Lesson 15


e) Internal Control.
 Understanding of Internal Control is used by the auditor  
1.  to identify types of potential misstatements;
2.  to consider factors that affect the risks of material misstatements; and
3.  to design the nature, timing and extent of further audit procedures. 

Definition of Internal Control
Internal control is the process designed and affected by those charged with governance, management, and
other personnel ………..
to provide reasonable assurance about the achievement of the entity’s objectives with regard to: 
1.  Reliability of financial reporting, 
2.  Effectiveness and efficiency of operations and 
3.  Compliance with applicable laws and regulations.  
It follows that internal control is designed and implemented to address identified business risks that
threaten the achievement of any of these objectives.

Components of Internal Control 
i) The control environment
ii) The entity’s risk assessment process
iii) The information system, including the related business processes relevant to financial 
reporting and communication.
iv) Control activities
v) Monitoring of controls 
i) The Control Environment
 It encompasses the following elements: 
(a) Communication and enforcement of integrity and ethical values.
(b) Commitment to competence
(c) Participation by those charged with governance
(d) Management’s philosophy and operating style
(e) Organizational structure
(f) Human resource policies and practices 
Auditor should evaluate how these components have been incorporated into the entity’s processes.

ii) The Entity’s Risk Assessment Process 
It is the process of identifying and responding to business risks
 that affect entity’s financial reporting.  
Such process includes how management:
1. identifies risks that affect entity’s ability to produce financial statement that give true and 
fair view,

2. estimates their significance, 
3. estimates likelihood of their occurrence and 
4. Decides upon actions to manage them. 
Risks relevant to financial reporting
– internal events, and 
– external events and circumstance  
That may occur and adversely affect an entity’s ability to:
• initiate,  
• record,
• process, and 
• report the financial information.  
Risks can arise due to circumstances such as the following: (internal/external) 

a) Changes in operating environment
b) New personnel
c) New or revamped information systems
d) Rapid growth
e) New technology
f) New business models, product or activities
g) Corporate restructurings
h) Expanded foreign operations
i) New accounting pronouncements 
iii) Information system, including the related business processes, relevant to financial
reporting and communication 
 The information system consists of:
1. infrastructure (physical and hardware components), 
2. software
3. people
4. procedures and 
5. data 
Infrastructure and software will be absent, or have less significance, in systems that are exclusively or
primarily manual. Many information systems make extensive use of IT.
Importance of Information System
Accordingly, an information system encompasses methods and records that: 
• Identify and record
 all valid transaction.
• Describe on a timely basis
 the transaction in sufficient detail to permit proper classification of 
transactions for financial reporting.
• Measure the value
 of transactions in a manner that permits recording their proper monetary value 
in the financial statements.
• Determine the time period
 in which transactions occurred to permit recording of transactions in 
the proper accounting period.
• Present properly
 the transactions and related disclosures in the financial statements. 
• Communication involves: 
– providing an understanding of individual roles and responsibilities pertaining to internal
– understanding roles of others and 
– doing exception reporting to higher level management. 
• Communication takes such forms as:
–  policy manuals, 
– accounting and financial reporting manuals and memorandum.  
• It may also be made  
– electronically, 
– orally and 
– through the actions of management  
iv) Control Activities
Control activities include:
a) Performance reviews
b) Information processing
c) Physical controls
d) Segregations of duties

a) Performance reviews
 These control activities include: 
– reviews and analyses of actual performance
 versus budgets, forecasts, and prior period

– 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; and 
– review of functional or activity performance
, such as a bank's Consumer loan manager's 
review of reports by branch, region, and loan type for loan approvals and collections
b) Information processing 
 A variety of controls are performed to check accuracy, completeness, and authorization of
 The two broad groupings of information systems control activities are: 
i. application controls and 
ii. general IT controls.  
Application controls
 apply to the processing of individual applications. These controls help ensure that
transactions occurred, are authorized, and are completely and accurately recorded and processed. 
General IT-controls
 commonly include controls over data center and network operations; system software
acquisition, change and maintenance; access security; and application system acquisition, development, and
maintenance. These controls apply to main-frame, mini-frame and end-user environments. 
c) Physical controls 
 These activities encompass the: 
i. physical security of assets
, including adequate safeguards such as secured facilities access to
assets and records;  
ii. authorization for access
 to computer programs and data files; and 
iii. periodic counting and comparison
 with amounts shown on control records (for example 
comparing the results of cash, security and inventory counts with accounting records). 
d) Segregation of duties
Assigning different people the responsibilities of authorizing transactions, recording transactions, and
maintaining custody of assets is intended to reduce the opportunities to allow any person to be in a position
to both commit and conceal errors or fraud in the normal course of the person's duties. Examples of
segregation of duties include reporting, reviewing and approving reconciliations, and approval and control
of documents.
v) Monitoring of Control 
The auditor should obtain an understanding of the major types of activities that 
i. the entity uses to monitor internal control over financial reporting, and 
ii. how the entity initiates corrective actions to its controls. 
Monitoring means and includes:
Ensuring that internal controls are operating as intended.

