1. 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.

2. 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).
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3. 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.
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4. 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.
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5. 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.
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6. 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.
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7. 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)
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8. 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
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9. 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.
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10. 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
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11. 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.
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12. 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
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13. Performing an Audit of ICFR Figure 7-2
LO# 6
Performing an Audit of ICFR Figure 7-2
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14. 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.
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15. 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.
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16. Using a Top-Down Approach Figure 7-3
LO# 8
Using a Top-Down Approach Figure 7-3
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17. Identify Entity-Level Controls
LO# 5
Identify Entity-Level Controls
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18. 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
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19. 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
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20. 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
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21. Select Controls to Test
LO# 8
Select Controls to Test
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22. 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.
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23. 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
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24. 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.
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25. 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.
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26. 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.
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27. 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.
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28. 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.
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29. 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.
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30. 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.
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31. 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
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32. 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
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33. 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 )
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34. 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.
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35. 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.
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36. 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.”
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37. 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.
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38. Advanced Module 2: Generalized Audit Software
LO# 18
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39. 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.
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40. 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.
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