1 CHAPTER 5 INTERNAL CONTROL OVER FINANCIAL REPORTING.
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Transcript of 1 CHAPTER 5 INTERNAL CONTROL OVER FINANCIAL REPORTING.
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Define Internal Controls - COSO Internal controls is a process designed
to provide reasonable assurance of achieving the following:Generating reliable financial accounting
informationSafeguarding assetsComplying with applicable laws and
regulationsOperating efficiently and effectively
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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
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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
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LO2 - The components of an internal control system
An internal control system consists of five components
1. Control environment: overall attitude, awareness, and actions of significant internal groups to maintain a well-controlled organization (tone at the top)
2. Risk assessment: process designed to identify and manage risks that may affect its ability to achieve its objectives
3. Control activities: policies and procedures established by management to help ensure that internal control objectives are achieved and risks mitigated
4. Information and communication: process of identifying, capturing, and exchanging information in a timely fashion to enable the organization to achieve its objectives
5. Monitoring: process that assesses the quality of internal controls over time
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CONTROL ENVIRONMENTCONTROL ENVIRONMENT
RISK ASSESSMENTRISK ASSESSMENT
CONTROL CONTROL ACTIVITIESACTIVITIES
Information & Information & CommunicationCommunication
MONITORINGMONITORING
Internal Control Components
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LO4 - Understanding & Assessing the Control Environment – The most pervasive of them allThere 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
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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
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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
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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
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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
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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
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Overview of Controls Testing - Pervasive Control Activities (types of) Some control procedures are found in almost
all accounting systems:a) Segregation of dutiesb) Authorization proceduresc) Documented transaction traild) Physical controls to limit access to assetse) Independent reconciliation f) Competent, trustworthy employees
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(a) Segregation of Duties
Very fundamental, should always separate:AuthorizationRecord keepingCustody (Physical)
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(b) Authorization Procedures
These ensure that only authorizedTransactions take placeActivities take placeAccess to records are permitted
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(c) Documentation
Documentation must be such that a proper audit trail existsThis will obviously be more difficult in a
computerized environment, but still can be achieved.
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(e) Reconciliation
Comparisons must always be done between what was submitted and what was processedWhat physically exists and what is recorded Internal records and external records
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Overview of Controls Testing – Integrated Audit (per PCAOB) vs. Normal Audit
Compare Exhibit 5.11 and Exhibit 5.12 on page 168 & 169
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Control Effectiveness and Control Risk Assessment Process for evaluating controls:
1. Obtain an understanding of risks and internal controls
2. Make a preliminary assessment of control risk and decide whether to test operation of control procedures
3. Test operating effectiveness of controls4. Based on the results of testing, determine
whether to revise the assessment of control risk and incorporate this revision into the substantive testing
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1. Obtain an UnderstandingAuditor 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)
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2. 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)
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3. 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)