Audit Midterm Exam Ch 7 Internal Control

Deficiencies in Internal Control

- A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect material misstatements on a timely basis. - A significant deficiency is a deficiency in internal control over financial reporting (or combination of deficiencies) that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company's financial reporting. - A material weakness is a deficiency in internal control over financial reporting (or a combination of deficiencies) such that there is a reasonable possibility that a material misstatement of the company's financial statements will not be prevented or detected on a timely basis. - Significant deficiencies and material weaknesses are required to be communicated IN WRITING to management and those charged with governance

Internal Control Definition

- A process, effected by the entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding, achievement of (the entity's) objectives relating to: - Operations - Reporting, and - Compliance

Management's Report on Internal Control under Section 404a

- Acknowledgment of responsibility for internal control - An assessment of internal control effectiveness as of the last day of the company's fiscal yearn using suitable criteria - Support the evaluation with sufficient evidence

Service Organizations (2)

- Auditor should obtain understanding of the outsourced function by following one or more of: - Contacting service organization to obtain information. - Visiting service organization and performing necessary procedures. - Obtaining a report from service organization - Terms: - Service auditor—provides examination of service organization's controls. - User Auditor—Uses that report.

Enterprise Risk Management (ERM)

- COSO issued a new internal control framework in 2004 on enterprise risk management. It does not replace the original COSO internal control framework. - It goes beyond internal control to focus on how organizations can effectively manage risks and opportunities. - The auditing standards are still structured around the original COSO internal control framework.

Control Environment Factors

- Commitment to integrity and ethical values (TONE AT THE TOP). - Board of directors demonstrates independence from management and exercises oversight of internal control. - Establishment of effective structure, including reporting lines, and appropriate authorities and responsibilities. - Commitment to attract, develop, and retain competent employees. - Holding employees accountable for internal control responsibilities.

Service Organizations (1)

- Computer service organizations provide processing services to customers who decide not to invest in their own processing of particular data - Examples: Outsource processing of payroll or Internet sales.

Internal Control in the Small Company

- Due to lack of employees, internal control is seldom strong in small businesses - Specific practices for small businesses - Record all cash receipts immediately - Deposit all cash receipts intact daily - Make all payments by serially numbered - checks, with exception of petty cash disbursements - Reconcile bank accounts monthly and retain copies - Use serially numbered invoices, Pos, and receiving reports - Issue checks to vendors only in payment of approved invoices that have been matched with purchase orders and receiving reports - Balance subsidiary ledger with control accounts - Prepare comparative financial statements monthly to disclose significant variations in any category of revenue or expense

Monitoring

- Enables management to assess the quality of internal control. - Ongoing monitoring activities - Regularly performed supervisory and management activities - Example: Continuous monitoring of customer complaints - Separate evaluations - Performed on nonroutine basis - Example: Periodic audits by internal audit

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

Assessing Risks at the Assertion Level

- Examples: - Failure to recognize an impairment loss on a long-lived asset affects only the valuation assertion - Inaccurate counting of inventory at year-end affect the valuation of inventory and the accuracy of cost of goods sold - Responses - Decisions are made here as to the appropriate combination of tests of controls and substantive procedures - Planned assessed level of control risk: The level of control risk the auditors assume in designing further audit procedures, which include an appropriate combination of tests of controls and substantive procedures

Assessing Risks at the Financial Statement Level

- Examples: - Preparing the period-end financial statements, including the development of significant accounting estimates and preparation of the notes - The selection and application of significant accounting policies - IT general controls (are they designed appropriately?) - The control environment - Responses to high risks - Assigning more experience staff or those with specialized skills - Providing more supervision and emphasizing the need to maintain professional skepticism - Incorporating additional elements of unpredictability in the selection of further audit procedures to be performed - Increasing the overall scope of audit procedures, including the nature, timing or extent

3. Assess Risks of Material Misstatement

- General approach: - Identify risks while obtaining an understanding of the client and its environment, including its internal control - Relate the identified risks to what can go wrong at the relevant assertion level. e.g - Existence of receviables—DO ALL EXIST? - Consider whether the risks are of a magnitude that could result in a material misstatement - Consider the likelihood that the risks could result in a material misstatement

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

Control Objectives

- In each area of internal control (reporting, operations and compliance) - Control objectives and Sub objectives exist - Example: Area of reporting - Top level objective - prepare and issue reliable financial information - Detailed level applied to A/R sub objectives 1. All goods shipped are accurately billed in the proper period 2. Invoices are accurately recorded for all authorized shipments and only for such shipments 3. Authorized and only authorized sales returns and allowances are accurately recorded 4. The continued completeness and accuracy of A/R is ensured 5. Accounts receivable records are safeguarded

Auditors' Overall Approach with Internal Control

- Overall approach of an audit: 1. Plan the audit 2. Obtain an understanding of the client and its environment, including internal control 3. Assess the risks of material misstatement and design further audit procedures 4. Perform further audit procedures 5. Complete the audit 6. Form an opinion and issue the audit report - Steps 2-4 relate most directly to the role of internal control in financial statement audits

Foreign Corrupt Practices Act

- Passed in 1977 in response to American corporation practice of paying bribes and kickbacks to officials in foreign countries to obtain business - The Act: - Requires an effective system of internal control - Makes illegal payment of bribes to foreign officials

Control Activities

- Performance reviews: - Review of actual vs budget - Review of performance of employees - Transaction control activities - Authorization - Documents to support transactions - Use of serial numbers on documents - Physical controls - Security over records - Security over assets - Segregation of duties - Segregate authorization, recording and custody of assets

