Chapter 1:

Auditing and Internal

Control
COURSE CODE: CIA 3008 IT Auditing, Hall, 4e
COURSE TITLE : IT Audit

WEEK 1:

IT Audit Function, Knowledge and

Fundamental Auditing Concepts

DR. KHAIRUL SAIDAH BINTI ABAS AZMI

ROOM NUMBER: B2-3
EMAIL: khairul_saidah@um.edu.my
 Auditing
o Information technology (IT) developments have had
tremendous impact on auditing.
o Business organizations undergo different types of audits for
different purposes.
o Most common are external (financial) audits, internal audits and
fraud audits.

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 External (Financial) Audits
o Independent attestation performed by an expert (i.e., CPA) who
expresses an opinion regarding the fair presentation of financial
statements.
o Required by SEC for all public companies.
o Key concept is independence:
o Similar to a trial by judge.
o Auditor collects evidence and renders opinion.
o Basis of public confidence in financial statements.
o Strict rules must be followed.
o Defined by SEC, FASB, AICPA and SOX.
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Attest Service vs.
Advisory Services
o Requirements of attestation services:
o Written assertions and practitioner’s written report.
o Formal establishment of measurement criteria.
o Limited to examination, review, and application of agreed-upon
procedures.
o Advisory services are offered to improve client’s operational
effectiveness and efficiency.
o SOX greatly restricts the types of non-audit services auditors may
render to audit clients.
o Unlawful to provide many accounting, financial, internal audit,
management, human resource or legal services unrelated to the
audit.
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 Internal Audits
o Internal auditing is an independent appraisal function to
examine and evaluate activities within, and as a service to, an
organization.
o Internal auditors perform a wide variety of activities including
financial, operational, compliance and fraud audits.
o Auditors may work for the organization or task may be
outsourced.
o Independence is self-imposed, but auditors represent the interests of
the organization.

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External vs. Internal Auditors
o External auditors represent outsiders while internal auditors
represent organization’s interests.
o Internal auditors often cooperate with and assist external
auditors in some aspects of financial audits.
o Extent of cooperation depends upon the independence and
competence of the internal audit staff.
o External auditors can rely in part on evidence gathered by
internal audit departments that are organizationally independent
and report to the board of directors’ audit committee.

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 Fraud Audits
o Recent increase in popularity as a corporate governance tool.
o Objective to investigate anomalies and gather evidence of fraud
that may lead to criminal convictions.
o May be initiated by management who suspect employee fraud or
the board of directors who suspect executive fraud.
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Role of Audit Committee
o Subcommittee of the board of directors
o Usually three members who are outsiders.
o SOX requires at least one member must be a “financial expert”.
o Serves as independent “check and balance” for the internal
audit function.
o SOX mandates that external auditors report to the audit
committee:
o Committee hires and fires auditors and resolve disputes.

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Auditing Standards
o Three classes of auditing standards: general qualification, field
work, and reporting.
o Specific guidance provided by AICPA Statements on Auditing
Standards (SASs) as authoritative interpretations of GAAS.
o First one issued in 1972.
o If recommendations are not followed, auditor must be able to show
why a SAS does not apply to a given situation.
o Conducing an audit is a systematic and logical process that
applies to all forms of information systems.

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 Generally Accepted Auditing Standards
General Standards Standards of Field Work Reporting Standards
1. The auditor must have adequate 1. Audit work must be adequately 1. The auditor must state in the report
technical training and proficiency. planned. whether financial statements were
prepared in accordance with generally
accepted accounting principles.

2. The auditor must have 2. The auditor must gain a sufficient 2. The report must identify those
independence of mental attitude. understanding of the internal control circumstances in which generally accepted
structure. accounting principles were not applied.

3. The auditor must exercise due 3. The auditor must obtain sufficient, 3. The report must identify any items that
professional care in the performance competent evidence. do not have adequate informative
of the audit and the preparation of disclosures.
the report.

