Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 7-1...

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

7-1

Chapter SevenAuditing Internal Control over Financial Reporting

Chapter SevenAuditing Internal Control over Financial Reporting


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Management Responsibilities under Section 404

Section 404 of the Sarbanes-Oxley Act requires managements of publicly traded companies in the

United States to issue an internal control report that explicitly accepts responsibility for establishing and maintaining ‘adequate’ internal control over financial

reporting.


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Management Responsibilities under Section 404

Management must comply with the following in order for its public accounting firm to complete an audit of

internal control over financial reporting.

1. Accepts responsibility for the effectiveness of the entity’s internal control over financial reporting.

2. Evaluate the effectiveness of the entity’s internal control over financial reporting using suitable control criteria.

3. Support its evaluation with sufficient evidence, including documentation.

4. Present a written assessment of the effectiveness of the entity’s internal control over financial reporting as of the end of the entity’s most recent fiscal year.

1. Accepts responsibility for the effectiveness of the entity’s internal control over financial reporting.

2. Evaluate the effectiveness of the entity’s internal control over financial reporting using suitable control criteria.

3. Support its evaluation with sufficient evidence, including documentation.

4. Present a written assessment of the effectiveness of the entity’s internal control over financial reporting as of the end of the entity’s most recent fiscal year.


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Auditor Responsibilities under Section 404

The entity’s independent auditor must audit and report on management’s assertion about the effectiveness of internal control. The auditor is required to conduct an ‘integrated audit’ of the entity’s internal control over financial reporting and its financial statements.


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Internal Control over Financial Reporting Defined

Internal control over financial reporting 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 generally accepted accounting principles (GAAP). Controls include procedures that:

1.1. Pertain to the maintenance of records that fairly reflect the Pertain to the maintenance of records that fairly reflect the transactions and dispositions of the assets of the company.transactions and dispositions of the assets of the company.

2.2. Provide reasonable assurance that transactions are Provide reasonable assurance that transactions are recorded in accordance with GAAP.recorded in accordance with GAAP.

3.3. Provide reasonable assurance regarding prevention or Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or timely detection of unauthorized acquisition, use or disposition of the company’s assets.disposition of the company’s assets.

1.1. Pertain to the maintenance of records that fairly reflect the Pertain to the maintenance of records that fairly reflect the transactions and dispositions of the assets of the company.transactions and dispositions of the assets of the company.

2.2. Provide reasonable assurance that transactions are Provide reasonable assurance that transactions are recorded in accordance with GAAP.recorded in accordance with GAAP.

3.3. Provide reasonable assurance regarding prevention or Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or timely detection of unauthorized acquisition, use or disposition of the company’s assets.disposition of the company’s assets.


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Internal Control Deficiencies Defined

Material

Consequential

Inconsequential

Remote More than remote

MaterialMaterialweaknessweakness

Significant Significant deficiencydeficiency

Insignificant deficiencyInsignificant deficiency

L I K E L I H O O DL I K E L I H O O D

MMAAGGNNIITTUUDDEE


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Management’s Assessment Process

Management must:Management must:

1.1. Design and implement an effective system of internal control. Design and implement an effective system of internal control. This process involves determining whether a necessary This process involves determining whether a necessary control is missing or an existing control is not properly control is missing or an existing control is not properly designed.designed.

2.2. Develop an ongoing assessment process for the internal Develop an ongoing assessment process for the internal controls in place. Management must assess the likelihood controls in place. Management must assess the likelihood that failure of a control could result in a misstatement.that failure of a control could result in a misstatement.

3.3. Management must decide which business units to include in Management must decide which business units to include in the assessment process.the assessment process.

Management must:Management must:

1.1. Design and implement an effective system of internal control. Design and implement an effective system of internal control. This process involves determining whether a necessary This process involves determining whether a necessary control is missing or an existing control is not properly control is missing or an existing control is not properly designed.designed.

2.2. Develop an ongoing assessment process for the internal Develop an ongoing assessment process for the internal controls in place. Management must assess the likelihood controls in place. Management must assess the likelihood that failure of a control could result in a misstatement.that failure of a control could result in a misstatement.

3.3. Management must decide which business units to include in Management must decide which business units to include in the assessment process.the assessment process.


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Management’s Documentation

Management must develop sufficient Management must develop sufficient documentation to support its assessment of the documentation to support its assessment of the

effectiveness of internal control. This effectiveness of internal control. This documentation may take many forms, such as documentation may take many forms, such as paper, electronic files, or other media. It also paper, electronic files, or other media. It also

includes policy manuals, job descriptions, includes policy manuals, job descriptions, flowcharts, and process models.flowcharts, and process models.

