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9 - 1Copyright 2003 Pearson Education Canada Inc.
CHAPTER 9The Study of theInternal Control
and Assessment of Control Risk
9 - 2Copyright 2003 Pearson Education Canada Inc.
What is What is internal internal controlcontrol??
9 - 3Copyright 2003 Pearson Education Canada Inc.
What is What is internal internal controlcontrol??
Internal control consists of the policies &procedures established & maintained bymanagement to assist in orderly &efficient conduct of business.
9 - 4Copyright 2003 Pearson Education Canada Inc.
- reliability of controls
Internal control is a process designed toprovide reasonable assurance regardingthe achievement of management’s ob-jectives regarding:
Accounting Records
Our recordsare reliable!
9 - 5Copyright 2003 Pearson Education Canada Inc.
- reliability of controls- optimizing use of resources
Internal control is a process designed toprovide reasonable assurance regardingthe achievement of management’s objectives regarding:
Waste
9 - 6Copyright 2003 Pearson Education Canada Inc.
- reliability of controls- optimizing use of resources- safeguarding of assets
Internal control is a process designed toprovide reasonable assurance regardingthe achievement of management’s ob-jectives regarding:
9 - 7Copyright 2003 Pearson Education Canada Inc.
- reliability of controls- optimizing use of resources- safeguarding of assets- preventing & detecting fraud & error
Internal control is a process designed toprovide reasonable assurance regardingthe achievement of management’s ob-jectives regarding:
9 - 8Copyright 2003 Pearson Education Canada Inc.
performpreliminaryanalytical
procedures
Steps in audit planningSteps in audit planning
preplan
understandinternal control
and assesscontrol risk
setmateriality, and
assess acceptableaudit risk andinherent risk
obtainbackgroundinformation
obtain information about client’s legal obligations
9 - 9Copyright 2003 Pearson Education Canada Inc.
performpreliminaryanalytical
procedures
Steps in audit planningSteps in audit planning
preplan
Why is an understand- ing of internal control im- portant?
setmateriality, and
assess acceptableaudit risk andinherent risk
understandinternal control
and assesscontrol risk
obtainbackgroundinformation
obtain information about client’s legal obligations
9 - 10Copyright 2003 Pearson Education Canada Inc.
Second Examination Standard:A sufficient understanding of internalcontrol should be obtained to plan the audit.
Why is anunderstanding
of internalcontrol
important?
9 - 11Copyright 2003 Pearson Education Canada Inc.
Audit Risk has 3 components Audit Risk has 3 components which combine to make the which combine to make the
audit risk modelaudit risk model::
= x xaudit risk
inherent risk
control risk
detection risk
therisk that material
misstatements will not be prevented ordetected by
internal controls
9 - 12Copyright 2003 Pearson Education Canada Inc.
Key Internal Control ConceptsKey Internal Control Concepts
- internal control is the client’s respon- sibility and should be designed to help the client attain goals
9 - 13Copyright 2003 Pearson Education Canada Inc.
- internal control is the client’s respon- sibility and should be designed to help the client attain goals- internal control should provide rea- sonable but not absolute assurance; cost/benefit must be considered
Key Internal Control ConceptsKey Internal Control Concepts
9 - 14Copyright 2003 Pearson Education Canada Inc.
- internal control is the client’s respon- sibility and should be designed to help the client attain goals- internal control should provide rea- sonable but not absolute assurance; cost/benefit must be considered- internal control has inherent limita- tions (e.g., misunderstandings, mis- takes, fatigue, carelessness, collusion, management override)
Key Internal Control ConceptsKey Internal Control Concepts
9 - 15Copyright 2003 Pearson Education Canada Inc.
What are the components of What are the components of internal control?internal control?
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the controlenvironment
What are the elements ofWhat are the elements ofinternal control?internal control?
9 - 17Copyright 2003 Pearson Education Canada Inc.
The control environment is theactions, policies, and procedures thatreflect management’s attitude regard-
ing controls and their importance.
All of these controls are unnecessary!
9 - 18Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Factors related to the Control Environment:Environment:
9 - 19Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- management’s philosophy and operating style
9 - 20Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- management’s philosophy and operating style Consider the following: - their approach to taking and monitoring business risk
9 - 21Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:- management’s philosophy and operating style Consider the following: - their attitude and actions toward financial reporting
9 - 22Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- management’s philosophy and operating style Consider the following: - their emphasis on meeting financial and operating goals
...our bonusesare based on net income.We all want fat bonuses!
What can we do?
9 - 23Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- board of directors & committees The audit committee maintains communication between the Board of Directors and internal and external auditors.
