CHAPTER 16

CONSIDERATION OF INTERNAL CONTROL

IN A FINANCIAL STATEMENTS AUDIT

I. Review Questions

1. An auditor obtains an understanding of a client’s internal control structure as a

part of the control risk assessment process in order (1) to plan the nature, timing,
and extent of subsequent substantive audit procedures, and (2) to obtain
information about reportable conditions (control deficiencies) to report to the
client.

2. The primary reason for conducting an evaluation of a client’s existing internal

control system is to give the auditors a basis for finalizing the details of the
account balance audit program – to determine the nature, timing and extent of
subsequent substantive audit procedures.

A secondary purpose for conducting an evaluation of internal control is to be

able to make constructive suggestions for improvements. Officially, the
profession considers these suggestions a part of the audit function and does not
define the work as a MAS consultation.

Another purpose of the evaluation is to report to management and the board of

directors or its audit committee any discovery of “any reportable conditions” of
internal control deficiencies.

3. Refer to page 590, 1st paragraph of the textbook.

4. 1. Advantages of control questionnaire:

Easy to complete.
Checklist of questions.
Less chance of overlooking something important.
Disadvantages:
May contain numerous irrelevant questions.
Tendency to treat it like another form to fill out.

2. Advantages of memorandum documentation:

Can explain the precise controls applicable to the particular client.
(precise tailoring)
Requires penetrating analysis.
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Minimizes tendency toward perfunctory review.

Disadvantages:
Hard to write. Often lengthy.
Hard to revise in subsequent years.

3. Advantages of flowchart:
Graphic presentation of systems.
Shows the steps required and the flow of forms and documents.
Easy to read and analyze.
Easy to update in subsequent years.
Disadvantages:
Takes some time to draw neatly.

5. “Observation,” in a test of control procedure, refers to auditors looking to see

whether client personnel stamped, initialed, or left other signs that their assigned
control procedures had been performed.

“Reperformance,” in a test of control procedure, refers to auditors doing again

the control that was supposed to have been performed by the client personnel
(recalculating, looking up the right price, comparing quantities, and so forth).

6. Written reports on internal accounting control (IAC) for external use.

Type of Engagement Character of Report

Special IAC study
Service auditor engaged to report for
benefit of user auditor and their
mutual client.
Report on IAC with opinion on IAC
system taken as a whole.
A special-purpose report on IAC can
take special forms, the main feature of
which includes an opinion relating to
the controls applied by the service
organization to the client
organization’s transactions.

7. The auditor must obtain a sufficient understanding of the client’s system of

internal financial controls to identify the types of potential material
misstatements of financial statement components, and the risks associated with
each. Such understanding is obtained by gathering evidence relating to the basic
elements of the client’s internal financial controls.

8. The auditor obtains an initial understanding of the client’s financial controls by

studying the organizational structure, inquiring of management, and studying
last year’s working papers if a recurring audit.
 Consideration of Internal Control in a Financial Statements Audit 16-3
9. The documentation of the auditor’s understanding must provide clear evidence
of support for the auditor’s conclusions regarding the assessed level of control
risk. This is especially necessary if control risk is assessed below the maximum
level. The documentation at this point typically consists of some combination of
narrative memoranda, questionnaires or checklists, and internal control
flowcharts, as well as documentation of the auditor’s conclusions, and the
reason(s) for assessing control risk below maximum, if applicable.

10. Testing of internal financial controls may permit the auditor to further reduce the
assessed level of control risk. This, in turn, should lead to a decrease in the
nature, timing, and/or extent of substantive audit testing in the circumstances.

11. The following factors may cause the auditor to decide not to test the client’s
internal financial controls beyond obtaining an initial understanding:
a. Controls may already have been evaluated as ineffective;
b. Further testing is not cost effective (i.e., the cost of further testing is
greater than the cost savings resulting from reduced substantive testing)

12. Some combination of the following means is typically utilized by the auditor in
testing a client’s internal financial controls:
a. Reprocessing transactions through the client’s system;
b. Observation of controls; and
c. Document examination and testing.

13. Misrepresentation is a form of financial statement misstatement caused by

intentional efforts by management to distort reported financial position and/or
results of operations. Misappropriation is a form of fraud whereby one or more
employees effect a transfer of assets from employer to employee, accompanied
by concealment in the form of account or substance alteration.

14. The following are some examples of internal control weaknesses and suggested
expanded substantive testing, given the weaknesses:
a. Perpetual inventory records not maintained: Expand test counts during
inventory observation
b. Bank accounts not reconciled: Expand year-end audit of cash accounts
c. Customer exceptions to monthly statements not investigated and
cleared: Expand accounts receivable confirmation at year-end.

