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Fundamentals of Auditing

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Fundamentals of Auditing ­ACC 311
VU
Lesson 15
UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT
AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
e) Internal Control.
Understanding of Internal Control is used by the auditor
1.
to identify types of potential misstatements;
2.
to consider factors that affect the risks of material misstatements; and
3.
to design the nature, timing and extent of further audit procedures.
Definition of Internal Control
Internal control is the process designed and affected by those charged with governance, management, and
other personnel ...........
to provide reasonable assurance about the achievement of the entity's objectives with regard to:
1.
Reliability of financial reporting,
2.
Effectiveness and efficiency of operations and
3.
Compliance with applicable laws and regulations.
It follows that internal control is designed and implemented to address identified business risks that
threaten the achievement of any of these objectives.
Components of Internal Control
i)
The control environment
ii)
The entity's risk assessment process
iii)
The information system, including the related business processes relevant to financial
reporting and communication.
iv)
Control activities
v)
Monitoring of controls
i)
The Control Environment
It encompasses the following elements:
(a)
Communication and enforcement of integrity and ethical values.
(b)
Commitment to competence
(c)
Participation by those charged with governance
(d)
Management's philosophy and operating style
(e)
Organizational structure
(f)
Human resource policies and practices
Auditor should evaluate how these components have been incorporated into the entity's processes.
ii)
The Entity's Risk Assessment Process
It is the process of identifying and responding to business risks that affect entity's financial reporting.
Such process includes how management:
1. identifies risks that affect entity's ability to produce financial statement that give true and
fair view,
2. estimates their significance,
3. estimates likelihood of their occurrence and
4. Decides upon actions to manage them.
Risks relevant to financial reporting include:
­  internal events, and
­  external events and circumstance
That may occur and adversely affect an entity's ability to:
 initiate,
 record,
 process, and
 report the financial information.
Risks can arise due to circumstances such as the following: (internal/external)
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Fundamentals of Auditing ­ACC 311
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a) Changes in operating environment
b) New personnel
c) New or revamped information systems
d) Rapid growth
e) New technology
f)  New business models, product or activities
g) Corporate restructurings
h) Expanded foreign operations
i)  New accounting pronouncements
iii)
Information system, including the related business processes, relevant to financial
reporting and communication
The information system consists of:
1. infrastructure (physical and hardware components),
2. software
3. people
4. procedures and
5. data
Infrastructure and software will be absent, or have less significance, in systems that are exclusively or
primarily manual. Many information systems make extensive use of IT.
Importance of Information System
Accordingly, an information system encompasses methods and records that:
 Identify and record all valid transaction.
 Describe on a timely basis the transaction in sufficient detail to permit proper classification of
transactions for financial reporting.
 Measure the value of transactions in a manner that permits recording their proper monetary value
in the financial statements.
 Determine the time period in which transactions occurred to permit recording of transactions in
the proper accounting period.
 Present properly the transactions and related disclosures in the financial statements.
Communication
 Communication involves:
­  providing an understanding of individual roles and responsibilities pertaining to internal
control,
­  understanding roles of others and
­  doing exception reporting to higher level management.
 Communication takes such forms as:
­  policy manuals,
­  accounting and financial reporting manuals and memorandum.
 It may also be made
­  electronically,
­  orally and
­  through the actions of management
iv)
Control Activities
Control activities include:
a) Performance reviews
b) Information processing
c) Physical controls
d) Segregations of duties
a) Performance reviews
These control activities include:
­  reviews and analyses of actual performance versus budgets, forecasts, and prior period
performance;
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Fundamentals of Auditing ­ACC 311
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­
relating different sets of data - operating or financial - to one another, together with
analyses of the relationships and investigative and corrective actions;
­  comparing internal data with external sources of information; and
­  review of functional or activity performance, such as a bank's Consumer loan manager's
review of reports by branch, region, and loan type for loan approvals and collections
b) Information processing
A variety of controls are performed to check accuracy, completeness, and authorization of
transactions.
The two broad groupings of information systems control activities are:
i.
application controls and
ii.
general IT controls.
Application controls apply to the processing of individual applications. These controls help ensure that
transactions occurred, are authorized, and are completely and accurately recorded and processed.
General IT-controls commonly include controls over data center and network operations; system software
acquisition, change and maintenance; access security; and application system acquisition, development, and
maintenance. These controls apply to main-frame, mini-frame and end-user environments.
c) Physical controls
These activities encompass the:
physical security of assets, including adequate safeguards such as secured facilities access to
i.
assets and records;
authorization for access to computer programs and data files; and
ii.
iii.
periodic counting and comparison with amounts shown on control records (for example
comparing the results of cash, security and inventory counts with accounting records).
d) Segregation of duties
Assigning different people the responsibilities of authorizing transactions, recording transactions, and
maintaining custody of assets is intended to reduce the opportunities to allow any person to be in a position
to both commit and conceal errors or fraud in the normal course of the person's duties. Examples of
segregation of duties include reporting, reviewing and approving reconciliations, and approval and control
of documents.
v)
Monitoring of Control
The auditor should obtain an understanding of the major types of activities that
i.
the entity uses to monitor internal control over financial reporting, and
ii.
how the entity initiates corrective actions to its controls.
Monitoring means and includes:
Ensuring that internal controls are operating as intended.
­  If monitoring is not done, people may stop performing the functions they are required to
perform.
­  It also involves assessing the quality of internal control performance over times.
­  Monitoring may be ongoing activities, separate evaluations or a combination of the two.
Monitoring includes:
a) Supervisions, functions of managers
b) Internal audit
c) Communication from external parties indicating areas requiring
3.
Assessing the Risk of Material Misstatement
The auditor should identify and assess the risks of material misstatement at the financial statement level, and
at the assertion level for classes of transactions, account balances, and disclosures. For this purpose, the
auditor:
 Identifies risks throughout the process of obtaining an understanding of the entity and its
environment, including relevant controls that relate to the risks, and by considering the
classes of transactions, account balances, and disclosures in the financial statements.
 Relates the identified risks to what can go wrong at the assertion level;
 Considers whether the risks are of a magnitude that could result in a material misstatement
of the financial statements; and
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Fundamentals of Auditing ­ACC 311
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Considers the likelihood that the risks could result in a material misstatement of the
financial statements.
Significant Risks that require Special Audit Considerations
Significant risks
These relate to:
 non-routine transactions (unusual)
 judgmental matters (e.g. accounting estimates)
 non-routine transactions arising from matters such as:
greater management intervention to specify the accounting treatment
greater manual intervention for data collection and processing
complex calculations or accounting principles.
For significant risks, to the extent the auditor has not already done so, the auditor should evaluate the
design of the entity's related controls, including relevant control activities, and determine whether they have
been implemented.
If management has not appropriately responded by implementing controls over significant risks and if, as a
result, the auditor judges that there is a material weakness in the entity's internal control, the auditor
communicates this matter to those charged with governance as required in paragraph 8. In these
circumstances, the auditor also considers the implications for the auditor's risk assessment.
Risks for which substantive procedures alone do not provide sufficient appropriate audit evidence
As part of the risk assessment as described in the above paragraph, the auditor should evaluate the design
and determine the implementation of the entity's controls, including relevant control activities, over those
risks for which, in the auditor's judgment, it is not possible or practicable to reduce the risks of material
misstatement at the assertion level to an acceptably low level with audit evidence obtained only from
substantive procedures.
Examples of situations where the auditor may find it impossible to design effective substantive procedures
that by themselves provide sufficient appropriate audit evidence that certain assertions are not materially
misstated include the following:
 An entity that conducts its business using IT to initiate orders for the purchase and delivery of
goods based on predetermined rules of what to order and in what quantities and to pay the related
accounts payable based on system-generated decisions initiated upon the confirmed receipt of
goods and terms of payment. No other documentation of orders placed or goods received is
produced or maintained, other than through the IT system.
 An entity that provides services to customers via electronic media (for example, an Internet service
provider or a telecommunications company) and uses IT to create log of the services provided to
its customers, initiate and process its billings for the services and automatically record such
amounts in electronic accounting records that are part of the system used to produce the entity's
financial statements.
Revision of Risk Assessment
While performing tests of controls or substantive procedures auditor finds that controls are not performing
effectively and misstatements found are not in accordance with expectations of misstatements, the auditor
should revise his assessment of risk and modify the further planned audit procedures.
4.
Communicating with those Charged with Governance and Management
The auditor should make those charged with governance or management aware, as soon as practicable, and
at an appropriate level of responsibility, of material weaknesses in the design or implementation of internal
control which have come to the auditor's attention.
5.
Documentation
The auditor should document:
(a)
The discussion among the engagement team regarding the susceptibility of the entity's financial
statements to material misstatement due to error or fraud, and the significant decisions reached;
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Fundamentals of Auditing ­ACC 311
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(b)
Key elements of the understanding obtained regarding each of the aspects of the entity and its
environment, including each of the internal control components, to assess the risks of material
misstatement of the financial statements; the sources of information from which the understanding
was obtained; and the risk assessment procedures;
(c)
The identified and assessed risks of material misstatement at the financial statement level and at the
assertion level; and
(d)
The risks identified and related controls evaluated.
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Table of Contents:
  1. AN INTRODUCTION
  2. AUDITORSí REPORT
  3. Advantages and Disadvantages of Auditing
  4. OBJECTIVE AND GENERAL PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS
  5. What is Reasonable Assurance
  6. LEGAL CONSIDERATION REGARDING AUDITING
  7. Appointment, Duties, Rights and Liabilities of Auditor
  8. LIABILITIES OF AN AUDITOR
  9. BOOKS OF ACCOUNT & FINANCIAL STATEMENTS
  10. Contents of Balance Sheet
  11. ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
  12. Business Operations
  13. Risk Assessment Procedures & Sources of Information
  14. Measurement and Review of the Entityís Financial Performance
  15. Definition & Components of Internal Control
  16. Auditing ASSIGNMENT
  17. Benefits of Internal Control to the entity
  18. Flow Charts and Internal Control Questionnaires
  19. Construction of an ICQ
  20. Audit evidence through Audit Procedures
  21. SUBSTANTIVE PROCEDURES
  22. Concept of Audit Evidence
  23. SUFFICIENT APPROPRIATE AUDIT EVIDENCE AND TESTING THE SALES SYSTEM
  24. Control Procedures over Sales and Debtors
  25. Control Procedures over Purchases and Payables
  26. TESTING THE PURCHASES SYSTEM
  27. TESTING THE PAYROLL SYSTEM
  28. TESTING THE CASH SYSTEM
  29. Controls over Banking of Receipts
  30. Control Procedures over Inventory
  31. TESTING THE NON-CURRENT ASSETS
  32. VERIFICATION APPROACH OF AUDIT
  33. VERIFICATION OF ASSETS
  34. LETTER OF REPRESENTATION VERIFICATION OF LIABILITIES
  35. VERIFICATION OF EQUITY
  36. VERIFICATION OF BANK BALANCES
  37. VERIFICATION OF STOCK-IN-TRADE AND STORE & SPARES
  38. AUDIT SAMPLING
  39. STATISTICAL SAMPLING
  40. CONSIDERING THE WORK OF INTERNAL AUDITING
  41. AUDIT PLANNING
  42. PLANNING AN AUDIT OF FINANCIAL STATEMENTS
  43. Audits of Small Entities
  44. AUDITORíS REPORT ON A COMPLETE SET OF GENERAL PURPOSE FINANCIALSTATEMENTS
  45. MODIFIED AUDITORíS REPORT