Mindanao State University
College of Business Administration and Accountancy
DEPARTMENT OF ACCOUNTANCY
Marawi City
CONSIDERATION OF INTERNAL CONTROL IN AN AUDIT OF FINANCIAL STATEMENTS
Accounting 151
NATURE OF INTERNAL CONTROL
Internal control refers to the process designed, implemented
and maintained by those charged with governance,
management and other personnel to provide reasonable
assurance about the achievement of an entity‟s objectives
with regard to reliability of financial reporting, effectiveness
and efficiency of operations, and compliance with
applicable laws and regulations.
A. Internal control is a process.
Internal control is a means to an end and not an
end in itself. It is a part of and is integrated with the
basic management processes of planning,
executing and monitoring. A management tool, it
enables them to function and monitors their
conduct and continued relevance.
B. Internal control involves people.
Internal control is not merely policy manuals and
forms but people at every level of organization. It is
effected by the management, those charged with
governance and entity‟s staff personnel.
Management establishes a control environment
and maintains policies and procedures to assist in
achieving the entity‟s objectives. Those charged
with governance, on the other hand, ensure the
integrity of the accounting and financial reporting
systems through oversight of management. Staff
personnel should also perform their respective
functions in order to achieve the objectives of the
entity.
C. Internal control provides reasonable assurance of
achieving the entity’s objectives.
Internal control, no matter how effective, can
provide an entity with only reasonable assurance
about achieving the entity‟s objectives. The
likelihood of their achievement is affected by the
inherent limitations of internal control:
 Management‟s usual requirement that the
cost of an internal control should not
exceed the expected benefits to be
derived.
 Most internal controls tend to be directed
at routine transactions rather than non-
routine transactions.
 The potential for human error due to
carelessness, distraction, mistakes of
judgment and the misunderstanding of
instructions.
 The possibility of circumvention of internal
controls through collusion among
employees.
 The possibility of management overriding
internal control.
 The possibility that procedures may
become inadequate due to changes in
conditions and compliance with
procedures may deteriorate.
D. Internal control is geared towards the achievement
of an entity’s objectives.
Every entity sets out on a mission, establishing
objectives it wants to achieve and strategies for
achieving them. Objectives may be set for the
entity as a whole or for specific activities.
Regardless, objectives fall into three categories:
 Effectiveness and efficiency of operations
which relates to the use of entity‟s resources
and vary based on management‟s choices
about structure and performance.
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
 Reliability of financial reporting which is
driven primarily by external requirements.
 Compliance with laws and regulations
which is dependent on external factors and
tend to be similar across all entities in some
cases and across an industry in others.
In an audit of financial statements, the auditor is
only concerned with those policies and procedures
within the accounting and internal control systems
that are relevant to the financial statement
assertions. Therefore, the objective that is the most
relevant to the audit is the financial reporting
objective.
Operational and compliance objectives may be
relevant to the audit only if they relate to data the
auditor evaluates to determine the reliability of
some financial statement assertions.
The term “controls” refers to any aspects of one or more of
the components of internal control.
COMPONENTS OF INTERNAL CONTROL
Internal control, for purposes of the PSAs, can be divided
into five inter-related components. These are derived from
the way management runs a business and are integrated
with the management process. These components are:
A. Control environment.
B. Risk assessment process.
C. Control activities.
D. Information system and related business processes
relevant to financial reporting and communication.
E. Monitoring of controls.
This division provides a useful framework for auditors to
consider how different aspects of an entity‟s internal control
may affect the audit. Moreover, the division does not
necessarily reflect how an entity designs, implements and
maintains internal control or how it may classify any
particular component.
Note: The control environment, risk assessment process,
monitoring and communication components of the internal
control systems are considered as organizational or high
level controls whereas the control activities and information
systems components are considered functional or activity
level controls.
 CONTROL ENVIRONMENT
The control environment is the foundation for all other
components of internal control, providing discipline and
structure. It sets the tone of an organization, influencing the
control consciousness of its people. The control environment
includes the governance and management functions and
the attitudes, awareness, and actions of those charged
with governance and management concerning the
entity‟s internal control and its importance in the entity. The
responsibility for establishing a strong internal control
environment rests with both those charged with
governance and the management of the entity.
Elements of the control environment that may be relevant
when obtaining an understanding of the control
environment include the following:
A. Communication and enforcement of integrity and
ethical values.
Integrity and ethical values are essential elements
that influence the effectiveness of the design,
administration and monitoring of controls. The
effectiveness of controls cannot rise above the
integrity and ethical values of the people who
create, administer and monitor them.
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 Integrity and ethical behavior are the product of
the entity‟s ethical and behavioral standards, how
they are communicated, and how they are
reinforced in practice. Integrity and ethical values
are expressed through:
 Existence and implementation of codes of
conduct and other policies regarding
acceptable business practice, conflicts of
interest or expected standards or ethical
and moral behavior.
 Dealings with employees, suppliers,
customers, investors, creditors, insurers,
competitors and auditors.
 Actions to eliminate or mitigate incentives
or temptations that might prompt
personnel to engage in dishonest, illegal, or
unethical acts.
B. Commitment to competence.
Competence should reflect the knowledge and
skills necessary to accomplish tasks that define the
individual‟s job. How well these tasks need to be
accomplished generally is a management decision
which should be made considering the entity‟s
objectives and management‟s strategies and plans
for achievement of the objectives. Commitment to
competence is expressed through:
 Formal or informal job description or other
means of defining tasks that comprise
particular jobs.
 Analyses of the knowledge and skills
necessary to perform jobs adequately.
C. Participation by those charged with governance
An entity‟s control consciousness is influenced
significantly by those charged with governance,
the board of directors and the audit committee, if
any. Attributes of those charged with governance
include:
 Their independence from management.
 Their experience and stature.
 The extent of their involvement and the
information they receive and the scrutiny
of activities.
 The appropriateness of their actions,
including the degree to which difficult
questions are raised and pursued with
management and their interaction with
internal and external auditors.
Audit Committee Policy
An audit committee is, in a corporation, a
committee comprising a majority of independent
non-executive members of the board of directors
to which has been assigned the oversight of the
financial reporting and auditing process. The audit
committee can alert the entire board of directors
to problems before they become serious. The
Philippine SEC‟s Code of Corporate Governance
provides that the audit committee should be
composed of at least 3 board members with the
following qualifications:
 Preferably with accounting and finance
background.
 One of whom shall be an independent
director.
 Another should have related audit
experience.
D. Management’s philosophy and operating style.
This factor affects the way the entity is managed
including the kind of business risks accepted.
Management‟s philosophy and operating style
encompass a broad range of characteristics which
include:
 Their approach to taking and managing
business risks.
 Their attitudes and actions toward financial
reporting.
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
 Their attitudes toward information
processing and accounting functions and
personnel.
E. Organizational structure.
An entity‟s organizational structure provides
framework within which its activities for achieving its
objectives are planned, executed, controlled, and
reviewed. Establishing a relevant organizational
structure include considering key areas of authority
and responsibility and appropriate lines of
reporting.
The appropriateness of an entity‟s organizational
structure depends, in part, on its size and the
nature of its activities. Activities may relate to what
is sometimes referred to as the value chain
(inbound or receiving activities, operation or
production, outbound or shipping activities,
marketing, sales and service.) There may be
support functions relating to administration, human
resources or technology development.
Controls involving organizational structure are
expressed through:
 Appropriateness of the entity‟s
organizational structure and its ability to
provide the necessary information flow to
manage its activities.
 Adequacy of definition of key manager‟s
responsibilities and their understanding of
these responsibilities.
 Adequacy of knowledge and experience
of key managers in light of responsibilities.
F. Assignment of authority and responsibility.
This factor pertains to how authority and
responsibility for operating activities are assigned
and how reporting relationships and authorization
hierarchies are established. The assignment of
authority and responsibility may include policies
relating to appropriate business practices,
knowledge and experience of key personnel, and
resources provided for carrying out duties. In
addition, it may include policies and
communications directed at ensuring that all
personnel understand the entity‟s objectives, know
how their individual actions interrelate and
contribute to those objectives, and recognize how
and for what they will be held accountable.
G. Human resource policies and practices.
Human resource policies and practices often
demonstrate important matters in relation to the
control consciousness of an entity. Such policies
and practices relate to recruitment orientation,
training, valuation, counseling, promotion,
compensation and remedial actions.
Standards for recruiting the most qualified
individuals with emphasis on educational
background, prior work experience, past
accomplishments and evidence of integrity and
ethical behavior demonstrate an entity‟s
commitment to competent and trustworthy people.
Training policies that communicate prospective
roles and responsibilities and include practices such
as training schools and seminars illustrate expected
levels of performance and behavior. Promotions
driven by periodic performance appraisals
demonstrate the entity‟s commitment to the
advancement of qualified personnel to higher
levels of responsibility. Controls involving human
resources policies and practices include:
 The extent to which policies and
procedures for hiring, training, promoting
and compensating employees are in
place.
