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Chapter Seven. Auditing Internal Control over Financial Reporting. Management Responsibilities under Section 404.
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Chapter Seven Auditing Internal Control overFinancial Reporting
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).
Management Responsibilities under Section 404 Management must comply with the following in order for its public accounting firm to complete an audit of ICFR. Accepts responsibility for the effectiveness of the entity’s ICFR. Evaluate the effectiveness of the entity’s ICFR using suitable control criteria. Support its evaluation with sufficient evidence, including documentation. Present a written assessment of the effectiveness of the entity’s ICFR as of the end of the entity’s most recent fiscal year.
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 auditof the entity’s ICFR and its financial statements.
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.
Internal Control Deficiencies Defined A control deficiencyexists when the design or operationof 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 deficiencyis 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.
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 weaknessin 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).
Internal Control Deficiencies Defined Materialweakness MAGNITUDE Material Significant deficiency Not material but significant Not material or significant Control deficiency Remote Reasonably possible or probable L I K E L I H O O D
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.
Framework Used by Management to Conduct Its Assessment COSO 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.
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, job descriptions, flowcharts, and process models.
Integrating the Audits of Internal Control and Financial Statements Tests of internalcontrol Substantiveauditprocedures 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.
Effect of the Audit of Internal Control on the Financial Statement Audit When 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 in connection with the audit of the financial statements, auditing standards require the auditor to perform some substantive procedures for all significant accounts and disclosures.
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: • Misstatements detected. • The auditor’s risk evaluations in connection with the selection and application of substantive procedures, especially those related to fraud. • Findings with respect to illegal acts and related-party transactions. • Indications of management bias in making accounting estimates and in selecting accounting principles.
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. Materiality.
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.
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.
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; and Changes from the prior period in account or disclosure characteristics.
Sources of Misstatement Understand the flow of transactions related to the relevant assertions, including initiation, authorization, processing, and recording; 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; and 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.
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; (3) Importance of the control.
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 is still issued. Remediation of a Material Weakness
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.
Auditor Documentation Requirements The auditor must properly document the processes, procedures, judgements, 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.
Auditor Documentation Requirements The auditor’s documentation of the process, procedures, judgements and results relating to the audit of ICFR should include: 1. Auditor’s understanding and evaluation of the design of ICFR; 2. The process used to determine the points at which material 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.
Types of Reports Relating to the Audit of ICFR An unqualified opinion signifies that the client’s internal control is designed and operating effectively. A serious scope limitation requires the auditor to disclaim an opinion. An adverse opinion is required if a material weakness is identified.
Types of Reports Relating to the Audit of ICFR Report Modification Based on Control Deficiencies Likelihood/Magnitude of Misstatement Type ofAudit Report Controldeficiency Unqualifiedopinion Significantdeficiency Materialweakness Adverseopinion
Types of Reports Relating to the Audit of Internal Control Report Modification Based on Scope Limitation Seriousness ofScope Limitation Type ofAudit Report Minoreffect Unqualifiedopinion Disclaimopinion orwithdraw Severe limitation
Other Reporting Issues • 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 other information contained in management’s report on internal control. • There is a remediated material weakness at an interim date.
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.
Advanced Module: Use of Service Organisations Many companies use a service organisation to process transactions. If the service organisation’s services make up part of a company’s information system, then they are considered part of the information and communication component of the company’s internal control over financial report. Thus, both management and the auditor must consider the activities of the service organisation.
Advanced Module: Use of Service Organisations • Management and the auditor should perform the following procedures with respect to the activities performed by the service organisation: • obtain an understanding of the controls at the service organisation that are relevant to the entity’s internal control and the controls at the user organisation over the activities of the service organisation; and • obtain evidence that the controls which are relevant to management’s assessment and the auditor’s opinion are operating effectively. Sometimes a SAS 70 report is issued.
Advanced Module: 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.’