4. The report shall contain an expression of

the auditor’s opinion on the financial
statements as a whole.

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Auditing Standards
o Management assertions and audit objectives:
o Existence or Occurrence; Completeness; Rights and Obligations;
Valuation or Allocation; Presentation and Disclosure.
o Auditors develop audit objectives and design audit procedures based
on these assertions.
o Auditors seek evidential matter that corroborates assertions.
o Auditor must determine whether internal control weaknesses and
misstatements are material.
o Auditors must communicate the results of their tests, including an
audit opinion.
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 Audit Objectives and Audit Procedures
Based on Management Assertions
Management Assertions Audit Objectives Audit Procedure

Existence or occurrence Inventories listed on the balance sheet Observe the counting of physical inventory.
exist.

Completeness Accounts payable include all Compare receiving reports, supplier invoices,
obligations to vendors for the period. purchase orders, and journal entries for the
period and the beginning of the next period.

Rights and obligations Plant \and equipment listed in the Review purchase agreements, insurance
balance sheet are owned by the entity. policies, and related documents.

Valuation or allocation Accounts receivable are stated at net Review entity’s aging of accounts and
realizable value. evaluate the adequacy of the allowance for
uncorrectable accounts.

Presentation and disclosure Contingencies not reported in financial Obtain information from entity lawyers
accounts are properly disclosed in about the status of litigation and estimates
footnotes. of potential loss.
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 Audit Risk
o Probability that auditor will render unqualified (clean) opinion on financial
statements that are, in fact, materially misstated.
o Inherent risk (IR) is associated with unique characteristics of client’s business or
industry.
o Control risk (CR) is the likelihood the control structure is flawed because controls
are either absent or inadequate to prevent or detect errors.
o Detection risk (DR) is the risk auditors are willing to take that errors not detected
or prevented by the control structure will not be detected by the auditor.

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Audit Risk (con’t)
o Audit risk components in a model used to determine the scope, nature and
timing of substantive tests:
o Audit risk model: AR = IR x CR x DR
o If acceptable audit risk is 5%, the planned detection risk will depend upon the
control structure.
o The stronger the internal control structure, the lower the control risk and the
less substantive testing the auditor must do.
o Substantive tests are labor intensive and time consuming, which drives up audit
costs and cause disruption.
o Management’s best interests are served by a strong internal control structure.

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Phases of an IT
Audit

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 The IT Audit (con’t)
o First step is audit planning which includes the analysis of audit risk.
o Techniques for gathering evidence include questionnaires, management
interviews, reviewing system documentation and observing activities.
o Objective of tests of controls is to determine if adequate controls
are in place and functioning.
o Third phase focuses on financial data and a detailed investigation of
specific account balances and transactions through substantive
tests.
o Files may be extracted using Computer-Assisted-Audit Tools and
Techniques (CAATTs) software.

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Internal Control
o Management required by law to establish and maintain
adequate system of internal controls.
o Brief history of internal control legislation:
o SEC Acts of 1933 and 1934.
o Copyright Law of 1976.
o Foreign Corrupt Practices (FCPA) of 1977 requires companies
registered with the SEC to:
o Keep records that fairly and reasonably reflect firm’s transactions and
financial position.
o Maintain a system of internal control that provides reasonable assurance
that organization objectives are met.
o Committee of Sponsoring Organizations (COSO) - 1992

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Internal Control (con’t)
o Sarbanes-Oxley Act of 2002 (SOX) requires management of
public companies to implement adequate internal control system
over their financial reporting process. Under Section 302:
o Managers must certify organization’s internal controls quarterly and
annually.
o External auditors must perform certain procedures quarterly to
identify any material control modifications that may impact financial
reporting.
o Section 404 requires management of public companies to access
the effectiveness of their internal controls in an annual report.

