Chapter 10 Instructors Guide.docx

Chapter 10 Instructors Guide.docx

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Chapter10InstructorsGuide

Chapter10

Section404AuditsofInternalControl

andControlRisk

Thischapterillustratestheauditor’sresponsibilitiesrelatedtointernalcontrolrequiredbySection404oftheSarbanesOxleyActandPCAOBStandard2.Therequirementsforanintegratedauditoffinancialstatementsandanauditofinternalcontroloverfinancialreportinghavehadthemostsignificanteffectontheauditingprofessionasanythinginseveraldecades.Thischapteroutlinesmanagement’sandtheauditor’sresponsibilitiesrelatedtodocumentation,assessment,andreportingontheoperatingeffectivenessofinternalcontroloverfinancialreportingrequiredbySection404.ThischapteralsohighlightsthekeycomponentsofCOSO’sInternalControl–IntegratedFramework,whichistheframeworkbeingusedbypubliccompaniestoassesstheoperatingeffectivenessofinternalcontrol.Thechapterconcludesbycontrastingtheauditor’sresponsibilitiesrelatedtointernalcontrolinauditsofpublicandnonpubliccompanies.

Wespendthreetofourhoursonthisimportantchapter.Ourgreatestconcernisforstudentstounderstandthepubliccompanyauditor’stestingandreportingresponsibilitiesandtoseetheinterrelationshipofinternalcontrolwiththerestoftheaudit.Itisalsoimportantforthemtodevelopastrongunderstandingofkeyinternalcontrolconceptsandtodevelopskillsinidentifyingcontrolsanddeficienciesininternalcontrol.

Thefollowingarethemajortopicswecover:

⏹Chapteropeningvignette

⏹Relationshipwiththerestoftheaudit

⏹Internalcontrolobjectives

⏹Management’sresponsibilitiesforinternalcontrol

⏹Auditorresponsibilitiesforunderstanding,testingandreportingoninternalcontrol

⏹Transaction-relatedauditobjectives

⏹COSOcomponentsofinternalcontrol

·Thecontrolenvironment

·Riskassessment

·Controlactivities

·Informationandcommunication

·Monitoring

⏹Obtainanddocumentanunderstandingofinternalcontrol

⏹Assesscontrolrisk

⏹Identifycontrolsanddeficiencies

⏹Testsofcontrols

⏹Practicalapplication

⏹Section404reportingoninternalcontrol

⏹Evaluating,reporting,andtestinginternalcontrolfornonpubliccompanies

⏹Otherhomeworkproblems

ChapterOpeningVignette–“GoodInternalControlPreventsMoreEmbezzlementsthanGoodAuditorsFind”

Itisimportantforstudentstounderstandseveralimportantthingsthatarehighlightedinthisvignette.First,defalcationsdooccur,andtheycanbesignificantinamount.Embezzlementsinthemillionsofdollarsarecommoneveninsmallcompanies.Second,auditors'detailedproceduresarelimitedintheirscopeandtendtofocusonlargertransactionsandevents.Auditproceduresaredesignedtoprovidereasonable,notabsolute,assurancethatmaterialmisstatementsduetofraudaredetected.Third,althoughauditorsofbothpublicandnonpubliccompaniesgainanunderstandingoftheirclients'internalcontrol,clientsareaprimarysourceformostoftheinformationaboutthesystems.

Theimplicationofthisvignetteistwofold.First,anyclientdocumentorcircumstancethatlooksatallinappropriateshouldbecarefullyinvestigated.Auditorswon'thavemanychancestofindadefalcationandmustcapitalizeonanyfraudindicatorsthatappearunusual.Second,theclient'sinternalcontrolshouldbeviewedintermsofdeficienciesthatwouldallowforerrorsorfraudandeffectiverecommendationstobemade.Preventionisthebestapproachandtheauditorsareconsideredtobetheexpertsininternalcontrol.

RelationshipWiththeRestoftheAudit

OurstartingpointforthischapterisFigure8-1（page209）,sothatstudentscanseeingeneralhowinternalcontrolevaluationtiesintotheplanningprocessandrelatestodesigningauditprograms.

（SeeFigure8-1）

Next,wereferstudentstothesecondstandardoffieldworkandask,"Whyisobtaininganunderstandingoftheentityanditsenvironment,includinginternalcontrolandassessingcontrolrisksoimportantinauditing?

"TrytogainagreementthatitisrelatedtotheconceptofexpectationofmisstatementsdevelopedinChapter9.

Wereferstudentstotheauditriskmodelusedforplanning:

PDR=AAR÷（IRxCR）.Itisimportantforstudentstounderstandthatthischapterdealswithcontrolriskandhowitrelatestosubstantivetests（PDR）.UseT-10-1toshowstudentstwoaspects:

theimportanceofinternalcontrolinevidencedeterminationforfinancialstatementauditpurposes,andtherelationshipofinternalcontroltootherfactors.

