chapter 6 internal control in a financial statement audit mcgraw-hill/irwin copyright © 2008 by the...

Chapter 6Chapter 6

Internal Control in a Financial Statement

Audit

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

6-2

Internal ControlInternal 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.

LO# 1

6-3

Internal Control

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.

LO# 1

6-4

Internal Control

Reliability of Financial Reporting

Effectiveness & Efficiency

of Operations

Compliance with Laws & Regulations

Objectives

LO# 2

6-5

Controls Relevant to the Audit

Generally, internal controls pertaining to the preparation of financial statements for external purposes are

relevant to an audit.

Reliability of Financial Reporting

Effectiveness & Efficiency

of Operations

Compliance with Laws & Regulations

Objectives

LO# 3

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Controls Relevant to the Audit

Controls relating to operations and compliance objectives may be relevant when they relate to data the

auditor uses to apply auditing procedures.

Reliability of Financial Reporting

Effectiveness & Efficiency

of Operations

Compliance with Laws & Regulations

Objectives

LO# 3

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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

LO# 4

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Components of Internal ControlLO# 4

6-9

Components of Internal ControlLO# 4

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The Effect of Information Technology on Internal Control

LO# 5

6-11

Planning an Audit Strategy

Audit Risk Model

AR = IR × CR × DRIn 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.

LO# 6

6-12

LO# 6

Planning an Audit Strategy

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Substantive Strategy

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 do not pertain to an assertion.

Controls are assessed as ineffective.

Testing the effectiveness of controls is

inefficient.

LO# 6

6-14

Reliance Strategy

Obtain Understanding of Internal Control

Plan to Rely on Internal Control and Assess Control Risk

Below Maximum

LO# 6

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Assertions

Occurrence

Completeness

Authorization

Accuracy

Cutoff

Classification

LO# 6

6-16

AssertionsLO# 6

6-17

AssertionsLO# 6

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Obtain an Understanding of Internal Control

Identify types of potential

misstatements

Design tests of controls and substantive procedures

Pinpoint the factors that affect the risk of material

misstatement

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:

LO# 7

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Control EnvironmentLO# 7

6-20

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 systemsRapid 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:

LO# 7

6-21

Information Systems and Communication

An effective accounting system gives appropriate consideration to establishing methods and records that will

1. Identify and record all valid transactions.

2. Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting.

3. Measure the value of transactions in a manner that permits recording their proper monetary value in the financial statements.

4. Determine the time period in which transactions occurred to permit recording of transactions in the proper accounting period.

5. Properly present the transactions and related disclosures in the financial statements.

LO# 7

6-22

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

LO# 7

6-23

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.

LO# 7

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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.

LO# 7

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The Limitations of an Entity’s Internal Control

Management Override of

Internal Control

Human Errors or Mistakes

Collusion

LO# 7

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Factors Contributing to Fraud

LO# 7

6-27

Documenting the Understanding of Internal Control

Procedure Manuals and Organizational

ChartsNarrative Description

Internal Control Questionnaires

Flowcharts

LO# 8

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Assessing Control RiskIdentify specific

controls that will be relied

upon.

Perform tests of controls

Conclude on the achieved level of control risk.

LO# 9

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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.

LO# 10

6-30

Documenting the Assessed Level of Control Risk

LO# 10

6-31

Substantive Procedures

LO# 11

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Timing of Audit Procedures

Interim

Year End

Let’s look at the EarthWear Clothiers example again to see the timing of their audit

procedures.

LO# 12

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Timing of Audit Procedures

LO# 12

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Interim Audit Procedures

Interim Tests of Controls

1. Assertion being tested not significant2. Control has been effective in prior audits3. Efficient use of staff time

Interim Substantive Procedures

1. Assertion probably has low control risk2. May increase the risk of material

misstatements 3. Still requires some year end testing

LO# 12

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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.

LO# 13

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Report #1Describes the service organization’s controls and assesses whether they

are suitably designed to achieve specified internal control objectives.

Report #2Goes further by testing whether the

controls provide reasonable assurance that the related control objectives were

achieved during the period.

An auditor may reduce control riskcontrol risk below the maximum onlyonly on the

basis of a service auditor’s report that includes tests of the

controls.

LO# 13

Auditing Accounting Applications Processed by Service Organizations

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Communication of Internal Control-Related Matters

Reportable Conditions

Material Weakness

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.

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.

LO# 14

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Examples of Reportable Conditions

LO# 14

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Types of Controls in an IT Environment

General Controls

1. Data center & network operations

2. System software acquisition, change and maintenance

3. Access security4. Application system

acquisition, development, and maintenance

Application Controls

1. Data capture controls2. Data validation controls3. Processing controls4. Output controls5. Error controls

LO# 15

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Types of Controls in an IT Environment

LO# 15

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Types of Controls in an IT Environment

LO# 15

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Types of Controls in an IT Environment

LO# 15

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Flowcharting SymbolsLO# 16

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End of Chapter 6