INTERNAL CONTROLS IN AUDITING

Presented by: Hardik Shah (S00096042) Bing BingWang

(S00043503)

Contents

Introduction Objectives of Internal control Components of Internal control Famous cases Substantive tests and Tests of control Case study analysis

INTRODUCTION

Today, communication and Integrity of financial information is of utmost importance to the companies.

Integrity function performed by the auditing profession

Auditors need to obtain an understanding of internal control and an evaluation of the extent to which controls may be relied on to assure the accuracy and reliability of accounting records.

Internal Controls: Defined

A process designed, implemented & maintained by

Those charged with governance, Management, Other personnel

To provide reasonable assurance

About achievement of entity’s objectives with regard to.....

Reliability of Financial Reporting

Compliance with laws and

regulations

Effectiveness & Efficiency of

operations

Safeguarding of assets

In accounting and auditing internal control is defined as:

Objectives of Internal control

A

• Accurate and Reliable Financial information

C

• Compliance with laws and regulations

E

• Effective & Efficient operations

• Safeguarding of assets

Components of Internal control

C • Control Activities

R • Risk Assessment Process

I• Information & Communication

M • Monitoring

E • Environment

Components of Internal control

Control activities – actions supported by management policies to address risk. Five specific control activities:

- Adequate separation of duties - Proper authorization of transactions and activities - Adequate documents and records - Physical control over assets and records independent checks on performance

Components of Internal control (contd..)

Risk assessment - identification and analysis of risks relevant to financial reporting in accordance with accounting standards.

Information and communication – ensuring that the entity’s control environment, risks, control activities and performance results are communicated company-wide.

Components of Internal control (contd..)

Monitoring – ongoing/ periodic assessment of the quality of internal control performance. Sources include, studies of existing internal controls, internal auditor reports and so on.

Control environment – the actions, policies and procedures that reflect the overall attitudes of top management, directors and owners of an entity towards internal control. Sub-elements for the auditor to consider:

- management’s philosophy and operating style - organizational structure - assignment of authority and responsibility - internal audit - human resources

Famous cases for Internal control failures

AWA Limited v Daniels – Auditors were sued for negligence as they failed to bring the deficiencies of internal control to the board of AWA limited

The HIH collapse – Royal commission found that HIH failed to review its corporate governance model to assess its suitability for changing circumstances in the insurance industry.

- Arthur Andersons failed to blow the whistle

SUBSTANTIVE TESTS AND TESTS OF CONTROLS

There are 2 basic methods for testing the accuracy of the Financial Statements:

Substantive Tests – where the contents of the FS are checked by looking for evidence that proves the figures and words are correct

Tests of Controls – where the systems that produce and protect the contents of the FS are checked. If the systems work, then the resulting FS should be accurate.

Tests of Controls

The audit procedures designed to evaluate the operating effectiveness

of controls in preventing, or detecting and correcting, material

misstatements at the assertion level.

Difference between a ‘test of control’ and a ‘substantive test of

transactions’?

A test of control focuses on assessing the quality of the evidence or information that has been processed by the accounting system.

A substantive test of a transaction relates to only tracing the accounting information the source documents to journals and to the General ledger (and subsidiary ledgers).

The auditor would be testing to see whether the purchase has been recorded correctly in the accounting records, recognizing that the reliability of that recording can be enhance by the presence of internal controls along the processing stream

A test of control focuses on the quality of the source documents whereas a substantive test of transaction concentrates on whether the source document has been recorded correctly in the accounting book.

Difference between a ‘test of control’ and a ‘substantive

test of control’?

The following is the description of the purchasing system at Dean. No other controls exist apart from those described.

“The company has no buying department so employees place orders in their own area of responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is sent to the goods inward department and copy 3 is sent to the supplier.”

“Goods are received, but not checked, by the goods inwards clerk. Once received, the advice note and purchase order for those goods are sent to the purchase ledger clerk.”

“When the supplier’s invoice is received the purchase ledger clerk checks the calculations on it, initials it and staples the advice note and purchase order to it. She enters the invoice on to the purchase ledger.”

“The invoice is then sent to the manager responsible for the employee who ordered the goods. The manager codes the invoice and returns it to the purchase ledger clerk. Purchase invoices are coded, entered on an analysis sheet and posted to the nominal ledger monthly by journal entry.”

“The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The purchase ledger control account is reconciled monthly by the purchase ledger clerk who also reconciles suppliers’ statements.”

Case Study Analysis

“The company has no buying department so employees place orders in their own area of responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is sent to the goods inward department and copy 3 is sent to the supplier.”

“Goods are received, but not checked, by the goods inwards clerk. Once received, the advice note and purchase order for those goods are sent to the purchase ledger clerk.”

“When the supplier’s invoice is received the purchase ledger clerk checks the calculations on it, initials it and staples the advice note and purchase order to it. She enters the invoice on to the purchase ledger.”

“The invoice is then sent to the manager responsible for the employee who ordered the goods. The manager codes the invoice and returns it to the purchase ledger clerk. Purchase invoices are coded, entered on an analysis sheet and posted to the nominal ledger monthly by journal entry.”

“The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The purchase ledger control account is reconciled monthly by the purchase ledger clerk who also reconciles suppliers’ statements.”

Case Study Analysis (contd..)

“The company no buying department so employees place orders in their own area of responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is sent to the goods inward department and copy 3 is sent to the supplier.”

“Goods are received, but not checked, by the goods inwards clerk. Once received, the advice note and purchase order for those goods are sent to the purchase ledger clerk.”

