Chapter 7Chapter 7

Auditing Internal Control over

Financial Reporting

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved

7-2

Management Responsibilities under Section 404

Section 404 of the Sarbanes-Oxley Act requires managements of publicly traded companies to issue

an internal control report that explicitly accepts responsibility for establishing and maintaining

“adequate” internal control over financial reporting (ICFR).

LO# 1

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Management Responsibilities under Section 404

Management must comply with the following in order for its public accounting firm to complete an audit of

ICFR.

1. Accepts responsibility for the effectiveness of the entity’s ICFR.

2. Evaluate the effectiveness of the entity’s ICFR using suitable control criteria.

3. Support its evaluation with sufficient evidence, including documentation.

4. Present a written assessment of the effectiveness of the entity’s ICFR as of the end of the entity’s most recent fiscal year.

1. Accepts responsibility for the effectiveness of the entity’s ICFR.

2. Evaluate the effectiveness of the entity’s ICFR using suitable control criteria.

3. Support its evaluation with sufficient evidence, including documentation.

4. Present a written assessment of the effectiveness of the entity’s ICFR as of the end of the entity’s most recent fiscal year.

LO# 1

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Auditor Responsibilities under Section 404

The entity’s independent auditor must audit and report on the effectiveness of ICFR. The auditor is required to conduct an integrated auditintegrated audit of the entity’s ICFR and its financial statements.

LO# 2

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ICFR Defined

ICFR is defined as a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. Controls include procedures that:

1.1. Pertain to the maintenance of records that fairly reflect the Pertain to the maintenance of records that fairly reflect the transactions and dispositions of the assets of the company.transactions and dispositions of the assets of the company.

2.2. Provide reasonable assurance that transactions are Provide reasonable assurance that transactions are recorded in accordance with GAAP.recorded in accordance with GAAP.

3.3. Provide reasonable assurance regarding prevention or Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or timely detection of unauthorized acquisition, use or disposition of the company’s assets.disposition of the company’s assets.

1.1. Pertain to the maintenance of records that fairly reflect the Pertain to the maintenance of records that fairly reflect the transactions and dispositions of the assets of the company.transactions and dispositions of the assets of the company.

2.2. Provide reasonable assurance that transactions are Provide reasonable assurance that transactions are recorded in accordance with GAAP.recorded in accordance with GAAP.

3.3. Provide reasonable assurance regarding prevention or Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or timely detection of unauthorized acquisition, use or disposition of the company’s assets.disposition of the company’s assets.

LO# 3

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Internal Control Deficiencies Defined

A control deficiency exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.

A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company's financial reporting.

LO# 4

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Internal Control Deficiencies Defined

A control deficiency may be serious enough that it is to be considered not only a significant deficiency but also a material weakness in the system of internal control. A material weakness is a deficiency, or a combination of deficiencies, in ICFR, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.

As illustrated on the next slide, the auditor must consider two dimensions of the control deficiency: likelihood reasonably possible) and magnitude (material, consequential, or inconsequential).

LO# 4

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Internal Control Deficiencies Defined

Material

Not materialbut significant

Not materialor significant

Remote Reasonably possible or probable

MaterialMaterialweaknessweakness

Significant Significant deficiencydeficiency

Control deficiencyControl deficiency

L I K E L I H O O DL I K E L I H O O D

MMAAGGNNIITTUUDDEE

LO# 4

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Management’s Assessment Process

Management must follow a top-down, risk-based Management must follow a top-down, risk-based approach:approach:

1.1. Identify financial reporting risks and controls.Identify financial reporting risks and controls.

2.2. Evaluate evidence about the operating effectiveness of Evaluate evidence about the operating effectiveness of ICFR.ICFR.

3.3. Consider which locations to include in the evaluation.Consider which locations to include in the evaluation.

Management must follow a top-down, risk-based Management must follow a top-down, risk-based approach:approach:

1.1. Identify financial reporting risks and controls.Identify financial reporting risks and controls.

2.2. Evaluate evidence about the operating effectiveness of Evaluate evidence about the operating effectiveness of ICFR.ICFR.

3.3. Consider which locations to include in the evaluation.Consider which locations to include in the evaluation.

LO# 5

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Management’s Documentation

Management must develop sufficient Management must develop sufficient documentation to support its assessment of the documentation to support its assessment of the

effectiveness of internal control. This effectiveness of internal control. This documentation may take many forms, such as documentation may take many forms, such as paper, electronic files, or other media. It also paper, electronic files, or other media. It also

includes policy manuals, job descriptions, includes policy manuals, job descriptions, flowcharts, and process models.flowcharts, and process models.