Management must develop sufficient Management must develop sufficient documentation to support its assessment of the documentation to support its assessment of the

effectiveness of internal control. This effectiveness of internal control. This documentation may take many forms, such as documentation may take many forms, such as paper, electronic files, or other media. It also paper, electronic files, or other media. It also

includes policy manuals, job descriptions, includes policy manuals, job descriptions, flowcharts, and process models.flowcharts, and process models.


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Framework Used by Management to Conduct Its Assessment

Most entities use the framework developed by COSO.Most entities use the framework developed by COSO.This framework identifies three primary objectives of This framework identifies three primary objectives of

internal control: (1) reliable financial reporting;internal control: (1) reliable financial reporting;(2) efficiency and effectiveness of operations;(2) efficiency and effectiveness of operations;and (3) compliance with laws and regulations.and (3) compliance with laws and regulations.

Most entities use the framework developed by COSO.Most entities use the framework developed by COSO.This framework identifies three primary objectives of This framework identifies three primary objectives of

internal control: (1) reliable financial reporting;internal control: (1) reliable financial reporting;(2) efficiency and effectiveness of operations;(2) efficiency and effectiveness of operations;and (3) compliance with laws and regulations.and (3) compliance with laws and regulations.

COSO


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Performing an Audit of Internal Control over Financial Reporting

Plan the engagement.

Evaluate management’sassessment process.

The auditor typically obtains his or her understanding of management’s assessment process through inquiry of

management and others.


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Evaluate management’sassessment process.

Obtain and document anunderstanding of internal control.

As part of gaining this understanding the auditor must:

1.1. Understand and assess Understand and assess company-level controls.company-level controls.

2.2. Evaluate the effectiveness of Evaluate the effectiveness of the audit committee.the audit committee.

3.3. Identify significant accounts.Identify significant accounts.4.4. Identify relevant financial Identify relevant financial

statement assertions.statement assertions.

1.1. Understand and assess Understand and assess company-level controls.company-level controls.

2.2. Evaluate the effectiveness of Evaluate the effectiveness of the audit committee.the audit committee.

3.3. Identify significant accounts.Identify significant accounts.4.4. Identify relevant financial Identify relevant financial

statement assertions.statement assertions.

5.5. Identify significant processes Identify significant processes and major classes of and major classes of transactions.transactions.

6.6. Understand the period-end Understand the period-end financial reporting process.financial reporting process.

7.7. Perform walkthroughs.Perform walkthroughs.8.8. Identify controls to test.Identify controls to test.

5.5. Identify significant processes Identify significant processes and major classes of and major classes of transactions.transactions.

6.6. Understand the period-end Understand the period-end financial reporting process.financial reporting process.

7.7. Perform walkthroughs.Perform walkthroughs.8.8. Identify controls to test.Identify controls to test.


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Evaluate the management’sassessment process.


Evaluate the design effectivenessof internal control.

Controls are effectively designed when they prevent or detect errors or fraud that could result in material

misstatements in the financial statements.


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Test and evaluate the operatingeffectiveness of internal control.

In testing the effectiveness of controls, the auditor needs to consider the nature, timing, and extent of testing.


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Test and evaluate the operatingeffectiveness of internal control.

Form an opinion of theeffectiveness of internal control.

The auditor should evaluate all evidence

before forming an opinion on internal control,

including (1) the adequacy of management’s

assessment, (2) the results of the auditor’s evaluation, (3) the negative results of substantive procedures

performed, (4) any control deficiencies.


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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 internal control over financial reporting.

Failure to obtain written Failure to obtain written representations from representations from

management, including management, including management’s refusal to management’s refusal to

furnish them, constitutes a furnish them, constitutes a limitation on the scope of the limitation on the scope of the audit sufficient to preclude an audit sufficient to preclude an

unqualified opinion.unqualified opinion.

Failure to obtain written Failure to obtain written representations from representations from

management, including management, including management’s refusal to management’s refusal to

furnish them, constitutes a furnish them, constitutes a limitation on the scope of the limitation on the scope of the audit sufficient to preclude an audit sufficient to preclude an

unqualified opinion.unqualified opinion.


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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 internal control over financial reporting, the auditor should be able to perform sufficient testing of controls to assess control risk for all relevant assertions at a low level.

When an entity has effective internal control over financial reporting, 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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Reporting on Internal Control

Sarbanes-Oxley requires management’s description of internal control to include:

1. A statement of management’s responsibility for establishing and maintaining adequate internal control.

2. A statement identifying the framework used by management to conduct the required assessment of the effectiveness of the company’s internal control.

3. An assessment of the effectiveness of the company’s internal control as of the end of the most recent fiscal year, including an explicit statement as to whether internal control is effective.

