1. INTERNAL CONTROL OVER FINANCIAL REPORTING
CHAPTER 5 - a
INTERNAL CONTROL OVER FINANCIAL REPORTING

2. LO1 - The Quality of an Organization’s Internal Controls
The quality of an organization's internal controls affects not only the reliability of its financial reporting, but also its ability to make good decisions and stay in business
Internal control processes must effectively address risks that are present in the industry and in the organization
Auditors gain an understanding of their client's control system in order to
Better understand the client, its risks, and how it manages those risks
Assess control risk and identify types of most likely misstatements
Plan extent of substantive testing needed
Report on effectiveness of internal controls (publicly-held companies)

3. Define Internal Controls - COSO
Internal controls is a process designed to provide reasonable assurance of achieving the following:
Generating reliable financial accounting information
Safeguarding assets
Complying with applicable laws and regulations
Operating efficiently and effectively

4. The Need for Control
Control is part of corporate governance whereby the owners and creditors of an organization exert control and require accountability for its resources
Governance begins with stockholders, who delegate certain responsibilities to the board of directors and in turn to management
That delegation must occur within a framework of control and accountability
The control system exists to ensure that
Responsibilities are properly identified
Tasks are assigned in accordance with responsibilities and accountability

5. Who is Interested in an Organization's Control System?
Board of directors and the audit committee
Management
Regulators
Internal and external auditors
Suppliers and customers
Investors and creditors
Customers or others using the Web for commerce

6. The Integrated Audit
The Sarbanes-Oxley Act of 2002 requires publicly held companies to report on the effectiveness of their internal controls over financial reporting
The Public Company Accounting Oversight Board requires external auditors to perform an integrated audit of the effectiveness of internal controls and financial reporting
In essence, the auditor must attest to both the financial statements and management's assertions regarding the effectiveness of internal controls over financial reporting

7. LO2 - The components of an internal control system
An internal control system consists of five components
Control environment: overall attitude, awareness, and actions of significant internal groups to maintain a well-controlled organization (tone at the top)
Risk assessment: process designed to identify and manage risks that may affect its ability to achieve its objectives
Control activities: policies and procedures established by management to help ensure that internal control objectives are achieved and risks mitigated
Information and communication: process of identifying, capturing, and exchanging information in a timely fashion to enable the organization to achieve its objectives
Monitoring: process that assesses the quality of internal controls over time

8. The logical loop
There is a logical loop to an organization's internal controls, starting with
1. Design of the control environment
2. Identification of organizational risks and controls to minimize those risks
3. Design and implementation of controls and a communication system
4. Monitoring of the effectiveness of the controls to mitigate risk

9. Internal Control Components
MONITORING
Information & Communication
CONTROL
ACTIVITIES
RISK ASSESSMENT
CONTROL ENVIRONMENT

10. LO3 – Management monitors internal control
Done through ongoing activities or separate evaluations
Either of these include the following internal and external parties
Internal Auditors
Customers
Regulators

11. LO4 - Understanding & Assessing the Control Environment – The most pervasive of them all
There are a number of factors an auditor should look at when evaluating an organization's control environment:
Management's philosophy and operating style
Organizational structure, including assignment of authority and responsibility
Board of directors and audit committee
Human resource policies and practices
Integrity and ethical values
Commitment to competence
Compensation and evaluation programs
Effectiveness of the internal audit function

12. LO5 - Reporting on Internal Control - Management Reports to External Parties Ex 5.2
The Sarbanes-Oxley Act of 2002 requires publicly held companies to report on the effectiveness of their internal controls over financial reporting
The report must describe the following:
Statement of management's responsibility for establishing and maintaining effective internal controls over financial reporting
Identify the framework used by management to evaluate internal controls
Assessment of the effectiveness of the company's internal controls
Description of any material deficiencies in internal control
Statement that the report has been audited
The external auditor must attest to management's report

13. Reporting on Internal Control – Internal Management Reports
Management often requests reports on the quality of its internal controls in order to ensure the company can achieve its major objectives and is not exposed to unnecessary risks
Management receives reports from three sources:
Ongoing monitoring reports from operations
Internal audit reports
External audit reports

14. LO6 - Audit Reporting on Internal Control
External auditors of non-public companies must report to management significant internal control deficiencies in the design or operation of internal controls that are identified in the normal course of a financial audit.
Such reports are for management's use and are not intended to be distributed to the public
External auditors of public companies must go beyond the report to management and also report on management's assertion regarding the effectiveness of internal controls over financial reporting
Includes an opinion on the client's internal controls
Included in the company's annual report

15. Audit Reporting on Internal Control
In performing an audit of controls, the auditor must
Review client documentation including how controls are supposed to work (design)
Review client testing of controls (operations)
Determine which controls to test, sample sizes, and how to judge whether a control is operating effectively
Reach conclusion about the effectiveness of client internal controls over financial reporting

16. LO7 Audit Reporting on Internal Control (continued)
The PCAOB's proposed report on internal controls would include a(n):
Description of internal control, its objectives, and inherent limitations
Definition of material deficiency in internal control
Description of all material deficiencies found
Opinion regarding effectiveness of company's internal controls

17. Audit Reporting on Internal Control (continued)
According to the Sarbanes-Oxley Act, if an auditor identifies significant or material deficiencies in internal control,
Those deficiencies must be reported to both management and the audit committee
Deficiencies must be reported to the audit committee even if management has addressed the deficiency and implemented new controls
The stated intent of the Sarbanes-Oxley Act is to ensure boards of directors understand they have a responsibility to improve the governance of the organization

18. LO8 - Relationship of Controls to Auditing
Minimum level of control is necessary for an entity to be auditable
The quality of internal controls affects the operating effectiveness and ultimately, the organization's ability to remain a going concern
The quality of internal controls drives the audit approach and amount of testing
Analysis of control deficiencies helps identify the types of likely misstatements
Inadequate controls may place an organization in violation of federal laws
Auditor is required to attest to management's assessment of the effectiveness of internal control over financial reporting for all public companies

19. Accounting Information Systems
Accounting systems capture, record, summarize, and report information
An accounting information system is typically not one big system, but a network of smaller accounting application/subsystem
Each application processes a unique type of transaction
Examples: sales, accounts receivable, accounts payable, cash receipt cash disbursements, payroll, inventory, etc
Each application has its own unique source documents, processes, and controls
The quality of internal control can vary between applications
The auditor develops understanding of how transactions are entered and processed, and the controls for each significant accounting application

20. Internal Control & Financial Statement Account Balances
Auditor assesses control risk for each relevant assertion for each important class of transactions and account balance as a basis for planning the audit
Auditor needs to understand and evaluate the internal control design for all important accounting applications
Auditor needs to evaluate the effectiveness of internal control over financial reporting for accounting applications that process material transactions

21. Internal Control & Financial Statement Account Balances (2)
Auditor has to evaluate controls in systems that
Record revenue
Deal with significant estimates
Process journal entries near the end of the year to close the books
Deal with off-statement financing or related party transactions
Auditor needs to jointly assess organization's control environment and the specific accounting system controls to evaluate the risk of material deficiency in internal control
To conclude internal controls are effective, auditor must obtain evidence that the control structure is soundly designed AND operating effectively