Audit Risk,

Audit Planning and Test of Controls

Course 6

Understanding, Assessing and

Testing Internal Controls

Assessment of control risk includes three steps:

(1) Obtaining an understanding of internal controls culminating in documentation of the controlsthe controls

(2) An initial assessment and response to assessed risk based on the design of internal controls culminating in an audit planning memorandum and audit plan (audit program).

(3) A final assessment based upon test of controls of operating effectiveness

Illustration

Audit Risk, the risk that the auditor gives a wrong opinion based on

the evidence, has three components: inherent risk, detection risk,

and control risk

Procedures to obtain an understanding

Procedures to obtain an understanding are

procedures used by the auditor to gather

evidence about the design and placement evidence about the design and placement

in operation of specific control policies and

procedures.

Information System Understanding

The auditor should obtain an understanding of the

information system in the following areas:

The classes of transactions significant to the financial

statements.

The procedures by which those transactions are

initiated, recorded, processed and reported in the initiated, recorded, processed and reported in the

financial statements.

The related accounting records,

How the information system captures events and

conditions,

The financial reporting process used to prepare the

entitys financial statements

Documentation of

the Understanding of

internal control

(1) The discussion among the audit team regarding the susceptibility of the entitys financial statements to material misstatement due to error or fraud.

(2) The understanding obtained regarding each of the internal control components, the sources of information for the understanding, and the risk assessment procedures.

(3) The results of the risk assessment both at (3) The results of the risk assessment both at the financial statement level and at the assertion level.

(4) The controls evaluated as a result of identification of significant risks and risks for which it is not possible to reduce risks of material misstatement.

Common documentation

techniques narrative descriptions

a written description of a client's internal control structure

internal control questionnaire

a series of questions about the controls in each audit a series of questions about the controls in each audit area mostly require yes or no

check lists

a list of controls that should normally be in place

flow charts

a symbolic, diagrammatic representation of the clients documents and their sequential flow in the organization.

Steps in Assessing Control Risks

Determine financial statement assertion about significant account balances and transactions.

E.g., completeness of payables balance

Based on the assertions, determine audit objectives

E.g., 'all accounts payable are recorded'

For each of these audit objective determine if you can For each of these audit objective determine if you can rely on internal controls

E.g.,is the initial recording of purchase orders reviewed

Identify the relevant internal controls for the most material financial statement assertion or audit objective

E.g., completeness review cash disbursements after balance sheet date for unrecorded liabilities

When assessing controls the auditor looks for weaknesses in the

controls for two reasons:

to determine the nature and extent of the substantive tests to be performed

to formulate constructive suggestions for to formulate constructive suggestions for improvements.

A management letter will contain communications of reportable conditions that are significant deficiencies in internal control

Weaknesses in internal control are the

absence of adequate controls, which

increases the risk of misstatements existing

in the financial statements.

controls do not exist at all where there should

be controls

controls are not operating properly.

In some cases, the presence of the

weakness might be so important or

pervasive that it may materially affect the

financial statements. This is called a

material weakness in internal control.

A four-step approach to identify significant weaknesses is sometimes recommended:

1 Identify existing controls.

2 Identify the absence of key controls (where controls are lacking).

3 Determine potential material misstatements that could result.

4 Consider the possibility of compensating controls. A compensating control is one elsewhere in the system that offsets a weakness.

If internal controls

are assessed below

the maximum (at

medium or low risk)

the assessment must the assessment must

be supported by

tests of control.

Overall response to assessed risk may include

(1) emphasizing to the audit team the need to maintain professional skepticism in gathering and evaluating audit evidence

(2) assigning more experienced staff or assigning staff with special skills or using assigning staff with special skills or using experts.

(3) providing more supervision.

(4) incorporating additional elements of unpredictability in the selection of further audit procedures to be performed.

NET Nature - Extent

and Timing

Nature of audit procedures refers to both their purpose (tests of controls or substantive procedures) and their type (inspection, observation, inquiry, confirmation, recalculation, reperformance, or analytical procedures ).recalculation, reperformance, or analytical procedures ).

Extent generally means the quantity of an audit procedure to be performed (e.g., the size of an audit sample or the number of observations).

Timing refers to when audit procedures are performed or the period or date to which the audit evidence applies.

The Audit Planning Memo Includes

Background information

The objectives of the audit

The assessment of engagement risk and potential

follow-up

An identification of other auditors or experts that will An identification of other auditors or experts that will

be relied upon in the audit

An assessment of materiality.

Inherent risks

Audit Planning Memo Also Includes

Conclusions regarding the control environment

Classification of the clients CIS environment

An evaluation of the quality of the accounting and

internal control systems

Audit approach for each account balance and audit Audit approach for each account balance and audit

objective for which an inherent risk has been

identified.

The timing and scheduling of audit work.

Audit budget, detailed for each level of expertise

available in the audit team.

Audit Plan (Audit Program)

The auditor should develop an audit plan in order to implement the overall audit strategy.

The audit plan (program) The audit plan (program) serves as a set of instructions to assistants involved in the audit and as a means to control and record the proper execution of the work. (Illustration 8.9)

Tests of Controls

TESTS OF CONTROLS are audit procedures to

test the effectiveness of control policies

and procedures in support of a reduced

control risk.

Tests of controls are necessary in two circumstances. (2006

ISA 500 not in text)

1. When the auditors risk assessment includes

an expectation of the operating effectiveness

of controls, the auditor is required to test

those controls to support the risk those controls to support the risk

assessment.

2. When substantive procedures alone do not

provide sufficient appropriate audit

evidence, the auditor is required to perform

tests of controls to obtain audit evidence

about their operating effectiveness.

Timing of Tests of

Controls

The timeliness of evidential matter is about when the

evidence was obtained and the portion of the audit

period to which it may be applied.

some tests of controls, such as observation of inventory,

pertain only to the point in time at which the auditing pertain only to the point in time at which the auditing

procedure was applied

the auditor performs other tests that are capable of

providing audit evidence that the control operated

effectively at relevant times during the audit period.

Extent of Tests of Control

The more reliance the auditor puts on controls in their audit, the greater is the extent (amount) of the auditors tests of controls. In addition, as controls. In addition, as the rate of expected variability of the control increases, the auditor increases the extent of testing of that control.

Evaluate Sufficiency and Appropriateness of

Audit Evidence

What is sufficient appropriate audit evidence is influenced by such factors as the:

Significance of the potential misstatement

Effectiveness of managements responses and controls to address the risks.

Experience gained during previous audits with respect Experience gained during previous audits with respect to similar potential misstatements.

Results of audit procedures performed,

Source and reliability of the available information.

Persuasiveness of the audit evidence.

Understanding of the entity and its environment, including its internal control.