Internal Control in a Financial Statement Audit Chapter 6 Internal Control in a Financial Statement Audit McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Internal Control LO# 1 Internal control plays an important role in how management meets its stewardship or agency responsibilities. Management has the responsibility to maintain controls that provides reasonable assurance that adequate control exists over the entity’s assets and records. Proper internal control not only ensures that assets and records are safeguarded but also creates an environment in which efficiency and effectiveness are encouraged and monitored. Management also needs a control system that generates reliable information for decision making. The auditor needs assurance about the reliability of the data generated by the information system in terms of how it affects the fairness of the financial statements and how well the assets and records of the entity are safeguarded.

Internal Control LO# 1 The auditor uses risk assessment procedures to obtain an understanding of the entity’s internal control and uses this understanding to identify the types of potential misstatements, ascertain factors that affect the risk of material misstatement, and design tests of controls and substantive procedures. The auditor’s understanding of the internal control is a major factor in determining the overall audit strategy. The auditor’s responsibilities for internal control are discussed under two major topics: (1) obtaining an understanding of internal control and (2) assessing control risk.

Internal Control Objectives Reliability of Financial Reporting Effectiveness & Efficiency of Operations Compliance with Laws & Regulations Objectives

Controls Relevant to the Audit LO# 3 Controls Relevant to the Audit Reliability of Financial Reporting Effectiveness & Efficiency of Operations Compliance with Laws & Regulations Objectives Generally, internal controls pertaining to the preparation of financial statements for external purposes are relevant to an audit.

Controls Relevant to the Audit LO# 3 Controls Relevant to the Audit Objectives Reliability of Financial Reporting Effectiveness & Efficiency of Operations Compliance with Laws & Regulations Controls relating to operations and compliance objectives may be relevant when they relate to data the auditor uses to apply auditing procedures.

Components of Internal Control LO# 4 Components of Internal Control Control Environment Entity’s Risk Assessment Process Information System and Related Business Processes Relevant to Financial Reporting & Communication Control Procedures Monitoring of Controls

Components of Internal Control LO# 4 Components of Internal Control

Components of Internal Control LO# 4 Components of Internal Control

The Effect of Information Technology on Internal Control

Planning an Audit Strategy LO# 6 Planning an Audit Strategy Audit Risk Model AR = IR × CR × DR In applying the audit risk model, the auditor must assess control risk. The figure on the next slide presents a flowchart of the auditor’s decision process when considering internal control in planning an audit.

Planning an Audit Strategy LO# 6 Planning an Audit Strategy

Substantive Strategy LO# 6 After obtaining an understanding of internal control, an auditor may choose to follow a substantive strategy and set control risk at the maximum for some or all assertions because of one or all of the following factors: Controls are assessed as ineffective. Controls do not pertain to an assertion. Testing the effectiveness of controls is inefficient.

Reliance Strategy Obtain Understanding of Internal Control LO# 6 Reliance Strategy Obtain Understanding of Internal Control Plan to Rely on Internal Control and Assess Control Risk Below Maximum

Assertions Occurrence Completeness Authorization Accuracy Cutoff LO# 6 Occurrence Completeness Authorization Accuracy Cutoff Classification

LO# 6 Assertions

LO# 6 Assertions

Obtain an Understanding of Internal Control LO# 7 Obtain an Understanding of Internal Control The auditor should obtain an understanding of each of the five components of internal control in order to plan the audit. This knowledge is used to: Identify types of potential misstatements Pinpoint the factors that affect the risk of material misstatement Design tests of controls and substantive procedures

LO# 7 Control Environment

The Entity’s Risk Assessment Process LO# 7 The Entity’s Risk Assessment Process The risk assessment process should consider external and internal events and circumstances that may arise and adversely affect the entity’s ability to initiate, record, process and report financial data consistent with the assertions of management in the financial statements. Changes in the operating environment New personnel New or revamped information systems Rapid growth New technology New business models, products, or activities Corporate restructuring Expanded international growth New accounting pronouncements Client business risk can arise or change due to the following circumstances:

Information Systems and Communication LO# 7 Information Systems and Communication An effective accounting system gives appropriate consideration to establishing methods and records that will Identify and record all valid transactions. Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting. Measure the value of transactions in a manner that permits recording their proper monetary value in the financial statements. Determine the time period in which transactions occurred to permit recording of transactions in the proper accounting period. Properly present the transactions and related disclosures in the financial statements.

