MODULE 3

Park Avenue CPA ReviewPark Avenue CPA ReviewJoseph A. Maffia, CPAJoseph A. Maffia, CPA

Park Avenue CPA ReviewPark Avenue CPA ReviewJoseph A. Maffia, CPAJoseph A. Maffia, CPA

JMaffia@ParkAveCPAReview.JMaffia@ParkAveCPAReview.comcom

Joseph A. Maffia, CPAJoseph A. Maffia, CPA

JMaffia@ParkAveCPAReview.JMaffia@ParkAveCPAReview.comcom

Joseph A. Maffia, CPAJoseph A. Maffia, CPA

Understanding Internal control The second standard of fieldwork states:

A sufficient understanding of the entity and its environment, including internal control, to assess the risk of material misstatement of the financial statements whether due to error or fraud to design the nature timing and extent of further audit procedures.

Summary of Internal Control Definition A process, effected by the entity’s board of

directors, management, and other personnel, designed to provide reasonable assurance regarding, achievement of (the entity’s) objectives on:– Effectiveness and efficiency of operations– Reliability of financial reporting– Compliance with applicable laws and

regulations

Control Objectives

• In each area of internal control (financial reporting, operations and compliance)– Control objectives and– Sub objectives exist

• Example: Area of financial reporting– Top level objective – prepare and issue reliable financial information– Detailed level applied to A/R sub objectives

• All goods shipped are accurately billed in the proper period• Invoices are accurately recorded for all authorized shipments and only for

such shipments• Authorized and only authorized sales returns and allowances are

accurately recorded• The continued completeness and accuracy of A/R is ensured• Accounts receivable records are safeguarded

Controls over Financial Reporting• Preventive

– Aimed at avoiding the occurrence of misstatements in the financial statements

– Example: Segregation of duties• Detective

– Designed to discover misstatements after they have occurred– Example: Monthly bank reconciliations

• Corrective– Needed to remedy the situation uncovered by detective controls– Example: Backups of master file

• Controls overlap– Complementary – function together– Redundant – address same assertion or control objective– Compensating – reduces risk existing weakness will result in misstatement

Components of Internal Control

• CA

• CERAMIC

Components of Internal Control

• The Control Environment

• Risk Assessment

• The Accounting Information and Communication System

• Control Activities

• Monitoring

Control Environment Factors“ICHAMBO”

• Integrity and ethical values• Commitment to competence• Human resource policies and practices• Assignment of authority and responsibility• Management philosophy and operating style• Board of directors or audit committee• Organizational structure

Control Activities “PIPS”

• Performance reviews ( reviews of act vs. budget, forecasts, etc)

• Information processing (controls that check accuracy, completeness and authorization of transactions.

• Physical controls ( activities that assure the physical security of assets and records)

• Segregation of duties ( separate authorization, recording, and custody)

Control Activities Monitoring

• Internal Control Performance over time• Ongoing – recurring activities• Separate evaluations• Combination

COSO Components Defined

Control Environment• The control environment sets the tone of an organization, influencing the control

consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Control environment factors include the integrity, ethical values and competence of the entity's people; management's philosophy and operating style; the way management assigns authority and responsibility and organizes and develops its people; and the attention and direction provided by the board of directors.

Risk Assessment• Every entity faces a variety of risks from external and internal sources that must be

assessed. A precondition to risk assessment is establishment of objectives, linked at different levels and internally consistent. Risk assessment is the identification and analysis of relevant risks to achievement of the objectives, forming a basis for determining how the risks should be managed. Because economic, industry, regulatory and operating conditions will continue to change, mechanisms are needed to identify and deal with the special risks associated with change.

Control Activities Control activities are the policies and procedures that help ensure management directives

are carried out. They help ensure that necessary actions are taken to address risks to achievement of the entity's objectives. Control activities occur throughout the organization, at all levels and in all functions. They include a range of activities as diverse as approvals, authorizations, verifications, reconciliations, reviews of operating performance, security of assets and segregation of duties.

