2. 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 2 2

3. Control Objectives
In each area of internal control (financial reporting, operations and compliance)
Control objectives and
Subobjectives exist
Example: Area of financial reporting
Top level objective – prepare and issue reliable financial information
Detailed level applied to A/R subobjectives
All goods shipped are accurately billed in the proper period
Invoices are accurately recorded for all authorized shipments and only for such shipments
Authorized and only authorized sales returns and allowances are accurately recorded
The continued completeness and accuracy of A/R is ensured
Accounts receivable records are safeguarded

4. 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

5. Controls over Financial Reporting
Preventive
Aimed at avoiding the occurrence of misstatements in the financial statements
Example: Segregation of duties
Detective
Designed to discover misstatements after they have occurred
Example: Monthly bank reconciliations
Corrective
Needed to remedy the situation uncovered by detective controls
Example: Backups of master file
Controls overlap
Complementary – function together
Redundant – address same assertion or control objective
Compensating – reduces risk existing weakness will result in misstatement

6. Components of Internal Control
The Control Environment
Risk Assessment
The Accounting Information and Communication System
Control Activities
Monitoring 3 3

7. 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 4 4

8. 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 5 5

9. Control Activities Performance reviews Information processing
General control activities
Application control activities
Physical controls
Segregation of duties
Segregate authorization, recording and custody of assets 6 7

10. Segregation of Duties

11. 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 6

12. Monitoring Ongoing monitoring activities Separate evaluations
Regularly performed supervisory and management activities
Example: Continuous monitoring of customer complaints
Separate evaluations
Performed on nonroutine basis
Example: Periodic audits by internal audit 8

13. 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 9

14. Enterprise Risk Management (ERM)
COSO issued a new internal control framework in 2004 on enterprise risk management. It does not replace the original COSO internal control framework.
It goes beyond internal control to focus on how organizations can effectively manage risks and opportunities.
The auditing standards are still structured around the original COSO internal control framework.

15. Financial Statement Audits: The Role of Internal Control
Second Field Work Standard
The auditor must obtain a sufficient understanding of the entity and its environment, including its internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud, and to design the nature, timing, and extent of further audit procedures. [emphasis added]

16. 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

17. 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 nonroutine transactions

18. Obtaining the Understanding
Procedures include
Inquiring of entity personnel
Observing the application of specific controls
Inspecting documents and reports
Tracing transactions through the information system relevant to financial reporting
May also obtain evidence on operating effectiveness of various controls

19. Documenting the Understanding of Internal Control
Questionnaires
Typically standardized by firm
Written Narratives
Memos that describe flow of transactions
Flowcharts
Systems flowcharts
Walk-through
Trace one or two transaction through cycle 11

21. 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

22. The nature of transactions
Consider the nature of the transactions
Routine transactions—e.g., revenue, purchases, and cash receipts and disbursements
Nonroutine transactions—e.g., taking of inventory, calculating depreciation expense
Estimation transactions—e.g., determining the allowance for doubtful accounts
Generally routine transactions have the strongest controls

23. Assessing Risks at the Financial Statement Level
Examples
Preparing the period-end financial statements, including the development of significant accounting estimate and preparation of the notes
The selection and application of significant accounting policies
IT general controls
The control environment
Responses to high risks
Assigning more experience staff or those with specialized skills
Providing more supervision and emphasizing the need to maintain professional skepticism
Incorporating additional elements of unpredictability in the selection of further audit procedures to be performed
Increasing the overall scope of audit procedures, including the nature, timing or extent

24. Assessing Risks at the Assertion Level
Examples
Failure to recognize an impairment loss on a long-lived asset affects only the valuation assertion
Inaccurate counting of inventory at year-end affect the valuation of inventory and the accuracy of cost of goods sold
Responses
Decisions are made here as to the appropriate combination of tests of controls and substantive procedures

25. 4. Design and Perform audit procedures – test of controls (1 of 2)
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

26. 4. Perform further audit proce-dures—tests of controls (2 of 2)
Tests of controls include:
Inquiries of appropriate client personnel
Inspection of documents and reports
Observation of the application of controls
Reperformance of the controls
The results of the tests of controls are used to determine the nature, timing and extent of substantive procedures

27. Diagram of the Auditors’ Consideration of Internal Control

28. Other Considerations Audit decision aids
Checklist, standard form or computer program that helps auditors make a decision by ensuring that they have all relevant information or by assisting them in combining the information.
Use of the work of internal auditors
Must assess internal audit competence and objectivity and test work
Can rely on work of internal audit to reduce amount of testing done by independent auditors

29. Relationships Among Deficiencies
Deficiency in
Internal Control
Less than Significant Material
Significant Deficiency Weakness

30. 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

31. Approach to Audit of Internal Control under Section 404b
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

32. Internal Control in the Small Company
Due to lack of employees, internal control is seldom strong in small businesses
Specific practices for small businesses
Record all cash receipts immediately
Deposit all cash receipts intact daily
Make all payments by serially numbered checks, with exception of petty cash disbursements
Reconcile bank accounts monthly and retain copies
Use serially numbered invoices, Pos, and receiving reports
Issue checks to vendors only in payment of approved invoices that have been matched with purchase orders and receiving reports
Balance subsidiary ledger with control accounts
Prepare comparative financial statements monthly to disclose significant variations in any category of revenue or expense