 Appropriateness of remedial action taken
in response to departures from approved
policies and procedures.
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  Adequacy of employee candidate
background checks, particularly with
regard to prior actions or activities
considered to be unacceptable by the
entity.
 Adequacy of employee retention and
promotion criteria and information
gathering techniques and relation to the
code of conduct or other behavioral
guidelines.
 ENTITY’S RISK ASSESSMENT PROCESS
All entities, regardless of size, structure, nature or industry,
encounter risks at all levels within their organizations. Risks
affect each entity‟s ability to survive, successfully compete
within its industry, maintain its financial strength and positive
public image and maintain the overall quality of its
products, services and people. Whether from external and
internal sources, risks must be assessed and addressed by
the entity.
Risk assessment is the identification and analysis of relevant
risks to the achievement of the objectives, forming a basis
for determining how the risks should be managed. Because
economic, industry, regulatory and operating conditions
will continue to change, mechanisms are needed to
identify and deal with the special risks associated with
change.
There is no practical way to reduce business risk to zero. The
decision to be in business creates risk. Although success
cannot be ensured, management should have reasonable
assurance of being alerted when objectives are in danger
of not being achieved. Management should be able to
determine how much risk is to be prudently accepted and
strive to maintain risks within these levels. The goal of
internal control in this area focuses primarily on:
A. Developing consistency of objectives and goals
throughout the organization.
B. Identifying key success factors.
C. Timely reporting to management on performance
and expectations.
An entity‟s risk assessment process is its process for
identifying and responding to business risks and the results
thereof. The process of identifying and analyzing risk is an
ongoing iterative process and is a critical component of an
effective internal control system. Management must focus
carefully on risks at all levels of the entity and take the
necessary actions to manage them.
A. Risk identification.
Risk identification should be comprehensive. It
should consider all significant interactions of goods,
services and information between the entity and
relevant external parties which include potential
and current suppliers, investors, creditors,
shareholders, employees, customers as well as
public bodies and news media.
Risk identification is an iterative process and often is
integrated with the client‟s business planning
process. It is useful that it considers risk from a
“clean sheet of paper” approach and not merely
relate risk to the previous review. Risks can arise or
change due to circumstances such as the
following:
 Changes in regulatory or operating
environment – can result in changes in
competitive pressures and significantly
different risks.
 New personnel – new personnel may have
a different focus on or understanding of
internal control.
 New or revamped information systems –
significant and rapid changes in
information systems can change the risk
relating to internal control.
 Rapid growth – significant and rapid
expansion of operations can strain controls
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
and increase the risk of a breakdown in
controls.
 New technology – incorporating new
technologies into production processes or
information systems may change the risk
associated with internal control.
 New business models, products, or
activities – entering into business areas or
transactions with which an entity has little
experience may introduce new risks
associated with internal control.
 Corporate restructurings – restructurings
may be accompanied by staff reductions
and changes in supervision and
segregation of duties that may change the
risk associated with internal control.
 Expanded foreign operations – the
expansion or acquisition of foreign
operations carries new and often unique
risks that may affect internal control.
 New accounting pronouncements –
adoption of new accounting principles or
changing accounting principles may
affect risks in preparing financial
statements.
B. Risk analysis and management.
After the entity has identified entity wide and
activity risks, a risk analysis needs to be performed.
The methodology for analyzing risks can vary
largely because many risks are difficult to quantify.
Nonetheless, the process which may be more or
less formal usually includes:
 Estimating the significance of a risk – a risk
that does not have a significant effect on
the entity generally warrant no serious
concern.
 Assessing the likelihood or frequency of the
risk occurring – similarly, a low likelihood of
occurrence of the risk generally does not
call for a special attention.
 Considering how the risk should be
managed – this pertains to the assessment
of what actions need to be taken which
involves judgment based on assumptions
about the risk and reasonable analysis of
costs associated with reducing the level of
risk. This step entails installing additional
procedures or considering carefully
whether existing ones may be suitable for
addressing identified risks since a
procedure may satisfy multiple objectives.
 INFORMATION SYSTEM AND COMMUNICATION
Every enterprise must capture pertinent information relating
to external as well as internal events and activities. The
information must be identified by management as relevant
to managing the business. It must be delivered to people
who need it in a form and timeframe that enables them to
carry out their control and other responsibilities.
Information systems are used to generate information
necessary to carry out many control activities. An
information system is an integrated system of components
for collecting, storing and processing data and for
delivering information. It consists of infrastructure (physical
and hardware components), software, people, procedures
and data. Many information systems make extensive use of
information technology.
The information relevant to financial reporting objectives,
which includes the financial reporting system, consist of the
procedures and records established to initiate, record,
process and report entity transactions, as well as events
and conditions, and to maintain accountability for the
related assets, liabilities and equity. Transactions may be
initiated manually or automatically by programmed
procedures.
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Processes which are part of the information system are:
A. Recording – includes identifying and capturing the
relevant information for transactions or events.
B. Processing – includes functions such as edit and
validation, calculation, measurement, valuation,
summarization and reconciliation, whether
performed by automated or manual procedures.
C. Reporting – relates to the preparation of financial
reports as well as other information, in electronic or
printed format, that the entity uses in measuring
and reviewing the entity‟s financial performance
and in other functions.
An entity‟s information system typically includes the use of
standard journal entries that are required on a recurring
basis to record transactions. It also include the use of non-
standard journal entries to record non-recurring, unusual
transactions or adjustments.
Closely related to an entity‟s information system are its
business processes which refer to the entity‟s activities
designed to:
A. Develop, purchase, produce, sell and distribute an
entity‟s products and services.
B. Ensure compliance with laws and regulations.
C. Record information, including accounting and
financial reporting information.
Business processes result in the transactions that are
recorded, processed and reported by the information
system. Obtaining an understanding of the entity‟s business
processes, which include how transactions are originated,
assists the auditor obtain an understanding of the entity‟s
information system relevant to financial reporting in a
manner that is appropriate to the entity‟s circumstances.
Accordingly, the information system relevant to financial
reporting objectives, which includes the financial reporting
system, encompasses methods and records that:
A. Identify and record all valid transactions.
B. Describe on a timely basis the transactions in
sufficient detail to permit proper classification of
transactions for financial reporting.
C. Measure the value of transactions in a manner that
permits recording their proper monetary value in
the financial statements.
D. Determine the time period in which transactions
occurred to permit recording of transactions in the
proper accounting period.
E. Present properly the transactions and related
disclosures in the financial statements.
Information and Information System
Information is needed at all levels of the organization to run
the business and move towards the achievement of the
entity‟s objectives in all categories – operations, financial
reporting and compliance.
Financial information is used not only in developing
financial statements for external dissemination but also for
operating decisions such as monitoring performance and
allocating resources. Reliable internal financial
measurements also are essential to planning, budgeting,
pricing, evaluating vendor performance and evaluating
joint ventures and other alliances.
Operating information is essential for developing financial
statements. This includes the routine as well as information
on competitor‟s product releases or economic conditions
which can affect inventory and receivables valuations.
Operating information such as airborne particle emissions or
personnel data may be needed to achieve both
compliance and financial reporting objectives. As such,
information developed from internal and external sources is
relevant to all objectives categories.
Information systems sometimes operate in a monitoring
mode, routinely capturing specific data. In other cases,
special actions are taken to obtain needed information.
Moreover, information systems can be formal or informal.
Conversations with customers, suppliers, regulators and
employees often provide some of the most critical
information needed to identify risks and opportunities.
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
Similarly, attendance at professional or industry seminars
and memberships in trade and other associations can
provide valuable information.
Information Quality
The quality of system-generated information affects
management‟s ability to make appropriate decisions in
managing and controlling the entity‟s activities and to
prepare reliable financial reports. It is critical that reports
contain enough appropriate data to support effective
control.
In designing the information system, the following guide
questions on the quality of information must be addressed:
A. Is the needed information there?
B. Is the information there when required?
C. Is the information the latest available?
D. Is the information accurate?
E. Can the information be obtained easily by
appropriate parties?
Having the right information, on time, at the right place is
essential to effecting control. An information system, while
itself a component of internal control, also must be
controlled.
Communication
Communication involves providing an understanding of
individual roles and responsibilities pertaining to internal
control over financial reporting. It includes the extent to
which personnel understand how their activities in the
financial reporting information system relate to the work of
others and the means of reporting exceptions to an
appropriate higher level within the entity. Open
communication channels help ensure that exceptions are
reported and acted on.
Communication may take such forms as policy manuals,
accounting and financial reporting manuals, and
memoranda. Communication also can be made
electronically, orally and through the actions of
management which are in turn influenced by the history
and culture of the entity, drawing on past observations of
how their superiors dealt with similar situations.
