Chapter 1:

Auditing, Assurance, and

Internal Control
 AUDITING
Auditing is a systematic process of
objectively obtaining and evaluating
evidence regarding assertions about
economic actions and events to ascertain
the degree of correspondence between
those assertions and establishing criteria
and communicating the results to
interested users.
 INTERNAL AUDITS

Internal auditing: independent appraisal

function established within an organization to
examine and evaluate its activities as a service
to the organization
Financial Audits
Operational Audits
Compliance Audits
Fraud Audits
IT Audits
CIA
IIA
 IT AUDITS
IT audits: provide audit services where
processes or data, or both, are embedded in
technologies.
Subject to ethics, guidelines, and standards of the
profession (if certified)
CISA
Most closely associated with ISACA
Joint with internal, external, and fraud audits
Scope of IT audit coverage is increasing
Characterized by CAATTs
IT governance as part of corporate governance
 FRAUD AUDITS
Fraud audits: provide investigation services
where anomalies are suspected, to develop
evidence to support or deny fraudulent
activities.
Auditor is more like a detective
No materiality
Goal is conviction, if sufficient evidence of fraud
exists
CFE
ACFE
 EXTERNAL AUDITS

External auditing: Objective is that in all

material respects, financial statements are a
fair representation of organization’s
transactions and account balances.
SEC’s role
Sarbanes-Oxley Act
FASB - PCAOB
CPA
AICPA
 EXTERNAL vs. INTERNAL
External auditing:
Independent auditor (CPA)
Independence defined by SEC/S-OX/AICPA
Required by SEC for publicly-traded companies
Referred to as a “financial audit”
Represents interests of outsiders, “the public” (e.g.,
stockholders)
Standards, guidance, certification governed by AICPA, FASB,
PCAOB; delegated by SEC who has final authority
Internal auditing:
Auditor (often a CIA or CISA)
Is an employee of organization imposing independence on self
Optional per management requirements
Broader services than financial audit; (e.g., operational audits)
Represent interests of the organization
Standards, guidance, certification governed by IIA and ISACA
 FINANCIAL AUDITS
An independent attestation performed by an expert (i.e.,
an auditor, a CPA) who expresses an opinion regarding
the presentation of financial statements
Key concept: Independence
{Should be} Similar to a trial by judge
Culmination of systematic process involving:
Familiarization with the organization’s business
Evaluating and testing internal controls
Assessing the reliability of financial data
Product is formal written report that expresses an
opinion about the reliability of the assertions in financial
statements; in conformity with GAAP
ATTEST definition
Written assertions
Practitioner’s written report
Formal establishment of measurement criteria or their
description
Limited to:
Examination
Review
Application of agreed-upon procedures
ATTEST vs. ASSURANCE
ASSURANCE
Professional services that are designed to
improve the quality of information, both financial
and non-financial, used by decision-makers
IT Audit Groups in “Big Four”
IT Risk Management
I.S. Risk Management
Operational Systems Risk Management
Technology & Security Risk Services
Typically a division of assurance services
 AUDITING STANDARDS
Auditing standards
Set by AICPA
Authoritative
#1 = Ten Generally Accepted Auditing Standards
(GAAS)
Three categories:
General Standards
Standards of Field Work
Reporting Standards
# 2 = Statements on Auditing Standards (SASs)
SAS #1 issued by AICPA in 1972
 AUDITS
Systematic process
Five primary management assertions, and
correlated audit objectives and procedures
[Table 1-1]
Existence or Occurrence

Completeness
Rights & Obligations
Valuation or Allocation
Presentation or Disclosure
 AUDITS
Phases [Figure 1-3]
1. Planning
2. Obtaining evidence
Tests of Controls
Substantive Testing
CAATTs
Analytical procedures
3. Ascertaining reliability
MATERIALITY
4. Communicating results
Audit opinion
 Audit Risk Formula