– If monitoring is not done, people may stop performing the functions they are required to
– It also involves assessing the quality of internal control performance over times.
– Monitoring may be ongoing activities, separate evaluations or a combination of the two. 
Monitoring includes:
a) Supervisions, functions of managers
b) Internal audit
c) Communication from external parties indicating areas requiring  
3. Assessing the Risk of Material Misstatement
The auditor should identify and assess the risks of material misstatement at the financial statement level, and
at the assertion level for classes of transactions, account balances, and disclosures. For this purpose, the
• Identifies risks throughout the process of obtaining an understanding of the entity and its
environment, including relevant controls that relate to the risks, and by considering the
classes of transactions, account balances, and disclosures in the financial statements. 
• Relates the identified risks to what can go wrong at the assertion level;
• Considers whether the risks are of a magnitude that could result in a material misstatement 
of the financial statements; and 

• Considers the likelihood that the risks could result in a material misstatement of the
financial statements. 

Significant Risks that require Special Audit Considerations
Significant risks
These relate to: 
• non-routine transactions (unusual)
• judgmental matters (e.g. accounting estimates)
• non-routine transactions arising from matters such as: 
 greater management intervention to specify the accounting treatment
 greater manual intervention for data collection and processing
 complex calculations or accounting principles. 
For significant risks, to the extent the auditor has not already done so, the auditor should evaluate the
design of the entity’s related controls, including relevant control activities, and determine whether they have
been implemented.
If management has not appropriately responded by implementing controls over significant risks and if, as a
result, the auditor judges that there is a material weakness in the entity’s internal control, the auditor
communicates this matter to those charged with governance as required in paragraph 8. In these
circumstances, the auditor also considers the implications for the auditor’s risk assessment.

Risks for which substantive procedures alone do not provide sufficient appropriate audit evidence
As part of the risk assessment as described in the above paragraph, the auditor should evaluate the design
and determine the implementation of the entity’s controls, including relevant control activities, over those
risks for which, in the auditor’s judgment, it is not possible or practicable to reduce the risks of material
misstatement at the assertion level to an acceptably low level with audit evidence obtained only from
substantive procedures.
Examples of situations where the auditor may find it impossible to design effective substantive procedures
that by themselves provide sufficient appropriate audit evidence that certain assertions are not materially
misstated include the following: 
• An entity that conducts its business using IT to initiate orders for the purchase and delivery of
goods based on predetermined rules of what to order and in what quantities and to pay the related
accounts payable based on system-generated decisions initiated upon the confirmed receipt of
goods and terms of payment. No other documentation of orders placed or goods received is
produced or maintained, other than through the IT system. 
• An entity that provides services to customers via electronic media (for example, an Internet service
provider or a telecommunications company) and uses IT to create log of the services provided to
its customers, initiate and process its billings for the services and automatically record such
amounts in electronic accounting records that are part of the system used to produce the entity’s
financial statements. 

Revision of Risk Assessment
While performing tests of controls or substantive procedures auditor finds that controls are not performing
effectively and misstatements found are not in accordance with expectations of misstatements, the auditor
should revise his assessment of risk and modify the further planned audit procedures.

4. Communicating with those Charged with Governance and Management
The auditor should make those charged with governance or management aware, as soon as practicable, and
at an appropriate level of responsibility, of material weaknesses in the design or implementation of internal
control which have come to the auditor’s attention. 
5. Documentation
The auditor should document:
(a) The discussion among the engagement team regarding the susceptibility of the entity’s financial 
statements to material misstatement due to error or fraud, and the significant decisions reached; 

(b) Key elements of the understanding obtained regarding each of the aspects of the entity and its
environment, including each of the internal control components, to assess the risks of material
misstatement of the financial statements; the sources of information from which the understanding
was obtained; and the risk assessment procedures; 
(c) The identified and assessed risks of material misstatement at the financial statement level and at the
assertion level; and 
(d) The risks identified and related controls evaluated. 


Match each term or phrase on the left with the best description on the right. Descriptions may be used
once, more than once, or not at all.

1. Control environment. (a) Accounting system.

2. Management's philosophy (b) Adequate documents and record.

3. Functioning of the audit committee. (c) Control procedures.

4. Identify and record all valid transactions. (d) Element of the internal control structure.

5. Permit proper classification of transactions. (e) Factor that affect control environment.

6. Segregation of duties. (f) Financial statement assertion.

7. Adequate documents and records. (g) Independent check on performance.

8. Pre-numbered receiving reports (h) internal controls objective.

9. Preparation of reliable financial reports.

10. Reconciliation


 1. (d)  2. (e) 3. (g) 4. (h) 5. (a)
 6. (c) 7. (a) 8. (c) 9. (h) 10. (c) 

Fill in the blanks by selecting the most appropriate word/phrase: 
1. Members
 can appoint the auditors if they are not appointed by the Directors within 60 days of
i) SECP, directors, the company, members
ii) Directors, members, SECP, the company 
2. The part of the Statutory
 Report which relates to the Receipt and Payments is required to be
certified by the auditors. 
i) First extraordinary general meeting, statutory report, Annual General Meeting, First AGM
ii) Receipts and Payments, Financial Statements, Balance Sheet, Income Statement 

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