Material Weaknesses and Significant Deficiencies: A Guide for Nonprofit Boards

Board members of nonprofit organizations have a wide range of responsibilities. One of the most significant is their fiduciary responsibility to prevent and/or resolve material weaknesses and significant deficiencies within their organization. 

Material weaknesses and significant deficiencies are failures in an organization’s internal controls that lead to, or could lead to, a material misstatement of the organization’s financial statements. These are often identified by auditors and reported to the organization’s board, which is ultimately responsible for these issues when they occur. 

Nonprofit leaders shouldn’t wait for auditors to flag these issues. In fact, a strong and involved board will often be proud when it has a “clean record” of these sorts.  In order to do this, boards should conduct internal audits and internal risk assessments to identify and resolve potential issues before they occur.

Material weaknesses due to failures in internal controls can lead to major issues such as: instances of fraud or material errors (which may be due to fraud or unintentional error), increased audit fees as a result of additional test work that may need to be performed in order to ensure the impacts of the finding are quantified and corrected within the financial statements, and overall negative impacts to the organization’s reputation once word spreads surrounding identified findings. Therefore, nonprofit organizations must understand how to diagnose and address these issues as soon as possible. 

Definitions: Material Weaknesses and Significant Deficiencies

Before we explore how to identify material weaknesses and significant deficiencies, it’s important to define each of these terms. 

A material weakness occurs when there is a deficiency, or multiple deficiencies, in an organization’s internal controls which are serious enough that it’s reasonably possible the organization would be unable to prevent material financial misstatements. 

A significant deficiency is similar, although less severe than a material weakness in that it is unlikely to have a material effect on the organization’s financial statements. Significant deficiencies are, however, still a significant enough control issue to merit the attention of the nonprofit’s audit committee and board of directors. 

Auditors use their discretion to determine whether an issue is defined as a material weakness or a significant deficiency. Generally speaking, this is a question of materiality and is determined by the relative impact the error has on the accuracy of the organization’s financial statements. 

Identifying High-Risk Areas Where Material Weaknesses or Significant Deficiencies May Exist

It is important to note that an annual financial statement audit of a nonprofit entity is not designed to identify, correct, or prevent control failures. Under normal circumstances, an audit should conclude with a record of no such instances, and communications are generally required if such instances are found.

Material weaknesses tend to occur in the “higher-risk” areas of an organization’s financial statements, such as complex areas or areas with particularly high volumes of transactions or high-value transactions. Some example areas include:

• Revenue Recognition: applying the correct accounting standards for large capital contributions, particularly multi-year pledges or contingent contributions, can often be a high-risk area for nonprofits. If proper consideration/treatment was not given/applied to the conditions of certain contributions or grants and revenue was incorrectly recorded, this error may be significant enough to warrant a material weakness or significant deficiency. 

• Segregation of Duties Issues: errors may occur as a result of entries being processed and posted to an accounting system as a result of a lack of proper disaggregation between accounting responsibilities and/or lack of adequate accounting personnel. If there had been sufficient controls/resources in place, these errors may have been prevented. 

• Complex Accounting Areas: areas where an organization’s management exercises significant discretion over accounting decisions are also high-risk areas. Ensuring these decisions are made appropriately, and with sufficient oversight, is key to minimizing the potential of a material weakness or significant deficiency finding.  

Conducting internal audits and risk assessments gives an organization its best chance to identify control failures and address them proactively before they occur. In the unfortunate event that a control failure is identified through an audit, it is important to understand how to resolve these issues and prevent them from happening in the future.  

Resolving Material Weaknesses and Significant Deficiencies

If material weaknesses or significant deficiencies are found during an audit, the auditor will disclose these to the board in a governance letter. This letter outlines the issues that were identified and generally provides recommendations on how the organization should proceed on a go-forward basis. It is imperative that the board implement these recommendations in order to prevent the same issues from happening in subsequent periods. 

At Smith + Howard, our audit professionals also often recommend training seminars and provide additional resources that nonprofits can use to educate their staff and minimize the potential for the control issue to reoccur. 

Smith + Howard: Experienced Nonprofit Assurance Professionals

Control findings of any sort are extremely serious issues for nonprofit boards to be aware of. Boards, and especially audit and finance committees, have a fiduciary duty to prevent and/or correct these findings if they have been identified. 

With decades serving as an assurance firm for nonprofits, Smith + Howard is can provide confidence to organizations and their boards on these and other issues. We spend time with our clients throughout the year – not just during an audit engagement – to advise and assist as complex issues arise. This proactive approach makes for a stronger nonprofit organization and drives more efficient audit processes. 

To learn more about Smith + Howard’s audit and assurance services for nonprofits, contact an advisor today.