AUDIT RISK:
The probability that the auditor
will give an inappropriate opinion
on the financial statements: that
is, that the statements will
contain materials
misstatement(s) which the
auditor fails to find
 Audit Risk Formula

INHERENT RISK:
The probability that material
misstatements have occurred
Material vs. Immaterial
Includes economic conditions, etc.
Relative risk (e.g., cash)
 Audit Risk Formula

CONTROL RISK:
The probability that the internal
controls will fail to detect material
misstatements
 Audit Risk Formula

DETECTION RISK:
The probability that the audit
procedures will fail to detect material
misstatements
Substantive procedures
 Audit Risk Formula
AUDIT RISK MODEL:
AR = IR * CR * DR
example inventory with:
IR=40%, CR=60%, AR=5% (fixed)
.05 = .4 * .6 * DR
... then DR=4.8%
Why is AR = 5%?
What is detection risk?
Can CR realistically be 0?
Relationship between DR and substantive
procedures
 Audit Risk Model
Relationship between tests of controls
and substantive tests
Illustrate higher reliability of the internal controls and
the Audit Risk Model
What happens if internal controls are more reliable than last
audit?
Last year: .05 = .4 * .6 * DR [DR = 4.8]
This year: .05 = .4 * .4 * DR [DR = 3.2]
The more reliable the internal controls, the lower the CR
probability; thus the lower the DR will be, and fewer
substantive tests are necessary.
Substantive tests are labor intensive
 Role of Audit Committee
Selected from board of directors
Usually three members
Outsiders (S-OX now requires it)
Fiduciary responsibility to shareholders
Serve as independent check and balance
system
Interact with internal auditors
Hire, set fees, and interact with external auditors
Resolved conflicts of GAAP between external
auditors and management
 What is an IT Audit?

… most accounting transactions to be in

electronic form without any paper
documentation because electronic
storage is more efficient. … These
technologies greatly change the nature of
audits, which have so long relied on
paper documents.
 THE IT ENVIRONMENT
There has always been a need for an effective
internal control system.
The design and oversight of that system has
typically been the responsibility of accountants.
The I.T. Environment complicates the paper
systems of the past.
Concentration of data
Expanded access and linkages
Increase in malicious activities in systems vs. paper
Opportunity that can cause management fraud (i.e.,
override)
 THE IT ENVIRONMENT

Audit planning
Tests of controls
Substantive tests
CAATTs
 INTERNAL CONTROL
is … policies, practices, procedures
… designed to …
safeguard assets
ensure accuracy and reliability
promote efficiency
measure compliance with policies
 BRIEF HISTORY - SEC
SEC acts of 1933 and 1934
“Ivar Kreuger’s Contribution to U.S.
Financial Reporting,” Accounting Review,
Flesher & Flesher
All corporations that report to the SEC are
required to maintain a system of internal
control that is evaluated as part of the
annual external audit.
 BRIEF HISTORY - Copyright
Federal Copyright Act 1976
1. Protects intellectual property in the U.S.
2. Has been amended numerous times since
3. Management is legally responsible for violations of
the organization
4. U.S. government has continually sought
international agreement on terms for protection of
intellectual property globally vs. nationally
 BRIEF HISTORY - FCPA
Foreign Corrupt Practices Act 1977
1. Accounting provisions
▪ FCPA requires SEC registrants to establish and maintain books,
records, and accounts.
▪ It also requires establishment of internal accounting controls
sufficient to meet objectives.
1. Transactions are executed in accordance with management’s
general or specific authorization.
2. Transactions are recorded as necessary to prepare financial
statements (i.e., GAAP), and to maintain accountability.
3. Access to assets is permitted only in accordance with management
authorization.
4. The recorded assets are compared with existing assets at
reasonable intervals.
2. Illegal foreign payments
 BRIEF HISTORY - COSO
Committee on Sponsoring Organizations - 1992