“When the supplier’s invoice is received the purchase ledger clerk checks the calculations on it, initials it and staples the advice note and purchase order to it. She enters the invoice on to the purchase ledger.”

“The invoice is then sent to the manager responsible for the employee who ordered the goods. The manager codes the invoice and returns it to the purchase ledger clerk. Purchase invoices are coded, entered on an analysis sheet and posted to the nominal ledger monthly by journal entry.”

“The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The purchase ledger control account is reconciled monthly by the purchase ledger clerk who also reconciles suppliers’ statements.”

Case Study Analysis (contd..)

“The company no buying department so employees place orders in their own area of responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is sent to the goods inward department and copy 3 is sent to the supplier.”

“Goods are received, but not checked, by the goods inwards clerk. Once received, the advice note and purchase order for those goods are sent to the purchase ledger clerk.”

“When the supplier’s invoice is received the purchase ledger clerk checks the calculations on it, initials it and staples the advice note and purchase order to it. She enters the invoice on to the purchase ledger.”

“The invoice is then sent to the manager responsible for the employee who ordered the goods. The manager codes the invoice and returns it to the purchase ledger clerk. Purchase invoices are coded, entered on an analysis sheet and posted to the nominal ledger monthly by journal entry.”

“The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The purchase ledger control account is reconciled monthly by the purchase ledger clerk who also reconciles suppliers’ statements.”

Case Study Analysis (contd..)

“The company no buying department so employees place orders in their own area of responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is sent to the goods inward department and copy 3 is sent to the supplier.”

“Goods are received, but not checked, by the goods inwards clerk. Once received, the advice note and purchase order for those goods are sent to the purchase ledger clerk.”

“When the supplier’s invoice is received the purchase ledger clerk checks the calculations on it, initials it and staples the advice note and purchase order to it. She enters the invoice on to the purchase ledger.”

“The invoice is then sent to the manager responsible for the employee who ordered the goods. The manager codes the invoice and returns it to the purchase ledger clerk. Purchase invoices are coded, entered on an analysis sheet and posted to the nominal ledger monthly by journal entry.”

“The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The purchase ledger control account is reconciled monthly by the purchase ledger clerk who also reconciles suppliers’ statements.”

Case Study Analysis (contd..)

“The company no buying department so employees place orders in their own area of responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is sent to the goods inward department and copy 3 is sent to the supplier.”

“Goods are received, but not checked, by the goods inwards clerk. Once received, the advice note and purchase order for those goods are sent to the purchase ledger clerk.”

“When the supplier’s invoice is received the purchase ledger clerk checks the calculations on it, initials it and staples the advice note and purchase order to it. She enters the invoice on to the purchase ledger.”

“The invoice is then sent to the manager responsible for the employee who ordered the goods. The manager codes the invoice and returns it to the purchase ledger clerk. Purchase invoices are coded, entered on an analysis sheet and posted to the nominal ledger monthly by journal entry.”

“The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The purchase ledger control account is reconciled monthly by the purchase ledger clerk who also reconciles suppliers’ statements.”

Case Study Analysis (contd..)

“The company no buying department so employees place orders in their own area of responsibility. A three part order form is used; copy 1 is retained by the originator, copy 2 is sent to the goods inward department and copy 3 is sent to the supplier.”

“Goods are received, but not checked, by the goods inwards clerk. Once received, the advice note and purchase order for those goods are sent to the purchase ledger clerk.”

“When the supplier’s invoice is received the purchase ledger clerk checks the calculations on it, initials it and staples the advice note and purchase order to it. She enters the invoice on to the purchase ledger.”

“The invoice is then sent to the manager responsible for the employee who ordered the goods. The manager codes the invoice and returns it to the purchase ledger clerk. Purchase invoices are coded, entered on an analysis sheet and posted to the nominal ledger monthly by journal entry.”

“The cashier pays suppliers monthly on instructions from the purchase ledger clerk. The purchase ledger control account is reconciled monthly by the purchase ledger clerk who also reconciles suppliers’ statements.”

Case Study Analysis (contd..)

Dean – weaknesses and audit significance (in terms of resulting error)

1st WeaknessNo buying department There is no buying department.

Error: Staff may not buy the cheapest products

Dean – weaknesses and audit significance (in terms of resulting error)

1st WeaknessNo buying department There is no buying department.

Error: Staff may not buy the cheapest products

and may duplicate products

Dean – 6 weaknesses

2nd WeaknessUnnumbered Order Form The purchase order notes appear to be

unnumbered.

Error: So purchase order notes could go

missing.

Dean – 6 weaknesses

3rd WeaknessGoods not checked Goods are not checked for quality on

arrival

Error: Dean may accept damaged goods. (the

valuation of inventory may be wrong)

Dean – 6 weaknesses

4th WeaknessGoods Received Notes Dean does not generate Goods Received

Notes. (GRN)

Error: Dean will not be able to tell what stock

has arrived.

Dean – 6 weaknesses

5th WeaknessPurchase Day Book There is no purchase day book. (PDB)

instead Journals are used monthly

Error: So Dean will not know who they owe at

any point.

Dean – 6 weaknesses

6th WeaknessLack of segeration The purchase ledger clerk perfoms all

the duties in purchase orders.

Error: So she could cover up the fraud.

Effect on normal Audit Procedures

Normal Audit Procedures. the normal method of auditing information in

the income statement is to use control tests. Dean pruchases system

however, as can be seen that the Dean purchases system is very weak.

Conculsion so the Dean purchases will need substantive

testing and this will increase audit duration.

Thank You!