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 Internal Control Objectives, Principles,
and Models

o Internal control system comprises policies, practices, and

procedures to achieve four broad objectives:
o Safeguard assets of the firm.
o Ensure accuracy and reliability of accounting records and
information.
o Promote efficiency in the firm’s operations.
o Measure compliance with management’s prescribed policies and
procedures.

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 Modifying Principles
o Management responsibility made law by SOX.
o Objectives should be achieved regardless of the data
processing method used.
o Every system has limitations on its effectiveness including:
possibility of error, circumvention, management override and
changing conditions.
o System should provide reasonable assurance that broad
objectives are met.
o Cost to achieve improved control should not outweigh benefits.
o Cost of correcting material weaknesses is offset by benefits.

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The PDC Model

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 The PDC Model (con’t)
o Preventive controls are passive techniques designed to
reduce frequency of undesirable events occurring.
o More cost effective than detecting and correcting problems after
they occur. (eg. Separation of duties)
o Detective controls are devices, techniques and procedures
to identify and expose undesirable events that eluded the
preventive controls. (eg. Monthly reconciliation of bank
accounts)
o Corrective controls fix the identified problem. (eg. Trainings)

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The PDC Model (con’t)

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 COSO Internal Control Framework
1) The control environment is the foundation for the other four
control components and includes:
o Management integrity and ethical values, organizational structure,
board of director participation and management’s philosophy and
operating style.
2) A risk assessment must be performed to identify, analyze and
manage financial reporting risks.
3) An effective accounting information system will:
o Identify and record all valid financial transactions, provide timely
information and adequately measure and record transactions.
o SAS 109

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COSO Internal Control Framework (con’t)
4) Monitoring is the process by which the quality of internal
control design and operation can be assessed.
5) Control activities are policies and procedures to ensure
actions to deal with identified risk.
o Physical controls relate primarily to human activities employed in
accounting systems.
o Information technology controls.

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COSO Internal Control Framework (con’t):
Control Activities

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 Control Activities:
1) Physical Controls
• 1) Transaction Authorization
• 2) Segregation of Duties
• 3) Supervision
• 4) Accounting Records
• 5) Access Control
• 6) Independent Verification

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Control Activities:
a)Physical
o
Controls
i) Transaction authorization is to ensure all
processed transactions are valid.
o May be general (sales only to authorized
customer) or specific (extending the credit
limit of a customer).
o ii) Segregation of duties is designed to:
o Separate transaction authorization from
processing.
o Separate asset custody from
recordkeeping.
o Ensure a successful fraud requires
collusion between individuals with
incompatible responsibilities.
o iii) Supervision is a compensating control
for small organizations that cannot achieve
adequate segregation of duties.
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 Physical Controls (con’t)

o Iv) Accounting records are source documents, journals and

ledgers that provide an audit trail.
o Information needed for day to day operations and
essential in the financial audit process.
o v) Access controls ensure only authorized personnel have
assess to firm’s assets.
o vi) Verification procedures are independent checks to
identify errors and misrepresentations in the accounting
system.
o Management can assess the performance of individuals,
the integrity of the transaction processing system, and data
correctness.

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2) IT Controls
o Application controls ensure validity, completeness, and
accuracy of financial transactions.
o Includes check digits, batch balancing and payroll limits.
o General controls apply to all systems and include:
o IT governance, IT infrastructure, security and access to operating
systems and databases, application acquisition and development
and program change procedures.
o General controls needed to support functioning of application
controls. Both needed to ensure accurate financial reporting.

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IT Controls (con’t)

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COSO

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 Audit Implications of SOX

o Expanded role of auditors:

o Must attest to quality of client organization’s internal controls
with a separate audit opinion.
o Possible to render a qualified opinion on controls and an
unqualified opinion on financial statements.
o PCAOB Standard No. 5 requires auditors to understand:
o Transaction flows including controls pertaining to how
transactions are initiated, authorized, recorded, and reported.
o Auditors responsible for detecting fraudulent activity.

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“
Lesson Learned WEEK 1:

CHAPTER 1: Auditing and Int

ernal Control

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