Chapter 1: Auditing, Assurance, and Internal Control
Hall & Singleton, 2e
AUDITING Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and establishing criteria and communicating the results to interested users.
INTERNAL AUDITS
Internal auditing: independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization
Financial Audits Operational Audits Compliance Audits Fraud Audits IT Audits CIA IIA
IT AUDITS
IT audits: provide audit services where processes or data, or both, are embedded in technologies.
Subject to ethics, guidelines, and standards of the profession (if certified) CISA Most closely associated with ISACA Joint with internal, external, and fraud audits Scope of IT audit coverage is increasing Characterized by CAATTs IT governance as part of corporate governance
FRAUD AUDITS
Fraud audits: provide investigation services where anomalies are suspected, to develop evidence to support or deny fraudulent activities.
Auditor is more like a detective No materiality Goal is conviction, if sufficient evidence of fraud exists CFE ACFE
EXTERNAL AUDITS
External auditing: Objective is that in all material respects, financial statements are a fair representation of organization’s transactions and account balances.
SEC’s role Sarbanes-Oxley Act FASB - PCAOB CPA AICPA
EXTERNAL vs. INTERNAL
External auditing:
Independent auditor (CPA) Independence defined by SEC/S-OX/AICPA Required by SEC for publicly-traded companies Referred to as a “financial audit” Represents interests of outsiders, “the public” (e.g., stockholders) Standards, guidance, certification governed by AICPA, FASB, PCAOB; delegated by SEC who has final authority
Internal auditing:
Auditor (often a CIA or CISA) Is an employee of organization imposing independence on self Optional per management requirements Broader services than financial audit; (e.g., operational audits) Represent interests of the organization Standards, guidance, certification governed by IIA and ISACA
FINANCIAL AUDITS
An independent attestation performed by an expert (i.e., an auditor, a CPA) who expresses an opinion regarding the presentation of financial statements Key concept: Independence {Should be} Similar to a trial by judge Culmination of systematic process involving:
Familiarization with the organization’s business Evaluating and testing internal controls Assessing the reliability of financial data
Product is formal written report that expresses an opinion about the reliability of the assertions in financial statements; in conformity with GAAP
ATTEST definition
Written assertions Practitioner’s written report Formal establishment of measurement criteria or their description Limited to:
Examination Review Application of agreed-upon procedures
ATTEST vs. ASSURANCE
ASSURANCE
Professional services that are designed to improve the quality of information, both financial and nonfinancial, used by decision-makers
IT Audit Groups in “Big Four”
IT Risk Management I.S. Risk Management Operational Systems Risk Management Technology & Security Risk Services Typically a division of assurance services
AUDITING STANDARDS
Auditing standards
Set by AICPA Authoritative #1 = Ten Generally Accepted Auditing Standards (GAAS) Three categories: General Standards Standards of Field Work Reporting Standards # 2 = Statements on Auditing Standards (SASs) SAS #1 issued by AICPA in 1972
AUDITS
Systematic process Five primary management assertions, and correlated audit objectives and procedures [Table 1-1]
Existence or Occurrence Completeness Rights & Obligations Valuation or Allocation Presentation or Disclosure
AUDITS Phases [Figure 1-3] 1. Planning 2. Obtaining evidence
Tests of Controls Substantive Testing
CAATTs Analytical procedures
3. Ascertaining reliability
MATERIALITY
4. Communicating results
Audit opinion
Audit Risk Formula AUDIT The
RISK:
probability that the auditor will give an inappropriate opinion on the financial statements: that is, that the statements will contain materials misstatement(s) which the auditor fails to find
Audit Risk Formula INHERENT
RISK:
The
probability that material misstatements have occurred Material
vs. Immaterial
Includes
economic conditions, etc.
Relative
risk (e.g., cash)
Audit Risk Formula CONTROL The
RISK:
probability that the internal controls will fail to detect material misstatements
Audit Risk Formula DETECTION
RISK:
The
probability that the audit procedures will fail to detect material misstatements
Substantive
procedures
Audit Risk Formula
AUDIT RISK MODEL:
AR = IR * CR * DR example inventory with: IR=40%, CR=60%, AR=5% (fixed) .05 = .4 * .6 * DR ... then DR=4.8% Why is AR = 5%? What is detection risk? Can CR realistically be 0? Relationship between DR and substantive procedures
Audit Risk Model
Relationship between tests of controls and substantive tests
Illustrate higher reliability of the internal controls and the Audit Risk Model
What happens if internal controls are more reliable than last audit? Last year: .05 = .4 * .6 * DR [DR = 4.8] This year: .05 = .4 * .4 * DR [DR = 3.2] The more reliable the internal controls, the lower the CR probability; thus the lower the DR will be, and fewer substantive tests are necessary.
Substantive tests are labor intensive
Role of Audit Committee
Selected from board of directors Usually three members Outsiders (S-OX now requires it) Fiduciary responsibility to shareholders Serve as independent check and balance system Interact with internal auditors Hire, set fees, and interact with external auditors Resolved conflicts of GAAP between external auditors and management
What is an IT Audit? … most accounting transactions to be in electronic form without any paper documentation because electronic storage is more efficient. … These technologies greatly change the nature of audits, which have so long relied on paper documents.
THE IT ENVIRONMENT
There has always been a need for an effective internal control system. The design and oversight of that system has typically been the responsibility of accountants. The I.T. Environment complicates the paper systems of the past.
