Chapter 9 Notes.pdf

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University of Waterloo
Accounting & Financial Management
AFM 451
James Wainberg

Chapter 9 – Control Assessment and Testing Management vs. Auditor Responsibility  Management – responsible for its control environment, accounting system, and for establishing and maintaining a system of internal control procedures.  Auditor – responsible for EVALUATING existing I/C and assessing the RMM related to them. o Public accountants may help design ONLY for non-audit clients Internal Controls (IC) Internal controls help management:  Maintain operational effectiveness and efficiency  Minimize risks of asset loss  Enhance reliability of financial statements  Monitor compliance with laws and regulations Note: Management must balance cost of controls and the benefit of RMM reduction.  At some point, Costs > Benefits because it is NOT possible to reduce risks to 0. o Therefore, control systems generally do NOT provide ABSOLUTE assurance that objectives of internal control are satisfied  Organizations that tend to be complex are going to need sophisticated controls in order to function appropriately  Mgmt needs to decide what level of risk is ACCEPTABLE. General Type of Control Problems 1. Invalid transactions are recorded. o Fictitious sales are recorded & charged to nonexistent customers. o Matches to VALIDITY a.k.a. EXISTENCE 2. Valid transactions are omitted. o Shipments to customers never get recorded. o Matches to COMPLETENESS 3. Unauthorized transactions are executed. o A customer’s order is not approved for credit, yet the goods are shipped, billed and charged to the customer w/o requiring advance payment. o Matches to AUTHORIZATION 4. Transaction amounts are inaccurate. o A customer is billed and the sale is recorded in the wrong amt because the quantity shipped and the quantity billed are not the same, and the unit price is for a different produce. o Matches to ACCURACY. 5. Transactions are classified incorrectly. o Sales to sub company are recorded as sales to outsiders instead of intercompany sales. o Matches to CLASSIFICATION. 6. Transaction accounting is incomplete. Keval Shah Chapter 9 – AFM 451 1 o Sales are posted in total to the A/R control account, but some are NOT posted to the individual customer account records. o Matches to ACCOUNTING. 7. Transactions are recorded in incorrect period. o Shipments made in Jan are backdated and recorded as sales and charges to customers in December (previous year) or vice versa o Matches to PROPER PERIOD. Control Risk  The risk that the client’s internal control will fail to prevent or detect a material misstatement.  The auditor does not control this risk.  The auditor’s task is to ASSESS the risk. o Higher control risk means lowering detection risk.  Requires the auditor to increase substantive testing  Auditors often document control risk as either High, Moderate or Low (or as a probability: e.g., 1.0, 0.75, 0.50) Control Risk – “Clean” vs. “Dirty”  “Clean” Audit: Client’s accounting records are accurate, well maintained and easy to verify that good controls are in place. o Such audits require LESS substantive test work  “Dirty” Audit: Client’s accounting records are incomplete, riddled with errors and there appears to be poor or no controls present. o Example: Shoes box full of receipts poor controls, very poor audit trail  this can also lead to an un-auditable client  Un-Auditable Client: Accounting records and controls so poor that RMM cannot be reduced to acceptable levels. Control Test vs. Substantive Procedure  Control Test – The auditor wants to obtain evidence about the OPERATING EFFECTIVENESS of control procedures to provide indirect evidence about the RMM of monetary amounts in the F/S  Substantive Procedures – The auditor wants to obtain direct evidence about monetary misstatements  Note: A single procedure may produce both CONTROL and SUBSTANTIVE evidence. Control Risk & The Audit Program  The control risk assessment will affect the PROCEDURES included in the audit program.  If the controls are weak …  Nature – Different tests may be needed to provide more relevant and reliable evidence. + larger sample sizes (increase cost) o I.e. Confirmation, Analytical Procedures, Document Vouching etc. Keval Shah Chapter 9 – AFM 451 2  Timing - More testing will take place at year-end than at an interim date. (delays & increase cost) o I.e. Nov 1 (Interim Date), Dec 31 (Year-end) etc.  