15. Reportable conditions are matters coming to the auditor’s attention, as a result of
his/her study and evaluation of the client’s internal financial controls, relating to
significant deficiencies in the design or operation or of the internal controls that
could adversely affect the organization’s ability to record, process, summarize,
and report financial data consistent with the assertions of management in the
financial statements. The purpose of the reportable conditions letter is to inform
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the audit committee, or similar body within the organization, of weaknesses for
which they may not be aware. Such communication increases the likelihood
that the weaknesses will be corrected on a timely basis.
16. Use of any one of the approaches to studying and documenting a client’s
internal financial controls, by itself, is inadequate. Each approach adds a needed
dimension to the analysis. The memorandum requires depth of analysis not
found in the flowchart. The flowchart, on the other hand, promotes ease of
understanding and ready identification of strengths and weaknesses in controls.
The questionnaires and checklists add the dimension of completeness of
coverage. By using the three tools in combination, the auditor is able to gain a
deeper and clearer understanding of each of the subsets of the transaction cycles,
including major control strengths and weaknesses, thereby permitting more
accurate control risk assessments and more useful substantive audit programs
based on such assessments.

II. Multiple Choice Questions

1. b 8. a 15. d 22. a
2. a 9. b 16. c 23. a
3. b 10. c 17. b 24. d
4. d 11. b 18 b 25. b
5. b 12. a 19. a 26. d
6. b 13. b 20. d 27. b
7. b 14. b 21. a 28. d

III. Comprehensive Cases

Case 1. a. Given identified financial control weaknesses, the auditor may elect to
expand the extent of substantive testing, or search for and test compensating
controls. In the present case, the following errors and irregularities may
occur, given the control weaknesses in the payroll subset of the expenditure
cycle:
1. Hours may be in error, inasmuch as the time cards are prepared by
employees and not reviewed. This could lead to overstatement or
understatement of wages expense in the income statement. This
could also affect the carrying value of finished goods inventories if
Quicky is a manufacturing company.
2. The payroll could be “padded” inasmuch as signed checks are
returned to the department supervisors for distribution. This could
result in overstatements of salaries and wages expense on the
income statement. It could also cause a finished goods inventory
overstatement.
Consideration of Internal Control in a Financial Statements Audit 16-5
b. If, based on the initial understanding, controls are thought to be adequate,
the auditor should consider the following alternatives:
1. Document the understanding, assess control risk below maximum,
as considered appropriate, and document the basis for conclusions;
or
2. Document the understanding and test controls as a means for
further reduction in the assessed level of control risk. This
alternative would be chosen if the following conditions exist:
a. Controls are thought to be effective; and
b. Cost reductions through reduced substantive testing
exceed cost of further testing of controls.

c. 1. Auditors must study and evaluate internal control each year because the
environment within which the client operates is subject to constant
change; and controls must adapt to these changes if the system is to
remain effective. The auditor must identify the environmental changes
and determine that the relevant control points remain covered after the
changes.

2. A minimum audit is necessary, even under conditions of excellent

internal control, because of the following inherent limitations in all
internal control systems:
Internal control assumes the nonexistence of collusion;
Management can override the financial controls;
Temporary breakdowns in the control system may occur and
produce material errors;

Given that these inherent limitations could produce material financial

statement misstatements, and given that the audit report provides
reasonable assurance that the financial statements do not contain
material misstatements, the auditor must perform a minimum audit,
even under conditions of excellent internal control if such assurance is
to be provided.
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Case 2.
ISLANDER DRUG STORE, INC.
Processing Cash Collections
Internal Control Questionnaire

-Question Yes No
Are customers who pay by check identified via
store I.D. card or other means?
Does company policy prohibit accepting checks
for anything except merchandise sales plus
a nominal cash amount?
Is a receipt produced by the cash register given
to each customer?
Is the reading of each cash register taken
periodically by an employee who is
independent of the handling of cash
receipts?
Are cash counts made on a surprise basis by an
individual who is independent of the
handling of cash receipts?
Is the reading of each cash register compared
regularly to the cash received?
Is a summary listing of cash register readings
prepared by an employee who is
independent of physically handling cash
receipts?
Are receipts forwarded to an independent
employee who makes the bank deposits?
Are each day’s receipts deposited intact daily?
Is the summary listing of cash register receipts
reconciled to the duplicate deposit slips
authenticated by the bank?
Are entries to the cash receipts journal
prepared from duplicate deposit slips or the
summary listing of cash register readings?
Are the entries to the cash receipts journal
compared to the deposits per bank
statement?
Consideration of Internal Control in a Financial Statements Audit 16-7
Are areas involving the physical handling of
cash reasonably safeguarded?
Are employees who handle receipts bonded?
Are charged back items (NSF checks, etc.)
directed to an employee who does not
physically handle receipts or have access to
the books?