COSO Components Defined (cont.)

Information and Communication• Pertinent information must be identified, captured and communicated in a form and

timeframe that enables people to carry out their responsibilities. Information systems produce reports, containing operational, financial and compliance-related information, that make it possible to run and control the business. They deal not only with internally generated data, but also information about external events, activities and conditions necessary to informed business decision-making and external reporting. Effective communication also must occur in a broader sense, flowing down, across and up the organization. All personnel must receive a clear message from top management that control responsibilities must be taken seriously. They must understand their own role in the internal control system, as well as how individual activities relate to the work of others. They must have a means of communicating significant information upstream. There also needs to be effective communication with external parties, such as customers, suppliers, regulators and shareholders.

Monitoring• Internal control systems need to be monitored -- a process that assesses the quality of

the system's performance over time. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Ongoing monitoring occurs in the course of operations. It includes regular management and supervisory activities, and other actions personnel take in performing their duties. The scope and frequency of separate evaluations will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures. Internal control deficiencies should be reported upstream, with serious matters reported to top management and the board.

Financial Statement Assertions

• Relevant assertions are those that, without regard for controls, have a reasonable possibility of containing a material misstatement; types– Assertions about account balances (Accounts)– Assertions about classes of transactions and

events (Transactions)– Assertions about presentation and disclosure

(Disclosures)

Financial Statement Assertions: Auditing Standards Board

and International Standards Accounts Transactions Disclosures

Existence Occurrence Occurrence

Rights and obligations

Rights and obligations

Completeness Completeness Completeness

Valuation and allocation

Accuracy Accuracy and valuation

Cutoff

Classification Classification and understandability

Combined Assertions “PERVC”

• Presentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed

• Existence or Occurrence--Assets, liabilities, and equity interests exist and recorded transactions have occurred

• Rights and Obligations--The company holds rights to the assets, and liability are the obligations of the company

• Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts

• Completeness and Cutoff--All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded. Transactions and events have been recorded in the correct accounting period

Documenting the Understanding of Internal Control

• Questionnaires– Typically standardized by firm

• Written Narratives– Memos that describe flow of transactions

• Flowcharts– Systems flowcharts

• Walk-through– Trace one or two transaction through cycle

• Decision tables

Limitations of Internal Control

• Errors may arise from misunderstandings of instructions, mistakes of judgment, fatigue, etc.

• Controls that depend on the segregation of duties may be circumvented by collusion

• Management may override the structure

• Compliance may deteriorate over time

• Cost constraints

• Custom and cultural limitations

Foreign Corrupt Practices Act

• Passed in 1977 in response to American corporation practice of paying bribes and kickbacks to officials in foreign countries to obtain business

• The Act– Requires an effective system of internal control– Makes illegal payment of bribes to foreign officials– Applies to SEC corporations – Accurate set of books

Committee for sponsoring organizations of the Treadway

Commission

Sponsoring organizationsAmerican Accounting AssociationAICPAFinancial Executives InternationalThe Association for Accountants and Financial Professionals in BusinessThe Institute of Internal Auditors

Who are the sponsors?

22

• The Committee of Sponsoring Organizations of the Treadway Commission (COSO), was formed in 1985 to improve the quality of financial reporting through business ethics, effective internal controls and corporate governance. Based on these principles, they developed and published the COSO framework in 1992 as a foundation for establishing internal control systems and determining their effectiveness.

• Coso provides the framework for internal control – which is used to evaluate the internal control of an organization.