1. AICPA, AAA, FEI, IMA, IIA

2. Developed a management perspective model
for internal controls over a number of years
3. Is widely adopted
 BRIEF HISTORY – S-OX
Sarbanes-Oxley Act - 2002
1. Section 404: Management Assessment of Internal
Control
▪ Management is responsible for establishing and maintaining
internal control structure and procedures.
▪ Must certify by report on the effectiveness of internal control
each year, with other annual reports.
2. Section 302: Corporate Responsibility for Incident
Reports
▪ Financial executives must disclose deficiencies in internal
control, and fraud (whether fraud is material or not).
 Modifying Assumptions
1. Management responsibility
2. Reasonable assurance
no I.C.S. is perfect
benefits => costs
3. Methods of data processing
Objectives same regardless of DP method
Specific controls vary w/different technologies
 Modifying Assumptions

4. Limitations
Possibility of error
Possibility of circumvention
Management override
Changing conditions
 EXPOSURES AND RISK
Exposure (definition)
Risks (definition)
Types of risk
Destruction of assets
Theft of assets
Corruption of information or the I.S.
Disruption of the I.S.
 THE P-D-C MODEL
Preventive controls
Detective controls
Corrective controls
Which is most cost effective?
Which one tends to be proactive measures?
Can you give an example of each?
Predictive controls
 SAS 78: Consideration of Internal
Control in a Financial Statement Audit
● COSO (Treadway Commission)
The control environment
Risk assessment
Information & communication
Monitoring
Control activities
 SAS 78
(#1:Control Environment -- elements)
Describe how each one could adversely
affect internal control.
The integrity and ethical values
Structure of the organization
Participation of audit committee
Management’s philosophy and style
Procedures for delegating
 SAS 78
(#1:Control Environment -- elements)

Management’s methods of assessing

performance
External influences
Organization’s policies and practices
for managing human resources
 SAS 78
(#1:Control Environment -- techniques)
Describe possible activity or tool for each.
Assess the integrity of organization’s
management
Conditions conducive to management fraud
Understand client’s business and industry
Determine if board and audit committee are
actively involved
Study organization structure
 SAS 78
(#2:Risk Assessment)
Changes in environment
Changes in personnel
Changes in I.S.
New IT’s
Significant or rapid growth
New products or services (experience)
Organizational restructuring
Foreign markets
New accounting principles
 SAS 78
(#3:Information & Communication-elements)

Initiate, identify, analyze, classify and record

economic transactions and events.
Identify and record all valid economic
transactions
Provide timely, detailed information
Accurately measure financial values
Accurately record transactions
 SAS 78
(#3:Information & Communication-techniques)
Auditors obtain sufficient knowledge of I.
S.’s to understand:
Classes of transactions that are material
Accounting records and accounts used
Processing steps:initiation to inclusion in
financial statements ( illustrate)
Financial reporting process (including
disclosures)
 SAS 78
(#4: Monitoring)
By separate procedures (e.g., tests of
controls)
By ongoing activities (Embedded Audit
Modules – EAMs and Continuous
Online Auditing - COA)
 SAS 78
(#5: Control Activities)
Physical Controls (1-3)
Transaction authorization
Example:
Sales only to authorized customer
Sales only if available credit limit
Segregation of duties
Examples of incompatible duties:
Authorization vs. processing [e.g., Sales vs. Auth. Cust.]
Custody vs. recordkeeping [e.g., custody of inventory vs.
DP of inventory]
Fraud requires collusion [e.g., separate various steps in
process]
Supervision
Serves as compensating control when lack of
segregation of duties exists by necessity
Physical Controls (4-6)
Accounting records (audit trails; examples)
Access controls
Direct (the assets)
Indirect (documents that control the assets)
Fraud
Disaster Recovery
Independent verification
Management can assess:
The performance of individuals
The integrity of the AIS
The integrity of the data in the records
Examples
 IT Risks Model
Operations
Data management systems
New systems development
Systems maintenance
Electronic commerce (The Internet)
Computer applications