Concentration of data Expanded access and linkages Increase in malicious activities in systems vs. paper Opportunity that can cause management fraud (i.e., override)
THE IT ENVIRONMENT
Audit planning
Tests of controls
Substantive tests CAATTs
INTERNAL CONTROL
is … policies, practices, procedures … designed to …
safeguard assets ensure accuracy and reliability promote efficiency measure compliance with policies
BRIEF HISTORY - SEC SEC acts of 1933 and 1934
“Ivar Kreuger’s Contribution to U.S. Financial Reporting,” Accounting Review, Flesher & Flesher
All corporations that report to the SEC are required to maintain a system of internal control that is evaluated as part of the annual external audit.
BRIEF HISTORY - Copyright Federal Copyright Act 1976 1. Protects intellectual property in the U.S. 2. Has been amended numerous times since 3. Management is legally responsible for violations of the organization 4. U.S. government has continually sought international agreement on terms for protection of intellectual property globally vs. nationally
BRIEF HISTORY - FCPA Foreign Corrupt Practices Act 1977 1. Accounting provisions
FCPA requires SEC registrants to establish and maintain books, records, and accounts. It also requires establishment of internal accounting controls sufficient to meet objectives. 1. Transactions are executed in accordance with management’s general or specific authorization. 2. Transactions are recorded as necessary to prepare financial statements (i.e., GAAP), and to maintain accountability. 3. Access to assets is permitted only in accordance with management authorization. 4. The recorded assets are compared with existing assets at reasonable intervals.
2. Illegal foreign payments
BRIEF HISTORY - COSO Committee on Sponsoring Organizations - 1992 1. AICPA, AAA, FEI, IMA, IIA 2. Developed a management perspective model for internal controls over a number of years 3. Is widely adopted
BRIEF HISTORY – S-OX Sarbanes-Oxley Act - 2002 1. Section 404: Management Assessment of Internal Control Management is responsible for establishing and maintaining internal control structure and procedures. Must certify by report on the effectiveness of internal control each year, with other annual reports.
1. Section 302: Corporate Responsibility for Incident Reports Financial executives must disclose deficiencies in internal control, and fraud (whether fraud is material or not).
Modifying Assumptions 1. Management responsibility 2. Reasonable assurance no I.C.S. is perfect benefits => costs 2. Methods of data processing Objectives same regardless of DP method Specific controls vary w/different technologies
Modifying Assumptions 4.
Limitations
Possibility of error Possibility of circumvention Management override Changing conditions
EXPOSURES AND RISK Exposure (definition) Risks (definition) Types
of risk
Destruction
of assets Theft of assets Corruption of information or the I.S. Disruption of the I.S.
THE P-D-C MODEL Preventive
controls Detective controls Corrective controls Which
is most cost effective? Which one tends to be proactive measures? Can you give an example of each? Predictive
controls
SAS 78: Consideration of Internal Control in a Financial Statement Audit ■ COSO The
(Treadway Commission)
control environment Risk assessment Information & communication Monitoring Control activities
SAS 78 (#1:Control Environment -- elements)
Describe how each one could adversely affect internal control.
The
integrity and ethical values Structure of the organization Participation of audit committee Management’s philosophy and style Procedures for delegating
SAS 78 (#1:Control Environment -- elements) Management’s methods of assessing performance External influences Organization’s policies and practices for managing human resources
SAS 78 (#1:Control Environment -- techniques)
Describe possible activity or tool for each. Assess the integrity of organization’s management Conditions conducive to management fraud Understand client’s business and industry Determine if board and audit committee are actively involved Study organization structure
SAS 78 (#2:Risk Assessment)
Changes in environment Changes in personnel Changes in I.S. New IT’s Significant or rapid growth New products or services (experience) Organizational restructuring Foreign markets New accounting principles
SAS 78 (#3:Information & Communication-elements)
Initiate, identify, analyze, classify and record economic transactions and events.
Identify and record all valid economic transactions Provide timely, detailed information Accurately measure financial values Accurately record transactions
SAS 78 (#3:Information & Communication-techniques)
Auditors obtain sufficient knowledge of I.S.’s to understand: Classes
of transactions that are material
Accounting
records and accounts used
Processing
steps:initiation to inclusion in financial statements (illustrate)
Financial
reporting process (including disclosures)
SAS 78 (#4: Monitoring)
By separate procedures (e.g., tests of controls)
By ongoing activities (Embedded Audit Modules – EAMs and Continuous Online Auditing - COA)
SAS 78 (#5: Control Activities)
Physical Controls (1-3)
Transaction authorization
Sales only to authorized customer
Sales only if available credit limit
Segregation of duties
Example:
Examples of incompatible duties:
Authorization vs. processing [e.g., Sales vs. Auth. Cust.]
Custody vs. recordkeeping [e.g., custody of inventory vs. DP of inventory]
Fraud requires collusion [e.g., separate various steps in process]
Supervision
Serves as compensating control when lack of segregation of duties exists by necessity
Physical Controls (4-6)
Accounting records (audit trails; examples)
Access controls
Direct (the assets)
Indirect (documents that control the assets)
Fraud
Disaster Recovery
Independent verification
Management can assess:
The performance of individuals
The integrity of the AIS
The integrity of the data in the records
Examples
IT Risks Model Operations Data
management systems New systems development Systems maintenance Electronic commerce (The Internet) Computer applications
