audit Chapter 5

List several elements of a company's control environment

* Management's philosophy and operating style. * Company organization structure. * Functioning of the board of directors, particularly its audit committee. * Methods of assigning authority and responsibility. * Management's monitoring methods, including internal auditing. * Personnel policies and practices. * External influences.

Below are several of the ASB management assertions.A. OccurrenceB. CompletenessC. Rights and obligationsD. Allocation or valuationE. ClassificationF. ExistenceG. CutoffH. AccuracyI. UnderstandabilityFor each of the following control activities, identify the management assertion that best applies by placing the correct letter in the blank space below. 1.Match shipping documents with sales invoices before a sale is recorded. 2. Balance total of individual customers' receivables with the control account. 3. Sales manager approves taking discounts. 4. Computer check for billing the quantity shipped, list price, and total. 5. Account for numerical sequence of pre-numbered shipping documents.

1. A 2. E 3. D 4. H 5. B

What are the six steps auditors of public companies should use to audit internal control over financial reporting (ICOFR)?

1. Planning the engagement 2. Using a top-down approach to gain an understanding 3. Testing controls 4. Evaluating control deficiencies 5. Wrapping up: forming an opinion on the effectiveness of internal control over financial reporting 6. Reporting on internal control

Auditors are required to obtain a sufficient understanding of an entity's internal control. This understanding is required by the performance principle of GAAS. Required: A. What are some of the goals (purposes) for conducting an evaluation of an entity's internal control? B. What is the impact on substantive testing procedures if the auditor assesses control risk at the "maximum" level? What is the impact on substantive testing procedures if the auditor assesses control risk below the "maximum" level? C. Should auditors always try to obtain enough evidence to assess control risk below the "maximum" level? Explain.

A. The audit team has two primary reasons for conducting an evaluation of an entity's internal control. First, Sarbanes-Oxley requires an audit of the effectiveness of internal control that is an integrated part of the financial statement audit for publicly traded companies. The second reason for evaluating an entity's internal control is to comply with the performance principle of GAAS: To assess the risk of material misstatement to give the auditors a basis for planning the audit and determining the nature, timing, and extent of audit procedures for the substantive audit plan. The audit team assesses control risk. B. If auditors assess control risk as "maximum" or 100 percent (i.e., poor control), they will tend to perform a great deal of substantive procedures with large sample sizes (extent), at or near the entity's fiscal year end (timing), using procedures designed to obtain high-quality external evidence (nature). On the other hand, if auditors assess control risk as "low," usually around 10 to 20 percent (i.e., effective control), they can perform fewer substantive procedures with smaller sample sizes (extent), at an interim date before the entity's fiscal year end (timing), using a mixture of procedures designed to obtain high-quality external evidence and lower-quality internal evidence (nature). Of course, auditors may assess control risk between "low" and "maximum" (e.g., "moderate," "high," or "slightly below maximum") and adjust the substantive procedures accordingly. C. No. here may be occasions when the audit team chooses to test everything substantively rather than relying on internal controls to reduce substantive testing. For example, for fixed assets, there are usually a small number of very material transactions. Testing controls would not be efficient if the audit team is going to examine every transaction anyway.

Which of the following is the best way to compensate for the lack of adequate segregation of duties in a small organization?

Allowing for greater management oversight of incompatible activities.

Which of the following procedures is considered a test of controls?

An auditor interviews and observes appropriate personnel to determine segregation of duties

Which of the following statements is correct regarding internal control?

An inherent limitation to internal control is the fact that controls can be circumvented by management override.

What constitutes a material weakness?

Answer: A material weakness in internal control is defined as a deficiency, or combination of deficiencies, that results in a reasonable possibility that a material misstatement would not be prevented or detected on a timely basis. The following circumstances should be regarded as strong indicators that a material weakness exists: • Restatement of previously issued financial statements to reflect the correction of a misstatement. • Evidence of material misstatements (caught by the audit team) that were not prevented or detected by the client's internal controls. • Ineffective oversight of the financial reporting process by the entity's audit committee. • Indication of fraud (either material or immaterial) by senior management.

What is the difference between a significant deficiency and a material weakness?

Answer: The difference between a significant deficiency and a material weakness is the (1) likelihood and (2) materiality that a potential (or actual) misstatement would not be detected on a timely basis.

Which of the following activities performed by a department supervisor most likely would help in the prevention or detection of a payroll fraud?

Approving a summary of hours each employee worked during the pay period

Which of the following client internal control activities is not usually performed in the treasurer's department?

Approving vendors' invoices for payment.

