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Chapter 3

Auditing A Risk-Based Approach To Conducting A Quality Audit 10 th edition. Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg. Chapter 3. INTERNAL CONTROL OVER FINANCIAL REPORTING: RESPONSIBILITIES OF MANAGEMENT AND THE EXTERNAL AUDITORS. Learning Objectives.

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Chapter 3

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  1. AuditingA Risk-Based Approach To Conducting A Quality Audit 10th edition Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg Chapter 3 INTERNAL CONTROL OVER FINANCIAL REPORTING: RESPONSIBILITIES OF MANAGEMENT AND THE EXTERNAL AUDITORS

  2. Learning Objectives • Articulate the importance of internal control over financial reporting for organizations • Define internal control as presented in COSO’s 2013 Internal Control, Integrated Framework and identify the components of internal control • Describe the control environment component of internal control, list its principles, and provide examples of each principle • Describe the risk assessment component of internal control, list its principles, and provide examples of each principle

  3. Learning Objectives • Describe the control activities component of internal control, list its principles, and provide examples of each principle • Describe the information and communication component of internal control, list its principles, and provide examples of each principle • Describe the monitoring component of internal control, list its principles, and provide examples of each principle

  4. Learning Objectives • Identify management’s responsibilities related to internal control over financial reporting • Distinguish between material weaknesses, significant deficiencies, and control deficiencies in internal control over financial reporting • Articulate the importance of internal control over financial reporting for the external audit and apply the concepts related to management’s and the auditor’s assessments of internal control effectiveness

  5. THE AUDIT OPINION FORMULATION PROCESS

  6. Learning Objective 1 Articulate the Importance of Internal Control Over Financial Reporting for Organizations

  7. Importance of Internal Control Over Financial Reporting • Internal control helps: • Mitigate risks of not achieving organizational objectives • Provide assurance regarding reliability of financial information • Reduce occurrence of unforeseen circumstances • Improve quality of information

  8. Learning Objective 2 DEFINE INTERNAL CONTROL AS PRESENTED IN COSO’S 2013 INTERNAL CONTROL, INTEGRATED FRAMEWORK AND IDENTIFY THE COMPONENTS OF INTERNAL CONTROL

  9. Internal Control - Integrated Framework • COSO defines internal control as a process: • Effected by an entity’s board of directors, management, and other personnel • Designed to provide reasonable assurance regarding achievement of objectives relating to operations, reporting, and compliance • Effective internal control needs to: • Be effectively designed and implemented • Operate effectively

  10. Exhibit 3.1 - COSO Framework for Internal Control

  11. Components of internal control • Control environment • Set of standards, processes, and structures that provides the basis for carrying out internal control across the organization • Includes the tone at the top regarding importance of: • Internal control • Expected standards of conduct • Risk assessment:Process for identifying and assessing risks that may affect organizations from achieving objectives

  12. Components of internal control • Control activities:Actions established by policies and procedures • Help ensure that management’s directives regarding internal control are carried out • Information and communication • Information from internal and external sources • Communication is the process of providing, sharing, and obtaining necessary information • Monitoring:Helps determine whether the controls are present and continuing to function effectively

  13. Learning Objective 3 Describe the Control Environment Component of Internal Control, List its Principles, and Provide Examples of Each Principle

  14. COSO Component: Control Environment • Foundation for all other components of internal control • A strong control environment protects against risks related to reliability of financial statements • Examples of control environment deficiencies • Low level of control consciousness within an organization • Audit committee not having independent members • Absence of an ethics policy within an organization

  15. COSO Component: Control Environment PRINCIPLES

  16. Learning Objective 4 Describe the Risk Assessment Component of Internal Control, List Its Principles, and Provide Examples of Each Principle

  17. COSO Component - Risk Assessment Internal sources of risk External sources of risks Economic recessions decrease product or service demand Increase in competition Changes in regulation that make the business model unsustainable Changes in the reliability of source goods that reduce profitability • Changes in management responsibilities • Changes in internal information technology • Poorly conceived business model

  18. COSO Component - Risk Assessment PRINCIPLES

  19. Learning Objective 5 Describe the Control Activities Component of Internal Control, List Its Principles, and Provide Examples of Each Principle