Extent – More evidence will have to be gathered (increase cost) o I.e. Limited sample, all customer accounts, last 5 days sales etc. Control Objectives - Note: These match up quite well with the mgmt. assertions Control Objective Relation to Principal F/S Assertion Validity – Recorded transactions are valid and documented Existence (Validity),  Matching shipping documents w/ sales invoices before a sale is recorded – Ownership Prevents recording of undocumented sales Completeness – No transactions are omitted from accounting records  Every shipment should be matched with a sales invoice + shipping Completeness, Ownership documents are often pre-numbered Authorization – Transactions are authorized before they are recorded Existence, Ownership,  Credit sales must be preapproved Valuation Accuracy - Transaction dollar amounts are properly recorded  A manual/computer check that q invoiced = q shipped, plus check to see that Valuation correct list price is used Classification - Transactions recorded in the right accounts  Ensure that credited to the right customers Valuation, Presentation/  Classification errors b/w B/S and I/S present the greatest RMM because they Disclosure will change net income Accounting – Transactions recorded conform to GAAP  A clerk can balance the total of individual receivables with the control Valuation, account to determine if all entries to the control account have also been Presentation/ entered to individual customer accnts Disclosure  This is a useful category if you cannot identify a control problem in one of the other categories Existence, Proper Period - Transactions recorded in the proper period Completeness, Ownership,  Sales, purchases, inventories, expense accruals, accruals etc. Presentation/ Disclosure 3 Phases of Control Evaluations (Note: Work on these phases overlaps) I. UNDERSTANDING the internal controls II. ASSESSING control risk by identifying strengths and weaknesses in the accounting info system III. TESTING controls Note:  Efficiency is important! = Doing high-quality work to obtain SAAE evidence with minimum time and cost expenditure  There should be a cost-benefit trade-off between control evaluation and substantive audit work Keval Shah Chapter 9 – AFM 451 3 Cost Trade-Off Graph  Generally, the more auditors know about good controls, the less substantive year-end work they do  Key Controls: Important control procedures; auditors should identify and audit ONLY those controls  Note: Sometimes it may be easier NOT to test the controls  Auditors must make a trade-off between: o Costs of evaluating Internal Control o Costs of substantive audit tests  An EFFICIENT audit program looks for the combination of control evaluation and substantive work that provides an acceptable level of assurance at the lowest total cost Phase I: Understanding Internal Control  Done early in the audit.  Helps the auditor obtain overall acquaintance with: o Control Environment o Flow of transactions through accounting system  Recall: COSO and the flow of transactions through…  General Controls - PREVENTIVE in nature and can have a pervasive impact on various accounting cycles. OVERALL impact on accounting processes.  Auditors focus general and environmental controls in the preliminary evaluation of IC o Capable Personnel  Personnel problems  IC problems  High turnover in accounting jobs – more new, inexperienced ppl  Accounting personnel changes  warning signal o Performance Reviews  Mgmt reviews of how reported performance compares w/ expectations, budgets and prior years  Can be performed by auditors as part of their analytical procedures o Segregation of Duties – Often on UFE  Authorization, recording, custody and reconciliation of recorded to existing amounts – These 4 should be performed by diff departments  Works because: Keval Shah Chapter 9 – AFM 451 4  Fraud would require collusion of 2+ people and most ppl hesitate to ask for help when conducting wrongful tasks  Innocent errors are more likely to be found and flagged for corrections o Supervision  I.e. Oversee the credit manager’s performance or periodically compare the sum of customers balances with the A/R control account total  Great tool for MONITORING and MAINTAINING a system of IC o Controlled Access  Access to assets, important records, documents and BLANK FORMS (invoices, cheques) should be limited to authorized personnel o Periodic Comparison  Mgmt has responsibilit
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