 CONTROL ACTIVITIES
The policies (establishes what should be done) and
procedures (the actions of people to implement the
policies) to help ensure that management directives are
carried out are known as the control activities. They help
ensure that necessary actions are taken to address risks to
achievement of the entity‟s objectives.
Control activities have various objectives and are applied
at various organizational and functional levels. They include
a range of activities as diverse as approvals, authorizations,
verifications, reconciliations, reviews of operating
performance security of assets and segregation of duties.
Control activities can be divided into three categories –
operational controls, financial reporting controls and
compliance controls. This categorization is based on the
nature of the entity‟s objectives to which they relate.
Although some controls relate solely to one area, there is
often overlap.
Many different descriptions of types of controls have been
put forth including:
A. Preventive controls – attempt to deter or prevent
undesirable events from occurring. They are
proactive controls that help to prevent a loss.
Examples include segregation of incompatible
employee functions or duties and control physical
access to assets, facilities and information.
B. Detective controls – attempt to detect undesirable
acts. They provide evidence that a loss has
occurred but do not prevent a loss from occurring.
Examples include preparing bank reconciliation
and preparing monthly trial balance
C. Corrective controls – attempt to remedy problems
discovered with detective controls. Example
includes maintaining backup copies of transactions
and master files.
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 D. Manual controls – manually performed by
individuals. They may be solely manual or IT
dependent.
E. Automated controls – performed entirely by the
computer systems.
Categories of Control Activities
The following are certain control activities commonly
performed by personnel at various levels in organizations
and are relevant to a financial statement audit:
A. Approvals, authorizations and verifications.
Before a transaction is entered into with another
party, certain conditions must usually be met.
Authorization for the execution of transactions flows
from the stockholders to management and its
subordinates.
General authorization relates to a whole class of
transactions describing conditions under which
employees may initiate, record and process one
kind. Specific authorization, on the other hand,
applies only to a single, specific transaction.
B. Performance reviews.
Management review performance so as to
measure the extent to which goals and objectives
are being achieved. These control activities
include:
 Reviews and analyses of actual
performance versus budgets, forecasts,
and prior period performance.
 Relating different sets of data – operating
or financial – to one another, together with
analyses of the relationships and
investigative and corrective actions.
 Comparing internal data with external
sources of information.
 Review of functional or activity
performance.
C. Information processing.
These controls are performed to check accuracy,
completeness and authorization of transactions.
The two broad groupings of information systems
control activities are application controls, which
apply to the processing of specific type of
transactions, and general controls, which are
policies and procedures that relate to many
applications and support the effective functioning
of application controls by helping to ensure the
continued proper operation of information systems.
D. Physical controls.
Controls that encompass the physical security of
assets, including adequate safeguards such as:
 Secured facilities over access to assets and
records.
 The authorization for access to computer
programs and data files.
 The periodic counting and comparison
with amounts shown on control records.
The extent to which physical controls intended to
prevent theft of assets are relevant to the reliability
of financial statement preparation, and therefore
the audit, depends on circumstances such as
when assets are highly susceptible to
misappropriation.
E. Segregation of duties.
These refer to assigning different people the
responsibilities of authorizing transactions, recording
transactions, and maintaining custody of assets.
Segregation of duties is intended to reduce the
opportunities to allow any person to be in a
position to both perpetrate and conceal errors or
fraud in the normal course of the person‟s duties.
Certain control activities may depend on the existence of
appropriate higher level policies established by
management or those charged with governance. For
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
example, authorization controls may be delegated under
established guidelines, such as investment criteria set by
those charged with governance; alternatively, non-routine
transactions such as major acquisitions or divestments may
require specific high level approval, including in some
cases that of shareholders.
 MONITORING OF CONTROLS
Monitoring of controls is the process to assess the
effectiveness of internal control performance over time. It
involves assessing the effectiveness of controls on a timely
basis and taking necessary corrective actions. Monitoring is
done to ensure that controls continue to operate
effectively. Further, it applies to all activities within an
organization and sometimes to outside contractors as well.
Monitoring is necessary as internal control systems change
over time and its relevance may lessen and it might not be
able to address new risks. The way controls are applied
may also evolve. Once-effective procedures can become
less effective or perhaps no longer performed. This can be
due to the arrival of new personnel, varying effectiveness of
training and supervision, time and resource constraints or
additional pressures. Furthermore, circumstances for which
the internal system originally was designed also may
change causing it to be less able to warn of the risks
brought by new conditions.
Management accomplishes monitoring of controls through
ongoing activities, separate evaluations, or a combination
of the two.
A. Ongoing monitoring activities are often built into
the normal recurring activities of an entity and
include regular management and supervisory
activities.
B. Separate evaluations, on the other hand, are the
monitoring activities that are performed on a non-
routine basis such as functions performed by
internal auditors.
It is to be noted that the greater the degree and
effectiveness of ongoing monitoring is, the lesser the need is
for separate evaluations. The frequency of separate
evaluations necessary for management to have
reasonable assurance about the effectiveness of the
internal control system is a matter of management‟s
judgment. In making that determination, consideration
should be given to the following:
A. Nature and degree of changes occurring and their
associated risks.
B. Competence and experience of the people
implementing the controls.
C. Results of the ongoing monitoring.
INTERNAL CONTROL AND THE FINANCIAL STATEMENT AUDIT
Though not responsible for establishing and maintaining an
entity‟s accounting and internal controls systems, auditors
should give adequate consideration to these controls
because the quality of the entity‟s internal control systems
can have a significant impact on the audit, primarily on the
nature, timing and extent of the audit procedures to be
performed in gathering audit evidence. This is the case
when the controls in place are relevant to the audit, that is,
they pertain to the entity‟s objective of preparing financial
statements for external purposes that are presented fairly, in
all material respects, in accordance with the applicable
financial reporting framework and the management of risk
that may give rise to a material misstatement in those
financial statements.
It is a matter of the auditor‟s professional judgment,
whether a control, individually or in combination with
others, is relevant to the auditor‟s considerations in
assessing the risk of material misstatement and designing
and performing further procedures in response to assessed
risks. In exercising that judgment, the auditor considers the
circumstances, the applicable components and factors
such as:
A. The auditor‟s judgment about materiality.
B. The nature of the entity‟s business, including its
organization and ownership characteristics.
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 C. The diversity and complexity of entity‟s operations.
D. The size of the entity.
E. Applicable legal and regulatory requirements.
F. The nature and complexity of the systems that are
part of the entity‟s internal control, including the
use of service organizations.
AUDITOR’S CONSIDERATION OF INTERNAL CONTROL IN AN AUDIT
B.
An auditor‟s approach in the consideration of the client‟s
internal control in the audit generally consists of the
following steps:
A. Obtain an understanding of the client‟s internal
control.
B. Make a preliminary assessment of control risk.
C. Determine the appropriate response to the
assessed risks.
D. Reassess control risks.
E. Determine the nature, timing and extent of
substantive tests.
 OBTAIN AN UNDERSTANDING OF THE INTERNAL CONTROL
The auditor should obtain and document an understanding
of the client‟s internal control sufficient to provide a basis
for planning the audit. Specifically, the understanding is
used by the auditor in:
A. Identifying the types of potential misstatements
that can occur.
B. Considering factors that affect the risk of material
misstatement.
C. Designing the nature, timing and extent of audit
procedures to be performed.
In addition, the understanding may also provide the auditor
a basis for constructive suggestions to management about
improvements in the internal control.
Obtaining an understanding of the internal control involves
evaluating the design of a control considering whether it or
in combination with other controls can effectively prevent,
detect and correct material misstatements and determining
whether it has been implemented, that is, the control exists
and it has been placed in operation. At this stage, the
auditor is not required to obtain knowledge about the
operating effectiveness of the internal control. To
accomplish this, the auditor performs the following:
A. Performing a preliminary review.
In planning the audit examination, each of the five
components of internal control must be studied
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
and understood by the auditor. An understanding
of the components of the internal controls relevant
to the audit provides the auditor with a general
knowledge of the entity‟s organizational structure,
of methods to communicate responsibility and
authority and of methods used by management to
supervise the system.
In turn, an understanding of the flow of transactions
provides an auditor with a general knowledge of
the various classes of transactions and the methods
by which each significant class of transaction is
authorized, executed, initially recorded and
subsequently processed.
An initial understanding of the design of the entity‟s
internal control system is ordinarily obtained by:
 Making inquiries of appropriate individuals.
 Observing of entity‟s activities and
operations.
 Inspecting documents and records.
Identifying transaction cycles.
Because the number and nature of transactions
vary from industry to industry and from company to
company, an auditor must identify each client‟s
major transactions. In every business enterprise,
there are transactions that occur, consisting of the
cycle of steps necessary to complete the
exchange of assets or services between parties to
the transaction or the transfer or use of assets within
the business. These transactions are classified into
convenient groupings referred to as transaction
cycles – all of the classes of transactions for a
group of business related activities handled by the
same employees and subjected to the same
controls.
