Chapter 1:Auditing, Assurance, and

Internal Control

Hall & Singleton, 2e

AUDITING

Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and establishing criteria and communicating the results to interested users.

INTERNAL AUDITS

Internal auditing: independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization

Financial Audits Operational Audits Compliance Audits Fraud Audits IT Audits

CIA IIA

IT AUDITS

IT audits: provide audit services where processes or data, or both, are embedded in technologies.Subject to ethics, guidelines, and standards of the

profession (if certified) CISA Most closely associated with ISACA

Joint with internal, external, and fraud auditsScope of IT audit coverage is increasingCharacterized by CAATTs IT governance as part of corporate governance

FRAUD AUDITS

Fraud audits: provide investigation services where anomalies are suspected, to develop evidence to support or deny fraudulent activities.Auditor is more like a detectiveNo materialityGoal is conviction, if sufficient evidence of fraud

exists CFE ACFE

EXTERNAL AUDITS

External auditing: Objective is that in all material respects, financial statements are a fair representation of organization’s transactions and account balances.

SEC’s roleSarbanes-Oxley ActFASB - PCAOB

CPA AICPA

EXTERNAL vs. INTERNAL External auditing:

Independent auditor (CPA) Independence defined by SEC/S-OX/AICPA Required by SEC for publicly-traded companies Referred to as a “financial audit” Represents interests of outsiders, “the public” (e.g.,

stockholders) Standards, guidance, certification governed by AICPA, FASB,

PCAOB; delegated by SEC who has final authority Internal auditing:

Auditor (often a CIA or CISA) Is an employee of organization imposing independence on self Optional per management requirements Broader services than financial audit; (e.g., operational audits) Represent interests of the organization Standards, guidance, certification governed by IIA and ISACA

FINANCIAL AUDITS

An independent attestation performed by an expert (i.e., an auditor, a CPA) who expresses an opinion regarding the presentation of financial statements

Key concept: Independence {Should be} Similar to a trial by judge Culmination of systematic process involving:

Familiarization with the organization’s business Evaluating and testing internal controls Assessing the reliability of financial data

Product is formal written report that expresses an opinion about the reliability of the assertions in financial statements; in conformity with GAAP

ATTEST definition Written assertionsPractitioner’s written reportFormal establishment of measurement criteria or their

descriptionLimited to:

ExaminationReviewApplication of agreed-upon procedures

ATTEST vs. ASSURANCE

ASSURANCEProfessional services that are designed to improve

the quality of information, both financial and non-financial, used by decision-makers

IT Audit Groups in “Big Four” IT Risk Management I.S. Risk ManagementOperational Systems Risk ManagementTechnology & Security Risk ServicesTypically a division of assurance services

AUDITING STANDARDS

Auditing standardsSet by AICPAAuthoritative#1 = Ten Generally Accepted Auditing Standards

(GAAS)Three categories:

General StandardsStandards of Field WorkReporting Standards

# 2 = Statements on Auditing Standards (SASs)SAS #1 issued by AICPA in 1972

AUDITS

Systematic process Five primary management assertions, and

correlated audit objectives and procedures [Table 1-1]

Existence or OccurrenceCompletenessRights & ObligationsValuation or AllocationPresentation or Disclosure

AUDITS

Phases [Figure 1-3]

1. Planning2. Obtaining evidence

Tests of Controls Substantive Testing

CAATTs Analytical procedures

3. Ascertaining reliability MATERIALITY

4. Communicating results Audit opinion

Audit Risk Formula

AUDIT RISK:The probability that the auditor

will give an inappropriate opinion on the financial statements: that is, that the statements will contain materials misstatement(s) which the auditor fails to find

Audit Risk Formula

INHERENT RISK:The probability that material

misstatements have occurredMaterial vs. Immaterial

Includes economic conditions, etc.Relative risk (e.g., cash)

Audit Risk Formula

CONTROL RISK:The probability that the internal controls

will fail to detect material misstatements

Audit Risk Formula

DETECTION RISK:The probability that the audit

procedures will fail to detect material misstatements

Substantive procedures

Audit Risk Formula

AUDIT RISK MODEL:AR = IR * CR * DRexample inventory with:

IR=40%, CR=60%, AR=5% (fixed).05 = .4 * .6 * DR... then DR=4.8%

Why is AR = 5%?What is detection risk?Can CR realistically be 0?Relationship between DR and substantive

procedures

Audit Risk Model

Relationship between tests of controls and substantive tests Illustrate higher reliability of the internal controls and

the Audit Risk ModelWhat happens if internal controls are more reliable than last

audit?Last year: .05 = .4 * .6 * DR [DR = 4.8]This year: .05 = .4 * .4 * DR [DR = 3.2] The more reliable the internal controls, the lower the CR

probability; thus the lower the DR will be, and fewer substantive tests are necessary.

Substantive tests are labor intensive

Role of Audit Committee

Selected from board of directors Usually three members Outsiders (S-OX now requires it) Fiduciary responsibility to shareholders Serve as independent check and balance

system Interact with internal auditors Hire, set fees, and interact with external auditors Resolved conflicts of GAAP between external

auditors and management

What is an IT Audit?

… most accounting transactions to be in electronic form without any paper documentation because electronic storage is more efficient. … These technologies greatly change the nature of audits, which have so long relied on paper documents.

THE IT ENVIRONMENT

There has always been a need for an effective internal control system.

The design and oversight of that system has typically been the responsibility of accountants.

