Auditing Internal Control over Financial Reporting Chapter 7 Auditing Internal Control over Financial Reporting McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Management Responsibilities under Section 404 LO# 1 Management Responsibilities under Section 404 Section 404 of the Sarbanes-Oxley Act requires managements of publicly traded companies to issue an internal control report that explicitly accepts responsibility for establishing and maintaining “adequate” internal control over financial reporting (ICFR). 7-2

Management Responsibilities under Section 404 LO# 1 Management Responsibilities under Section 404 Management must comply with the following requirements in order for the external auditor to complete an audit of ICFR. Accept responsibility for the effectiveness of the entity’s ICFR. Evaluate the effectiveness of the entity’s ICFR using suitable control criteria. Support the evaluation with sufficient evidence, including documentation. Present a written assessment regarding the effectiveness of the entity’s ICFR as of the end of the entity’s most recent fiscal year. 7-3

Auditor Responsibilities under Section 404 and AS5 LO# 2 Auditor Responsibilities under Section 404 and AS5 The entity’s independent auditor must audit and report on the effectiveness of ICFR. The auditor is required to conduct an integrated audit of the entity’s ICFR and its financial statements. 7-4

LO# 3 ICFR Defined ICFR is defined as a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. Controls include procedures that: Pertain to the maintenance of records that fairly reflect the transactions and dispositions of the assets of the company. Provide reasonable assurance that transactions are recorded in accordance with GAAP. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets. 7-5

Internal Control Deficiencies Defined LO# 4 Internal Control Deficiencies Defined A control deficiency 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 misstatements on a timely basis. A significant deficiency is 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. 7-6

Internal Control Deficiencies Defined LO# 4 Internal Control Deficiencies Defined A control deficiency may be serious enough that it is to be considered not only a significant deficiency but also a material weakness in the system of internal control. A material weakness is a deficiency, or a combination of deficiencies, in ICFR, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. As illustrated on the next slide, the auditor must consider two dimensions of the control deficiency: likelihood (reasonably possible), and magnitude (material, consequential, or inconsequential) 7-7

Internal Control Deficiencies Defined LO# 4 Internal Control Deficiencies Defined Material weakness M A G N I T U D E Material Significant deficiency Not material but significant Control deficiency Not material or significant Remote Reasonably possible or probable L I K E L I H O O D 7-8

Management’s Assessment Process LO# 5 Management’s Assessment Process Management must follow a top-down, risk-based approach: Identify financial reporting risks and controls. Evaluate evidence about the operating effectiveness of ICFR. Consider which locations to include in the evaluation. 7-9

Framework Used by Management to Conduct Its Assessment LO# 5 Framework Used by Management to Conduct Its Assessment Most entities use the framework developed by COSO. This framework identifies three primary objectives of internal control: (1) reliable financial reporting; (2) efficiency and effectiveness of operations; and (3) compliance with laws and regulations. COSO 7-10

Management’s Documentation LO# 5 Management’s Documentation Management must develop sufficient documentation to support its assessment of the effectiveness of internal control. This documentation may take many forms, such as paper, electronic files, or other media. It also includes policy manuals, process models, flowcharts, job descriptions, documents, and forms. 7-11

Integrating the Audits of Internal Control and Financial Statements LO# 6 Integrating the Audits of Internal Control and Financial Statements An integrated audit is composed of the audits of internal control and the financial statements. The control testing impacts the planned substantive procedures. Also, the results of the substantive procedures are considered in the evaluation of internal control. Tests of internal control Substantive audit procedures 7-12

Performing an Audit of ICFR Figure 7-2 LO# 6 Performing an Audit of ICFR Figure 7-2 7-13

Planning the Audit of ICFR LO# 7 Planning the Audit of ICFR The planning process is similar to the process used for the audit of financial statements. Consider the following: Risk assessment and the risk of fraud. Scaling the audit. Using the work of others. 7-14

Special Consideration: Using the Work of Others LO# 7 Special Consideration: Using the Work of Others A major consideration for the external auditor is how much work is to be performed by others. In determining the extent to which the auditor may use the work of others, the auditor should: (1) evaluate the nature of the controls subjected to the work of others, (2) evaluate the competence and objectivity of the individuals who performed the work, and (3) test some of the work performed by others to evaluate the quality and effectiveness of their work. As the risk associated with the control being tested increases, the external auditor should do more of the work. 7-15

Using a Top-Down Approach Figure 7-3 LO# 8 Using a Top-Down Approach Figure 7-3 7-16

Identify Entity-Level Controls LO# 5 Identify Entity-Level Controls 7-17

Identifying Significant Accounts LO# 8 Identifying Significant Accounts Size and composition of the account Susceptibility to misstatement due to errors or fraud Volume of activity, complexity, and homogeneity of the individual transactions processed through the account or reflected in the disclosure Nature of the account or disclosure Accounting and reporting complexities associated with the account or disclosure 7-18

Identifying Significant Accounts LO# 8 Identifying Significant Accounts Exposure to losses in the account Possibility of significant contingent liabilities arising from the activities reflected in the account or disclosure Existence of related-party transactions in the account Changes from the prior period in account or disclosure characteristics 7-19

Sources of Misstatements LO# 8 Sources of Misstatements Understand the flow of transactions related to the relevant assertions Identify the points within the entity’s processes at which a misstatement could arise that would be material Identify the controls that management has implemented to address these potential misstatements Identify the controls that management has implemented over the prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could result in a material misstatement of the financial statements 7-20