BOARD OFDIRECTORS
auditcommittee
internalauditors
externalauditors
9 - 24Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- organizational structure The auditor should consider lines of responsibility and authority.
9 - 25Copyright 2003 Pearson Education Canada Inc.
What are theformal methods that
management uses to communicateinternal controls to
employees?
Factors related to the Control Environment:Factors related to the Control Environment:- assignment of authority and responsibility
EmployeeHandbook
CompanyPolicies
JobDescription
Memo:
9 - 26Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:- management’s control methods
Do management’smethods send a clear
message about theimportance of
control?
9 - 27Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- management’s control methods
Do manage-ment’s methodsserve to detect
misstatements?
Do management’s methods send a clear message
about the importance of
control?
9 - 28Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- systems development methodology
Does management have amethodology for developingand modifying systems and
procedures?
9 - 29Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- personnel policies and practices Management should ensure that compe- tent, trustworthy, motivated personnel are employed to meet client goals and objectives.
Employees are the critical component of effective internal control.
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With competent, trustworthy, motivated per-sonnel, even a poorly designed system ofinternal control may function adequately.
Employees are the critical com-ponent of effective internal control.
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Without such personnel, even a well-designed system will probably fail.
With competent, trustworthy, motivated per-sonnel, even a poorly designed system ofinternal control may function adequately.
9 - 32Copyright 2003 Pearson Education Canada Inc.
- management’s reaction to external influences
Factors related to the Control Environment:Factors related to the Control Environment:
Is management aware of external influences such as changes in the
economy and technology?
9 - 33Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- internal audit
Does an internal audit department exist? Does
it effectively monitorcontrol policies and procedures,
and enhance operational
effectiveness and efficiency?
9 - 34Copyright 2003 Pearson Education Canada Inc.
Factors related to the Control Environment:Factors related to the Control Environment:
- internal audit
Does internalaudit assist the
external auditors and reduce audit
fees?
Does an internal audit department exist?
Does it…?
9 - 35Copyright 2003 Pearson Education Canada Inc.
controlsystems
What are the elements ofWhat are the elements ofinternal control?internal control?
9 - 36Copyright 2003 Pearson Education Canada Inc.
Accounting systems have severalsubcomponents - classes of
transactions
accountingsystems
What are the elements ofWhat are the elements ofinternal control?internal control?
9 - 37Copyright 2003 Pearson Education Canada Inc.
controlprocedures
What are the components of What are the components of internal control?internal control?
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controlprocedures
Control procedures are policies and pro-cedures, in addition to those related to
other components, established to enablethe entity to address risks in the achievement of their objectives.
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Categories of Control Categories of Control ProceduresProcedures
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1. Adequate segregation of duties - separate custody of assets from accounting
The Controller
Categories of Control Categories of Control ProceduresProcedures
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1. Adequate segregation of duties - separate custody of assets from authorization of transactions
As custodian ofthe corporate auto fleet, I hereby authorize retire- ment of auto #43 because of obso- lescence.
#43
Joe
Categories of Control Categories of Control Procedures Procedures
9 - 42Copyright 2003 Pearson Education Canada Inc.
1. Adequate segregation of duties - separate operational responsibility from record keeping responsibility
Categories of Control Categories of Control ProceduresProcedures
Example: Ace company has two plants; one inGreat Britain and one in Canada. Manage-ment is deciding whether the plant controllersshould report directly to the plant managersor the corporate vice president of finance.
9 - 43Copyright 2003 Pearson Education Canada Inc.
plantcontroller
V.P.-production
V.P.- finance
plantmanager
plantcontroller
V.P.-production
V.P.- finance
plant manager
plantcontroller
plant manager
plantcontroller
plant manager
Which arrangement creates a potential conflict of interest?
plantcontroller
plant controller
9 - 44Copyright 2003 Pearson Education Canada Inc.
plantcontroller
V.P.-production
V.P.- finance
plant manager
plantcontroller
plant manager
Which arrangement creates a potential conflict of interest?
If the plant controller reports directly to theplant manager, a potential conflict of interestexists. In an effort to make that plant’s resultsappear favourable, the plant manager may at-
tempt to influence the plant controller.
9 - 45Copyright 2003 Pearson Education Canada Inc.
1. Adequate segregation of duties - separate duties within EDP
Categories of Control Categories of Control ProceduresProcedures
9 - 46Copyright 2003 Pearson Education Canada Inc.
What kind of company typically has What kind of company typically has difficulty accomplishing adequate difficulty accomplishing adequate
segregation of duties?segregation of duties?
9 - 47Copyright 2003 Pearson Education Canada Inc.
