Z\ Fla a TA » a =] =]Learning Objectives After studying this chapter, you should be able to: + Understand the basic definition of internal control. + Discuss why internal controls are important. + Distinguish between the different components of internal control. + Describe the elements of the control environment. + Evaluate how management's objectives are related to risk assessment. + Explain the effects of information and communication on the internal control system. + Distinguish between the major types of control activities. + Give examples of major types of control activities. + Identify monitoring controls. + Know what is meant by design of controls.Definition Internal controls are a system consisting of specific policies and procedures designed to provide management with reasonable assurance that the goals and objectives it believes important to the entity will be met. 1. Reliability of Financial Reporting 2. Efficiency and Effectiveness of Operations 3. Compliance with Laws and Regulations + Internal Controls are put into place to Minimize RiskMANAGEMENT AND AUDITORS RESPONSIBILITY FOR INTERNAL CONTROL 1, MANAGEMENT RESPONSIBILITIES 2. AUDITORS RESPONSIBILITIES FOR UNDERSTANDING INTERNAL CONTROLS 1, REASONABLE ASSURANCE 1, CONTROL OVER RELIABILITY OF 2. INHERENT LIMITATIONS FINANCIAL REPORTING 2, CONTROL OVER CLASSES OF TRANSACTIONS.Transaction-Related Audit Objective—General Form 1.Recorded transactions exist (occurrence). 2. Existing transactions are recorded (completeness). 3. Recorded transactions are stated at the correct amounts (accuracy). 4, Recorded transactions are correctly included in the master files and are correctly summarized. (posting and summarization) 5. Transactions are correctly classified (classification), 6. Transactions are recorded on the correct dates (timing). Sales Transaction-Related Audit Objectives ‘Recorded sales are for shipments made to existing customers. 2. Existing sales transactions are recorded. 3. Recorded sales are for the amount of goods shipped and are correctly billed and recorded. 4, Sales transactions are correctly included in the master files and are correctly summarized 5, Sales transactions are correctly classified. 6. Sales are recorded on the correct dates. 3. AUDITORS RESPONSIBILITY FOR TESTING OF CONTROLSCOSO Major Components of Internal Control MONITORING RISK ASSESSMENT INFORMATION AND ‘CONTROL ACTIVITIES COMMUNICATIONComponents of Internal Control 1. Control Environment: Factors that set the tone of the organization, influencing the control consciousness of its people. The seven factors ar + Integrity and ethical values, + Commitment to Competence, + Board of directors and audit committee + Management's philosophy and Operating style, + Organizational Structure. + Human Resource Policies and PracticesMAJOR COMPONENTS OF INTERNAL CONTROL 2. The Entity’s Risk Assessment + Management Must Identify the Risk + Identification + Significance of Risk + Assesses the likelihood of occurrence + Develop Actions and PoliciesMajor Components of Internal Control 3. CONTROL ACTIVITIES Various policies and procedures that help to ensure those necessary actions are taken to address risks affecting achievement of entity's objectives: 1. Adequate Separation of Duties 2. Proper Authorization of Transactions (General and Specific Authorization) 3. Adequate Documents and Records 4. Physical Controls over assets and records 5, Independent Checks on PerformanceMajor Components of Internal Control 4. ACCOUNTING INFORMATION AND COMMUNICATION Methods and policies established to record, process, summarize, and report transactions and to maintain accountability of related assets and liabilities. Must accomplish: + Identify and record all valid transactions. + Measure the value properly. + Record in the proper time period. + Properly present and disclose. + Communicate responsibilities to employees.Major Components of Internal Control 5. MONITORING OF INTERNAL CONTROLS + Internal Control Over TimesLimitations of Internal Controls: No matter how well internal controls are designed, they can only provide reasonable assurance that objectives have been achieved. Some limitations are inherent in all internal control systems. These include : 1, Judgment: 2. Breakdowns: 3, Management Override: 4. Collusion:Resistant in Implementing Internal Controls or non-existent? ‘There is not enough staff to have adequate segregation of duties. + It is too expensive. ‘The employees are trusted and controls are not necessary.OBTAIN AND DOCUMENT UNDERSTANDING OF INTERNAL CONTROL (AUDITOR'S WORK) rs1. NARRATIVE2. FLOW CHART3. INTERNAL CONTROL QUESTIONNAIRE Risk Factors YouNo | TEVALUATING INTERNAL CONTROL IMPLEMENTATION + Update and Evaluate Auditor's Previous Experience with the Entity + Make Inquiries of Client Staff + Examine Documents and Records (Components) + Observe Entity Activities and Operations + Perform Walk troughs of the Accounting SystemASSESS CONTROL RISK (Class of Transactions) 1. ASSESS WHETHER FINANCIAL STATEMENTS ARE AUDIT ABLE OR NOT + Integrity of Management + Adequacy of Accounting Policies (Duplicate Sales Invoices) + Identify and Evaluate Control Deficiencies, Significant Deficiencies, and Material Weaknesses + 1. Control deficiency. + 2. Significant deficiency + 3. Material weakness.| ‘commUNtCATH TEST OF CONTROLS PROCEDURES FOR TEST OF CONTROLS + 1. Make inquiries of appropriate client personnel + 2, Examine documents, records, and reports + 3. Observe control-related activities + 4. Re-perform client procedures EXTENT OF PROCEDURES + Reliance on Evidence from the Prior Year’s Audit + Testing of Controls Related to Significant Risks: + Testing Less Than the Entire Audit PeriodREPORTING ON INTERNAL CONTROLS 1. Unqualified Opinion 2. Adverse Opinion 3. Qualified Opinion 4. Disclaimer of Opinion