  20. COSO Component: Control Activities • Ensure that management’s directives regarding controls are accomplished • Performed within processes • May be preventive or detective • May be manual or automated

  21. COSO Component: Control Activities PRINCIPLES

  22. Transaction Processing • Business Process Transactions • Control activities include verifications, reconciliations, authorizations and approvals • Accounting Estimates • Control activities should provide reasonable assurance that: • The data are accurate • The estimates are faithful to the data • The underlying estimation model reflects current economic conditions and has proven to provide reasonable estimates in the past

  23. Transaction Processing • Adjusting, Closing, and Other Unusual Entries • Control activities include: • Documented support for all entries • Reference to underlying supporting data with a well-developed transaction trail • Transaction trail:Records that allow auditors to trace transactions from origination through final disposition, or vice versa • Review by CFO or controller

  24. Automated and Manual Transaction Controls • Input Controls: Designed to ensure that authorized transactions are correct and complete, and that only authorized transactions can be input • Processingcontrols: Designed to ensure that: • Correct program used for processing • All transactions are processed • Transactions update appropriate files • Output controls: Designed to ensure that: • All data are completely processed • Output is distributed only to authorized recipients

  25. Other Important Control Activities • Segregation of duties: Protect against risk that individuals may collude to conceal a fraud • Requires that a minimum of two employees be involved such that one does not have: • Authority and ability to process transactions • Custodial responsibilities • Physical controls over assets: Protect and safeguard assets from accidental or intentional destruction and theft

  26. Learning Objective 6 Describe the Information and Communication Component of Internal Control, List Its Principles, and Provide Examples of Each Principle

  27. COSO Component - Information and Communication • Process of identifying, capturing, and exchanging information in a timely fashion to enable accomplishment of the organization’s objectives • Information • Required by an organization from internal and external sources to carry out its internal control responsibilities • Communication • Process of providing, sharing, and obtaining information internally • Requires two-way communication with external parties

  28. COSO Component - Information and Communication PRINCIPLES

  29. Learning Objective 7 Describe the Monitoring Component of Internal Control, List Its Principles, and Provide Examples of Each Principle

  30. COSO Component - Monitoring • Process that provides feedback on effectiveness of each of the five components of internal control • Managers select either of the following or a combination of both • Mix of ongoing evaluations • Separate evaluations • Requires that identified deficiencies in internal control be communicated to the personnel concerned with follow-up action taken

  31. COSO Component – Monitoring PRINCIPLES

  32. Learning Objective 8 Identify management’s responsibilities related to internal control over financial reporting

  33. MANAGEMENT RESPONSIBILITES • Design, implement, maintain internal control to mitigate risks of material misstatements in the financial statements • Document internal control • Test effectiveness of internal control • Annually report on the design and operating effectiveness of controls

  34. EXHIBIT 3.6 - STEPS IN MANAGEMENT’S EVALUATION OF INTERNAL CONTROL OVER FINANCIAL REPORTING

  35. Learning Objective 9 Distinguish between material weaknesses, significant deficiencies, and control deficiencies in internal control over financial reporting

  36. Assessing Internal Control Deficiencies • Control deficiency: Shortcoming in internal controls such that objective of reliable financial reporting may not be achieved • Could be in design or operation • Significant deficiency:A deficiency, or a combination of deficiencies, in internal control over financial reporting 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

  37. Assessing Internal Control Deficiencies • Material weakness • A deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis

  38. INDICATORS OF A MATERIAL WEAKNESS

  39. Learning Objective 10 ARTICULATE THE IMPORTANCE OF INTERNAL CONTROL OVER FINANCIAL REPORTING FOR THE EXTERNAL AUDIT AND APPLY THE CONCEPTS RELATED TO MANAGEMENT’S AND THE AUDITOR’S ASSESSMENTS OF INTERNAL CONTROL EFFECTIVENESS

  40. Importance of Internal Control FOR the External Audit • Auditors are required to identify and assess risks of material misstatement due to fraud or error • The auditor needs to understand the company’s internal controls to determine appropriate audit procedures • Integrated audit: Occurs when an auditor provides an opinion on: • The effectiveness of the client’s internal control over financial reporting and • The financial statements

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