What kind of company typically has What kind of company typically has difficulty accomplishing adequate difficulty accomplishing adequate
segregation of duties?segregation of duties?
Small companies frequently have diffi-culty with segregation of duties becauseof fewer employees and cost constraints.
9 - 48Copyright 2003 Pearson Education Canada Inc.
What is collusioncollusion??
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Collusion is the defeat of adequate separation of duties wherein Employees cooperate to perpetrate fraud.
...we’re agreed.We’ll be rich be-yond our wildest
dreams!
What is collusioncollusion??
9 - 50Copyright 2003 Pearson Education Canada Inc.
What is the most effective way to What is the most effective way to preventprevent collusion? collusion?
9 - 51Copyright 2003 Pearson Education Canada Inc.
Hire competent, trustworthy,motivated personnel.
What is the most effective way to What is the most effective way to preventprevent collusion? collusion?
9 - 52Copyright 2003 Pearson Education Canada Inc.
Why is collusion particularly Why is collusion particularly troublesome for auditors?troublesome for auditors?
9 - 53Copyright 2003 Pearson Education Canada Inc.
Competent, untrustworthy, motivatedpersonnel oftenknow how to conceal theirfraud.
Why is collusion particularly Why is collusion particularly troublesome for auditors?troublesome for auditors?
9 - 54Copyright 2003 Pearson Education Canada Inc.
1. Adequate segregation of duties2. Proper authorization of transactions and activities
Categories of Control Categories of Control ProceduresProcedures
9 - 55Copyright 2003 Pearson Education Canada Inc.
1. Adequate segregation of duties2. Proper authorization of transactions and activities - general authorization - management establishes authorization policies
Categories of Control Categories of Control ProceduresProcedures
accountspayablepolicies &procedures
cashreceiptspolicies &procedures
personnelpolicies &procedures
9 - 56Copyright 2003 Pearson Education Canada Inc.
1. Adequate segregation of duties2. Proper authorization of transactions and activities - specific authorization - management makes authorizations on a case-by- case basis. I’m the
president andI want to approve
every cashpayment!
Categories of Control Categories of Control ProceduresProcedures
9 - 57Copyright 2003 Pearson Education Canada Inc.
1. Adequate segregation of duties2. Proper authorization of transactions and activities3. Adequate documents and records should provide reasonable assurance that all assets are properly controlled and all transactions are correctly recorded.
Categories of Control Categories of Control ProceduresProcedures
9 - 58Copyright 2003 Pearson Education Canada Inc.
DocumentDocumentGuidelinesGuidelinesDocumentsshould be:prenumbered and accountedfor
PURCHASE ORDER 32494 Date: Vendor: 234 Reynolds Rd. Winnipeg, MB R2V 4E3 Purchasing agent: Quantity Description Price
WAIT FORESTU N I V E R S I T Y
total cost of order
Est. shipment date: Terms of sale (including discounts and freight costs): Carrier:
Internal Use Only: (routing instructions)1.PO made in purchasing 3. receiving notes ship2.Copies to vendor, receiv. 4. acctg. reconciles
M a n u f a c t u r i n g
9 - 59Copyright 2003 Pearson Education Canada Inc.
DocumentDocumentGuidelinesGuidelinesDocumentsshould be:preparedduring or soon after therelated transaction
PURCHASE ORDER 32494 Date: Vendor: 234 Reynolds Rd. Winnipeg, MB R2V 4E3 Purchasing agent: Quantity Description Price
WAIT FORESTU N I V E R S I T Y
total cost of order
Est. shipment date: Terms of sale (including discounts and freight costs): Carrier:
Internal Use Only: (routing instructions)1.PO made in purchasing 3. receiving notes ship2.Copies to vendor, receiv. 4. acctg. reconciles
M a nu f a ct ur i n g
9 - 60Copyright 2003 Pearson Education Canada Inc.
DocumentDocumentGuidelinesGuidelinesDocumentsshould be:understand-able andcorrectlydesigned(includingrouting andauthorization)
PURCHASE ORDER 32494 Date: Vendor: 234 Reynolds Rd. Winnipeg, MB R2V 4E3 Purchasing agent: Quantity Description Price
WAIT FORESTU N I V E R S I T Y
total cost of order
Est. shipment date: Terms of sale (including discounts and freight costs): Carrier:
Internal Use Only: (routing instructions)1.PO made in purchasing 3. receiving notes ship2.Copies to vendor, receiv. 4. acctg. reconciles
M a n u f a c t u r i n g
9 - 61Copyright 2003 Pearson Education Canada Inc.
