innovative ideas, based on industry best practices, about ways to augment internal control systems, streamline operations, and cut back on expenses.
Think of management letters as an extra bonus to issuing audited financial statements. American Institute of CPAs standards specifically require auditors to communicate two types of deficiencies to management in writing:
- Material weaknesses. These are defined as “a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the organization’s financial statements will not be prevented or detected and corrected on a timely basis.”
- Significant deficiencies. These are “less severe than a material weakness, yet important enough to merit attention by those charged with governance.”
Operating inefficiencies and other deficiencies in internal control systems are not necessarily required to be communicated in writing. However, most auditors include these less significant items in their management letters to inform their clients about risks and opportunities to improve operations.
A management letter may cover a broad range of topics, including segregation of duties, account reconciliations, physical asset security, credit policies, employee performance, safety, Internet use, and expense reduction. In general, the write-up for each deficiency includes three elements:
- The auditor describes the condition, identifies the cause (if possible), and explains why it needs improvement.
- This section quantifies the problem’s potential monetary effects and identifies any qualitative effects, such as decreased employee morale or delayed financial reporting.
- Here, the auditor suggests a solution or lists alternative approaches if the appropriate course of action is unclear.
Some letters present deficiencies in order of significance or potential for cost reduction, while others organize comments based on functional area or location.
When your CPA delivers your audited financial statements, pay close attention to the management letter and compare it to the previous year’s letter. Too often, the same items recur year after year. Commit to making some targeted improvements this year and use the write-ups in the management letter to help track the results.