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

Summary 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 7-2

Foreign 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 7-3

Components of Internal Control  The Control Environment  Risk Assessment  The Accounting Information and Communication System  Control Activities  Monitoring 7-4

Control 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 7-5

Risk Assessment--Factors Indicative of Increased 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 7-6

Control Activities  Performance reviews  Information processing General control activities Application control activities  Physical controls  Segregation of duties Segregate authorization, recording and custody of assets 7-7

Objectives 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 7-8

Monitoring  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 7-9

Limitations 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 7-10

Auditors’ Overall Approach with Internal Control  Overall approach of an audit 1. 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 7-11

2. Obtain an understanding of the client and its environment, 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 7-12

3. Assess the risks of material misstatement 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 7-13

4. Perform Further Audit Procedures – Test 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 7-14

Consideration of the Work of Internal 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. 7-15

Service Organizations 1/2  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. 7-16

Service Organizations 2/2  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. 7-17

Relationships Among Deficiencies Deficiency in Internal Control Less thanSignificantMaterial SignificantDeficiencyWeakness 7-18

Management’s Report on Internal Control under 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 7-19

Approach to Audit of Internal Control under 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 7-20