In a manufacturing concern, the typical major
transaction cycles are:
 Sales and collection cycle – includes the
procedures and policies for obtaining
orders from customers, approving credit,
shipping merchandise, preparing sales
invoices, recording revenue and accounts
receivable and handling and recording
cash receipts.
 Acquisition and disbursements cycle –
includes the procedures for initiating
purchases for raw materials, other assets or
services, placing purchase orders,
inspecting goods upon receipt and
preparing receiving reports, recording
liabilities to suppliers, authorizing payments
and making and recording cash
disbursements.
 Production or conversion cycle – includes
procedures for storing materials, placing
materials into production, assigning
production costs to inventories and
accounting for the cost of goods sold.
 Payroll cycle – includes procedures for
hiring, terminating, determining pay rates,
timekeeping, computing gross payroll,
payroll taxes and amounts withheld from
gross pay, maintaining payroll records and
preparing and distributing paychecks.
 Investing and financing cycle – the
investing cycle includes procedures for
authorizing, executing and recording
transactions involving purchase and sale of
marketable equity securities and
temporary as well as long-term fixed
tangible assets while the financing cycle
includes procedures for authorizing,
executing and recording transactions
involving bank loans, leases, bonds
payable and share capital.
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 Identification of transaction cycles based on
common transaction flows provides the following
advantages:
 It enables the auditor to gain an adequate
understanding of the flow of transactions
from inception to conclusion, to make sure
that he has identified all significant
processes and has noted and evaluated
each phase of the transaction flow.
 It enables the auditor to better evaluate
the impact of internal control or lack of it
on specific financial statement items
affected and, therefore, assists him in
determining the nature, timing and extent
of substantive tests.
C. Documenting the system.
After obtaining an understanding of the internal
control, the auditor should document his
understanding. Documentation of the auditor‟s
understanding of the internal control structure is
influenced by the size and complexity of the entity,
as well as, the nature of the entity‟s internal control
structure.
Generally, the more complex the internal control
structure and the more extensive the procedures to
be performed the more extensive the auditor‟s
documentation should be. This documentation
need not be in any particular form but commonly
takes the following forms:
 Internal accounting control questionnaire.
 Flowcharts.
 Narrative description.
 Internal control checklist.
 Decision tables.
D. Performing a transaction walkthrough.
Following documentation, a single transaction (or a
small number of transactions) for each major
segment of the internal control is selected and
followed or walked through the accounting system.
This task involves tracing one or two transactions
through the entire accounting systems from their
initial recording at source to their final destination
as a component of an account balance in the
financial statements. The walkthrough may also be
started at the termination of the transaction and
tracing back to its inception.
The purpose of a transaction walkthrough (or a
“sample of one” test) is to verify or confirm the
auditor‟s understanding of the entity‟s internal
control system, determine whether the internal
control is being implemented and to familiarize the
audit trail. If the transaction walkthrough isolates
differences from narratives, questionnaires or
flowcharts, the reason for such differences should
be resolved and the auditor‟s documentation
revised if necessary.
In performing walkthroughs, the following are to be
considered by the auditor:
 A walkthrough should be done every year.
 The walkthrough should be performed
after the documentation of the
understanding of the internal control is
made.
 The auditor who prepared or updated the
flowcharts should be the one to do the
walkthrough because of the acquired
familiarity with the system.
E. Identifying controls that are potentially reliable.
In obtaining an understanding of the entity‟s
internal control the auditor should be alert for
controls that are likely to prevent or detect and
correct material misstatement in specific assertion.
Generally, it is useful to obtain an understanding of
controls and relate them to assertions in the
context of processes and systems in which they
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
exist because individual control activities often do
not in themselves address a risk. Often, only
multiple control activities, together with other
components of internal control, will be sufficient to
address a risk.
Controls can be either directly or indirectly related
to an assertion. The more indirect the relationship,
the less effective that control may be in preventing,
or detecting and correcting, misstatements in that
assertion. For example, a sales manager‟s review of
a summary of sales activity for specific stores by
region ordinarily is only indirectly related to the
completeness assertion for sales revenue.
Accordingly, it may be less effective in reducing risk
for that assertion than controls more directly
related to that assertion, such as matching shipping
documents with billing documents.
Methods of Documenting the Understanding
A. Internal control questionnaire.
Internal control questionnaire contains a series of
questions designed to identify control points and
techniques and detect control weaknesses. Most
questions are designed to yield, “yes”, “no” or “not
applicable” answers to questions.
Advantages:
 They provide audit assurance that
attention is given to presence or absence
of all controls listed and that certain
features of the system are not overlooked.
 They provide a means of obtaining uniform
documentation of internal control system
reviewed.
 They provide inexperienced audit staff
members with guidance in performing
internal control reviews.
 They facilitate the early detection of
potential weaknesses in the system.
Disadvantages:
 Auditor may view the questionnaire device
for accomplishing an automatic evaluation
of internal control.
 Controls listed in the questionnaire may not
suit the particular circumstances of a
specific audit.
 The auditor may overlook pertinent control
not included in the questionnaire.
B. Flowcharts.
Flowcharts are a symbolic diagram of a specific
part of an internal control system indicating the
sequential flow of data and/or authority. A properly
prepared flowchart should reflect all operations,
movement, delays and filing procedures with
whatever is being charted and should also indicate
the conversion of source of document into
accounting information.
Advantages:
 Flowcharts are easily understood.
 A better overall picture of a complex
system is achieved when a flowchart is
used.
 EDP systems are commonly documented
with flowcharts which make it easier for
EDP purchase personnel to relate to the
auditors.
 Flowcharts are easier to update.
Disadvantages:
 Higher level of knowledge and training are
required to prepare a good flowchart of a
complex system.
 Flowcharts take more time to prepare and
require more knowledge.
 It is more difficult to spot internal control
weakness.
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 The following techniques are used by auditors to
assist them in preparing flowcharts:
 Standardized symbols – auditors use a
uniform set of symbols developed by ANSI
(American National Standards Institute).
 Processing – processing symbols are used
to identify any procedures applied to
documents.
 Flow lines – the follow of documents should
be from top to bottom and left to right.
 Documents – when a document is created,
its source should be indicated. Multiple
documents symbols are required when
multiple copies of the document are
prepared and their disposition should be
shown.
 Annotations – comment and explanations
should be used to make the flowchart
easier to understand or more complete.
C. Narrative description.
A narrative description is a written description of a
particular phase or phases of a control system.
Some auditors prepare narrative descriptions to
accompany internal control questionnaires or
flowcharts in order to provide information not
otherwise included.
Advantages:
 Narrative is flexible and may be tailor
made for engagement.
 It requires a detailed analysis and thus
forces auditor to understand functioning of
the system.
Disadvantages:
 Auditor may not have the ability to
describe the system correctly and
concisely.
 This may require more time and careful
study.
 Auditor may overlook important portions of
internal control system.
 A poorly written internal control narrative
can lead to a misunderstanding of the
system.
D. Internal control checklist.
An internal control checklist contains a detailed
enumeration of the methods and practices which
characterize good internal control or of item to be
considered in reviewing internal control. In most
cases, this tool is used together with the narrative
approach.
E. Decision trees or tables.
Decision trees are graphic illustrations that depict
the logic of an operation or process. They generally
employ questions with "yes" or "no" answers, which
direct the user to the next relevant questions.
Decision tables, on the other hand, are graphic
illustrations that depict the logical relationships of a
system in table form.
Advantages and disadvantages are similar to
those of the flowchart.
The auditor could use any combination of the forms above
to document an entity‟s internal control structure, thereby
maximizing the advantages of each.
Required Understanding with Respect to Internal Control
PSA 315 requires the following in relation to obtaining an
understanding of the internal control system of an entity:
A. As part of obtaining an understanding of the
control environment, the auditor shall evaluate
whether:
 Management, with the oversight of those
charged with governance, has created
and maintained a culture of honesty and
ethical behavior.
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
 The strengths in the control environment
elements collectively provide an
appropriate foundation for the other
components of internal control
 Those other components are not
undermined by control environment
weaknesses.
Important Notes:
 The existence of a satisfactory control
environment can be a positive factor
when the auditor assesses the risks of
material misstatement. However, although
it may help reduce the risk of fraud, a
satisfactory control environment is not an
absolute deterrent to fraud.
 The control environment in itself does not
prevent, or detect and correct, a material
misstatement. However, it may influence
the evaluation of the auditor as to the
effectiveness of other controls and thereby,
the auditor‟s assessment of the risks of
material misstatement.
B. The auditor shall obtain an understanding of
whether the entity has a process for:
 Identifying business risks relevant to financial
reporting objectives.
 Estimating the significance of the risks.
 Assessing the likelihood of their occurrence.
 Deciding about actions to address those
risks.