The I.T. Environment complicates the paper systems of the past.Concentration of dataExpanded access and linkages Increase in malicious activities in systems vs. paperOpportunity that can cause management fraud (i.e.,

override)

THE IT ENVIRONMENT

Audit planning

Tests of controls

Substantive testsCAATTs

INTERNAL CONTROL

is … policies, practices, procedures … designed to …

safeguard assetsensure accuracy and reliabilitypromote efficiencymeasure compliance with policies

BRIEF HISTORY - SEC

SEC acts of 1933 and 1934

“Ivar Kreuger’s Contribution to U.S. Financial Reporting,” Accounting Review, Flesher & Flesher

All corporations that report to the SEC are required to maintain a system of internal control that is evaluated as part of the annual external audit.

BRIEF HISTORY - Copyright

Federal Copyright Act 1976

1. Protects intellectual property in the U.S.2. Has been amended numerous times since3. Management is legally responsible for violations of

the organization4. U.S. government has continually sought

international agreement on terms for protection of intellectual property globally vs. nationally

BRIEF HISTORY - FCPA

Foreign Corrupt Practices Act 19771. Accounting provisions

FCPA requires SEC registrants to establish and maintain books, records, and accounts.

It also requires establishment of internal accounting controls sufficient to meet objectives.

1. Transactions are executed in accordance with management’s general or specific authorization.

2. Transactions are recorded as necessary to prepare financial statements (i.e., GAAP), and to maintain accountability.

3. Access to assets is permitted only in accordance with management authorization.

4. The recorded assets are compared with existing assets at reasonable intervals.

2. Illegal foreign payments

BRIEF HISTORY - COSO

Committee on Sponsoring Organizations - 1992

1. AICPA, AAA, FEI, IMA, IIA

2. Developed a management perspective model

for internal controls over a number of years

3. Is widely adopted

BRIEF HISTORY – S-OX

Sarbanes-Oxley Act - 20021. Section 404: Management Assessment of Internal

Control Management is responsible for establishing and maintaining

internal control structure and procedures. Must certify by report on the effectiveness of internal control

each year, with other annual reports.

2. Section 302: Corporate Responsibility for Incident Reports Financial executives must disclose deficiencies in internal

control, and fraud (whether fraud is material or not).

Modifying Assumptions

1. Management responsibility

2. Reasonable assurance no I.C.S. is perfect benefits => costs

3. Methods of data processing Objectives same regardless of DP method Specific controls vary w/different

technologies

Modifying Assumptions

4. Limitations Possibility of error Possibility of circumvention Management override Changing conditions

EXPOSURES AND RISK

Exposure (definition)

Risks (definition)

Types of riskDestruction of assetsTheft of assetsCorruption of information or the I.S.Disruption of the I.S.

THE P-D-C MODEL

Preventive controlsDetective controlsCorrective controls

Which is most cost effective?Which one tends to be proactive measures?Can you give an example of each?

Predictive controls

SAS 78: Consideration of Internal Control in a Financial Statement Audit

• COSO (Treadway Commission)The control environmentRisk assessmentInformation & communicationMonitoringControl activities

SAS 78(#1:Control Environment -- elements)

Describe how each one could adversely affect internal control.

The integrity and ethical valuesStructure of the organizationParticipation of audit committeeManagement’s philosophy and styleProcedures for delegating

SAS 78 (#1:Control Environment -- elements)

Management’s methods of assessing performance

External influencesOrganization’s policies and practices for

managing human resources

SAS 78 (#1:Control Environment -- techniques)

Describe possible activity or tool for each. Assess the integrity of organization’s

management Conditions conducive to management fraud Understand client’s business and industry Determine if board and audit committee are

actively involved Study organization structure

SAS 78 (#2:Risk Assessment)

Changes in environment Changes in personnel Changes in I.S. New IT’s Significant or rapid growth New products or services (experience) Organizational restructuring Foreign markets New accounting principles

SAS 78 (#3:Information & Communication-elements)

Initiate, identify, analyze, classify and record Initiate, identify, analyze, classify and record economic transactions and events.economic transactions and events.

Identify and record all valid economic transactions

Provide timely, detailed informationAccurately measure financial valuesAccurately record transactions

SAS 78(#3:Information & Communication-techniques)

Auditors obtain sufficient knowledge of I.S.’s to understand:Classes of transactions that are materialAccounting records and accounts usedProcessing steps:initiation to inclusion in

financial statements (illustrate)Financial reporting process (including

disclosures)

SAS 78(#4: Monitoring)

By separate procedures (e.g., tests of controls)

By ongoing activities (Embedded Audit Modules – EAMs and Continuous Online Auditing - COA)

SAS 78(#5: Control Activities)

Physical Controls (1-3)Transaction authorization

Example: Sales only to authorized customer Sales only if available credit limit

Segregation of dutiesExamples of incompatible duties:

Authorization vs. processing [e.g., Sales vs. Auth. Cust.] Custody vs. recordkeeping [e.g., custody of inventory vs.

DP of inventory] Fraud requires collusion [e.g., separate various steps in

process]

SupervisionServes as compensating control when lack of segregation

of duties exists by necessity

Physical Controls (4-6)Accounting records (audit trails; examples)Access controls

Direct (the assets) Indirect (documents that control the assets)Fraud Disaster Recovery

Independent verificationManagement can assess:

The performance of individuals The integrity of the AIS The integrity of the data in the records Examples

IT Risks Model

OperationsData management systemsNew systems developmentSystems maintenanceElectronic commerce (The Internet)Computer applications