Controls over Financial Reporting

- Preventive: Aimed at avoiding the occurrence of misstatements in the financial statements - Example: Segregation of duties - Detective: Designed to discover misstatements after they have occurred Example: Monthly bank reconciliations - Corrective: Needed to remedy the situation uncovered by detective controls - Example: Backups of master file (to allow correction of data entry errors) - Controls overlap: - Complementary - function together (e.g. cash disbursements must be authorized and bank reconciliations should be prepared—ensures that unauthorized transactions are prevented or detected - Redundant - address same assertion or control objective - Compensating - reduces risk existing weakness will result in misstatement (e.g. owner of small business may look over accounting records)

Obtaining the Understanding

- Procedures include: - Inquiring of entity personnel - Observing the application of specific controls - Inspecting documents and reports - Tracing transactions through the information system relevant to financial reporting - May also obtain evidence on operating effectiveness of various controls

Documenting the Understanding of Internal Control

- Questionnaires: Typically standardized by firm - Written Narratives: Memos that describe flow of transactions - Flowcharts: Systems flowcharts - Walk-through: Trace one or two transaction through cycle

Transaction Cycles

- Revenue (Sales and Collections): including processes, procedures, and policies for obtaining orders from customers, approving credit, shipping merchandise, preparing sales invoices (billing), recording revenue and accounts receivable, and handling and recording cash receipts. - Acquisitions (Purchases and Disbursements): including processes, procedures, and policies for initiating purchases of inventory, other assets, and services; placing purchase orders, inspecting goods upon receipt, and preparing receiving reports; recording liabilities to vendors; authorizing payment; and making and recording cash disbursements. - Conversion (Production): including processes, procedures, and policies for storing materials, placing materials into production, assigning production costs to inventories, and accounting for the cost of goods sold. - Payroll: including processes, procedures, and policies for hiring, terminating, and determining pay rates; timekeeping; computing gross payroll, payroll taxes, and amounts withheld from gross pay; maintaining payroll records; and preparing and distributing paychecks. - Financing: including processes, procedures, and policies for authorizing, executing, and recording transactions involving bank loans, leases, bonds payable, and capital stock. - Investing: including processes, procedures, and policies for authorizing, executing, and recording transactions involving investments in fixed assets and securities.

4. Perform Further Audit Procedures- Test of Controls (2)

- Tests of controls include: - Inquiries of appropriate client personnel - Inspection of documents and reports - Observation of the application of controls - Reperformance of the controls - The results of the tests of controls are used to determine the nature, timing and extent of substantive procedures

2. Obtain an understanding of the client and its environment, including internal control

- The understanding of internal control is used to help the auditor to: - Identify types of potential misstatements - Consider factors that affect the risks of material misstatement. - Design tests of controls (when applicable) and substantive procedures. - Auditors must consider all five internal control components - Control environment - Accounting information system - Risk assessment - Control activities - Monitoring - Also consider areas difficult to control like non-routine transactions (e.g accounting estimates)

Approach to Audit of Internal Control under Section 404b

- This section applies to public companies with a market capitalization of $75 million or more. For those companies, the auditors audit internal control as a part of an integrated audit as follows: - Plan the engagement - Use a top-down approach to identify the controls to test - Test and evaluate design effectiveness of internal control - Test and evaluate operating effectiveness of internal control - Form an opinion on effectiveness of internal control over financial reporting

Service Organizations (3)

- Types of Service Auditor Reports - Type 1—Management's description of the system and the suitability of the design of controls - Type 2—Attributes of 1, plus assurance on the operating effectiveness of controls - A Type 2 report may provide the user auditor with a basis for assessing control risk below the maximum.

Use of the work of Internal Auditors

- Work of Internal Auditors may be used in two ways: - Obtaining audit evidence by using the internal auditors' work performed as a part of their normal responsibilities, and - Using internal auditors to provide direct assistance on the external audit. - CPA can rely on work of internal auditors to reduce amount of testing - CPA must assess internal auditors' competence and objectivity - If intent is to rely upon work of internal auditors, test that work - Can obtain assistance in performing procedures, but CPA remains responsible for the audit.

4. Perform Further Audit Procedures- Test of Controls (1)

Assume there is a lower PLANNED ASSESSED level of control risk - Approach: - Identify controls likely to prevent or detect material misstatements (those controls that auditor intends to rely on) - Perform tests of controls (those controls that auditor intends to rely on) to determine whether they are operating effectively - Tests of controls address: - How controls were applied - The consistency with which controls were applied - By whom or by what means (e.g., electronically) the controls were applied

The Nature of Transactions

Auditors use their understanding of the client's information systems to identify risks of material misstatement that relate to recording of transactions such as the following: - Consider the nature of the transactions - Routine transactions—e.g., revenue, purchases, and cash receipts and disbursements - Non-routine transactions—e.g., taking of inventory, calculating depreciation expense - Estimation transactions—e.g., determining the allowance for doubtful accounts - Generally routine transactions have the strongest controls

Components of Internal Control

INTERNAL CONTROL OF AN ORGANIZATION INCLUDES FIVE COMPONENTS: - The Control Environment - Risk Assessment - Control Activities - Information System Relevant to Financial Reporting and Communication - Monitoring Activities

Management's Risk Assessment

Organizations should: - Clearly specify objectives to allow the identification and assessment of risks related to those objectives. - Identify and analyze risks to the achievement of its objectives to determine how they may be managed. - Consider potential fraud relating to the achievement of objectives. - Identify and assess changes that could impact internal control.