If the entity has established such risk assessment
process, the auditor shall obtain an understanding
of it and the results thereof. Where the auditor
identifies risks of material misstatement that
management failed to identify, the auditor shall
evaluate whether there was an underlying risk of a
kind that the auditor expects would have been
identified by the entity‟s risk assessment process.
If there is such a risk, the auditor shall obtain an
understanding of why that process failed to identify
it, and evaluate whether the process is appropriate
to its circumstances or if there is a significant
deficiency in the entity‟s risk assessment process.
If the entity has not established such a process or
has an ad hoc process, the auditor shall discuss
with management whether business risks relevant
to financial reporting objectives have been
identified and how they have been addressed. The
auditor shall evaluate whether the absence of a
documented risk assessment process is appropriate
in the circumstances, or represents a significant
deficiency in the entity‟s internal control.
C. An understanding of the information system,
including the related business processes, relevant
to financial reporting, includes the following areas:
 The classes of transactions in the entity‟s
operations that are significant to the
financial statements.
 The procedures, within both information
technology (IT) and manual systems, by
which those transactions are initiated,
recorded, processed, corrected as
necessary, transferred to the general
ledger and reported in the financial
statements.
 The related accounting records, supporting
information and specific accounts in the
financial statements that are used to
initiate, record, process and report
transactions; this includes the correction of
incorrect information and how information
is transferred to the general ledger. The
records may be in either manual or
electronic form.
 How the information system captures
events and conditions, other than
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 transactions, that are significant to the
financial statements.
 The financial reporting process used to
prepare the entity‟s financial statements,
including significant accounting estimates
and disclosures.
 Controls surrounding journal entries,
including non-standard journal entries used
to record non-recurring and/or unusual
transactions or adjustments.
Furthermore, the auditor shall obtain an
understanding of how the entity communicates
financial reporting roles and responsibilities and
significant matters relating to financial reporting,
including:
 Communications between management
and those charged with governance.
 External communications, such as those
with regulatory authorities.
D. The auditor should obtain an understanding of
control activities relevant to the audit, being those
the auditor judges it necessary to understand in
order to assess the risks of material misstatement at
the assertion level and design further audit
procedures responsive to assessed risks.
An audit does not require an understanding of all
the control activities related to each significant
class of transactions, account balance, and
disclosure in the financial statements or to every
assertion relevant to them. The auditor‟s emphasis
may be on identifying and obtaining an
understanding of control activities that address the
areas where the auditor considers that risks of
material misstatement are likely to be higher.
When multiple control activities each achieve the
same objective, it is unnecessary to obtain an
understanding of each of the control activities
related to such objective.
E. The auditor should obtain an understanding of the
major activities that the entity uses to monitor
internal control over financial reporting, including
those related to those control activities relevant to
the audit, and how the entity initiates corrective
actions to its controls.
Moreover, the auditor shall obtain an
understanding of the sources of the information
used in the entity‟s monitoring activities, and the
basis upon which management considers the
information to be sufficiently reliable for the
purpose.
 MAKE A PRELIMINARY ASSESSMENT OF CONTROL RISK
After obtaining and understanding of the accounting and
internal control systems, the auditor should make a
preliminary assessment of control risk at the assertion level,
for each material account balance or class of transactions.
In assessing control risk, the auditor considers the errors or
irregularities that could occur and that could result in
material misstatements in the financial statements and
identifies relevant control procedures designed to prevent
the errors or irregularities.
There are two possible risk assessments pertaining to control
risk – a high or at the maximum level and a less than high or
below maximum level. The preliminary assessment of
control risk should be high unless the auditor:
A. Is able to identify internal controls relevant to the
assertion which are likely to prevent or detect and
correct a material misstatement.
B. Plans to perform test of controls to support the
assessment.
In identifying control policies and procedures relevant to
specific assertions, the auditor should keep in mind that
some policies and procedures have a pervasive effect on
many account balances or classes of transactions and on
numerous assertions while others have a specific effect on
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
only one account or class of transactions and one
assertion.
The process of arriving at the auditor‟s assessments of
control risk is an iterative process that is refined as the
auditor obtains more and more evidence about the
effectiveness of various internal control policies and
procedures.
 DETERMINE THE APPROPRIATE RESPONSE TO THE ASSESSED
RISKS OF MATERIAL MISSTATEMENTS
In order to reduce audit risk to an acceptably low level, the
auditor should determine overall responses to assessed risks
at the financial statement level and should design and
perform further audit procedures to respond to assessed
risks at the assertion level. The overall responses and the
nature, timing and extent of the further audit procedures
are matters for the professional judgment of the auditor.
The following are the possible responses an auditor may
adopt to address the assessed risks:
A. Overall responses at the financial statement level.
Overall responses to address the assessed risks of
material misstatement at the financial statement
level may include:
 Emphasizing to the audit team the need to
maintain professional skepticism.
 Assigning more experienced staff or those
with special skills or using experts.
 Incorporating additional elements of
unpredictability in the selection of further
audit procedures to be performed.
 Making general changes to the nature,
timing, or extent of audit procedures,
 Providing more supervision.
The assessment of the risks of material misstatement
at the financial statement level, and thereby the
auditor‟s overall responses, is affected by the
auditor‟s understanding of the control environment.
An effective control environment may allow the
auditor to have more confidence in internal control
and the reliability of audit evidence generated
internally within the entity and thus, for example,
allow the auditor to conduct some audit
procedures at an interim date rather than at the
period-end. Weaknesses in the control environment,
however, have the opposite effect.
B. Specific responses at the assertion level.
The appropriate response to the assessed risks at
the assertion level depends on whether or not the
preliminary assessment of control risk is high or at
less than high level. The assessment of control risk
affects inversely the detection risk that the auditor
may accept and consequently, the nature, timing
and extent of the further audit procedures.
If the preliminary assessment of control risk is at the
maximum level, the response at the assertion level
would be to adopt an audit approach that relies
primarily on substantive tests, that is, a no reliance
approach. Accordingly, the auditor does not
perform tests of controls anymore and proceeds
directly into designing the nature, timing and
extent of substantive procedures. Hence, the
auditor prepares only a substantive test audit
program.
On the other hand, if the auditor assesses the
preliminary control risk at less than the maximum
level, the auditor anticipates using the reliance
approach. In using the reliance approach, the
auditor should perform tests of controls to obtain
sufficient appropriate audit evidence that the
controls were operating effectively. Thus, the
auditor prepares both a test of controls audit
program and a substantive tests audit program.
 REASSESS CONTROL RISK
The auditor should evaluate whether the internal controls
are designed and operating as contemplated in the
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preliminary assessment of control risk. If the auditor finds
that the risk of material misstatement for particular audit
objectives is higher than originally expected, the auditor
should re-assess the level of control risk and the auditor will
have to reconsider the assurance needed from substantive
tests. If the reassessed control risk remains at less than high
or below the maximum level, the auditor may continue with
the planned reliance approach. Otherwise, the auditor
switches to the non-reliance approach.
If the tests of controls reveal a departure from, or
breakdown in, prescribed controls, the auditor should
consider its cause and documents the conclusions
reached. What amendment(s) need to be made to
planned substantive tests will depend in part on the reasons
for the departure.
In evaluating the effectiveness of controls, the auditor
considers all the control components taken together. The
various components contribute to internal control in
different ways. The entity level components must be
effective for internal control as a whole to be effective. If
the auditor concludes that internal control as it relates to
the entity as a whole is effective, there is a lower risk that
other, lower level aspects of internal control will be
overridden or bypassed and that misstatements may occur.
The assessed control risk should be documented.
Documentation requirements depend mainly on the
control risk assessment. If the assessment is high or at a
maximum level, the understanding of the internal controls
and the control risk assessment must be documented. If the
assessment is less than high or below the maximum level,
the basis for the control risk assessment must be
documented, in addition to the documentation of the
understanding of internal controls and the control risk
assessment.
 DETERMINE NATURE, TIMING AND EXTENT OF SUBSTANTIVE
PROCEDURES
Irrespective of the assessed risk of material misstatement,
the auditor should design and perform substantive
procedures for each material class of transactions, account
balance and disclosures. The assessed level of control risk
for an assertion has a direct effect on the design of
substantive tests. The lower the assessed level of control risk,
the less evidence the auditor needs from substantive tests.
As the assessed level of control risk decreases, the auditor
may modify substantive tests in the following ways:
A. Changing the nature of substantive tests from more
effective procedures to less effective procedures.
B. Changing the timing of substantive tests from
performing them at year end to performing them
at interim date.
C. Changing the extent of substantive tests from using
larger sample size to smaller sample size.
Ordinarily, the assessed level of control risk cannot be
sufficiently low to eliminate the need to perform any
substantive tests for all the financial statement assertions.
Consequently, regardless of the assessed level of control
risk, the auditor should perform some substantive tests for
significant account balance and transaction classes.