4. A statement that the public account firm that audited the financial statements included in the annual report has issued an attestation report on management’s assessment of internal control.

1. A statement of management’s responsibility for establishing and maintaining adequate internal control.

2. A statement identifying the framework used by management to conduct the required assessment of the effectiveness of the company’s internal control.

3. An assessment of the effectiveness of the company’s internal control as of the end of the most recent fiscal year, including an explicit statement as to whether internal control is effective.

4. A statement that the public account firm that audited the financial statements included in the annual report has issued an attestation report on management’s assessment of internal control.


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The Auditor’s Report on Internal Control over Financial Reporting

Once the auditor has completed the audit of internal control, he or she must issue an appropriate report to accompany management’s assessment, published in

the company’s annual report.


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Types of Reports Relating to the Audit of Internal Control

The auditor’s report contains opinions on two separate items: (1) management’s assessment of the

effectiveness of internal control over financial reporting, and (2) the effectiveness of internal control over financial reporting based on the auditor’s independent audit work.


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OpinionOpinion

An An unqualifiedunqualified opinion opinion signifies that the client’s signifies that the client’s

internal control is internal control is designed and operating designed and operating

effectively.effectively.

An An unqualifiedunqualified opinion opinion signifies that the client’s signifies that the client’s

internal control is internal control is designed and operating designed and operating

effectively.effectively.

A A qualifiedqualified opinion is opinion is issued when there is a issued when there is a

limitation on the scope of limitation on the scope of the auditor’s work. the auditor’s work.

A A qualifiedqualified opinion is opinion is issued when there is a issued when there is a

limitation on the scope of limitation on the scope of the auditor’s work. the auditor’s work.

A serious scope A serious scope limitation requires the limitation requires the auditor to auditor to disclaimdisclaim an an

opinion. opinion.

A serious scope A serious scope limitation requires the limitation requires the auditor to auditor to disclaimdisclaim an an

opinion. opinion.

An An adverseadverse opinion is opinion is required if a material required if a material

weakness is identified. weakness is identified.

An An adverseadverse opinion is opinion is required if a material required if a material

weakness is identified. weakness is identified.


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Report Modification Based on Control DeficienciesReport Modification Based on Control Deficiencies

Likelihood ofLikelihood ofMisstatementMisstatement

Type ofType ofAudit ReportAudit Report

InconsequentialInconsequentialdeficiencydeficiency

SignificantSignificantdeficiencydeficiency

MaterialMaterialweaknessweakness

UnqualifiedUnqualifiedopinionopinion

AdverseAdverseopinionopinion


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Report Modification Based on Scope LimitationReport Modification Based on Scope Limitation

Reason forReason forScope LimitationScope Limitation

Type ofType ofAudit ReportAudit Report

MinorMinoreffecteffect

Management imposed/Management imposed/more than minor effectmore than minor effect

SeverSeverlimitationlimitation

UnqualifiedUnqualifiedopinionopinion

DisclaimDisclaimopinion oropinion orwithdrawwithdraw

QualifiedQualifiedopinionopinion


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Elements of the Auditor’s Report

1. A title that includes the word ‘independent.’2. An identification of management’s conclusion about the effectiveness of

the company’s internal control over financial reporting.3. A definition of internal control over financial reporting.4. A statement that the auditor planned and performed the audit to obtain

reasonable assurance about whether effective internal control is maintained.

5. A statement that an audit includes obtaining an understanding of internal control, valuating management’s assessment of testing the design and effectiveness of internal control and any other procedures.

6. A paragraph stating that internal control may not prevent or detect misstatements because of inherent limitations.

7. The auditor’s opinion on whether management’s assessment of the effectiveness of internal control is fairly stated.

8. The auditor’s opinion on whether the company maintained effective internal control.


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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 Tests of internalinternalcontrolcontrol

Tests of Tests of internalinternalcontrolcontrol

SubstantiveSubstantiveauditaudit

proceduresprocedures

SubstantiveSubstantiveauditaudit

proceduresprocedures


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Effect of the Audit of Internal Control on the Financial Statement Audit

If the auditor performs an integrated audit, he or she will have access to a large amount of information

about the client’s controls. This information can make the financial statement audit more efficient and result

in reduced substantive procedures.

Regardless of the level of control risk Regardless of the level of control risk in connection with the audit of the in connection with the audit of the

financial statements, auditing financial statements, auditing standards require the auditor to standards require the auditor to

perform some substantive procedures perform some substantive procedures for all significant accounts and for all significant accounts and

disclosures.disclosures.

Regardless of the level of control risk Regardless of the level of control risk in connection with the audit of the in connection with the audit of the

financial statements, auditing financial statements, auditing standards require the auditor to standards require the auditor to

perform some substantive procedures perform some substantive procedures for all significant accounts and for all significant accounts and

disclosures.disclosures.


