Chapter 10 Section 404 Audits of Internal Control and Control Risk

1. Chapter 10Section 404 Audits of Internal Control and Control Risk Internal Control Risk Internal Control .

2. Presentation Outline • An Overview of Internal Control • The Components of Internal Control • Process for Understanding Internal Control and Assessing Control Risk • Communications with the Audit Committee and Management

3. I. An Overview of Internal Control • Internal Control Defined • Reasonable Assurance • Section 404 Reporting Requirements for Management • Key Components of Managements’ Assessment of Internal Control • Auditor Responsibilities for Understanding Internal Control

4. A. Internal Control Defined An entity’s system of internal control consists of policies and procedures designed to provide management with reasonable assurance that the company achieves its objectives and goals including: • Reliability of financial reporting • Compliance with applicable laws and regulations • Effectiveness and efficiency of operations

5. B. Reasonable Assurance Code the missing cash to bad debts. Reasonable assurance involves two considerations: • The cost of the entity’s internal control should not exceed the expected benefits. • Limitations exist in any entity’s internal control. Collusion

6. C. Section 404 Reporting Requirements for Management Section 404 of Sarbanes-Oxley requires the management of public companies to issue an internal control report that includes: • A statement that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting. • An assessment of the effectiveness of the internal control structure and procedures for financial reporting as of the end of the company’s fiscal year.

7. D. Key Components of Managements’ Assessment of Internal Control • Management must evaluate the design of internal control over financial reporting. • Management must test the operating effectiveness of those controls.

8. E. Auditor Responsibilities for Understanding Internal Control • Public and private companies – A sufficient understanding of internal control is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed. (2nd standard of fieldwork) • Public companies – Section 404 requires effort beyond that stated above so that the auditor can provide a report on internal controls that contains the following two opinions: • Whether management’s assessment of the effectiveness of internal control over financial reporting as of the end of the fiscal period is fairly stated in all material respects. • Whether the company maintained, in all material respects, effective internal control over financial reporting as of the specified date.

9. II. The Components of Internal Control The internal control framework for most U.S. companies is the Committee of Sponsoring Organizations of the Treadway Commission (COSO) Internal Control—Integrated Framework, issued in 1992. • The Control Environment • Risk Assessment • Control Activities • Information and Communication • Monitoring

10. The control environment is concerned with the actions, policies, and procedures that reflect the overall attitude of the client’s top management, directors, and owners of an entity about internal control and its importance. Integrity and ethical values Commitment to competence Board of directors and audit committee Management’s philosophy and operating style Organizational structure Assignment of authority and responsibility Human resource policies and practices A. The Control Environment

11. 1. Integrity and Ethical Values • Management actions to remove incentives that prompt a person to behave improperly. • Communication of behavioral standards by codes of conduct and example.

12. 2. Commitment to Competence Management’s consideration of the competence levels for specific jobs and how those translate into requisite skills and knowledge.

13. 3. Board of Directors and Audit Committee • Board delegates responsibility for internal control to management and is charged with regular independent assessments of management-established internal control. • The major stock exchanges require listed companies to have an audit committee composed of entirely independent directors who are financially literate.

14. 4. Management’s Philosophy and Operating Style Management, through its activities, provides clear signals to employees about the importance of internal control. For example, are sales and earnings targets unrealistic, and are employees encouraged to take aggressive actions to meet those targets.

15. 5. Organizational Structure Understanding the client’s organizational structure provides the auditor with an understanding of how the client’s business functions and implements controls.

16. Employee Job Descriptions 6. Assignment of Authority and Responsibility Formal methods of communication including: • Top management memoranda concerning internal control • Organizational operating plans • Employee job descriptions

17. 7. Human Resource Policies and Practices • If employees are honest and trustworthy, other controls can be absent and reliable financial statements will still result. • Methods by which persons are hired, trained, promoted, and compensated are important elements of internal control.

18. Client management’s identification and analysis of risks relevant to the preparation of the financial statements in accordance with GAAP. Client Management’s Risk Assessment Auditor Risk Assessment B. Risk Assessment

19. 1. Client Management’s Risk Assessment Client management assesses risk as part of designing and operating internal controls to minimize errors and fraud. Three steps involve: • Identify factors that may increase risk • Determine significance of risk and likelihood of occurrence • Develop specific actions to reduce risk to an acceptable level.

