Chapter wise test series for 15 Days Hard Challnge

Ch 3 Risk Assessment and Internal control

1. So far as the auditor is concerned, the examination and evaluation of the internal control
system is an indispensable part of the overall audit programme. The auditor needs reasonable
assurance that the accounting system is adequate and that all the accounting information
which should be recorded has in fact been recorded. Internal control normally contributes to
such assurance. Explain stating clearly the benefits of evaluation of internal control to the
auditor. (RTP MAY 19
and RTP Nov 2022)
Ans. So far as the auditor is concerned, the examination and evaluation of the internal
control system is an indispensable part of the overall audit programme. The auditor needs
reasonable assurance that the accounting system is adequate and that all the accounting
information which should be recorded has in fact been recorded. Internal control normally
contributes to such assurance. The auditor should gain an
understanding of the accounting system and related internal controls and should study and
evaluate the operations of these internal controls upon which he wishes to rely in determining
the nature, timing and extent of other audit procedures.
Benefits of Evaluation of Internal Control to the Auditor The review of internal controls will
enable the auditor to know:
i) Internal control system is adequate & operating effectively.
ii) Internal control is able to prevent, detect & correct material misstatement.
iii) Internal control properly safeguards the assets.
iv) Internal control ensures correct recording of transaction.
v) Reports & Certificate provided by management are reliable.
vi) Internal control are weak / excessive in a particular area.
vii) Effective internal audit department is in operation.
viii) Suggestions can be given to management to improve the I.C. system.
ix) Extensive Substantive procedures are required.
x) Audit procedures or techniques need to be changed from planned one.

2. XYZ & Associates, Chartered Accountants, while evaluating the operating effectiveness of
internal controls, detects deviation from controls. In such a situation, state the specific
inquiries to be made by an auditor to understand these matters and their potential
consequences.

Ans. Evaluating the Operating Effectiveness of Controls: When evaluating the operating
effectiveness of relevant controls, the auditor shall evaluate whether misstatements that have
been detected by substantive procedures indicate that controls are not operating effectively.
The absence of misstatements detected by substantive procedures, however, does not provide
audit evidence that controls related to the assertion being tested are effective.
When deviations from controls upon which the auditor intends to rely are detected, the
auditor shall make specific inquiries to understand these matters and their potential
consequences, and shall determine whether:
a) The tests of controls that have been performed provide an appropriate basis for reliance
on the controls;
b) Additional tests of controls are necessary; or
c) The potential risks of misstatement need to be addressed using substantive procedures.
A material misstatement detected by the auditor's procedures is a strong indicator of the
existence of a significant deficiency in internal control.

3. Determining materiality involves the exercise of professional judgment. A percentage is

often applied to a chosen benchmark as a starting point in determining materiality for the
financial statements as a whole. Discuss stating the factors that may affect the identification
of an appropriate benchmark. (SM) (RTP MAY 18 and Exam May 23)

Ans. Determining materiality involves the exercise of professional judgment. A percentage is

often applied to a chosen benchmark as a starting point in determining materiality for the
financial statements as a whole. Factors that may affect the identification of an appropriate
benchmark include the following:
• The elements of the financial statements
Example - assets, liabilities, equity, revenue, expenses
• Whether there are items on which the attention of the users of the particular entity's
financial statements tends to be focused
Example - for the purpose of evaluating financial performance users may tend to focus on
profit, revenue or net assets.
• The nature of the entity, where the entity is at in its life cycle, and the industry and
economic environment in which the entity operates
• The entity's ownership structure and the way it is financed and
Example- if an entity is financed solely by debt rather than equity, users may put more
emphasis on assets, and claims on them, than on the entity's earnings
• The relative volatility of the benchmark.

4. Much of the information obtained by the auditor's inquiries is obtained from management
and those responsible for financial reporting. However, the auditor may also obtain
information, or a different perspective in identifying risks of material misstatement, through
inquiries of others within the entity and other employees with different levels of authority.
Explain with the help of examples. [RTP Nov 2020 and MTP Sep 22]

Ans. Inquiries of Management and Others Within the Entity: Much of the information
obtained by the auditor's inquiries is obtained from management and those responsible for
financial reporting. However, the auditor may also obtain information, or a different
perspective in identifying risks of material misstatement, through inquiries of others within
the entity and other employees with different levels of authority.
Examples
 Inquiries directed towards those charged with governance may help the auditor
understand the environment in which the financial statements are prepared.
 Inquiries directed toward internal audit personnel may provide information about
internal audit procedures performed during the year relating to the design and
effectiveness of the entity's internal control and whether management has satisfactorily
responded to findings from those procedures.
  Inquiries of employees involved in initiating, processing or recording complex or
unusual transactions may help the auditor to evaluate the appropriateness of the
selection and application of certain accounting policies.
 Inquiries directed toward in-house legal counsel may provide information about such
matters as litigation, compliance with laws and regulations, knowledge of fraud or
suspected fraud affecting the entity, warranties, post- sales obligations, arrangements
(such as joint ventures) with business partners and the meaning of contract terms.
 Inquiries directed towards marketing or sales personnel may provide information about
changes in the entity's marketing strategies, sales trends, or contractual arrangements
with its customers.
 Inquiries directed to the risk management function (or those performing such roles)
may provide information about operational and regulatory risks that may affect
financial reporting.
 Inquiries directed to information systems personnel may provide information about
system changes, system or control failures, or other information system- related risks.

5. List out some matters that the auditor may consider in determining whether a deficiency or
combination of deficiencies in internal control constitutes a “significant deficiency”.
[New SM Question]
Ans. Examples of matters that the auditor may consider in determining whether a deficiency
or combination of deficiencies in internal control constitutes a significant deficiency
• The likelihood of deficiencies leading to material misstatements in the financial
statements in the future.
• The susceptibility to loss or fraud of the related asset or liability.
• The subjectivity & complexity of determining estimated amounts, such as fair value
accounting estimates.
• The financial statement amounts exposed to the deficiencies.
• The volume of activity that has occurred or could occur in account balance or class of
transactions exposed to the deficiency or deficiencies.
• The importance of the controls to the financial reporting process, for example:
o General monitoring controls (such as oversight of management).
o Controls over the prevention and detection of fraud.
o Controls over the selection and application of significant accounting policies.
o Controls over significant transactions with related parties.
o Controls over significant transactions outside the entity's normal course of
business.
· Controls over period-end financial reporting process (such as controls over non-recurring
journal entries).
• The cause and frequency of the exceptions detected as a result of the deficiencies in the
controls.
• The interaction of the deficiency with other deficiencies in internal control.

6. In what ways an effective two-way communication between auditor and those charged
with governance is important? [New SM Question]

Ans: Communication from auditor is important with those charged with governance. An
effective two way communication is important in assisting: -
a) The auditor and those charged with governance in understanding matters related to the
audit in context, and in developing a constructive working relationship. This relationship
is developed while maintaining the auditor's independence and objectivity.
b) The auditor in obtaining from those charged with governance information relevant to the
audit. For example, those charged with governance may assist the auditor in
understanding the entity and its environment, in identifying appropriate sources of audit
evidence, and in providing information about specific transactions or events; and
c) Those charged with governance in fulfilling their responsibility to oversee the financial
reporting process, thereby reducing the risks of material misstatement of the financial
statement