DocumentDocumentGuidelinesGuidelines
Documentsshould be:designedformultiplepurposes
bc
PURCHASE ORDER 32494 Date: Vendor: 234 Reynolds Rd. Winnipeg, MB R2V 4E3 Purchasing agent: Quantity Description Price
WAIT FORESTU N I V E R S I T Y
total cost of order
Est. shipment date: Terms of sale (including discounts and freight costs): Carrier:
Internal Use Only: (routing instructions)1.PO made in purchasing 3. receiving notes ship2.Copies to vendor, receiv. 4. acctg. reconciles
M a n u f a c t u r i n g
a
9 - 62Copyright 2003 Pearson Education Canada Inc.
2. Proper authorization of transactions and activities3. Adequate documents and records4. Adequate safeguards over assets and records - physical: locking rooms, fenced areas, fireproof safes, safe deposit boxes, security guards; access; backup files and recovery
Categories of Control Categories of Control ProceduresProcedures
9 - 63Copyright 2003 Pearson Education Canada Inc.
2. Proper authorization of transactions and activities3. Adequate documents and records4. Adequate safeguards over assets and records5. Independent, continuous checks on performance - those reviewing performance should be independent of those performing a task
Categories of Control Categories of Control ProceduresProcedures
9 - 64Copyright 2003 Pearson Education Canada Inc.
5. Independent checks on performance
Categories of Control Categories of Control ProceduresProcedures
Segregation of duties is the leastexpensive method of performing
independent checks.
9 - 65Copyright 2003 Pearson Education Canada Inc.
The accounting information andThe accounting information andcommunication system should becommunication system should be
designed to satisfy audit objectives.designed to satisfy audit objectives.
9 - 66Copyright 2003 Pearson Education Canada Inc.
- existence - the system should ensure that recorded transactions exist - no fictitious transactions
The accounting information andThe accounting information andcommunication system should becommunication system should be
designed to satisfy audit objectives:designed to satisfy audit objectives:
9 - 67Copyright 2003 Pearson Education Canada Inc.
- existence- completeness - the system should en- sure that all existing transactions are recorded
The accounting information andThe accounting information andcommunication system should becommunication system should be
designed to satisfy audit objectives:designed to satisfy audit objectives:
9 - 68Copyright 2003 Pearson Education Canada Inc.
How do the How do the existenceexistence and and completenesscompletenessobjectives differ?objectives differ?
The accounting information andThe accounting information andcommunication system should becommunication system should be
designed to satisfy audit objectives:designed to satisfy audit objectives:
- existence- completeness
9 - 69Copyright 2003 Pearson Education Canada Inc.
How do the How do the existenceexistence and and completenesscompletenessobjectives differ?objectives differ?
Existence con-cerns the existence offictitious data; i.e., overstatement.
9 - 70Copyright 2003 Pearson Education Canada Inc.
How do the How do the existenceexistence and and completenesscompletenessobjectives differ?objectives differ?
Existence con-cerns the existence offictitious data; i.e., overstatement.
Completeness concerns omission of information; i.e., under-
statement.
9 - 71Copyright 2003 Pearson Education Canada Inc.
- existence- completeness- accuracy - the system should ensure that recorded transactions are stated at the correct amounts
The accounting information andThe accounting information andcommunication system should becommunication system should be
designed to satisfy audit objectives:designed to satisfy audit objectives:
9 - 72Copyright 2003 Pearson Education Canada Inc.
- existence- completeness- accuracy- classification - the system should en- sure that transactions are properly classified, possibly through use of a chart of accounts.
The accounting information andThe accounting information andcommunication system should becommunication system should be
designed to satisfy audit objectives:designed to satisfy audit objectives:
9 - 73Copyright 2003 Pearson Education Canada Inc.
- existence- completeness- accuracy- classification- timing - the system should ensure that transactions are recorded on the cor- rect dates. Generally, transactions should be recorded during or shortly after their occurrence.
The accounting information andThe accounting information andcommunication system should becommunication system should be
designed to satisfy audit objectives:designed to satisfy audit objectives:
9 - 74Copyright 2003 Pearson Education Canada Inc.
- existence- completeness- accuracy- classification- timing- posting and summarization -the system should ensure that transactions are included in the accounting records and accurately summarized.
The accounting information andThe accounting information andcommunication system should becommunication system should be
designed to satisfy audit objectives:designed to satisfy audit objectives:
9 - 75Copyright 2003 Pearson Education Canada Inc.
Monitoring activitiesMonitoring activities deal with deal with ongoing or periodic assessmentongoing or periodic assessment
of internal control.of internal control.
9 - 76Copyright 2003 Pearson Education Canada Inc.
