2. Nature of an Integrated Audit
Auditors of public companies should report on:
Financial statements and
Internal control over financial reporting
Based on provisions of PCAOB Standard No. 5, the audits of internal control and financial reporting should be integrated

3. Sarbanes-Oxley Act of 2002 Section 404
404(a) – requires annual report filed with SEC to include an internal control report
Management acknowledges responsibility for establishing and maintaining adequate internal control
Provides assessment of internal control effectiveness at end of fiscal year
404(b) – requires CPA firm to audit internal control and express an opinion on effectiveness of internal control. (Required for companies with a capitalization in excess of $75,000,000)

4. Management’s Responsibility
Accept responsibility for effectiveness
Evaluate the effectiveness using suitable criteria
Support the evaluation with sufficient evidence
Provide a report on internal control

5. Management’s Report on I/C
Report must:
State that it is management’s responsibility to establish and maintain adequate internal control.
Identify management’s framework for evaluating internal control.
Include management’s assessment of the effectiveness of the company’s internal control over financial reporting as of the end of the most recent fiscal period, including a statement as to whether internal control over financial reporting is effective.
Include a statement that the company’s auditors have issued an attestation report on management’s assessment.

6. Management Assessment
Management can be assisted by consultants but not by the CPA firm that conducts the audit of financial statements
Must understand definition of internal control adopted by the SEC
Evaluation must use an accepted “control framework” such as Internal Control-Integrated Framework created by COSO.
Must understand concepts of control deficiency, significant deficiency and material weakness

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

9. Control concepts Control deficiency
exists when the design or operation of a control does not allow management or employees, in the normal course of performing their functions, to prevent or detect misstatements on a timely basis
Levels of severity of control deficiencies
Less than a significant deficiency
Significant deficiency – less severe than material weakness yet important enough to merit attention
Material weakness – reasonable possibility that a material misstatement will not be prevented or detected

10. Objective of Management’s Evaluation of I/C
Provide a reasonable basis for its annual assessment
Process
Evaluate design effectiveness of controls
Evaluate operating effectiveness of internal control
Documentation of process
Reporting

11. Auditor’s Objective
Plan and perform the audit to obtain reasonable assurance about whether material weaknesses exist to express an opinion on company’s internal control over financial reporting
Evidence gathered as of date specified in management’s assessment – normally the last day of the company’s fiscal year

12. Audit Steps Plan the engagement
Use a top-down approach to identify controls to test
Test and evaluate design effectiveness of internal control
Test and evaluate operating effectiveness of internal control
Form an opinion on the effectiveness of internal control

14. Plan the Engagement
Efficient planning requires coordination with financial statement audit
Consider matters such as:
Client’s industry
Regulatory matters
Client’s business
Recent changes in client’s operations

15. Auditors’ Consideration of I/C
Difference between audit of internal control and audit of financial statements
Time period
Audit of internal control –as of date
Audit of financial statements – entire financial statement period
Differences between small and large clients
Degree of complexity of operations

16. Top-Down Approach

17. Top-Down Approach
Goal is to focus on testing those controls that are most important to auditor’s conclusion on internal control, avoiding those that are less important
Starts at top
Entity-level controls – those in control environment or monitoring components of internal control
Emphasize those relating to audit committee effectiveness, fraud, and period-end process
Direct or indirect effect

19. Significant Accounts and Disclosures
Account significant if reasonable possibility that it could contain a misstatement that individually or in aggregate has a material effect on financial statements
Factors
Size and composition.
Susceptibility of loss due to errors or fraud.
Volume of activity, complexity, and homogeneity of individual transactions.
Nature of the account.
Accounting and reporting complexity.
Exposure to losses.
Possibility of significant contingent liabilities.
Existence of related party transactions.
Changes from the prior period.

20. Identifying Relevant Assertions
Those that have meaningful bearing on whether account is presented fairly
(1) existence or occurrence;
(2) completeness;
(3) valuation or allocation;
(4) rights and obligations; and/or
(5) presentation and disclosure.

21. Design Effectiveness
Routine transactions are for recurring activities,
Examples: sales, purchases, cash receipts and disbursements, and payroll.
Nonroutine transactions occur only periodically; they generally are not part of the routine flow of transactions
Examples: transactions such as counting and pricing inventory, calculating depreciation expense, or determining prepaid expenses.
Accounting estimates are activities involving management’s judgments or assumptions,
Examples: determining the allowance for doubtful accounts, estimating warranty reserves and assessing assets for impairment

22. Likely Source of Misstatements
Understand the flow of transactions;
Verify points within the company’s processes at which a misstatement could arise that could be material;
Identify the controls management has implemented to address these potential misstatements; and
Identify the controls management has implemented to prevent or detect on a timely basis unauthorized acquisition, use, or disposition of the company’s assets that could result in a material misstatement.

23. Selecting Controls Not necessary to design tests of all controls
Redundant controls
Do not need to test if duplicate control is tested
Design tests for preventive and/or detective controls
Complementary controls
Should both be tested

24. Performing Walk-Throughs
Tracing a transaction from its origination through the company’s information system until it is reflected in the company’s financial reports
Provide evidence to:
Verify that they have identified points at which a significant risk of misstatement to a relevant assertion exists.
Verify their understanding of the design of controls, including those related to the prevention or detection of fraud.
Evaluate the effectiveness of the design of controls.
Confirm whether controls have been placed in operation (implemented).

25. Tests of Operating Effectiveness
Nature
Inquiries, inspections, observations and reperformance
Vary exact tests when possible
Timing
Sufficient period of time
Periodic controls – wait to after report date
Extent
Depend on frequency of control

26. Frequency of Testing

27. Relationship Between Audits
Tests of controls
Same for internal control audit and financial statement audit
Evidence from internal control audit can be used for financial statement audit
Differences between audits
Objectives are different
Integrated audit
Testing should be spread through the year to satisfy both objectives

28. Effects of Internal Control Testing on Audit Substantive Procedures
Integrated audit requires tests of controls for all major account and relevant assertions
Will lead to decreased scope of substantive procedures
However, significant deficiencies or material weaknesses could lead to more substantive procedures
Not acceptable to omit substantive procedures completely

29. Effect of Substantive Procedures on Audit of Internal Control
Findings from substantive procedures may affect audit of internal control
Could provide evidence of effectiveness or ineffectiveness of internal control over financial reporting
Example: Identification of material misstatement in financial statements is indicative of at least a significant deficiency in internal control

30. Form an opinion Evaluate:
1. The results of their evaluation of the design,
2. The results of tests of the operating effectiveness of controls,
3. Negative results of substantive procedures performed during the financial statement audit, and
4. Any identified control deficiencies.

32. Circumstances Affecting the Auditors’ Opinions

33. Other Communication Requirements
Communicate in writing to management
All control deficiencies regardless of severity
To audit committee
Material weaknesses, significant deficiencies and that all deficiencies have been communicated to management
To board of directors
If conclude oversight of financial reporting and internal control is ineffective

34. Other Report
Reporting on Whether a Previously Reported Material Weakness Continues to Exist
Management believes material weakness has been eliminated
Auditor engaged to report on whether material weakness continues to exist
Engagement focused on evidence regarding material weakness

35. Integrated Audis for Nonpublic Companies
A nonpublic company may choose to have an integrated audit of its financial statements and its internal control. While the service is very similar to that for public companies, it differs as follows: