Consideration of Internal Control

CONSIDERATION OF INTERNAL CONTROL
INTERNAL CONTROL is the process designed and affected by those charged with
governance, management, and other personnel to provide reasonable assurance about the achievement
of the entity’s objectives with reliability of FINANCIAL REPORTING, effectiveness and efficiency of
operations and compliance with applicable laws and regulations.
 In the audit of FS, the auditor is only concerned with those policies and procedures within the
accounting and internal control systems that are relevant to the financial statement assertions,
 Components of Internal Control:
1. Control Environment – includes the attitudes, awareness, and actions of the mgmt. and those
charged with governance concerning the entity’s IC and its importance in the entity.
 Integrity and ethical values
 Mgmt. philosophy and operating style
 Active participation of those charged w/ governance
 Commitment in competence
 Personnel policies and procedures
 Assignment of responsibility and authority/ organizational structure
2. Risk Assessment – mgmt. should adopt policies and procedures that are designed to identify
and analyze business risks.
For audit purposes, the auditor is only concerned with risks that are relevant to preparation of
reliable financial statements.
 Business risk – is the risk that the entity’s business objectives will not be attained as a
result of internal and external factors such as technological developments, changes in
customer demand, etc.
3. Information and Communication Systems
An information system encompasses methods and records that:
 Identify and record all valid transactions,
 Describe on a timely basis the transactions in sufficient detail to permit proper
classification,
 Measure transactions in their proper monetary value,
 Determine the time period to permit recording of transactions in proper accounting
period, and
 Present properly the transactions and disclosures in FS.
Communication involves providing an understanding of individual roles and responsibilities
pertaining to internal control over financial reporting.
4. Control Activities – are policies and procedures that help ensure that mgmt. directives are
carried out. Specific control procedures that are relevant to FS audit would include:
 Performance reviews- review and analysis of actual performance vs. budgets, forecasts,
and PY’s.
 Information Processing – to check accuracy, completeness, and authorization of
transactions.
 Physical Controls – physical security of assets, authorization for access to programs and
data files, periodic counting and comparison w/ amounts shown on control records.
 Segregation of Duties – assigning different people the responsibilities of authorizing
transactions, recording transactions, and maintaining custody of assets.
5. Monitoring – the process of assessing the quality of internal control performance over time.
 Auditors are not responsible for establishing and maintaining an entity’s accounting and internal
control systems: that is the responsibility of the management.
STEPS IN CONSIDERATION INTERNAL CONTROL

1. OBTAIN UNDERSTANDING OF THE INTERNAL CONTROL
 Evaluating the design of a control
 This can be obtained by: making inquiries of appropriate individuals, inspecting
documents and records, and observing entity’s activities and operations.
 Determining whether it has been implemented

 This can be accomplished by performing a WALK-THROUGH TEST. This involves tracing
one or two transactions through the entire accounting systems, from their initial
recording at source to their final destination as a component of an account balance in
the FS.
2. DOCUMENT THE UNDERSTANDING OF ACCOUNTING AND INTERNAL CONTROL SYSTEMS
 This documentation need not be in particular from. Some commonly used forms are:
narrative description, flowchart and diagrams of flow of transactions, internal control
questionnaire providing mgmt. responses
3. ASSESS THE LEVEL OF CONTROL RISK
 If ICs related to a particular assertion is not effective, the auditor may assess the control
risk at high level.
 If the auditor concludes that it is more efficient to rely on entity’s IC, the auditor would
plan to assess control risk at less than high level.
4. PERFORM TEST OF CONTROLS