Explain the different opinions that auditors can issue for an entity's internal control over financial reporting

Auditors can issue the following opinions for an audit of an entity's internal control over financial reporting: • Unqualified. No material weaknesses exist. • Disclaimer. The audit team cannot perform all of the procedures considered necessary and therefore cannot issue an opinion.

If a control total were to be computed on each of the following data items, which would best be identified as a hash total for a payroll IT application?

Department numbers.

What is the difference between an internal control's design effectiveness and its operating effectiveness?

Design effectiveness determines whether the controls over financial reporting, if operating effectively, would be expected to prevent or detect errors or fraud that could result in a material financial misstatement. Operating effectiveness is whether the control is operating as designed and whether the person performing the control possesses the necessary authority and qualifications to perform the control effectively.

Which of the following should an auditor do when control risk is assessed at the maximum level?

Document the assessment

Which of the following outcomes is a likely benefit of information technology used for internal control?

Enhanced timeliness of information.

Which of the following is a step in an auditor's decision to assess control risk at below the maximum?

Identify specific internal control policies and activities that are likely to detect or prevent material misstatements.

Which of the following most likely would not be considered an inherent limitation of the potential effectiveness of an entity's internal controls?

Incompatible duties.

Which of the following would most likely be classified as a material weakness?

Ineffective oversight of the financial reporting process by the company's audit committee.

Which of the following is not a component of internal controls?

Inherent risk.

What are some of the problems in establishing an internal control system in small business?

Internal control problems in small business would include: A. Separation of functional responsibilities would be difficult because of the small number of employees. B. The owner manager has to assume a greater role to oversee and supervise authorization, recordkeeping, and custodial functions. C. The owner manager must be diligent, competent, and have a high degree of integrity.

Which of the following is a factor in the control environment?

Management's philosophy and operating style.

Generally accepted auditing standards (GAAS) give auditors considerable discretion to decide the amount of work required to satisfy auditing standards guiding internal control evaluation and related audit planning. Which of the descriptions below best expresses the minimum amount of work permitted by GAAS for nonpublic companies?

Obtain an understanding of client environment, accounting, and control activities. Document the decision to assess control risk at maximum. Perform an extensive but not 100% substantive audit on financial statement transactions and balances.

List and explain briefly the phases of an internal control evaluation

Phase 1: Understanding and document the client's internal control structure. This phase includes a general knowledge of the control environment, including the identification of entity level controls. In addition, the auditor should gain an understanding of the flow of transactions through the accounting system and document this understanding using a questionnaire, narrative descriptions and perhaps flowcharts. Phase 2: Assessing the control risk on a preliminary basis. At this point of the process, the strengths and weaknesses of the system are analyzed and should be documented in a bridge work paper. A preliminary assessment of internal controls is completed. At this point, a decision is made as to which controls are going tested and a required degree of compliance is determined. Phase 3: Performing tests of controls audit procedures and reassess control risk. When the audit team determines that a specific control activity could have a significant effect in reducing control risk to a low level for a specific assertion, they perform test of that control activity to obtain specific audit evidence about the effectiveness of the design or operation of that control activity. At this point, the actual degree of compliance is compared with the required degree of compliance. The audit team then must determine the final assessment of control risk and then determine whether any changes to the substantive testing plan must be made.

Which of the following is not an objective of internal controls over financial reporting as defined by the Sarbanes-Oxley Act?

Policies and procedures that provide reasonable assurance regarding the compliance with applicable laws and regulations.

When auditing financial statements of a private company, the minimum work an auditor must perform in connection with a company's internal control is best described by which of the following statements?

Prepare auditing working papers that document the auditor's understanding of the company's internal control.

Which of the following is not an input control activity?

Reasonableness tests.

Which of the following payroll control activities would most effectively ensure that payment is made only for work performed?

Require employees to have their direct supervisors approve their time cards.

Which of the following is an information technology general control?

Separation of duties in the IT department.

Which of the following audit procedures most likely would provide an auditor with the most assurance about the effectiveness of the operation of an entity's internal control?

Successful re-performance of the control activity.

When an auditor plans to rely on controls that have changed since they were last tested, which of the following courses of action would be most appropriate?

Test the operating effectiveness of such controls in the current audit.

Which of the following areas can external auditors rely on internal auditors' work in auditing internal controls?

Testing of low risk internal control activities

Which of the following statements best describes why an auditor would use only substantive procedures to evaluate specific relevant assertions and risks?