• www.coso.org

Auditors’ Overall Approach with Internal Control

• Overall approach of an audit1. Plan the audit2. Obtain an understanding of the client and its environment,

including internal control3. Assess the risks of material misstatement and design further

audit procedures4. Perform further audit procedures5. Complete the audit6. Form an opinion and issue the audit report

• Steps 2-4 relate most directly to the role of internal control in financial statement audits

Relationships Among Deficiencies

Deficiency inInternal Control

Less than Significant MaterialSignificant Deficiency Weakness

PCAOB Audits

Integrated audits

Sarbanes-Oxley Act of 2002

• Section 404– 404(a) – requires annual report filed with SEC to

include an internal control report• Management acknowledges responsibility for establishing

and maintaining adequate internal control• Provides assessment of internal control effectiveness at end

of fiscal year

– 404(b) – requires CPA firm to audit internal control and express an opinion on effectiveness of internal control. (Required for companies with a capitalization in excess of $75,000,000)

Management’s Report on Internal Control under Section 404a

• Acknowledgment of responsibility for internal control

• An assessment of internal control effectiveness as of the last day of the company’s fiscal yearn using suitable criteria

• Support the evaluation with sufficient evidence

Approach to Audit of Internal Control under Section 404b

• This section applies to public companies with a market capitalization of $75 million or more. For those companies, the auditors audit internal control as a part of an integrated audit as follows:– Plan the engagement– Use a top-down approach to identify the controls to test – Test and evaluate design effectiveness of internal control– Test and evaluate operating effectiveness of internal control– Form an opinion on effectiveness of internal control over

financial reporting

Nature of an Integrated Audit

• Auditors of public companies should report on:– Financial statements and– Internal control over financial reporting

• Based on provisions of PCAOB Standard No. 5, the audits of internal control and financial reporting should be integrated

Management’s Responsibility

• Accept responsibility for effectiveness• Evaluate the effectiveness using suitable

criteria• Support the evaluation with sufficient

evidence• Provide a report on internal control

Management’s Report on I/C

• Report must:– State that it is management’s responsibility to establish and maintain

adequate internal control.– Identify management’s framework for evaluating internal control.– Include management’s assessment of the effectiveness of the

company’s internal control over financial reporting as of the end of the most recent fiscal period, including a statement as to whether internal control over financial reporting is effective.

– Include a statement that the company’s auditors have issued an attestation report on management’s assessment.

Management Assessment

• Management can be assisted by consultants but not by the CPA firm that conducts the audit of financial statements

• Must understand definition of internal control adopted by the SEC

• Evaluation must use an accepted “control framework” such as Internal Control-Integrated Framework created by COSO.

• Must understand concepts of control deficiency, significant deficiency and material weakness

Objective of Management’s Evaluation of I/C

• Provide a reasonable basis for its annual assessment

• Process– Evaluate design effectiveness of controls– Evaluate operating effectiveness of internal

control– Documentation of process– Reporting

Auditor’s Objective

• Plan and perform the audit to obtain reasonable assurance about whether material weaknesses exist to express an opinion on company’s internal control over financial reporting

• Evidence gathered as of date specified in management’s assessment – normally the last day of the company’s fiscal year

Audit Steps

1. Plan the engagement2. Use a top-down approach to identify controls

to test3. Test and evaluate design effectiveness of

internal control4. Test and evaluate operating effectiveness of

internal control5. Form an opinion on the effectiveness of

internal control

Plan the Engagement

• Efficient planning requires coordination with financial statement audit

• Consider matters such as:– Client’s industry– Regulatory matters– Client’s business– Recent changes in client’s operations

Auditors’ Consideration of I/C

• Difference between audit of internal control and audit of financial statements– Time period

• Audit of internal control –as of date• Audit of financial statements – entire financial

statement period

• Differences between small and large clients– Degree of complexity of operations

Top-Down Approach

Top-Down Approach

• Goal is to focus on testing those controls that are most important to auditor’s conclusion on internal control, avoiding those that are less important

• Starts at top – Entity-level controls – those in control

environment or monitoring components of internal control

• Emphasize those relating to audit committee effectiveness, fraud, and period-end process

• Direct or indirect effect

Significant Accounts and Disclosures

• Account significant if reasonable possibility that it could contain a misstatement that individually or in aggregate has a material effect on financial statements

• Factors– Size and composition.– Susceptibility of loss due to errors or fraud.– Volume of activity, complexity, and homogeneity of individual

transactions.– Nature of the account.– Accounting and reporting complexity.– Exposure to losses.– Possibility of significant contingent liabilities.– Existence of related party transactions.– Changes from the prior period.

