Chapter 07 Internal Control McGraw-Hill/IrwinCopyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 07

Internal Control

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Summary of Internal Control DefinitionSummary of 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 on:

Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable laws and

regulations

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Foreign Corrupt Practices ActForeign 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

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Components of Internal Control Components of Internal Control

The Control Environment

Risk Assessment

The Accounting Information and Communication System

Control Activities

Monitoring

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Control Environment FactorsControl 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

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Risk Assessment--Factors Indicative of Risk Assessment--Factors Indicative of Increased Financial Reporting RiskIncreased 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

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Control ActivitiesControl Activities

Performance reviews

Information processing General control activities

Application control activities

Physical controls

Segregation of duties Segregate authorization, recording and

custody of assets

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Objectives of an Accounting SystemObjectives 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

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MonitoringMonitoring

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

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Limitations of Internal ControlLimitations 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

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Auditors’ Overall Approach with Auditors’ Overall Approach with Internal Control Internal Control

Overall approach of an audit1. 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

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

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3. Assess the risks of material 3. Assess the risks of material misstatementmisstatement

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 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

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4. Perform Further Audit Procedures – 4. Perform Further Audit Procedures – Test of ControlsTest of Controls

Approach: Identify controls likely to prevent or detect material

misstatements Perform tests of controls 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

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Consideration of the Work of Internal Consideration of the Work of Internal Auditors Auditors

Using the work of internal auditors CPA can rely on work of internal audit to reduce

amount of testing CPA must assess internal audit competence and

objectivity If intent is to rely upon work of internal audit, test that

work

Obtaining direct assistance of internal auditors

Can obtain assistance in performing procedures, but CPA remains responsible for the audit.

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Service Organizations Service Organizations 1/21/2

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.

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Service Organizations Service Organizations 2/22/2

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.

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Relationships Among DeficienciesRelationships Among Deficiencies

Deficiency in

Internal Control

Less than Significant Material

Significant Deficiency Weakness

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Management’s Report on Internal Control Management’s Report on Internal Control under Section 404aunder 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

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Approach to Audit of Internal Control Approach to Audit of Internal Control under Section 404bunder 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

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