1. Internal Control Chapter 7

2. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-2 Summary of Internal Control Definition A process...designed to provide reasonable assurance...regarding, achievement of (the entity’s) objectives on: Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable laws and regulations

3. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-3 Components of Internal Control The Control Environment Risk Assessment The Accounting Information and Communication System Control Activities Monitoring

4. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-4 Control Environment Factors Integrity and ethical values Commitment to competence Board of directors or audit committee Management philosophy and operating style Organizational structure Human resource policies and practices Assignment of authority and responsibility

5. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-5 Risk Assessment--Factors Indicative of Increased Financial Reporting Risk Changes in the regulatory or operating environment Changes in personnel Implementation of a new or modified information system Rapid growth of the organization Changes in technology affecting production processes or information systems Introduction of new lines of business, products, or processes

6. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-6 Objectives of an Accounting System Identify and record valid transactions Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions Measure the value of transactions appropriately Determine the time period in which the transactions occurred to permit recording in the proper period Present properly the transactions and related disclosures in the financial statements

7. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-7 Control Activities Performance reviews Information processing Physical controls Segregation of duties

8. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-8 Segregation of Duties

9. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-9 Monitoring Ongoing monitoring activities Separate evaluations

10. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-10 Limitations of Internal Control Errors may arise from misunderstandings of instructions, mistakes of judgment, fatigue, etc. Controls that depend on the segregation of duties may be circumvented by collusion Management may override the structure Compliance may deteriorate over time

11. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-11 The Auditors’ Consideration of Internal Control Obtain an understanding Document the understanding Determine planned assessed level of control risk Design additional tests of control Reassess control risk If necessary, modify planned substantive tests

12. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-12

13. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-13 Documenting Internal Control Questionnaires Written Narratives Flowcharts

14. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-14

15. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-15 The Relationships Among Control Deficiencies

16. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-16 Content of Management’s Report on Internal Control Acknowledgment of responsibility for internal control An assessment of internal control effectiveness as of the last day of the company’s fiscal year

17. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 7-17 Approach to Audit of Internal Control Plan the engagement Evaluate management’s assessment process Obtain an understanding of internal control Test and evaluate design effectiveness of internal control Test and evaluate operating effectiveness of internal control Form an opinion on control effectiveness