Internal auditing departmentsInternal auditing departments frequently perform monitoring frequently perform monitoring
activities.activities.
9 - 77Copyright 2003 Pearson Education Canada Inc.
accountingsystems
the controlenvironment
control procedures
What are the elements ofWhat are the elements ofinternal control?internal control?
9 - 78Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview Obtain an understanding
of internal control.
HOW?HOW?
9 - 79Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
- review prior year’s working papers- interview prior year auditors- interview client personnel- study client policies and procedures- study client documents, records, information and communication system
Obtain an understandingof internal control.
9 - 80Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
How do auditors document their under-
standing of internalcontrol?
9 - 81Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
- narratives- flowcharts- internal control questionnaires
How do auditors document their under-
standing of internalcontrol?
9 - 82Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
- narratives- flowcharts- internal control questionnaires
What is aninternal controlquestionnaire?
How do auditors document their under-
standing of internalcontrol?
9 - 83Copyright 2003 Pearson Education Canada Inc.
Internal Control QuestionnaireInternal Control Questionnaire
- a series of questions about internal controls and their application to groups of accounts and cycles
9 - 84Copyright 2003 Pearson Education Canada Inc.
Internal Control QuestionnaireInternal Control Questionnaire
- a series of questions about internal controls and their application to groups of accounts and cycles- generally, a “no” answer indicates an internal control weakness
9 - 85Copyright 2003 Pearson Education Canada Inc.
Internal Control QuestionnaireInternal Control Questionnaire
What are theadvantages provided by
an IC questionnaire?
- a series of questions about internal controls and their application to groups of accounts and cycles- generally, a “no” answer indicates an internal control weakness
9 - 86Copyright 2003 Pearson Education Canada Inc.
What are theadvantages provided by
an IC questionnaire?
Internal Control QuestionnaireInternal Control Questionnaire
- can be designed to cover most aspects of internal control - is relatively applicable from one en- gagement to another- when complete, can be quickly re- viewed for weaknesses
9 - 87Copyright 2003 Pearson Education Canada Inc.
Internal Control QuestionnaireInternal Control Questionnaire
What are thedisadvantages of using
an IC questionnaire?
9 - 88Copyright 2003 Pearson Education Canada Inc.
Internal Control QuestionnaireInternal Control Questionnaire
- concentrates on pieces of internal con- trol rather than the system as a whole- has questionable reliability; oral cli- ent responses should be supported by other evidence- may be too standardized for some clients, especially smaller clients
What are thedisadvantages of using
an IC questionnaire?
9 - 89Copyright 2003 Pearson Education Canada Inc.
Arefinancial statements
auditable?
ControlExamina-
tionOverview
9 - 90Copyright 2003 Pearson Education Canada Inc.
Arefinancial statements
auditable?
ControlExamina-
tionOverview
When would theWhen would theanswer be answer be NONO??
9 - 91Copyright 2003 Pearson Education Canada Inc.
Arefinancial statements
auditable?
ControlExamina-
tionOverview
- management lacks integrity- significantly deficient accounting records or internal controls
When would theWhen would theanswer be answer be NONO??
9 - 92Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
Assess control risk, basedon understanding.
9 - 93Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
Assess the cost/benefit offurther enhancing under-
standing of internal control.
9 - 94Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
max. support low
Assesscontrol
risk.
9 - 95Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
- maximum: poor controls indicate a very risky situation or more efficient to do 100% substantive audit
max. support low
Assesscontrol
risk.
9 - 96Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
- maximum: poor controls indicate a very risky situation or not efficient- supportable: risk is at a level supported by understanding obtained
max. support low
Assesscontrol
risk.
9 - 97Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
- supportable: risk is at a level supported by understanding obtained- low: effective controls indi- cate a lower level of risk that could be supported
max. support low
Assesscontrol
risk.
9 - 98Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
Plan & perform tests of controls.
9 - 99Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
Decidewhether the initial
internal control assessmentwas appropriate.
9 - 100Copyright 2003 Pearson Education Canada Inc.
ControlExamina-
tionOverview
Based on appropriatelevel of detection risk,
perform substantive tests.
9 - 101Copyright 2003 Pearson Education Canada Inc.
When should weaknesses be When should weaknesses be reported to the clientreported to the client??
9 - 102Copyright 2003 Pearson Education Canada Inc.
When should weaknesses be When should weaknesses be reported to the clientreported to the client??
When there are significantdeficiencies in the design oroperation of internal control.
9 - 103Copyright 2003 Pearson Education Canada Inc.
GAAS requires the auditor to communicate(oral or written) with the
audit committeeregarding the significant
deficiencies.
Significant deficienciesin the design or operation of
internal control.