Management must develop sufficient Management must develop sufficient documentation to support its assessment of the documentation to support its assessment of the

effectiveness of internal control. This effectiveness of internal control. This documentation may take many forms, such as documentation may take many forms, such as paper, electronic files, or other media. It also paper, electronic files, or other media. It also

includes policy manuals, job descriptions, includes policy manuals, job descriptions, flowcharts, and process models.flowcharts, and process models.

LO# 6

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Framework Used by Management to Conduct Its Assessment

Most entities use the framework developed by COSO.Most entities use the framework developed by COSO.This framework identifies three primary objectives of This framework identifies three primary objectives of

internal control: (1) reliable financial reporting;internal control: (1) reliable financial reporting;(2) efficiency and effectiveness of operations;(2) efficiency and effectiveness of operations;and (3) compliance with laws and regulations.and (3) compliance with laws and regulations.

Most entities use the framework developed by COSO.Most entities use the framework developed by COSO.This framework identifies three primary objectives of This framework identifies three primary objectives of

internal control: (1) reliable financial reporting;internal control: (1) reliable financial reporting;(2) efficiency and effectiveness of operations;(2) efficiency and effectiveness of operations;and (3) compliance with laws and regulations.and (3) compliance with laws and regulations.

COSO

LO# 7

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Performing an Audit of ICFR

LO# 8

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Integrating the Audits of Internal Control and Financial Statements

An integrated audit is composed of the audits of internal control and the financial statements. The control testing impacts the planned substantive procedures. Also, the results of the substantive procedures are considered in

the evaluation of internal control.

Tests of Tests of internalinternalcontrolcontrol

Tests of Tests of internalinternalcontrolcontrol

SubstantiveSubstantiveauditaudit

proceduresprocedures

SubstantiveSubstantiveauditaudit

proceduresprocedures

LO# 9

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Effect of the Audit of Internal Control on the Financial Statement Audit

When the auditor performs an integrated audit, he or she will have access to a large amount of information about the client’s controls. This information can make the financial statement audit more efficient and result

in reduced substantive procedures.

Regardless of the level of control risk Regardless of the level of control risk in connection with the audit of the in connection with the audit of the

financial statements, auditing financial statements, auditing standards require the auditor to standards require the auditor to

perform some substantive procedures perform some substantive procedures for all significant accounts and for all significant accounts and

disclosures.disclosures.

Regardless of the level of control risk Regardless of the level of control risk in connection with the audit of the in connection with the audit of the

financial statements, auditing financial statements, auditing standards require the auditor to standards require the auditor to

perform some substantive procedures perform some substantive procedures for all significant accounts and for all significant accounts and

disclosures.disclosures.

LO# 9

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Effect of the Financial Statement Audit on the Audit of Internal ControlThe effectiveness of the audit of internal controls should lead the auditor to determine the implications of these findings on the financial statement audit. The auditor’s evaluation should include:

1.1. Misstatements detected.Misstatements detected.

2.2. The auditor’s risk evaluations in connection with the The auditor’s risk evaluations in connection with the selection and application of substantive procedures, selection and application of substantive procedures, especially those related to fraud.especially those related to fraud.

3.3. Findings with respect to illegal acts and related party Findings with respect to illegal acts and related party transactions.transactions.

4.4. Indications of management bias in making accounting Indications of management bias in making accounting estimates and in selecting accounting principles.estimates and in selecting accounting principles.

1.1. Misstatements detected.Misstatements detected.

2.2. The auditor’s risk evaluations in connection with the The auditor’s risk evaluations in connection with the selection and application of substantive procedures, selection and application of substantive procedures, especially those related to fraud.especially those related to fraud.

3.3. Findings with respect to illegal acts and related party Findings with respect to illegal acts and related party transactions.transactions.

4.4. Indications of management bias in making accounting Indications of management bias in making accounting estimates and in selecting accounting principles.estimates and in selecting accounting principles.

LO# 9

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Plan the Engagement

The planning process is similar to the process used for the audit of F/S.

Consider the following: Risk assessment and the risk of fraud. Scaling the audit. Using the work of others. Materiality.