（SeeT-10-1）

InternalControlObjectives（page290）

Webrieflyidentifyanddiscussthethreebroadobjectivesmanagementhaswhendesigninganeffectiveinternalcontrolsystem（reliablefinancialreporting,efficientandeffectiveoperations,andcompliancewithlawsandregulations）.Weusethisdiscussiontohighlightthatwhilemanagementfocusesoninternalcontrolsrelatedtothesebroadobjectives,theauditor’sfocusisonthosecontrolsrelatedtothereliabilityoffinancialreporting,whichmayincludesomecontrolsrelatedtooperationsandcompliancethatmightalsoimpactfinancialreporting.ThisisparticularlyimportanttoemphasizesincePCAOBStandard2specificallyrequirestheauditortoreportoninternalcontrolsoverfinancialreporting.WeuseT-10-2toillustratethesethreeobjectives.

（SeeT-10-2）

Management’sResponsibilitiesforInternalControl（page291）

Weusethissectionofthechaptertoemphasizethatmanagementandauditorresponsibilitiesforinternalcontrolaredifferent.Wemakesurestudentsknowthatmanagementisresponsibleforestablishingandmaintainingtheentity’sinternalcontrols.WethenemphasizethespecificSection404responsibilitiesformanagementtopubliclyreportontheoperatingeffectivenessofthosecontrols.Wecontrastthatwiththeauditor’sresponsibilitytounderstandandtestinternalcontroloverfinancialreportingtoprovideabasistoexpressanopinionontheoperatingeffectivenessofthosecontrols.

Webrieflyidentifyanddiscussthetwounderlyingconceptsrelatedtomanagement’sdesignandimplementationofinternalcontrol:

reasonableassuranceandinherentlimitations.Thisdiscussiontiesnicelytotheauditor'sresponsibilityandanachievedlevelofassuranceoflessthan100%.

WethencovertheSection404requirementsformanagementtoissueaninternalcontrolreportinitsForm10-KfiledwiththeSEC.Besuretoemphasizethekeyelementsrequiredinmanagement’sreport:

1.Astatementthatmanagementisresponsibleforestablishingandmaintaininganadequateinternalcontrolstructureandproceduresforfinancialreporting.

2.Anassessmentoftheeffectivenessontheinternalcontrolstructureandproceduresforfinancialreportingasoftheendofthecompany’sfiscalyear.Thatassessmentconsistsoftwokeycomponents:

▪Managementmustevaluatethedesignofinternalcontroloverfinancialreportingand

▪Managementmusttesttheoperatingeffectivenessofthosecontrols.

Figure10-1（page292）providesanillustrationofmanagement’sreportoninternalcontrol.

（SeeFigure10-1）

AuditorResponsibilitiesforUnderstanding,TestingandReportingonInternalControl（pages292-294）

Wecontrastmanagement’sresponsibilitieswiththeSection404responsibilitiesthatauditorsmustattesttoandissueareportonmanagement’sassessmentofinternalcontroloverfinancialreporting.WeemphasizethattoexpresstheopiniononinternalcontrolasrequiredbyPCAOBStandard2,theauditorobtainsanunderstandingofandperformstestsofcontrolsrelatedtoallsignificantaccountbalances,classesoftransactions,anddisclosuresrelatedtoassertionsinthefinancialstatements.Weemphasizethattherequiredunderstandingandtestingofallkeycontrolsisgenerallymuchmoreextensivethantheamountoftestingofinternalcontrolsrequiredinthefinancialstatementauditofanonpubliccompany.ThisconceptisillustratedbyFigure10-10onpage321.

（SeeFigure10-10）

Transaction-RelatedAuditObjectives（page293）

BecausePCAOBStandard2requirestheauditortotestcontrolsrelatedtoallsignificantaccountbalances,classesoftransactions,anddisclosuresrelatedtoassertionsinthefinancialstatements,webelieveitisimportanttodiscussthetransaction-relatedauditobjectivesthatwerefirstcoveredinChapter6.Itisimportanttoidentifythetransaction-relatedauditobjectivesandexplainwhyeachisimportanttopreventspecifictypesofmisstatements.

Ausefulwaytoapplytransaction-relatedauditobjectivesisbystartingwithTable10-1（page293）andexpandingonitasfollows:

a.ExamineeachofthesixobjectivesinTable10-1.

b.Askstudentstoidentifyaspecificmisstatementthatcouldoccurforeachobjectiverelatedtopayroll.

c.Askstudentstoidentifyaspecificinternalcontrolthatcouldpreventsuchamisstatement.Theuseofthecomponentsofinternalcontrolishelpfulindoingthis.

（SeeTable10-1andT-10-3）

PossiblesolutionforT-10-3（seenextpage）:

OBJECTIVE

TYPEOF

MISSTATEMENT

EXAMPLEOFINTERNAL

CONTROLTOPREVENT

MISSTATEMENT

Occurrence

Formeremployeecontinuestobepaid.

Completedtimecardapprovedbytheforeman,requiredforpreparationofpaycheck（authorizationandadequatedocumentsandrecords）.

Completeness

Atimecardislostandanemployeedoesnotgetpaid.

Useprenumberedtimecardsandaccountforallcards（adequatedocumentsandrecordsandinternalverification）.

Accuracy

Employeesarepaidthewrongamountbecauseofclericalerrorsincalculation.

Internalverificationofcalculations（internalverification）.

Postingand

summarization

Anemployee'swagesarepostedtothewrongemployeeearningsrecord.

Internalve