20. 2. Auditor Risk Assessment The auditor obtains knowledge about management’s risk assessment process by: • Determining how management identifies risks relevant to financial reporting • Evaluating their significance and likelihood of occurrence • Deciding the actions needed to address the risks.

21. Policies and procedures that client management has established to meet its objectives for financial reporting. Adequate segregation of duties Proper authorization of transactions and activities Adequate documents and records Physical control over assets and records Independent checks on performance C. Control Activities

22. 1. Adequate Segregation of Duties • Separation of the functions of authorization, recordkeeping, and custody. • Separating IT duties from User Departments

23. 2. Proper Authorization of Transactions and Activities • General authorization is permissible for routine events for which there are policies to follow. • For some transactions specific authorization is needed on a case-by-case basis.

24. 3. Adequate Documents and Records • Prenumbered consecutive documents so missing items are noticed • Prepared as near to transaction time as possible • Good design with instructions and appropriate spaces

25. 4. Physical Control Over Assets and Records • Deterrents to prevent physical access. • Access controls to prevent getting into computer system. • Backup and recovery procedures Incorrect Password

26. 5. Independent Checks on Performance Personnel are likely to forget or intentionally fail to follow procedures, or they may become careless unless someone observes and evaluates their performance.

27. Methods used to initiate, record, process, and report an entity’s transactions and to maintain accountability for related assets. For a small company with active involvement by the owner, a simple computerized accounting system that involves one honest, competent accountant may provide an adequate accounting system. A larger company requires a more complex system that includes carefully defined responsibilities and written procedures. D. Information and Communication

28. Client management’s ongoing and periodic assessment of the quality of internal control performance to determine whether controls are operating as intended and modified when needed. For many companies, especially larger ones, an internal audit department is essential for effective monitoring. To maintain internal audit independence, it is imperative that they be independent of operating and accounting departments; and that they report to a high level of authority, preferably the audit committee of the board of directors. E. Monitoring

29. III. Process for Understanding Internal Control and Assessing Control Risk • Phase 1: Obtain and Document Understanding of Internal Control: Design and Operation • Phase 2: Assess Control Risk • Phase 3: Design, Perform, and Evaluate Tests of Controls • Phase 4: Decide Planned Detection Risk and Substantive Tests

30. A. Phase 1: Obtain and Document Understanding of Internal Control • Three methods commonly used by auditors to obtain and document their understanding of the design of internal control are narratives, flowcharts, and internal control questionnaires (see Figure 10-4 on p. 286). • The auditor must also evaluate whether the designed controls are actually placed in operation. • PCAOB Standard 2 requires the auditor to perform at least one walkthrough for each major class of transactions. In a walkthrough, the auditor selects one or a few documents for the initiation of a transaction type and traces them through the entire accounting process.

31. B. Phase 2: Assess Control Risk Two specific assessments must be made to arrive at the preliminary assessment: • The first assessment is whether the entity is auditable. This is determined by considering the integrity of management and the adequacy of the accounting records. • Determine assessed control risk supported by the understanding obtained assuming the controls are being followed.

32. C. Phase 3: Design, Perform, and Evaluate Tests of Controls • If the results of tests of controls support the design and operating of controls as expected, the auditor uses the same assessed control risk as the preliminary assessment. Otherwise, assessed control risk must be reconsidered. • If the auditor wants a lower assessed control risk, more extensive tests of controls are applied. • PCAOB Standard 2 requires the auditor to determine whether controls are operating effectively at year end. The auditor may test at an interim date and later determine if changes have occurred.

33. D. Phase 4: Decide Planned Detection Risk and Substantive Tests • The greater the control risk (weak internal controls) the lower the detection risk the auditor can accept. • To lower detection risk, the auditor performs more substantive testing.

34. IV. Communications with the Audit Committee and Management As part of understanding internal control and assessing control risk, the auditor is required to communicate certain matters to the audit committee: • Significant deficiencies and material weaknesses must be communicated in writing to the audit committee as a part of every audit. Timely communication may help management in correcting the problem before their year-end report on internal control. • Less significant internal-control matters and recommendations for operational improvements may be communicated through a management letter. Although such letters are not required by auditing standards, they are often provided as a value-added service of the audit.

35. Summary • Internal control defined • Management and auditor responsibilities • The most prevalent internal control framework • Phases of understanding and assessing control risk • Communication of internal control matters Risk