Select Controls to Test LO# 8 Select Controls to Test 7-21

Test the Design and Operating Effectiveness of Controls LO# 9 Test the Design and Operating Effectiveness of Controls Evaluate design Test and evaluate operating effectiveness Nature: Inquiry, Inspection of documents, observation, and reperformance. Timing: Interim vs. “as of” date Extent: Consider (1) Nature of the control; (2) Frequency of operation; and (3) Importance of the control. 7-22

Internal Control Deficiencies Defined LO# 4 Internal Control Deficiencies Defined Material weakness M A G N I T U D E Material Significant deficiency Not material but significant Control deficiency Not material or significant Remote Reasonably possible or probable L I K E L I H O O D 7-23

Evaluate Identified Control Deficiencies LO# 10 Evaluate Identified Control Deficiencies As discussed previously, the auditor must consider the likelihood and magnitude of the control deficiency. 7-24

Evaluate Identified Control Deficiencies LO# 10 Evaluate Identified Control Deficiencies If a deficiency, or combination of deficiencies, prevents the auditor from having reasonable assurance that transactions are recorded properly, then the auditor should treat the deficiency as an indicator of a material weakness. 7-25

Remediation of a Material Weakness LO# 11 Remediation of a Material Weakness Remediation is the process of correcting a material weakness in the ICFR If a material weakness is corrected before the “as of” date, there must be sufficient time for both management and the auditor to test the operating effectiveness of the control – if not, an adverse opinion (or disclaimer) is still issued. 7-26

Written Representations LO# 12 Written Representations In addition to the management representations obtained as part of a financial statement audit, the auditor also obtains written representations from management related to the audit of ICFR. Failure to obtain written representations from management, including management’s refusal to furnish them, constitutes a limitation on the scope of the audit sufficient to preclude an unqualified opinion. 7-27

Auditor Documentation Requirements LO# 13 Auditor Documentation Requirements The auditor must properly document the processes, procedures, judgments, and results relating to the audit of internal control. When an entity has effective ICFR, the auditor should be able to perform sufficient testing of controls to assess control risk for all relevant assertions at a low level. 7-28

Auditor Documentation Requirements LO# 13 Auditor Documentation Requirements The auditor’s documentation of the process, procedures, judgments and results relating to the audit of ICFR should include: 1. The auditor’s understanding and evaluation of the design of each of the components of ICFR; 2. The process used to determine the points at which misstatements could occur; 3. The extent to which the auditor relied upon the work of others; and 4. The evaluation of any deficiencies discovered or other findings which could result in a report modification. 7-29

Types of Reports Relating to the Audit of ICFR LO# 14 Types of Reports Relating to the Audit of ICFR An unqualified opinion signifies that the client’s internal control is designed and operating effectively (no material weaknesses). A serious scope limitation requires the auditor to disclaim an opinion. An adverse opinion is required if a material weakness is identified. 7-30

Types of Reports Relating to the Audit of ICFR LO# 14 Types of Reports Relating to the Audit of ICFR Report Modification Based on Control Deficiencies Likelihood/Magnitude of Misstatement Type of Audit Report Control deficiency Unqualified opinion Significant deficiency Material weakness Adverse opinion 7-31

Types of Reports Relating to the Audit of Internal Control LO# 14 Types of Reports Relating to the Audit of Internal Control Report Modification Based on Scope Limitation Seriousness of Scope Limitation Type of Audit Report Minor effect Unqualified opinion Disclaim opinion or withdraw Severe limitation 7-32

Internal Control Audit Report LO# 14 Similar to F/S Audit Report except after scope paragraph there is a Definition paragraph and then an Inherent Limitations Paragraph Internal Control Audit Report can be presented in one of two ways: Separate Report (p. 247) Combined Report (p. 248-249) 7-33 33

Other Reporting Issues LO# 14 Management’s report is incomplete or improperly presented. The auditor decides to refer to the report of other auditors. A significant subsequent event has occurred. There is additional information contained in management’s report on internal control. There is a remediated material weakness at an interim date. 7-34 34

Additional Required Communications in an Audit of ICFR LO# 15 Additional Required Communications in an Audit of ICFR The auditor must communicate in writing to management and the audit committee all significant deficiencies and material weaknesses identified during the audit (AS5). This communication should be made prior to the issuance of the auditor’s report on ICFR. In addition, the auditor should communicate to management, in writing, all control deficiencies identified during the audit and inform the audit committee when such a communication has been made. 7-35

Advanced Module 1: Safeguarding of Assets LO# 17 Advanced Module 1: Safeguarding of Assets Safeguarding of assets is defined as policies and procedures that “provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.” 7-36

Advanced Module 2: Computer-Assisted Audit Techniques LO# 18 Advanced Module 2: Computer-Assisted Audit Techniques Computer-assisted audit techniques (CAATs) include: Generalized audit software packages. Custom audit software. Test data. 7-37

Advanced Module 2: Generalized Audit Software LO# 18 7-38

Advanced Module 2: Custom Audit Software LO# 18 Advanced Module 2: Custom Audit Software Custom audit software is generally written by auditors for specific audit tasks. It may be required when the client’s computer system is not compatible with the auditor’s generalized audit software. Custom software: Is expensive to develop. Requires long development time. May require extensive modification if the client changes its accounting application programs. 7-39

Advanced Module 2: Test Data LO# 18 Advanced Module 2: Test Data Test data are developed by the auditor to test the application controls in the client’s computer programs. The technique can be used to check (1) data validation controls and error detection routines, (2) processing logic controls, (3) arithmetic calculations, and (4) the inclusion of transactions in records, files, and reports. 7-40