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Effect of the Financial Statement Audit on the Audit of Internal Control

The effectiveness of the audit of internal controls should lead the auditor to determine the implications of these findings on the financial statement audit. The auditor’s evaluation should include:

1.1. Misstatements detected.Misstatements detected.

2.2. The auditor’s risk evaluations in connection with the The auditor’s risk evaluations in connection with the selection and application of substantive procedures, selection and application of substantive procedures, especially those related to fraud.especially those related to fraud.

3.3. Findings with respect to illegal acts and related party Findings with respect to illegal acts and related party transactions.transactions.

4.4. Indications of management bias in making accounting Indications of management bias in making accounting estimates and in selecting accounting principles.estimates and in selecting accounting principles.

1.1. Misstatements detected.Misstatements detected.

2.2. The auditor’s risk evaluations in connection with the The auditor’s risk evaluations in connection with the selection and application of substantive procedures, selection and application of substantive procedures, especially those related to fraud.especially those related to fraud.

3.3. Findings with respect to illegal acts and related party Findings with respect to illegal acts and related party transactions.transactions.

4.4. Indications of management bias in making accounting Indications of management bias in making accounting estimates and in selecting accounting principles.estimates and in selecting accounting principles.


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Special Considerations for an Audit of Internal Control

Special considerationSpecial considerationby managementby managementand the auditorand the auditor

Special considerationSpecial considerationby managementby managementand the auditorand the auditor

Using the work Using the work of others.of others.

Using the work Using the work of others.of others.

Multi-locations Multi-locations and business and business

units.units.

Multi-locations Multi-locations and business and business

units.units.

ServiceServiceorganizations.organizations.

ServiceServiceorganizations.organizations.

SafeguardingSafeguardingassets.assets.

SafeguardingSafeguardingassets.assets.


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Using the Work of Others

In determining the extent to which the auditor may use the work of others, the auditor should:

o Evaluate the nature of the controls Evaluate the nature of the controls subjected to the work of others.subjected to the work of others.

o Evaluate the competence and Evaluate the competence and objectivity of the individuals who objectivity of the individuals who performed the work.performed the work.

o Test some of the work performed by Test some of the work performed by others to evaluate the quality and others to evaluate the quality and effectiveness of their work.effectiveness of their work.

o Evaluate the nature of the controls Evaluate the nature of the controls subjected to the work of others.subjected to the work of others.

o Evaluate the competence and Evaluate the competence and objectivity of the individuals who objectivity of the individuals who performed the work.performed the work.

o Test some of the work performed by Test some of the work performed by others to evaluate the quality and others to evaluate the quality and effectiveness of their work.effectiveness of their work.


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Testing Multi-locationTotal number of units = 150Total number of units = 150Total number of units = 150Total number of units = 150

Is unit individually important?

Are there specific significant risks?

Are there units that are not important even when

aggregated?

Are there documented company-level controls over

this group?

NoNo

NoNo

NoNo

NoNo

135135Evaluate documents and test

controls over significant accounts at each location.

15 15 YesYes

130130Evaluate documents and test controls over specific risks.

5 5 YesYes

No further action required.7070 60 60 YesYes

Evaluate documents and test company-level controls over group.

Some testing of controls at individual locations.

YesYes


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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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Computer-Assisted Audit Techniques

Computer-assisted audit techniques include:Computer-assisted audit techniques include:

o Generalized audit software packages.Generalized audit software packages.

o Custom audit software.Custom audit software.

o Test data.Test data.

Computer-assisted audit techniques include:Computer-assisted audit techniques include:

o Generalized audit software packages.Generalized audit software packages.

o Custom audit software.Custom audit software.

o Test data.Test data.


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Generalized Audit SoftwareFunction Description

File or data accessReads and extracts data from a client's computer files or databases for further audit testing.

Selection operators Select from files or databases transactions that meet certain criteria.

Arithmetic functions

Perform a variety of arithmetic calculations (addition, subtraction, and so on) on transactions, files, and databases.

Statistical analysesProvide functions supporting various types of audit sampling.

Report generationPrepares various types of documents and reports.


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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:Custom software:

(1)(1) Is expensive to develop.Is expensive to develop.

(2)(2) Requires extended Requires extended development time.development time.

(3)(3) Is limited in scope of functions.Is limited in scope of functions.

Custom software:Custom software:

(1)(1) Is expensive to develop.Is expensive to develop.

(2)(2) Requires extended Requires extended development time.development time.

(3)(3) Is limited in scope of functions.Is limited in scope of functions.


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Test Data

This is data 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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End of Chapter 7

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 7-1...

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