RISKS FOR WHICH SUBSTANTIVE PROCEDURES ALONE DO NOT
PROVIDE SUFFICIENT APPROPRIATE AUDIT EVIDENCE
In respect of some risks, the auditor may judge that it is not
possible or practicable to obtain sufficient appropriate
audit evidence only from substantive procedures. Such risks
may relate to the inaccurate or incomplete recording of
routine and significant classes of transactions or account
balances, the characteristics of which often permit highly
automated processing with little or no manual intervention.
In such cases, the entity‟s controls over such risks are
relevant to the audit and the auditor shall obtain an
understanding of them.
TESTING THE EFFECTIVENESS OF CONTROLS
Otherwise known as compliance tests, tests of controls are
the audit procedures used to test either the design or
operating effectiveness of a client‟s internal control policy
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
or procedure to support a less than high control risk
assessment. Tests of controls could either be:
A. No trail tests – performed when the procedure to
be tested does not leave a visible audit trail in the
supporting documents of the performance of
control procedure by the client‟s employee.
B. Documentary trail tests – performed when the
procedure to be tested leaves a visible audit trail in
the supporting documents.
The audit trail is a record left by the accounting information
system of movements in the individual transaction data. This
record in the form of references to the processing of the
data provides a trail of the processing of transactions and
other events entered into by the entity.
Testing the operating effectiveness of controls include
considering:
A. How the controls were applied at relevant times
during the period under audit.
B. The consistency with which they were applied.
C. By whom or by what means they were applied.
Not all controls effected by the client should be tested.
Tests of controls are performed only on those controls that:
A. The auditor has determined are suitably designed
to prevent, or detect and correct, a material
misstatement in an assertion.
B. The auditor intends to rely on when designing
substantive tests of account balances.
Thus, an auditor would not rely on, therefore not test, a
particular control if the audit effort required to test the
control exceeded the reduction in year-end audit effort
that could be achieved by the reliance.
Tests of control activities are necessary to support a less
than high risk assessment because control activities and
related accounting procedures are applied in a more
detailed level and have more direct effects on specific
audit objectives and account balances within transaction
cycles than do controls that are part of the other
components of internal control.
Tests of Controls and Other Audit Procedures
A. Testing the operating effectiveness of controls is
different from obtaining an understanding of and
evaluating the design and implementation of
controls. However, the same types of audit
procedures are used. The auditor may, therefore,
decide it is efficient to test the operating
effectiveness of controls at the same time as
evaluating their design and determining that they
have been implemented.
B. Although some risk assessment procedures may not
have been specifically designed as tests of
controls, they may nevertheless provide audit
evidence about the operating effectiveness of the
controls and, consequently, serve as tests of
controls.
C. The auditor may design a test of controls to be
performed concurrently with a test of details on the
same transaction. Although the purpose of a test of
controls is different from the purpose of a test of
details, both may be accomplished concurrently
by performing a test of controls and a test of details
on the same transaction, also known as a dual-
purpose test. A dual-purpose test is designed and
evaluated by considering each purpose of the test
separately.
 NATURE OF TESTS OF CONTROLS
The tests generally consist of one, or a combination of, the
following procedures:
A. Inquiries of appropriate client personnel.
B. Observation of the application of policies and
procedures.
C. Inspection of documents, records and reports.
D. Reperformance of client procedures.
The nature of the particular control influences the type of
procedure required to obtain audit evidence about
whether the control was operating effectively. If operating
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effectiveness is evidenced by documentation, the auditor
may decide to inspect it to obtain audit evidence about
operating effectiveness. For other controls, however,
documentation may not be available or relevant. For
example, documentation of operation may not exist for
some factors in the control environment, such as
assignment of authority and responsibility, or for some types
of control activities, such as control activities performed by
a computer.
Usually, the auditor can acquire relevant information by
making appropriate inquiries. However, inquiry alone is not
sufficient to test the operating effectiveness of controls.
Accordingly, if the auditor believes a control activity may
have a significant effect in supporting a less than high
control risk assessment for a specific audit objective, the
auditor should perform other audit procedures in
combination with inquiry to obtain sufficient evidence that
the control is operating effectively. In this regard, inquiry
combined with inspection or reperformance may provide
more assurance than inquiry and observation, since an
observation is pertinent only at the point in time at which it
is made.
Tests based on observation, inquiry and inspection of
documents and records often provide sufficient evidence
about the operating effectiveness of a control. However, in
some instances, the auditor may also have to reperform the
application of a control to obtain adequate evidence that
it is operating effectively. When the auditor believes a
control is so significant that further evidence of its
effectiveness is necessary, it is appropriate to reperform its
application. If extensive reperformance of controls is likely
to be necessary, the auditor should consider whether it is
efficient to perform tests of controls in order to restrict the
scope of substantive testing.
When examining documentation, an auditor does not
examine all of the transactions and detailed records
related to the controls tested. Rather, the auditor selects a
sample from the population of all available transactions or
records for the period.
 TIMING OF TESTS OF CONTROLS
The timing of tests of controls depends on the auditor‟s
objective and determines the period of reliance on those
controls. If the auditor tests controls at a particular time, the
auditor only obtains audit evidence that the controls
operated effectively at that time. However, if the auditor
tests controls throughout the period, he obtains audit
evidence of the effectiveness of the operation of the
controls during that period.
Audit evidence pertaining only to a point in time may be
sufficient for the auditor‟s purpose, for example, when
testing controls over the entity‟s physical inventory counting
at the period end. If, on the other hand, the auditor intends
to rely on a control over a period, tests that are capable of
providing audit evidence that the control operated
effectively at relevant times during that period are
appropriate. Such tests may include tests of the entity‟s
monitoring of controls.
Using Audit Evidence Obtained During an Interim Period
When the auditor obtains audit evidence about the
operating effectiveness of controls during an interim period,
the auditor shall:
A. Obtain audit evidence about significant changes
to those controls subsequent to the interim period.
B. Determine the additional audit evidence to be
obtained for the remaining period.
Relevant factors in determining what additional
audit evidence to obtain about controls that were
operating during the period remaining after an
interim period, include:
 The significance of the assessed risks of
material misstatement at the assertion
level.
 The specific controls that were tested
during the interim period, and significant
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
changes to them since they were tested,
including changes in the information
system, processes, and personnel.
 The degree to which audit evidence about
the operating effectiveness of those
controls was obtained.
 The length of the remaining period.
 The extent to which the auditor intends to
reduce further substantive procedures
based on the reliance of controls.
 The control environment.
Additional audit evidence may be obtained, for
example, by extending tests of controls over the
remaining period or testing the entity‟s monitoring
of controls.
Using Audit Evidence Obtained From Previous Audit
In certain circumstances, audit evidence obtained from
previous audits may provide audit evidence where the
auditor performs audit procedures to establish its continuing
relevance. In determining whether it is appropriate to use
audit evidence about the operating effectiveness of
controls obtained in previous audits, and, if so, the length of
the time period that may elapse before retesting a control,
the auditor shall consider the following:
A. The effectiveness of other elements of internal
control, including the control environment, the
entity‟s monitoring of controls, and the entity‟s risk
assessment process.
B. The risks arising from the characteristics of the
control, including whether it is manual or
automated.
C. The effectiveness of general IT-controls.
D. The effectiveness of the control and its application
by the entity, including the nature and extent of
deviations in the application of the control noted in
previous audits, and whether there have been
personnel changes that significantly affect the
application of the control.
E. Whether the lack of a change in a particular
control poses a risk due to changing
circumstances.
F. The risks of material misstatement and the extent of
reliance on the control.
If the auditor plans to use audit evidence from a previous
audit about the operating effectiveness of specific controls,
the auditor should establish the continuing relevance of
that evidence by obtaining audit evidence about whether
significant changes in those controls have occurred
subsequent to the previous audit. Changes may affect the
relevance of the audit evidence obtained in previous
audits such that there may no longer be a basis for
continued reliance.
The auditor should obtain this evidence by performing
inquiry combined with observation or inspection, to confirm
the understanding of those specific controls, and:
A. If there have been changes that affect the
continuing relevance of the audit evidence from
the previous audit, the auditor shall test the controls
in the current audit.
B. If there have not been such changes, the auditor
shall test the controls at least once in every third
audit, and shall test some controls each audit to
avoid the possibility of testing all the controls on
which the auditor intends to rely in a single audit
period with no testing of controls in the subsequent
two audit periods.
The auditor‟s decision on whether to rely on audit evidence
obtained in previous audits for controls that have not
changed since they were last tested and are not controls
that mitigate a significant risk is a matter of professional
judgment.
In general, the higher the risk of material misstatement, or
the greater the reliance on controls, the shorter the time
period elapsed, if any, is likely to be. Factors that may
decrease the period for retesting a control, or result in not
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relying on audit evidence obtained in previous audits at all,
include the following:
A. A weak control environment.
B. Weak monitoring of controls.
C. A significant manual element to the relevant
controls.
