Internal Control over Financial Reporting: Comment on Quality of Organization's Controls

1. CHAPTER 5 INTERNAL CONTROL OVER FINANCIAL REPORTING

2. Comment on 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 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. Review 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. Discuss 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. Review 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. What are the components of an internal control system? 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. Discuss Understanding & Assessing the Control Environment 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

10. Reporting on Internal Control - Management Reports to External Parties 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

11. 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

12. Audit Reporting on Internal Control External auditors of non-public companies must report significant internal control deficiencies to management • Such reports are for management's use • 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

13. 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

14. 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

15. 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

16. Discuss 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

17. Review 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

18. Discuss 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

19. Discuss Internal Control & Financial Statement Account Balances • 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

20. Review Assessing the Effectiveness of Control Procedures • Management designs and implements specific control procedures to ensure that the company will achieve its control objectives - and if the control objectives are achieved, the management assertions are likely to be valid, and the account balance and transactions properly recorded • The auditor assesses the organization's control procedures within a framework of control objectives and management assertions • In order to perform this assessment, the auditor must understand the accounting processes within each system, the related accounts, and the risk associated with incorrect processes • With this knowledge, the auditor can identify which management assertions and control objectives are most likely to be violated • From this, the auditor can identify appropriate control procedures that can then be assessed for effectiveness in design and operation

21. Discuss Overview of Controls Testing - Pervasive Control Activities Some control procedures are found in almost all accounting systems: • Segregation of incompatible duties • Authorization procedures • Documented transaction trail • Physical controls to limit access to assets • Independent reconciliation • Competent, trustworthy employees

22. Comment on Control Effectiveness and Control Risk Assessment • Process for evaluating controls: Phase 1: Obtain an understanding of risks and internal controls Phase 2: Make a preliminary assessment of control risk and decide whether to test operation of control procedures Phase 3: Test operating effectiveness of controls Phase 4: Based on the results of testing, determine whether to revise the assessment of control risk and incorporate this revision into the substantive testing

23. Review Phase One - Obtain an Understanding Auditor needs to gain understanding of each significant accounting application operates and the control procedures used The auditor gathers evidence • Performing walkthroughs of the accounting system and processing procedures • Making inquires of management, and accounting and operational employees • Taking plant and operational tours • Reviewing client documentation including accounting manuals and program and system descriptions • Reviewing prior year audit work papers The auditor documents his/her understanding using flowcharts, questionnaires, and narratives

24. Review Phase Two - Make Preliminary Assessment of Control Risk After gaining an understanding, the auditor makes a preliminary assessment of control risk - this assessment is crucial because it drives the planning for the rest of the audit The relationship between the assessed level of control risk and the rigor of the subsequent substantive testing is inverse: • If control risk is assessed as high, • No reliance is placed on the client's internal controls • The amount and rigor of substantive testing must be increased • If control risk is assessed as low • The auditor would like to rely on the client's internal controls • The amount and rigor of substantive testing may not have to be increased • However, the auditor must test the controls to make sure they are operating effectively

25. Review Phase Three - Perform Tests of Controls • The preliminary assessment of control risk is based on the auditor's understanding of the control system and how it has operated in the past • When control risk is assessed low, and the auditor intends to rely on the client's controls, the auditor may reduce (or not increase) the amount of substantive testing • To ensure that the auditor's reliance on the client's control is warranted, the auditor must test the control to make sure it is operating effectively • Guidance on Sample Size for Testing Controls • Testing Controls Across Multiple Locations • Dual Purpose Tests • Assessing Control Risk as Moderate

26. Review Phase Four - Update Assessment of Control Risk & Need for Substantive Testing • If testing indicates the control is not operating effectively, the auditor will revise the preliminary assessment of control risk and incorporate this revision into the subsequent substantive testing