Evaluation of Internal Control System

Learning Objective 1 Contrast management’s need for internal control with the auditor’s need to consider internal control when designing an audit.

Inherent Limitations Reasonable Assurance Management’s Responsibility Key Concepts

Client’s Concerns Compliance with applicable laws and regulations Reliability of financial reporting Efficiency and effectiveness of operations

Auditor Concerns Controls over classes of transactions Controls related to reliability of financial reporting

Learning Objective 2 Explain the components of internal control.

The Control Environment Integrity and ethical values Commitment to competence Board of directors or audit committee participation Management’s philosophy and operating style

The Control Environment Organizational structure Assignment of authority and responsibility Human resources policies and practices

Risk Assessment Identify factors affecting risk. Assess significance of risks and likelihood of occurrence. Determine actions necessary to manage risk.

Control Activities 1. Adequate separation of duties 2. Proper authorization of transactions and activities 3. Adequate documents and records 4. Physical control over assets and records 5. Independent checks on performance

Adequate Separation of Duties Custody of assetsAccountingAuthorization of transactions The custody of related assets Operational responsibility Record-keeping responsibility IT DutiesUser departments

Proper Authorization of Transactions and Activities General authorization Specific authorization

Adequate Documents and Records Prenumbered consecutively Prepared at the time of transaction Designed for multiple uses Constructed to encourage correct preparation Simple enough to ensure understanding

Physical Control over Assets and Records Physical precautions Controls related to IT equipment, programs, and data files Physical controls Access controls Backup and recovery procedures

Independent Checks on Performance The need for independent checks arise because internal control tends to change over time unless there is a mechanism for frequent review.

Information and Communication The purpose of an accounting information and communication system is to… initiate, record, process, and report the transactions and to maintain accountability for the related assets.

Monitoring Management’s ongoing and periodic assessment of the quality of internal control performance … to determine whether controls are operating as intended and modified when needed.

Learning Objective 3 Explain methods used to obtain an understanding of internal control.

Understanding Internal Control and Assessing Control Risk Obtain Understanding of Internal Control: Design and Operation Assess Control Risk Test Controls Decide Planned Detection Risk and Substantive Tests

Reasons for Sufficiently Understanding Internal Control SLAuS requires the auditor to obtain an understanding of internal control for every audit. Minimum audit planning matters Auditability Potential material misstatements Detection risk Design of test

Procedures to Determine Design and Placement Update and evaluate auditor’s previous experience with the entity. Make inquires of client personnel. Read client’s policy and systems manuals. Examine documents and records. Observe entity activities and operations.

Documentation of the Understanding Narrative Flowchart Internal control questionnaire Internal control questionnaire

Learning Objective 4 Assess control risk by linking strengths and weaknesses of internal control to transaction- related audit objectives.

Assess Control Risk Obtain sufficient understanding for planning. Assess whether the entity is auditable. Determine assessed control risk. Assess if a lower control risk could be supported. Determine the appropriate assessed control risk.

Assess Control Risk Identify transaction-related audit objectives. Identify specific controls. Identify and evaluate weaknesses.

Identify and Evaluate Weaknesses Identify existing controls. Identify the absence of key controls. Determine misstatements that could result. Consider compensating controls.

The Control Risk Matrix Auditors use the control risk matrix to identify both controls and weaknesses and to asses control risk.

Communication Reportable conditions letter Management letters Audit committee communications

Learning Objective 5 Describe the process of designing and performing tests of controls.

Tests of Controls The procedures to test effectiveness of controls in support of a reduced assessed control risk are called tests of controls.

Procedures for Tests of Controls Make inquiries of client personnel. Examine documents, records, and reports. Observe control-related activities. Reperform client procedures.

Extent of Procedures Reliance on evidence from prior year’s audit Testing less than the entire audit period

Decide Planned Detection Risk and Design Substantive Tests The auditor uses the results of the control risk assessment process and tests of controls to determine the planned detection risk and related substantive tests. The auditor links the control risk assessments to the balance-related audit objectives.