1 evaluation of internal control system. 2 learning objective 1 contrast management’s need for...

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Evaluation of Internal ControlSystem

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Learning Objective 1

Contrast management’s need for

internal control with the auditor’s

need to consider internal control

when designing an audit.

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Internal Controls - Definition• "Internal control system" means all the policies and

procedures (internal controls) adopted by the management of an entity to assist in achieving management's objective of ensuring, as far as practicable,– the orderly and efficient conduct of its business,

including adherence to management policies, – the safeguarding of assets, – the prevention and detection of fraud and error, – the accuracy and completeness of the accounting

records, – and the timely preparation of reliable financial

information.

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InherentLimitations

ReasonableAssurance

Management’sResponsibility

Key Concepts

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Client’s Concerns

Compliance with applicable laws and regulations

Reliability of financial reporting

Efficiency and effectiveness of operations

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Auditor Concerns

Controls over classes of transactions(more than on account balances)

Controls related to reliability of financial reporting

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Explain the components

of internal control.

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Internal Controls – 2 Components(a) “The Control Environment“:

Which means the overall attitude, awareness and actions of directors and management regarding the internal control system and its importance in the entity. Factors affecting include:

– The function of the board of directors and its committees.

– Management's philosophy and operating style.– The entity's organizational structure and methods

of assigning authority and responsibility.– Management's control system including the internal

audit function, personnel policies and procedures and segregation of duties.

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Internal Controls – 2 Components(b) "control procedures" which means those

policies and procedures in addition to the control environment which management has established to achieve the entity's specific objectives.

“SPAM SOAP”

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Adequate Separationof Duties

A transaction can be dissected as follows;

C = Custody

A = Authority

R = Recording

E = Execution

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Proper Authorization of Transactions and Activities

General authorization

Specific authorization

General policies to be followed. Approves all transactions within the limits set by the policy.

Relates to the authorization of individual transaction

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Adequate Documentsand Records

Prenumbered consecutively

Prepared at the time of transaction

Designed for multiple uses

Constructed to encourage correct preparation

Simple enough to ensure understanding

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Physical Control overAssets and Records

Physical precautions

Controls related to IT equipment,programs, and data files

Physicalcontrols

Accesscontrols

Backup andrecovery

procedures

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Independent Checkson Performance

The need for independent checksarise because internal control tendsto change over time unless there isa mechanism for frequent review.

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The Accounting System

"Accounting system" means the series of tasks and records of an entity by which transactions are processed as a means of maintaining financial records. Such systems identify, assemble, analyze, calculate, classify, record, summarize and report transactions and other events.

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The Accounting System - Objectives–Transactions are executed in accordance with management's general or specific authorization.–All transactions and other events are promptly recorded in the correct amount, in the appropriate accounts and in the proper accounting period so as to permit preparation of financial statements in accordance with the Sri Lanka Accounting Standards. –Access to assets and records is permitted only in accordance with management's authorization.–Recorded assets are compared with the existing assets at reasonable intervals and appropriate action is taken regarding any differences.

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Explain methods used to

obtain an understanding

of internal control.

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Understanding Internal Controland Assessing Control Risk

Obtain Understanding of Internal Control:Design and Operation

Assess Control Risk Test Controls

Decide Planned Detection Riskand Substantive Tests

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Reasons for Sufficiently Understanding Internal Control

SLAuS requires the auditor toobtain an understanding of internal

control for every audit.

Minimum auditplanning matters

• Auditability• Potential material

misstatements• Detection risk• Design of test

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Procedures to DetermineDesign and Placement

Update and evaluate auditor’s previousexperience with the entity.

Make inquires of client personnel.

Read client’s policy and systems manuals.

Examine documents and records.

Observe entity activities and operations.

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Documentation ofthe Understanding

Narrative(139)

Narrative(139)

FlowchartFlowchart Internalcontrol

Questionnaire(141)

Internalcontrol

Questionnaire(141)

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Assess control risk by linking

strengths and weaknesses of

internal control to transaction-

related audit objectives.

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Assess Control Risk

Obtain sufficient understanding for planning.

Assess whether the entity is auditable.

Determine assessed control risk.

Assess if a lower control risk could be supported.

Determine the appropriate assessed control risk.

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Assess Control Risk

Identify transaction-related audit objectives.

Identify specific controls.

Identify and evaluate weaknesses.

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Identify and Evaluate Weaknesses

Identify existing controls.

Identify the absence of key controls.

Determine misstatements that could result.

Consider compensating controls.

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Communication• As a result of obtaining an understanding of the

accounting and internal control systems and tests of control, the auditor may become aware of weaknesses in the systems. The auditor should make management aware, as soon as practical and at an appropriate level of responsibility, of material weaknesses in the design or operation of the accounting and internal control systems, which have come to the auditor's attention. The communication to management of material weaknesses would ordinarily be in writing.

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Describe the process of designing

and performing tests of controls.

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The Need for Test of Controls

If the auditor, after obtaining an understanding of the accounting system and control environment, expects to be able to rely on his assessment of control risk to reduce the extent of substantive procedures, he should make a preliminary assessment of control risk for material financial statement assertions, and plan and perform tests of control to support that assessment.

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Tests of Controls

The procedures to test effectivenessof controls in support of a reduced

assessed control risk are calledtests of controls.

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Procedures forTests of Controls

Make inquiries of client personnel.

Examine documents, records, and reports.

Observe control-related activities.

Reperform client procedures.

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Extent of Procedures

Reliance on evidence from prior year’s audit

Testing less than the entire audit period

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Decide Planned Detection Riskand Design Substantive Tests

The auditor uses the results of the control riskassessment process and tests of controls todetermine the planned detection risk and

related substantive tests.

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The level of detection risk relates directly to the auditor's substantive procedures. The auditor's control risk assessment, together with the inherent risk assessment, influences the nature, timing and extent of substantive procedures to be performed to reduce detection risk, and therefore audit risk, to an acceptably low level. Some detection risk would always be present even if an auditor were to examine 100 percent of the account balance or class of transactions because, for example, most audit evidence is persuasive rather than conclusive.

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The auditor should consider the assessed levels of inherent and control risks in determining the nature, timing and extent of substantive procedures required to reduce audit risk to an acceptable level..