Week 4 Internal Cotrols lecture part 4

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Part 4 of our discussion of internal controls.

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Step 3a: Testing Controls: Design Effectiveness:

Step 3a: Testing Controls: Design Effectiveness Design effectiveness determines whether the controls over financial reporting, if operating effectively , would be expected to prevent or detect errors or fraud that could result in a material misstatement in the financial statements. After an understanding of internal controls is gained through inquiry, inspection, and observation, the controls are evaluated for the possibility that the controls would not prevent or detect a misstatement. 5- 1

Step 3b: Testing Controls: Operating Effectiveness:

Step 3b: Testing Controls: Operating Effectiveness Operating effectiveness is whether the control is operating as designed and whether the person performing the control possesses the necessary authority and qualifications to perform the control effectively. A sample of transactions is examined using inquiry, observation, inspection, and reperformance. Tests of controls would not be performed if design is not evaluated as effective. 5- 2

Step 4a: Evaluate identified deficiencies:

Step 4a: Evaluate identified deficiencies Whether the result of a design deficiency or an operating deficiency, an internal control deficiency exists when the design or operation of a control does not allow the entity’s management or employees to detect or prevent misstatements in a timely fashion. A design deficiency is a problem relating to either a necessary control that is missing or an existing control that is so poorly designed that it fails to satisfy the control’s objective. An operating deficiency , on the other hand, occurs when a properly designed control is either ignored or inappropriately applied (possibly because employees are poorly trained). More serious internal control deficiencies can be categorized into one of two groups, significant deficiencies or material weaknesses , depending on their severity. 5- 3

Step 4b: Identify significant deficiencies:

Step 4b: Identify significant deficiencies Significant deficiencies are defined as conditions, or combinations of conditions, that could adversely affect the organization’s ability to initiate, record, process, and report financial data in the financial statements. While not material, they are important enough to bring to the attention of those charged with governance (usually the audit committee). Absence of appropriate separation of duties. Absence of appropriate reviews and approvals of transactions. Evidence of failure of control procedures. 5- 4

Step 4c: Identify Material Weaknesses:

Step 4c: Identify Material Weaknesses A material weakness in internal control is defined as a deficiency, or combination of deficiencies, that results in a reasonable possibility that a material misstatement would not be prevented or detected on a timely basis. Indicators of possible material weakness Restatement of previously issued financial statements to reflect the correction of a misstatement. Evidence of material misstatements (caught by the audit team) that were not prevented or detected by client’s internal controls. Ineffective oversight of financial reporting process by entity’s audit committee. Indication of fraud (either material or immaterial) by senior management. 5- 5

Summary of Internal Control Deficiencies:

Summary of Internal Control Deficiencies Three categories Internal control deficiency Significant deficiency Material weaknesses The difference between a significant deficiency and a material weakness is the (1)  likelihood and (2)  materiality that a potential (or actual) misstatement would not be detected on a timely basis. 5- 6

Step 5: Wrapping up :

Step 5: Wrapping up Auditors can issue one of three types of opinions on internal control over financial reporting: Unqualified . No material weaknesses found. Disclaimer of opinion . The audit team cannot perform all of the procedures considered necessary. Adverse opinion . One or more material weaknesses found . Evaluate management’s report on the effectiveness of internal control. 5- 7

Step 6: Reporting on Internal Control:

Step 6: Reporting on Internal Control Can be a separate report on internal control Opinion on financial statements contained in separate audit report Extra paragraph added to report on internal control referencing opinion on financial statements. Or an integrated audit report and report on internal control and the financial statements Includes auditor’s opinions on 1) internal control effectiveness , and 2) the fairness of the company’s financial statements . 5- 8

Modifications to the Auditors’ Standard Report on Internal Control:

Modifications to the Auditors’ Standard Report on Internal Control Material weaknesses in the entity’s internal control over financial reporting Effect of an adverse opinion on internal control on the auditor’s opinion on the financial statements Restriction on the scope of the engagement 5- 9

Exhibit 5.18 – Report on Internal Control over Financial Reporting if a Material Weakness Exists:

Exhibit 5.18 – Report on Internal Control over Financial Reporting if a Material Weakness Exists 5- 10

Exhibit 5.20 – Modifications to Auditors’ Report on Internal Control Over Financial Reporting:

Exhibit 5.20 – Modifications to Auditors’ Report on Internal Control Over Financial Reporting 5- 11

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