LO# 10

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Special Consideration:Using the Work of Others

A major consideration for the external auditor is how much the A major consideration for the external auditor is how much the work performed by others. In determining the extent to which work performed by others. In determining the extent to which the auditor may use the work of others, the auditor should:the auditor may use the work of others, the auditor should:(1) evaluate the nature of the controls subjected to the work of (1) evaluate the nature of the controls subjected to the work of others, others, (2) evaluate the competence and objectivity of the individuals (2) evaluate the competence and objectivity of the individuals who performed the work, and who performed the work, and (3) test some of the work performed by others to evaluate the (3) test some of the work performed by others to evaluate the quality and effectiveness of their work.quality and effectiveness of their work.

As the risk associated with the control being tested increases, As the risk associated with the control being tested increases, the external auditor should do more of the work.the external auditor should do more of the work.

A major consideration for the external auditor is how much the A major consideration for the external auditor is how much the work performed by others. In determining the extent to which work performed by others. In determining the extent to which the auditor may use the work of others, the auditor should:the auditor may use the work of others, the auditor should:(1) evaluate the nature of the controls subjected to the work of (1) evaluate the nature of the controls subjected to the work of others, others, (2) evaluate the competence and objectivity of the individuals (2) evaluate the competence and objectivity of the individuals who performed the work, and who performed the work, and (3) test some of the work performed by others to evaluate the (3) test some of the work performed by others to evaluate the quality and effectiveness of their work.quality and effectiveness of their work.

As the risk associated with the control being tested increases, As the risk associated with the control being tested increases, the external auditor should do more of the work.the external auditor should do more of the work.

LO# 10

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Using a Top-Down ApproachLO# 11

See Table 7-3

See Table 7-4

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Test ControlsLO# 12

Evaluate design Test and evaluate operating effectiveness

Nature, timing, and extent

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Evaluate Identified Control Deficiencies

LO# 13

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Evaluate Identified Control Deficiencies

LO# 13

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Written Representations

In addition to the management representations obtained as part of a financial statement audit, the auditor also

obtains written representations from management related to the audit of ICFR.

Failure to obtain written Failure to obtain written representations from representations from

management, including management, including management’s refusal to management’s refusal to

furnish them, constitutes a furnish them, constitutes a limitation on the scope of the limitation on the scope of the audit sufficient to preclude an audit sufficient to preclude an

unqualified opinion.unqualified opinion.

Failure to obtain written Failure to obtain written representations from representations from

management, including management, including management’s refusal to management’s refusal to

furnish them, constitutes a furnish them, constitutes a limitation on the scope of the limitation on the scope of the audit sufficient to preclude an audit sufficient to preclude an

unqualified opinion.unqualified opinion.

LO# 15

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Auditor Documentation Requirements

The auditor must properly document the processes, procedures, judgments, and results relating to the audit

of internal control.

When an entity has effective ICFR, the auditor should be able to perform sufficient testing of controls to assess control risk for all relevant assertions at a low level.

When an entity has effective ICFR, the auditor should be able to perform sufficient testing of controls to assess control risk for all relevant assertions at a low level.

LO# 16

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Reporting on ICFRSarbanes-Oxley requires management’s description of

internal control to include:

1. A statement of management’s responsibility for establishing and maintaining adequate internal control.

2. A statement identifying the framework used by management to conduct the required assessment of the effectiveness of the company’s internal control.

3. An assessment of the effectiveness of the company’s internal control as of the end of the most recent fiscal year, including an explicit statement as to whether internal control is effective.

1. A statement of management’s responsibility for establishing and maintaining adequate internal control.

2. A statement identifying the framework used by management to conduct the required assessment of the effectiveness of the company’s internal control.

3. An assessment of the effectiveness of the company’s internal control as of the end of the most recent fiscal year, including an explicit statement as to whether internal control is effective.

LO# 17

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The Auditor’s Report on ICFR

Once the auditor has completed the audit of internal control, he or she must issue an appropriate report to accompany management’s assessment, published in

the company’s annual report.

LO# 18

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Auditor’s Report Relating to the Audit of Internal Control

The auditor’s report contains an opinion the effectiveness of ICFR based on the auditor’s

independent audit work.

LO#

13 & 14

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Types of Reports Relating to the Audit of ICFR

An An unqualifiedunqualified opinion signifies that the client’s opinion signifies that the client’s internal control is designed and operating internal control is designed and operating

effectively.effectively.

An An unqualifiedunqualified opinion signifies that the client’s opinion signifies that the client’s internal control is designed and operating internal control is designed and operating

effectively.effectively.

A serious scope limitation requires the auditor to A serious scope limitation requires the auditor to disclaimdisclaim an opinion. an opinion.

A serious scope limitation requires the auditor to A serious scope limitation requires the auditor to disclaimdisclaim an opinion. an opinion.