D. Personnel changes that significantly affect the
application of the control.
E. Changing circumstances that indicate the need
for changes in the control.
F. Weak general IT-controls.
Controls over Significant Risks
When the auditor plans to rely on controls over a risk the
auditor has determined to be a significant risk, the auditor
shall test those controls in the current period.
 EXTENT OF TESTS OF CONTROLS
When more persuasive audit evidence is needed regarding
the effectiveness of a control, the greater is the extent of
testing the controls. Matters the auditor may consider in
determining the extent of tests of controls include the
following:
A. The frequency of the performance of the control
by the entity during the period.
B. The length of time during the audit period that the
auditor is relying on the operating effectiveness of
the control.
C. The expected rate of deviation from a control.
D. The relevance and reliability of the audit evidence
to be obtained regarding the operating
effectiveness of the control at the assertion level.
E. The extent to which audit evidence is obtained
from tests of other controls related to the assertion.
Testing Indirect Controls
In some circumstances, it may be necessary to obtain audit
evidence supporting the effective operation of indirect
controls. For example, when the auditor decides to test the
effectiveness of a user review of exception reports detailing
sales in excess of authorized credit limits, the user review
and related follow up is the control that is directly of
relevance to the auditor. Controls over the accuracy of the
information in the reports are described as „indirect‟
controls.
EVALUATING THE OPERATING EFFECTIVENESS OF CONTROLS
When performing tests of controls, an auditor may find
differences between what was expected based on the
documentation obtained and what actually occurred. For
example, a vendor‟s invoice may have been paid without
the accounts payable manager‟s initials of approvals. Such
differences are called exceptions, deviations or
occurrences rather than errors because an exception does
not necessarily mean that an error had been made in the
accounting records.
When deviations from controls upon which the auditor
intends to rely are detected, the auditor should make
specific inquiries to understand these matters and their
potential consequences, and should determine whether:
A. The tests of controls that have been performed
provide an appropriate basis for reliance on the
controls.
B. Additional tests of controls are necessary.
C. The potential risks of misstatement need to be
addressed using substantive procedures.
The concept of effectiveness of the operation of controls
recognizes that some deviations in the way controls are
applied by the entity may occur. Deviations from
prescribed controls may be caused by such factors as
changes in key personnel, significant seasonal fluctuations
in volume of transactions and human error. The detected
rate of deviation, in particular in comparison with the
expected rate, may indicate that the control cannot be
relied on to reduce risk at the assertion level to that
assessed by the auditor.
When evaluating the operating effectiveness of relevant
controls, the auditor should evaluate whether misstatements
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
that have been detected by substantive procedures
indicate that controls are not operating effectively. A
material misstatement detected by the auditor‟s
procedures may indicate the existence of a significant
deficiency in internal control. However, the absence of
misstatements detected by substantive procedures does
not provide audit evidence that controls related to the
assertion being tested are effective.
COMMUNICATING DEFICIENCIES IN INTERNAL CONTROL TO
THOSE CHARGED WITH GOVERNANCE AND MANAGEMENT
As a result of obtaining an understanding of the internal
control of the entity and performing tests of controls, the
auditor may become aware or be able to identify
deficiencies in the system. Philippine standards require the
auditor to communicate significant internal control
deficiencies noted in the audit of financial statements.
 INTERNAL CONTROL DEFICIENCIES
A deficiency in internal control exists when:
A. A control is designed, implemented or operated in
such a way that it is unable to prevent, or detect
and correct, misstatements in the financial
statements on a timely basis.
B. A control necessary to prevent, or detect and
correct, misstatements in the financial statements
on a timely basis is missing.
Such deficiency is considered significant when it is or in
combination with other deficiencies in internal control, in
the auditor‟s professional judgment, is of sufficient
importance to merit the attention of those charged with
governance.
The significance of a deficiency or a combination of
deficiencies in internal control depends not only on
whether a misstatement has actually occurred, but also on
the likelihood that a misstatement could occur and the
potential magnitude of the misstatement. Significant
deficiencies may exist even though the auditor has not
identified misstatements during the audit.
Examples of matters that the auditor may consider in
determining whether a deficiency or combination of
deficiencies in internal control constitutes a significant
deficiency include:
A. The susceptibility to loss or fraud of the related asset
or liability.
B. The likelihood of the deficiencies leading to
material misstatements in the financial statements
in the future.
C. The subjectivity and complexity of determining
estimated amounts, such as fair value accounting
estimates.
D. The financial statement amounts exposed to the
deficiencies.
E. The volume of activity that has occurred or could
occur in the account balance or class of
transactions exposed to the deficiency or
deficiencies
F. The importance of the controls to the financial
reporting process; for example:
 General monitoring controls.
 Controls over the prevention and detection
of fraud.
 Controls over the selection and application
of significant accounting policies.
 Controls over significant transactions with
related parties.
 Controls over significant transactions outside
the entity‟s normal course of business.
 Controls over the period-end financial
reporting process.
G. The cause and frequency of the exceptions
detected as a result of the deficiencies in the
controls.
H. The interaction of the deficiency with other
deficiencies in internal control.
Indicators of significant deficiencies in internal control
include:
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 A. Evidence of ineffective aspects of the control
environment, such as:
 Indications that significant transactions in
which management is financially interested
are not being appropriately scrutinized by
those charged with governance.
 Identification of management fraud,
whether or not material, that was not
prevented by the entity‟s internal control.
 Management‟s failure to implement
appropriate remedial action on significant
deficiencies previously communicated.
B. Absence of a risk assessment process within the
entity where such a process would ordinarily be
expected to have been established.
C. Evidence of an ineffective entity risk assessment
process, such as management‟s failure to identify a
risk of material misstatement that the auditor would
expect the entity‟s risk assessment process to have
identified.
D. Evidence of an ineffective response to identified
significant risks (e.g., absence of controls over such
a risk).
E. Misstatements detected by the auditor‟s
procedures that were not prevented, or detected
and corrected, by the entity‟s internal control.
F. Restatement of previously issued financial
statements to reflect the correction of a material
misstatement due to error or fraud.
G. Evidence of management‟s inability to oversee the
preparation of the financial statements.
Note: Law or regulation in some jurisdictions may establish a
requirement, particularly for audits of listed entities, for the
auditor to communicate to those charged with
governance or to other relevant parties such as regulators
one or more specific types of deficiency in internal control
that the auditor has identified during the audit.
 REQUIRED PROCEDURES FOR THE AUDITOR
A. The auditor shall determine whether, on the basis of
the audit work performed, the auditor has
identified one or more deficiencies in internal
control.
In determining whether the auditor has identified
one or more deficiencies in internal control, the
auditor may discuss the relevant facts and
circumstances of the auditor‟s findings with the
appropriate level of management. This discussion
provides an opportunity for the auditor to alert
management on a timely basis to the existence of
deficiencies of which management may not have
been previously aware.
The level of management with whom it is
appropriate to discuss the findings is one that is
familiar with the internal control area concerned
and that has the authority to take remedial action
on any identified deficiencies in internal control. In
some circumstances, it may not be appropriate for
the auditor to discuss the auditor‟s findings directly
with management, for example, if the findings
appear to call management‟s integrity or
competence into question
B. If the auditor has identified one or more
deficiencies in internal control, the auditor shall
determine, on the basis of the audit work
performed, whether, individually or in combination,
they constitute significant deficiencies.
Controls may be designed to operate individually
or in combination to effectively prevent, or detect
and correct, misstatements. For example, controls
over accounts receivable may consist of both
automated and manual controls designed to
operate together to prevent, or detect and
correct, misstatements in the account balance.
A deficiency in internal control on its own may not
be sufficiently important to constitute a significant
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
deficiency. However, a combination of deficiencies
affecting the same account balance or disclosure,
relevant assertion, or component of internal control
may increase the risks of misstatement to such an
extent as to give rise to a significant deficiency.
C. The auditor shall communicate in writing significant
deficiencies in internal control identified during the
audit to those charged with governance on a
timely basis.
Form of Communication
Communicating significant deficiencies in writing to
those charged with governance reflects the
importance of these matters, and assists those
charged with governance in fulfilling their oversight
responsibilities.
Timing of Communication
In determining when to issue the written
communication, the auditor may consider whether
receipt of such communication would be an
important factor in enabling those charged with
governance to discharge their oversight
responsibilities.
In addition, for listed entities in certain jurisdictions,
those charged with governance may need to
receive the auditor‟s written communication
before the date of approval of the financial
statements in order to discharge specific
responsibilities in relation to internal control for
regulatory or other purposes. For other entities, the
auditor may issue the written communication at a
later date.
Nevertheless, in the latter case, as the auditor‟s
written communication of significant deficiencies
forms part of the final audit file, the written
communication is subject to the overriding
requirement for the auditor to complete the
assembly of the final audit file on a timely basis.