Information processing LO# 7 Control Activities Control activities are the policies and procedures that help ensure that management’s directives are carried out. Those control procedures that are relevant to the audit include Performance reviews Information processing Physical controls Segregation of duties

Monitoring of Controls LO# 7 Monitoring of Controls Monitoring of controls is a process that assesses the quality of internal control performance over time. Internal Auditors An effective internal audit function has clear lines of authority and reporting, qualified personnel, and adequate resources to enable these personnel to carry out their assigned duties.

The Effect of Entity Size on Internal Control LO# 7 The Effect of Entity Size on Internal Control While the basic concepts of the five components should be present in all entities, they are likely to be less formal in a small or midsize entity than in a large entity.

The Limitations of an Entity’s Internal Control LO# 7 The Limitations of an Entity’s Internal Control Management Override of Internal Control Human Errors or Mistakes Collusion

Factors Contributing to Fraud LO# 7 Factors Contributing to Fraud

Documenting the Understanding of Internal Control LO# 8 Documenting the Understanding of Internal Control Procedure Manuals and Organizational Charts Narrative Description Internal Control Questionnaires Flowcharts

Assessing Control Risk LO# 9 Identify specific controls that will be relied upon. Perform tests of controls Conclude on the achieved level of control risk.

Documenting the Assessed Level of Control Risk The auditor’s assessment of control risk and the basis for the achieved level can be documented using a structured working paper, an internal control questionnaire, or a memorandum. Let’s look at an example from EarthWear Clothiers to see how the control risk for two accounts that differ in terms of their nature, size and complexity is documented.

Documenting the Assessed Level of Control Risk

Substantive Procedures LO# 11 Substantive Procedures

Timing of Audit Procedures LO# 12 Timing of Audit Procedures Interim Year End Let’s look at the EarthWear Clothiers example again to see the timing of their audit procedures.

Timing of Audit Procedures LO# 12 Timing of Audit Procedures

Interim Audit Procedures LO# 12 Interim Audit Procedures Interim Tests of Controls Assertion being tested not significant Control has been effective in prior audits Efficient use of staff time Interim Substantive Procedures Assertion probably has low control risk May increase the risk of material misstatements Still requires some year end testing

Auditing Accounting Applications Processed by Service Organizations LO# 13 Auditing Accounting Applications Processed by Service Organizations In some instances, a client may have some or all of its accounting transactions processed by an outside service organization. Because the client’s transactions are subjected to the controls of the service organization, one of the auditor’s concerns is the internal control system in place at the service organization. It is not uncommon for service organizations to have an auditor issue one of two types of reports on their operations.

Auditing Accounting Applications Processed by Service Organizations LO# 13 Auditing Accounting Applications Processed by Service Organizations Report #1 Describes the service organization’s controls and assesses whether they are suitably designed to achieve specified internal control objectives. Report #2 Goes further by testing whether the controls provide reasonable assurance that the related control objectives were achieved during the period. An auditor may reduce control risk below the maximum only on the basis of a service auditor’s report that includes tests of the controls.

Communication of Internal Control-Related Matters LO# 14 Communication of Internal Control-Related Matters Significant deficiencies in the design or operation of internal control that could adversely affect the organization’s ability to initiate, record, process, and report financial data consistent with management’s assertions. Reportable Conditions A material weakness is a significant deficiency, or combination of significant deficiency that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. Material Weakness

Examples of Reportable Conditions LO# 14 Examples of Reportable Conditions

Types of Controls in an IT Environment LO# 15 Types of Controls in an IT Environment General Controls Data center & network operations System software acquisition, change and maintenance Access security Application system acquisition, development, and maintenance Application Controls Data capture controls Data validation controls Processing controls Output controls Error controls

Types of Controls in an IT Environment LO# 15 Types of Controls in an IT Environment

Types of Controls in an IT Environment LO# 15 Types of Controls in an IT Environment

Types of Controls in an IT Environment LO# 15 Types of Controls in an IT Environment

Flowcharting Symbols LO# 16

End of Chapter 6