An An adverseadverse opinion is required if a material opinion is required if a material weakness is identified. weakness is identified.

An An adverseadverse opinion is required if a material opinion is required if a material weakness is identified. weakness is identified.

LO#

18 & 19

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Types of Reports Relating to the Audit of ICFR

Report Modification Based on Control DeficienciesReport Modification Based on Control Deficiencies

Likelihood/MagnitudeLikelihood/Magnitudeof Misstatementof Misstatement

Type ofType ofAudit ReportAudit Report

ControlControldeficiencydeficiency

SignificantSignificantdeficiencydeficiency

MaterialMaterialweaknessweakness

UnqualifiedUnqualifiedopinionopinion

AdverseAdverseopinionopinion

LO# 19

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Types of Reports Relating to the Audit of Internal Control

Report Modification Based on Scope LimitationReport Modification Based on Scope Limitation

Reason forReason forScope LimitationScope Limitation

Type ofType ofAudit ReportAudit Report

MinorMinoreffecteffect

SeverSeverlimitationlimitation

UnqualifiedUnqualifiedopinionopinion

DisclaimDisclaimopinion oropinion orwithdrawwithdraw

LO# 19

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Additional Required Communications in an Audit of ICFR

The auditor must communicate in writing to management and the audit committee all significant deficiencies and material weaknesses identified during the audit (AS5). This communication should be made prior to the issuance of the auditor’s report on ICFR. In addition, the auditor should communicate to management, in writing, all control deficiencies identified during the audit and inform the audit committee when such a communication has been made.

LO# 17

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Advanced Module 1: Special Considerations for an Audit of

Internal Control

ServiceServiceorganizations.organizations.

ServiceServiceorganizations.organizations.

SafeguardingSafeguardingassets.assets.

SafeguardingSafeguardingassets.assets.

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Use of Service OrganizationsMany companies use service organization to

process transactions. If the service organization’s services make up part of a company’s information

system, then they are considered part of the information and communication component of the company’s internal control over financial report. Thus, both management and the auditor must

consider the activities of the service organization.

LO# 21

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Use of Service OrganizationsManagement and the auditor should perform the following procedures with respect to the activities performed by the service organization: (1) obtain an understanding of the controls at the service organization that are relevant to the entity’s internal control and the controls at the user organization over the activities of the service organization and (2) obtain evidence that the controls which are relevant to management’s assessment and the auditor’s opinion are operating effectively.

LO# 21

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Safeguarding of Assets

Safeguarding of assets is defined as policies and procedures that “provide reasonable assurance regarding prevention or timely

detection of unauthorized acquisition, use or disposition of the company’s assets that could

have a material effect on the financial statements.”

LO# 23

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Advanced Module 2: Computer-Assisted Audit Techniques

Computer-assisted audit techniques include:Computer-assisted audit techniques include:

• Generalized audit software packages.Generalized audit software packages.

• Custom audit software.Custom audit software.

• Test data.Test data.

Computer-assisted audit techniques include:Computer-assisted audit techniques include:

• Generalized audit software packages.Generalized audit software packages.

• Custom audit software.Custom audit software.

• Test data.Test data.

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Generalized Audit SoftwareFunction Description

File or data accessReads and extracts data from a client's computer files or databases for further audit testing.

Selection operators Select from files or databases transactions that meet certain criteria.

Arithmetic functions

Perform a variety of arithmetic calculations (addition, subtraction, and so on) on transactions, files, and databases.

Statistical analysesProvide functions supporting various types of audit sampling.

Report generationPrepares various types of documents and reports.

LO# 23

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Custom Audit Software

Custom audit software is generally written by auditors for specific audit tasks. It may be required when the client’s computer system is not compatible with the

auditor’s generalized audit software.

Custom software:Custom software:

(1)(1) Is expensive to develop.Is expensive to develop.

(2)(2) Requires extended development time.Requires extended development time.

(3)(3) Is limited in scope of functions.Is limited in scope of functions.

Custom software:Custom software:

(1)(1) Is expensive to develop.Is expensive to develop.

(2)(2) Requires extended development time.Requires extended development time.

(3)(3) Is limited in scope of functions.Is limited in scope of functions.

LO# 23

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Test Data

This is data developed by the auditor to test the application controls in the client’s computer programs.

The technique can be used to check (1) data validation controls and error detection routines, (2) processing logic controls, (3) arithmetic calculations, and (4) the inclusion of transactions in records, files, and reports.

LO# 23

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End of Chapter 7