Section 404 Audits of Internal Control and Control Risk

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

2. Internal Control Objectives Reliability of financial reporting Efficiency and effectiveness of operations Compliance with laws and regulations

3. Management’s Responsibilities For Internal Control Management - responsible for establishing and maintaining internal control I/C offers reasonable assurance I/C has inherent limitations

4. Management’s Responsibilities For Internal Control Management’s Section 404 reporting responsibilities • Design of internal control over financial reporting • Focus is on controls over mgmt. assertions (Ch 6) • Operating effectiveness of controls • Must be tested and evaluated for effectiveness

5. Auditor Responsibilities Related to Internal Control Second standard of fieldwork: A sufficient understanding of internal controlis to be obtained in order to plan the audit and to determine the nature,timing, and extent of tests to be performed. Control over classes of transactions (vs. account balances) Auditor responsibilities for testing and reporting (Ch. 2) on internal control

6. Five Components of Internal Control Control environment Risk assessment Information and communication Control activities Monitoring

7. The Control Environment Actions, policies and procedures that reflect overall attitudes of top management (“tone from the top”) • Integrity and ethical values • Commitment to competence • Board of directors or audit committee participation • Management’s philosophy and operating style • Organizational structure • Assignment of authority and responsibility • Human resources policies and practices

8. Risk Assessment For audit purposes: management’s identification and analysis of risks relevant to the preparation of financial statements in conformity with GAAP.

9. Control Activities Policies and procedures (in addition to those in the Other four components) • Adequate separation of duties • Proper authorization of transactions and activities • Adequate documents and records • Physical control over assets and records • Independent checks on performance

10. Custody of assets Accounting from Authorization of transactions The custody of related assets from Operational responsibility Record-keeping responsibility from IT duties User departments from Adequate Separation of Duties

11. Proper Authorization of Transactions and Activities General authorization – policies for the organization to follow. Specific authorization – applies to Individual transactions

12. Adequate Documents and Records Prenumbered consecutively Prepared at the time of transaction Simple enough to ensure understanding Designed for multiple use Constructed to encourage correct preparation

13. Physical Control over Assetsand Records The most important measure for safeguarding assets and records is the use of physical precautions – limit access to assets/records.

14. Independent Checks on Performance The need for independent checks arises because internal controls tend to change over time unless there is a mechanism for frequent review.

15. Information and Communication The purpose of an accounting information and communication system is to… initiate, record, process, and report the entity’s transactions and to maintain accountability for the related assets.

16. Monitoring Monitoring activities deal with 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.

17. How the Size of the Business Affects Internal Control In general the SEC believes that small businesses should be expected to adhere to the same internal control standards that apply to larger public companies. The SEC has also stated that the burden to smaller companies can be disproportionate.

18. Phase 1 Obtain an understanding of internal control: design and operation Phase 3 Design, perform, and evaluate tests of controls Phase 2 Assess control risk. Phase 4 Decide planned detection risk and substantive tests. Four Phases of a Financial Statement Audit

19. Obtain and Document Understanding of Internal Control SAS 55 and PCAOB Standard 2 both require the auditor to obtain an understanding of internal control for every audit. • Procedures to obtain an understanding: • Design of internal controls • Whether placed in operation • Uses this information as a basis for the • integrated audit.

20. Methods Used Narrative Flowchart Internal control questionnaire

21. Narrative 1. The origin of every document and record in the system 2. All processing that takes place 3. The disposition of every document and record in the system 4. An indication of the controls relevant to the assessment of control risk

22. Evaluating Internal Control Operation Update and evaluate auditor’s previous experience with the entity. Make inquiries of client personnel. Examine documents and records. Observe entity activities and operations. Perform walkthroughs of the accounting system.

23. Assess Control Risk Assess whether the financial statements are auditable. Determine assessed control risk supported by the understanding obtained assuming the controls are being followed. Use of a control risk matrix to assess control risk

24. Control Risk Matrix Identify transaction-related audit objectives. Identify existing controls. Associate controls with transaction-related audit objectives. Identify and evaluate control deficiencies, significant deficiencies, and material weaknesses

25. SIGNIFICANCE Material LIKELIHOOD Remote Probable Immaterial Evaluating Significant Control Deficiencies Material Weakness

26. Communicate Internal Control Deficiencies and Related Matters • Audit committee communications • Significant deficiencies and material • weaknesses must be communicated Management letters

27. Tests of Controls The procedures to test effectiveness of controls in support of a reduced assessed control risk are called tests ofcontrols.

28. Procedures for Tests of Controls 1. Make inquiries of client personnel. 2. Examine documents, records, and reports. 3. Observe control-related activities. 4. Reperform client procedures.

29. Extent of Procedures • PCAOB 2 requires public company auditors • to test controls each year for all relevant assertions • for all significant accounts and transactions • Reliance on evidence from prior year’s audit • PCAOB 2 is concerned with adequacy of I/C as of • the end of the fiscal year • Timing of tests depends on the nature of controls • and frequency at which they are performed.

30. Procedures to Obtain an Understanding vs.Tests of Controls In obtaining an understanding, procedures are applied to all controls to identify those likely to prevent/detect Material misstatements in specified assertions. Test of of controls are applied only when the assessed control risk has not been done in obtaining an understanding. Procedures to obtain an understanding are performed on fewtransactions, while tests of controls are performed on larger samples.

31. Assessed control risk Type of procedure High level: Procedures to obtain an understanding Lower level: Tests of controls Inquiry Documentation Observation Reperformance Yes–extensive Yes–with transaction walk-through Yes–with transaction walk-through No Yes–some Yes–using sampling Yes–at multiple times Yes–using sampling Relationship of Assessed ControlRisk and Extent of Procedures (Table 10-3)

32. Decide Planned Detection Risk and Design Substantive Tests The auditor uses the results of the control risk assessment process and tests of controls to determine the planned detection risk and related substantive tests. The auditor links the control risk assessments to the balance-related audit objectives.

33. 1 The auditor’s opinion on 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. Section 404 Reporting on Internal Control

34. Section 404 Reporting on Internal Control 2 The auditor’s opinion on whether the company maintained, in all material respects, effective internal control over financial reporting as of the specified date.

35. Types of Opinions on Internal Controls Over Financial Reporting • Unqualified – • No identified material weaknesses • No scope limitations • Adverse • Material weaknesses exist • Qualified or disclaimer of opinion • Scope limitation

36. Internal controls over financial reporting Internal controls used to assess control risk below maximum Controls that must be tested in an audit of internal controls (ICFR opinion expressed) Controls that must be tested in an audit of financial statements Differences in Scope of Controls Tested: Nonpublic Company