Regardless of the timing of the written
communication of significant deficiencies, the
auditor may communicate these orally in the first
instance to management and, when appropriate,
to those charged with governance to assist them in
taking timely remedial action to minimize the risks
of material misstatement. Doing so, however, does
not relieve the auditor of the responsibility to
communicate the significant deficiencies in writing,
as required by PSA 265.
Extent of the Communication
The level of detail at which to communicate
significant deficiencies is a matter of the auditor‟s
professional judgment in the circumstances.
Factors that the auditor may consider in
determining an appropriate level of detail for the
communication include:
 The nature, size and complexity of the
entity.
 The nature of significant deficiencies that
the auditor has identified.
 The entity‟s governance composition.
 Legal or regulatory requirements regarding
the communication of specific types of
deficiency in internal control.
Other Consideration in the Communication
Management and those charged with
governance may already be aware of significant
deficiencies that the auditor has identified during
the audit and may have chosen not to remedy
them because of cost or other considerations. The
responsibility for evaluating the costs and benefits
of implementing remedial action rests with
management and those charged with
governance. Accordingly, the requirement to
communicate the significant deficiency applies
regardless of cost or other considerations that
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 management and those charged with governance
may consider relevant in determining whether to
remedy such deficiencies.
Moreover, the fact that the auditor communicated
a significant deficiency to those charged with
governance and management in a previous audit
does not eliminate the need for the auditor to
repeat the communication if remedial action has
not yet been taken. If a previously communicated
significant deficiency remains, the current year‟s
communication may repeat the description from
the previous communication, or simply reference
the previous communication.
The auditor may ask management or, where
appropriate, those charged with governance, why
the significant deficiency has not yet been
remedied. A failure to act, in the absence of a
rational explanation, may in itself represent a
significant deficiency.
D. The auditor shall also communicate to
management at an appropriate level of
responsibility on a timely basis:
 In writing, significant deficiencies in internal
control that the auditor has communicated
or intends to communicate to those charged
E.
with governance, unless it would be
inappropriate to communicate directly to
management in the circumstances.
 Other deficiencies in internal control
identified during the audit that have not
been communicated to management by
other parties and that, in the auditor‟s
professional judgment, are of sufficient
importance to merit management‟s
attention.
Appropriate Level of Responsibility
Ordinarily, the appropriate level of management is
the one that has responsibility and authority to
evaluate the deficiencies in internal control and to
take the necessary remedial action. For significant
deficiencies, the appropriate level is likely to be the
chief executive officer or chief financial officer (or
equivalent) as these matters are also required to
be communicated to those charged with
governance. For other deficiencies in internal
control, the appropriate level may be operational
management with more direct involvement in the
control areas affected and with the authority to
take appropriate remedial action.
Certain identified significant deficiencies in internal
control may call into question the integrity or
competence of management. Accordingly, it
may not be appropriate to communicate such
deficiencies directly to management.
Communicating Other Internal Control Deficiencies
During the audit, the auditor may identify other
deficiencies in internal control that are not
significant deficiencies but that may be of sufficient
importance to merit management‟s attention. The
determination as to which other deficiencies in
internal control merit management‟s attention is a
matter of professional judgment in the
circumstances, taking into account the likelihood
and potential magnitude of misstatements that
may arise in the financial statements as a result of
those deficiencies.
The communication of other deficiencies in internal
control that merit management‟s attention need
not be in writing but may be oral. Where the
auditor has discussed the facts and circumstances
of the auditor‟s findings with management, the
auditor may consider an oral communication of
the other deficiencies to have been made to
management at the time of these discussions.
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
Accordingly, a formal communication need not be
made subsequently.
If the auditor has communicated deficiencies in
internal control other than significant deficiencies
to management in a prior period and
management has chosen not to remedy them for
cost or other reasons, the auditor need not repeat
the communication in the current period. The
auditor is also not required to repeat information
about such deficiencies if it has been previously
communicated to management by other parties,
such as internal auditors or regulators.
It may, however, be appropriate for the auditor to
re-communicate these other deficiencies if there
has been a change of management, or if new
information has come to the auditor‟s attention
that alters the prior understanding of the auditor
and management regarding the deficiencies.
Nevertheless, the failure of management to
remedy other deficiencies in internal control that
were previously communicated may become a
significant deficiency requiring communication
with those charged with governance. Whether this
is the case depends on the auditor‟s judgment in
the circumstances.
The auditor shall include in the written
communication of significant deficiencies in internal
control:
 A description of the deficiencies and an
explanation of their potential effects.
In explaining the potential effects of the
significant deficiencies, the auditor need not
quantify those effects. The significant
deficiencies may be grouped together for
reporting purposes where it is appropriate to
do so. The auditor may also include in the
written communication suggestions for
remedial action on the deficiencies,
management‟s actual or proposed
responses, and a statement as to whether or
not the auditor has undertaken any steps to
verify whether management‟s responses
have been implemented.
 Sufficient information to enable those
charged with governance and management
to understand the context of the
communication. In particular, the auditor
shall explain that:
a. The purpose of the audit was for the
auditor to express an opinion on the
financial statements.
b. The audit included consideration of
internal control relevant to the
preparation of the financial statements
in order to design audit procedures
that are appropriate in the
circumstances, but not for the purpose
of expressing an opinion on the
effectiveness of internal control.
c. The matters being reported are limited
to those deficiencies that the auditor
has identified during the audit and
that the auditor has concluded are of
sufficient importance to merit being
reported to those charged with
governance.
The auditor may consider it appropriate to include
the following information as additional context for
the communication:
 An indication that if the auditor had
performed more extensive procedures on
internal control, the auditor might have
identified more deficiencies to be reported,
or concluded that some of the reported
deficiencies need not, in fact, have been
reported.
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  An indication that such communication has
been provided for the purposes of those
charged with governance, and that it may
not be suitable for other purposes.
Law or regulation may require the auditor or
management to furnish a copy of the auditor‟s
written communication on significant deficiencies
to appropriate regulatory authorities. Where this is
the case, the auditor‟s written communication may
identify such regulatory authorities.
CONSIDERATION SPECIFIC TO SMALLER ENTITIES
A. Smaller entities often have fewer employees which
may limit the extent to which segregation of duties
is practicable. However, in a small owner-
managed entity, the owner-manager may be able
to exercise more effective oversight than in a larger
entity. This oversight may compensate for the
generally more limited opportunities for
segregation of duties.
On the other hand, the owner-manager may be
more able to override controls because the system
of internal control is less structured. This is taken into
account by the auditor when identifying the risks of
material misstatement due to fraud.
B. The control environment within small entities is likely
to differ from larger entities. For example, those
charged with governance in small entities may not
include an independent or outside member, and
the role of governance may be undertaken
directly by the owner-manager where there are no
other owners.
C. Audit evidence for elements of the control
environment in smaller entities may not be
available in documentary form, in particular where
communication between management and other
personnel may be informal, yet effective. For
example, small entities might not have a written
code of conduct but, instead, develop a culture
that emphasizes the importance of integrity and
ethical behavior through oral communication and
by management example. Consequently, the
attitudes, awareness and actions of management
or the owner-manager are of particular
importance to the auditor‟s understanding of a
smaller entity‟s control environment.
Prepared by: Mohammad Muariff S. Balang, CPA, First Semester, AY 2013-2014
D. There is unlikely to be an established risk assessment
process in a small entity. In such cases, it is likely
that management will identify risks through direct
personal involvement in the business. Irrespective of
the circumstances, however, inquiry about
identified risks and how they are addressed by
management is still necessary.
E. Communication may be less structured and easier
to achieve in a small entity than in a larger entity
due to fewer levels of responsibility and
management‟s greater visibility and availability.
F. Information systems and related business processes
relevant to financial reporting in small entities are
likely to be less sophisticated than in larger entities,
but their role is just as significant. Small entities with
active management involvement may not need
extensive descriptions of accounting procedures,
sophisticated accounting records, or written
policies. Understanding the entity‟s systems and
processes may therefore be easier in an audit of
smaller entities, and may be more dependent on
inquiry than on review of documentation. The need
to obtain an understanding, however, remains
important.
G. The concepts underlying control activities in small
entities are likely to be similar to those in larger
entities, but the formality with which they operate
may vary. Further, small entities may find that
certain types of control activities are not relevant
because of controls applied by management. For
example, management‟s sole authority for granting
credit to customers and approving significant
purchases can provide strong control over
important account balances and transactions,
lessening or removing the need for more detailed
control activities.
H. Control activities relevant to the audit of a smaller
entity are likely to relate to the main transaction
cycles such as revenues, purchases and
employment expenses.
I. Management‟s monitoring of control is often
accomplished by management‟s or the owner-
manager‟s close involvement in operations. This
involvement often will identify significant variances
from expectations and inaccuracies in financial
data leading to corrective action to the control.
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