Testing the operating effectiveness of the relevant controls would not be efficient

Which of the following factors is most likely to affect the extent of the documentation of the auditor's understanding of a client's system of internal controls?

The degree to which information technology is used in the accounting function.

Which of the following is a definition of control risk?

The risk that a material misstatement will not be prevented or detected on a timely basis by the client's internal controls.

Which of the following is the least important audit reason for the auditor's obtaining an understanding of a company's internal control?

To serve as a basis for constructive suggestions

An auditor is evaluating a client's internal controls. Which of the following situations would be the most difficult internal control issue for an auditor to detect?

Two employees, who work in different departments, are circumventing an internal control.

An auditor is concerned about a policy of management override as a limitation of internal control. Which of the following tests would best assess the validity of the auditor's concern?

Verifying that approved spending limits are not exceeded.

Management's report on internal controls must include each of the following except:

a statement providing management's evaluation of the company's control environment.

After obtaining an understanding of the entity's internal control and assessing control risk, an auditor of a non-public company decided not to perform additional tests of controls. The auditor most likely concluded that the:

additional evidence to support a further reduction in control risk was not cost beneficial.

In an audit of financial statements, an auditor's primary consideration regarding an internal control policy or activity is whether the policy or activity:

affects management's financial statement assertions.

Control strengths and weaknesses should be documented in audit documentation, sometimes called:

bridge working papers.

A sales clerk enters a customer's six-number customer account. The computer program uses the first five numbers to calculate a sixth number. This resulting number is then compared to the sixth number entered by the sales clerk. This is an example of a:

check digit.

The "obtaining an understanding" work phase (Phase 1) of internal control evaluation would not give auditors an overall acquaintance with the client's:

control activity effectiveness.

The overall attitude and awareness of an entity's board of directors concerning the importance of the client's internal control usually is reflected in its:

control environment.

Control activities intended to ensure that transactions are recorded in the right period are designed to achieve the ASB assertion of:

cutoff

The appropriate separation of duties does not include:

data preparation.

An audit team's responsibility would not include:

designing client's internal controls.

In an audit of financial statements of a non-public company in accordance with generally accepted auditing standards, an auditor is required to:

document the auditor's understanding of the entity's internal control.

After obtaining an understanding of a client's financial reporting control activities, the auditor would next:

document the understanding obtained.

When the audit team increases the planned assessed level of control risk because certain control activities were determined to be ineffective, the audit team would most likely increase the:

extent of substantive tests of details

Sound internal control can be described as separating all of the following duties and responsibilities except for:

hiring of employees

Assessing control risk at below the maximum level most likely would involve:

identifying specific internal control activities that are relevant to specific financial statement assertions.

Obtaining an understanding of an internal control involves evaluating the design of the control and determining whether the control has been:

implemented.

After obtaining an understanding of internal controls and assessing control risk on the audit of a non-public company, an auditor decided to perform tests of controls. The auditor most likely decided that:

it would be efficient to perform tests of controls that would result in a reduction in planned substantive tests.

The primary objective of procedures performed to obtain an understanding of the entity's internal control is to provide an auditor with:

knowledge necessary for audit planning

As part of understanding the internal control, an auditor is not required to:

obtain knowledge about the operating effectiveness of the client's internal control activities.

The internal control in small business is highly dependent on the:

owner-manager's competence, as well as his/her ethics and integrity.

If auditors assess control risk at the maximum level, they will tend to:

perform a great deal of substantive testing during the audit.

Proper separation of duties reduces the opportunities to allow persons to be in positions to both:

perpetrate a fraud and then conceal it in the books.

In computer systems, the information technology general controls (ITGC) would not include:

processing control activities

Each of the following types of controls is considered to be an entity-level control, except those:

regarding the company's annual stockholder meeting.

In testing control activities, an auditor ordinarily selects from a variety of techniques, including:

reperformance and observation.

The ultimate purpose of assessing control risk is to contribute to the auditor's evaluation of the:

risk that material misstatements exist in the financial statements.

When obtaining an understanding of an entity's internal control in a financial statement audit at a non-public company, an auditor is not obligated to:

search for significant deficiencies in the operation of the internal control system.

Tracing bills of lading to sales invoices provides evidence that:

shipments to customers were invoiced.

Regardless of the assessed level of control risk, an auditor of a non-public company would perform some:

substantive tests to restrict detection risk for significant transaction classes.

A report on internal control effectiveness by the management team of public companies is required by:

the Sarbanes-Oxley Act of 2002.

A set of characteristics that helps to define a seriousness about employees' attitudes about the control activities in a company is referred to as:

the control environment.