TEST OF CONTROLS – are performed to obtain evidence about the effectiveness of the:
 Design of the accounting and internal control systems; or
 Operation of the internal control through the period
 According to PSA, the auditor should obtain audit evidence through test of control to support
any assessment of control risk at less than high level. The lower assessment of control risk, the
more support the auditor should obtain that the IC is suitably designed and operating
effectively.
 Nature of Test of Controls
 Inquiry – searching for appropriate information about the effectiveness of internal
control from knowledgeable persons inside or outside the entity.
 Observation – refers to looking at the process being performed by others.
 Inspection – involves examination of documents and records to provide evidence of
reliability depending on their nature and source and the effectiveness of IC over their
processing
 Reperformance – involves repeating the activity performed by the client to determine
whether proper results were obtained.
 Timing of tests of controls: auditors usually perform tests of controls during an interim visit, in
advance of period end. However, auditors cannot rely on it w/o considering the need to obtain
further evidence on the remainder of the period.
In determining whether or not to test the remaining period, these must be considered: the
results of the interim tests, the length of the remaining period, and whether changes have
occurred in accounting and internal control systems during the remaining period.
 Extent of test of controls: The auditor cannot examine all transactions related to certain control
procedures. In an audit, the auditor should examine the size of a sample suffiecient to support
the assessed level of control risk.
 Operating effectiveness vs. implementation
- When obtaining audit evidence of implementation by performing risk assessment
procedures, the auditor determines that the relevant controls exist and the entity is using
them.
- When performing tests of the operating effectiveness of controls, the auditor obtains audit
evidence that controls operate effectively. This includes obtaining evidence about how
controls were applied at relevant times during period under audit, the consistency which
they were applied, and by whom or by what means they were applied.
 Documenting the assessed level of control risk
- If the control risk is assessed at high level, the auditor should document his conclusion
that the control risk is at high level.
- If the control risk is assessed at less than high level, the auditor should document his
conclusion that control risk is less than high level and the basis for the assessment (basis
is actually the results of TOC)/
 Communication of Internal Control Weaknesses

- Auditor is required to report the matter to the appropriate level of mgmt., material
weakness in the design or operation of the accounting and IC systems.
- Auditors are not required to search for and/or identify material control weaknesses.
- Internal control weaknesses are documented in a formal management letter.
What is the relationship between internal control and internal audit?.

→ The internal control is a preventive tool employed to achieve specific objectives. The internal
audit is a detective tool employed to verify the extent of executive units’ compliance with
established controls. the relationship between internal control and internal audit is that there
is a complementary relationship where the internal control establishes the controls based on
which a business entity should be managed while the internal audit represents a detective
activity, which verifies the implementation of internal controls. This complementary
relationship is further confirmed by the matching objectives of internal control and internal
audit as both disciplines are ultimately intended to protect the shareholders – the entity’s
owners.
1. What is Substantive testing?

→ Substantive tests are audit procedures designed to substantiate the account balances or to
detect matrial misstatements in the financial statements
2. What are the three types of substantive tests?
→ The three types of substantive tests are analytical procedures, a test of details of
transactions, and tests of details of balances.
3. What is a substantive test of detail?
→ test of detail involves examining the actual details making up the various account balances.
This approach maybe take theform of test of details of balances or test details of transaction.
4. What is test of control and substantive test?
→ Test of control provide evidence that indicate a misstatement islikely occur. Substantive test,
on the other hand, provide evidence about the existence of misstatement in an account
balance.
5. What are the two types of substantive procedures?
→ The two types of substantive procedures are analytical procedures and tests of detail.
Analytical procedures generally provide less reliable evidence than the tests of detail.
6. What are the 3 types of audits?
→ The 3 types of audits are external audits, internal audits, and Internal Revenue Service (IRS)
audits.
7. What is the advantage of substantive test sample?
→ It is one of efficiency. Where client’s are smaller and less complicated,it isgenerally less
costly tonottest controls, but to focus the audit workon the balance sheet as of the end of the
client’s fiscal year. Furtheremore, by going into the client’s office of at one point in timeand
doing the entire audit, auditor scheduling problems are reducedand there is less disruption to
the client
8. Can you describe substantive tests?
→ substantive tests are those activities performed by the auditor during the substantive testing
stage of the audit that gather evidence as to the completeness, validity and/ or accuracy of
account balances and underlying classes of transeaction.
9. Is Test of details a substantive procedures?
→ Yes it is because the Test of details is a types of substantive procedures.

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CONSIDERATION OF INTERNAL CONTROL

STEPS IN CONSIDERATION INTERNAL CONTROL

 Determining whether it has been implemented

4. PERFORM TEST OF CONTROLS

 Communication of Internal Control Weaknesses

What is the relationship between internal control and internal audit?.

1. What is Substantive testing?

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