Identifying Relevant Assertions

• Relevant– Those that have meaningful bearing on whether

account is presented fairly

(1) existence or occurrence; (2) completeness; (3) valuation or allocation; (4) rights and obligations; and/or (5) presentation and disclosure.

Design Effectiveness

• Routine transactions are for recurring activities, – Examples: sales, purchases, cash receipts and disbursements, and

payroll.

• Nonroutine transactions occur only periodically; they generally are not part of the routine flow of transactions– Examples: transactions such as counting and pricing inventory,

calculating depreciation expense, or determining prepaid expenses.

• Accounting estimates are activities involving management’s judgments or assumptions,– Examples: determining the allowance for doubtful accounts,

estimating warranty reserves and assessing assets for impairment

Likely Source of Misstatements

• Understand the flow of transactions;• Verify points within the company’s processes at which a

misstatement could arise that could be material;• Identify the controls management has implemented to

address these potential misstatements; and• Identify the controls management has implemented to

prevent or detect on a timely basis unauthorized acquisition, use, or disposition of the company’s assets that could result in a material misstatement.

Selecting Controls

• Not necessary to design tests of all controls• Redundant controls

– Do not need to test if duplicate control is tested

• Design tests for preventive and/or detective controls

• Complementary controls– Should both be tested

Performing Walk-Throughs• Walk-through

– Tracing a transaction from its origination through the company’s information system until it is reflected in the company’s financial reports

– Provide evidence to:• Verify that they have identified points at which a significant risk of

misstatement to a relevant assertion exists.• Verify their understanding of the design of controls, including those

related to the prevention or detection of fraud.• Evaluate the effectiveness of the design of controls.• Confirm whether controls have been placed in operation (implemented).

Tests of Operating Effectiveness

• Nature– Inquiries, inspections, observations and

reperformance– Vary exact tests when possible

• Timing– Sufficient period of time– Periodic controls – wait to after report date

• Extent – Depend on frequency of control

Relationship Between Audits

• Tests of controls– Same for internal control audit and financial statement

audit– Evidence from internal control audit can be used for

financial statement audit

• Differences between audits– Objectives are different

• Integrated audit– Testing should be spread through the year to satisfy both

objectives

Effects of Internal Control Testing on Audit Substantive Procedures

• Integrated audit requires tests of controls for all major account and relevant assertions– Will lead to decreased scope of substantive

procedures– However, significant deficiencies or material

weaknesses could lead to more substantive procedures

– Not acceptable to omit substantive procedures completely

Effect of Substantive Procedures on Audit of Internal Control

• Findings from substantive procedures may affect audit of internal control– Could provide evidence of effectiveness or

ineffectiveness of internal control over financial reporting

– Example: Identification of material misstatement in financial statements is indicative of at least a significant deficiency in internal control

Form an opinion

Evaluate:1. The results of their evaluation of the design,2. The results of tests of the operating

effectiveness of controls,3. Negative results of substantive procedures

performed during the financial statement audit, and

4. Any identified control deficiencies.

Circumstances Affecting the Auditors’ Opinions

Other Communication Requirements

• Communicate in writing to management– All control deficiencies regardless of severity

• To audit committee– Material weaknesses, significant deficiencies and

that all deficiencies have been communicated to management

• To board of directors– If conclude oversight of financial reporting and

internal control is ineffective

Other Report

• Reporting on Whether a Previously Reported Material Weakness Continues to Exist– Management believes material weakness has

been eliminated– Auditor engaged to report on whether material

weakness continues to exist– Engagement focused on evidence regarding

material weakness

Integrated Audis for Nonpublic Companies

• A nonpublic company may choose to have an integrated audit of its financial statements and its internal control. While the service is very similar to that for public companies, it differs as follows: