Ch 7 Internal Control

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Ch 7 Internal Control
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Introduction

• The second standard of field work
• A sufficient understanding of internal control
  (I/C) is to be obtained
• to plan the audit and
• to determine the nature, timing and extent of
  tests to be performed

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Internal Control Definition

• A process ...designed to provide reasonable
  assurance...regarding, achievement of the
  entitys objectives on (per Committee of
  Sponsoring Organizations (COSO))
• Reliability of financial reporting
• Effectiveness and efficiency of operations
• Compliance with applicable laws and regulations

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Impact of Foreign Corrupt Practices Act (1977)

• Act covers all corps under jurisdiction of SEC
• Objective--to prevent American Corps payment of
  bribes to foreign officials to obtain business

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Impact of Foreign Corrupt Practices Act
(1977)--contd

• Requires Public Companies to have system of I/C
  to provide reasonable assurance that
• Transactions are executed with knowledge
  authorization of managers
• Transactions are recorded to result in reliable
  F/S
• Access to assets is limited
• Acctg records are periodically compared to
  existing assets

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Impact of Sarbanes-OxleySection 404

• Impact is for Public Companies
• Section 404 of SOX requires annual assessment of
  I/C by mgt AND an assertion by mgt that
• Officers have established and are maintaining
  effective I/C
• Officers have disclosed to auditors audit
  committee any significant deficienciesand any
  fraud
• The report details any significant changes in
  I/C
• Auditor must attest to mgts report of I/C

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Summary of Components of Internal Control

• (1) The Control Environment
• (2) Risk Assessment
• (3) The Accounting Information and Communication
  System
• (4) Control Activities
• (5) Monitoring

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(1) The Control Environment--Factors

• Integrity and ethical values
• Commitment to competence
• Board of directors or audit committee
• Management philosophy and operating style
• Organizational structure
• Assignment of authority and responsibility
• Human resource policies and practices
• Use of fidelity bonds

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(2) Risk Assessment--Factors Indicative of
Increased Financial Reporting Risk

• Changes in the regulatory or operating
  environment
• Changes in personnel
• Implementation of a new or modified information
  system
• Rapid growth of the organization
• Changes in technology affecting production
  processes or information systems
• Introduction of new lines of business, products,
  or processes

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(3) The Accounting Info. System--Objectives

• Identify and record valid transactions
• Describe and classify transactions on a timely
  basis
• Measure the value of transactions appropriately
• Determine and record the transactions in the
  proper time period
• Present the transactions and related disclosures
  properly in the F/S

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(4) Control Activities

• Policies and procedures to ensure that mgts
  directives are carried out
• Performance reviews--of F/S data
• Information processing--using general and
  application controls
• Physical controls--security over records and
  assets
• Segregation of duties--authorizing recording
  transactions asset custody

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(5) Monitoring

• Activities to determine that I/C is operating as
  intended
• Ongoing monitoring activities
• Separate evaluations
• Internal Audit function

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Limitations of Internal Control

• Even with an excellent system of I/C
• Errors from misunderstandings of instructions,
  mistakes of judgment, fatigue, etc.
• Controls that depend on the segregation of duties
  may be circumvented by collusion
• Management may override the structure
• Compliance may deteriorate over time

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Documenting Internal Control

• Questionnaires
• Flowcharts
• Written Narratives
• See examples following

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Written Narrative on Internal Control
Bennington Co., Inc.Cash Receipts
ProceduresDecember 31, 200X All cash receipts
are received by mail in the form of checks.
Lorraine Martin, cashier, picks up the mail every
morning at the post office and delivers in
unopened to Helen Ellis, the head bookkeeper.
Ellis opens and distributes the mail. Customers
checks are given to Martin, who records the
remittance in the cash receipts journal, prepares
duplicate deposit slips, and mails the days
receipts intact to First National Bank. The bank
returns the validated duplicate deposit slips by
mail, and Ellis files them in chronological
order. Ellis posts the accounts receivable
subsidiary ledger from the cash receipts journal
on a daily basis. Any customers checks
charged back by the bank are given by Ellis to
the manager, William Dale, who follows up and
redeposits the checks. Ellis also forwards
monthly bank statements unopened to Dale. Dale
reconciles the monthly bank statement, compares
the dates and amounts of deposits with the
entries in the cash receipts journal, and reviews
the propriety of sales discounts recorded in the
cash receipts journal. Martin, Ellis, and Dale
are all bonded. Val Martin HawkinsSeptember 6,
200X
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Flowcharting Symbols
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Cash Receipts Flowchart
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(No Transcript)
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Communication of Internal Control Matters

• Reportable conditions--Must communicate to
  BOD/Audit Committee
• Material weaknesses--more significant
  deficiencies--must report as above
• Other deficiencies--less significant weaknesses
  reported in management letter or memo or orally
• See bullseye chart
• See Reportable Condition letter

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Deficiencies in Design or Operation of Internal
Control
Reportable Conditions
Material Weaknesses