CHAPTER 5

1. CHAPTER 5 INTERNAL CONTROL OVER FINANCIAL REPORTING

2. Define Internal Controls - COSO • Internal controls is a process designed to provide reasonable assurance of achieving the following: • Generating reliable financial accounting information • Safeguarding assets • Complying with applicable laws and regulations • Operating efficiently and effectively

3. The Need for Control • Control is part of corporate governance whereby the owners and creditors of an organization exert control and require accountability for its resources • Governance begins with stockholders, who delegate certain responsibilities to the board of directors and in turn to management • That delegation must occur within a framework of control and accountability • The control system exists to ensure that • Responsibilities are properly identified • Tasks are assigned in accordance with responsibilities and accountability

4. The Integrated Audit • The Sarbanes-Oxley Act of 2002 requires publicly held companies to report on the effectiveness of their internal controls over financial reporting • The Public Company Accounting Oversight Board requires external auditors to perform an integrated audit of the effectiveness of internal controls and financial reporting • In essence, the auditor must attest to both the financial statements and management's assertions regarding the effectiveness of internal controls over financial reporting

5. LO2 - The components of an internal control system An internal control system consists of five components • Control environment: overall attitude, awareness, and actions of significant internal groups to maintain a well-controlled organization (tone at the top) • Risk assessment: process designed to identify and manage risks that may affect its ability to achieve its objectives • Control activities: policies and procedures established by management to help ensure that internal control objectives are achieved and risks mitigated • Information and communication: process of identifying, capturing, and exchanging information in a timely fashion to enable the organization to achieve its objectives • Monitoring: process that assesses the quality of internal controls over time

6. MONITORING Information & Communication CONTROL ACTIVITIES RISK ASSESSMENT CONTROL ENVIRONMENT Internal Control Components

7. LO4 - Understanding & Assessing the Control Environment – The most pervasive of them all There are a number of factors an auditor should look at when evaluating an organization's control environment: • Management's philosophy and operating style • Organizational structure, including assignment of authority and responsibility • Board of directors and audit committee • Human resource policies and practices • Integrity and ethical values • Commitment to competence • Compensation and evaluation programs • Effectiveness of the internal audit function

8. LO6 - Audit Reporting on Internal Control • External auditors of non-public companies must report to management significant internal control deficiencies in the design or operation of internal controls that are identified in the normal course of a financial audit. • Such reports are for management's use and are not intended to be distributed to the public • External auditors of public companies must go beyond the report to management and also report on management's assertion regarding the effectiveness of internal controls over financial reporting • Includes an opinion on the client's internal controls • Included in the company's annual report

9. LO7 Audit Reporting on Internal Control (continued) • The PCAOB's proposed report on internal controls would include a(n): • Description of internal control, its objectives, and inherent limitations • Definition of material deficiency in internal control • Description of all material deficiencies found • Opinion regarding effectiveness of company's internal controls

10. Audit Reporting on Internal Control (continued) • According to the Sarbanes-Oxley Act, if an auditor identifies significant or material deficiencies in internal control, • Those deficiencies must be reported to both management and the audit committee • Deficiencies must be reported to the audit committee even if management has addressed the deficiency and implemented new controls • The stated intent of the Sarbanes-Oxley Act is to ensure boards of directors understand they have a responsibility to improve the governance of the organization

11. CHAPTER 5 - b INTERNAL CONTROL OVER FINANCIAL REPORTING

12. Account Balance Assertions & Related Objectives • Presentation & Disclosure – an item is disclosed, classified, and described in accordance with the applicable financial reporting framework • Existence - an asset or a liability exists at a given date; • Rights and obligations - an asset or a liability pertains to the entity at a given date.. • Completeness - there are no unrecorded assets, liabilities, transactions or events, or undisclosed items • Valuation - an asset or liability is recorded at an appropriate carrying value

13. Transaction Assertions & Related Control Objectives • Occurrence – Recorded transactions and events have occurred and pertain to the entity • Completeness – All transactions and events that should have been recorded have been recorded • Accuracy – Amounts and other data have been recorded accurately • Cutoff – Transactions and events have been recorded in the correct accounting period • Classification – Transactions and events have been recorded in the proper accounts

14. Overview of Controls Testing - Pervasive Control Activities (types of) Some control procedures are found in almost all accounting systems: • Segregation of duties • Authorization procedures • Documented transaction trail • Physical controls to limit access to assets • Independent reconciliation • Competent, trustworthy employees

15. (a) Segregation of Duties • Very fundamental, should always separate: • Authorization • Record keeping • Custody (Physical)

16. (b) Authorization Procedures • These ensure that only authorized • Transactions take place • Activities take place • Access to records are permitted

17. (c) Documentation • Documentation must be such that a proper audit trail exists • This will obviously be more difficult in a computerized environment, but still can be achieved.

18. (d) Physical Controls to Assets • Security locks • Fences • Keys • Password etc • Vaults, safes

19. (e) Reconciliation • Comparisons must always be done between • what was submitted and what was processed • What physically exists and what is recorded • Internal records and external records

20. (f) Competent & Trustworthy employees • These employees help to make controls work

21. Overview of Controls Testing – Integrated Audit (per PCAOB) vs. Normal Audit • Compare Exhibit 5.11 and Exhibit 5.12 on page 168 & 169

22. Control Effectiveness and Control Risk Assessment • Process for evaluating controls: • Obtain an understanding of risks and internal controls • Make a preliminary assessment of control risk and decide whether to test operation of control procedures • Test operating effectiveness of controls • Based on the results of testing, determine whether to revise the assessment of control risk and incorporate this revision into the substantive testing

23. Obtain an Understanding Auditor needs to gain understanding of each significant accounting application operates and the control procedures used The auditor gathers evidence by • Performing walkthroughs of the accounting system and processing procedures and document via narrative memo and/or flowchart • Making inquires of management, and accounting and operational employees • Taking plant and operational tours • Reviewing client documentation including accounting manuals and program and system descriptions • Reviewing prior year audit work papers and then focus on changes The auditor documents his/her understanding using flowcharts (visio), questionnaires, and narratives (see pages 176 & 177)

24. Make Preliminary Assessment of Control Risk After gaining an understanding, the auditor makes a preliminary assessment of control risk - this assessment is crucial because it drives the planning for the rest of the audit The relationship between the assessed level of control risk and the rigor of the subsequent substantive testing is inverse: • If control risk is assessed as high, • No reliance is placed on the client's internal controls • The amount and rigor of substantive testing must be increased • If control risk is assessed as low • The auditor would like to rely on the client's internal controls • The amount and rigor of substantive testing may not have to be increased • However, the auditor must test the controls to make sure they are operating effectively (and document it)

25. Perform Tests of Controls • The preliminary assessment of control risk is based on the auditor's understanding of the control system and how it has operated in the past • When control risk is assessed low, and the auditor intends to rely on the client's controls, the auditor may reduce (or not increase) the amount of substantive testing • To ensure that the auditor's reliance on the client's control is warranted, the auditor must test the control to make sure it is operating effectively • Guidance on Sample Size for Testing Controls (Ch 9) • Testing Controls Across Multiple Locations • Dual Purpose Tests (transaction & substantive) • Assessing Control Risk as Moderate (see next slide)

26. Update Assessment of Control Risk & Need for Substantive Testing • If testing indicates the control is not operating effectively, the auditor will revise the preliminary assessment of control risk and incorporate this revision into the subsequent substantive testing