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Chapter 7
Understanding and assessing internal control
Learning objectives
7.1 Explain the concept of internal control, its inherent limitations and how it links to the audit
strategy.
7.2 Describe the general objectives of internal control and how the auditor uses them to develop
specific control objectives.
7.3 Identify and define each of the components of internal control.
7.4 Identify the steps in a financial report audit by which the auditor obtains an understanding of
internal control and assesses control risk, and the methods and procedures used by the auditor in
each step.
7.5 Distinguish between user controls and information technology (IT) controls, between general
controls and application controls and between automated controls and manual controls and
identify the general controls and application controls that affect the auditor’s assessment of
control risk in a computerised system.
7.6 Explain the role of the internal audit function in internal control and how it may affect the audit.
Lecture plan
It is important to link control risk assessment back to the audit risk model so that students understand
the importance of assessing control risk. Many students get confused about the two stages related to
control risk. Stage 1 is to gain an understanding of internal control and undertake a preliminary
assessment of control risk. At the end of this stage the auditor will prepare an audit program for each
major account balance/class of transactions/disclosure that will outline the degrees of tests of controls
and substantive testing. In stage 2 the auditor will undertake tests of controls for any control risk
assessment less than high to provide evidence for the preliminary assessment of control risk. We are
concentrating on stage 1 in this chapter.
You should outline the learning objectives for this chapter, and walk the students through how this
chapter fits into the flowchart of the planning and risk assessment stage of a financial report audit.
We also cover briefly the responsibility for internal control and the concepts of reasonable assurance
and inherent limitations.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 1
LO 7.2: Internal control objectives
This section introduces students to the objectives and characteristics of a satisfactory system of
internal control and distinguishes between preventative and detective controls, and management and
transaction controls.
There are a large number of slides for this section, which is a result of the different categorisation
schemes of controls used for IT environments.
Summary
We provide a summary slide of the main learning takeaways in this chapter.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 2
SOLUTIONS
REVIEW QUESTIONS
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 3
internal control and its importance in the entity. The internal control environment is
important because it sets the tone of an entity. It influences the control consciousness
of all personnel and is the foundation for the other components.
7.6 Management may monitor controls through ongoing activities such as supervisory
activities and/or separate evaluations. Internal audit may also contribute to the
monitoring process by making special inquiries at management’s direction or
generally reviewing operating practices. In addition, communications from external
parties, such as customer complaints and related follow-ups, may indicate problems
with internal control.
7.7 The auditor obtains an understanding of internal control to assess control risk and:
• identify the types of potential misstatements that could occur and the factors that
contribute to the risk that they will occur
• understand the accounting system sufficiently to identify the client documents and
so on that may be available and ascertain what data will be used in audit tests
• determine an efficient and effective approach to the audit.
7.8 Auditors confirm their assessment of internal control by conducting tests of controls,
if control risk has been assessed at less than high. Tests of controls provide evidence
that the controls exist and operate effectively throughout the period. An auditor
requires stronger evidence of the effectiveness of a procedure if the assessed level of
control risk is low than if it is medium, as the auditor will be placing greater reliance
on the control.
7.9 General controls in a computerised system are those controls that relate to all or many
computerised accounting applications to provide a reasonable level of assurance that
the overall objectives of internal control are achieved. Examples include segregation
of duties between operators and programmers, approval of changes to a program and
restricted access to the system.
Application controls apply to the processing of specific types of transactions related to
a computerised accounting application such as invoicing and payroll. Examples
include user controls such as control totals, input controls such as key verification,
and automated control activities such as check digits, limit checks and validity checks.
7.10 In an IT environment the auditor should commence by reviewing general controls. If
general controls are unreliable, the auditor will have little confidence in automated
application controls and confidence in manual application controls may be reduced. In
this situation, there is limited benefit in continuing to review, document and perform
tests of automated controls. The auditor must take a more substantive approach to the
audit.
If the general controls are reliable, the auditor may then make a preliminary review of
application controls and, if appropriate, a more detailed evaluation and testing of
application controls.
7.11 The work of internal audit may be used in an external audit where it is viewed as part
of an audit client’s internal control. ASA 610.15 (ISA 610.15) requires that when
determining whether the work of the internal audit is likely to be adequate for external
audit purposes, the external auditor must evaluate the internal audit’s:
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 4
• objectivity
• technical competence
• systematic and disciplined approach.
Further, in determining the effect of the internal audit’s work on the nature, timing
and extent of the external audit procedures, the external auditor also needs to
consider:
• the amount of judgment involved
• the assessed risks of material misstatement.
In addition, if the external auditor intends to use the work of the internal audit, the
external auditor needs to review the internal audit working papers and re-perform
some of the internal audit work. Further, the external auditor must discuss the planned
use of its work with internal audit so they can coordinate their activities, and read the
relevant reports of internal audit. In addition, external audit must communicate the
proposed use of internal audit to those charged with governance, as part of their
understanding of the proposed audit approach.
Direct assistance by internal audit to perform audit procedures under the direction,
supervision and review of external audit is prohibited by ASA 610.Aus 1.2 and ASA
610.Aus 25.1.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 5
testing of sales would need to be undertaken due to the inherent limitations of internal
control.
7.13 There is a lack of segregation of duties for:
• the accounts receivable clerk: the cheques received from debtors are forwarded to
the accounts receivable clerk, who also has a recording function and could
manipulate the accounts receivable balance to cover up a misappropriated cheque
• the accounts payable clerk: the accounts payable clerk has cash payments duties
and performs the bank reconciliation, so they may be able to misappropriate funds
without being discovered. The bank reconciliation should be performed by
someone independent of the payments and receipts functions to provide a cross-
check on these functions.
7.14 Internal control activities that the auditor might rely on include the following.
• Purchasing is centralised rather than left to each office.
• Levels of approval are implemented for asset purchases over $5000 and over
$20 000.
• When an asset is received, details are matched to the original purchase order.
• Payment is made on receipt of order and invoice—supporting documentation is
needed for payment.
• Segregation of duties: the divisional manager, the purchasing officer, the higher
levels of authorisation (if required), the receiving clerk in the warehouse and the
accounts payable staff are all separate.
• Assets are all bar coded as soon as they arrive and are entered into an asset
register.
7.15 Control activities include:
• Having pre-numbered internal documents. This enables the sequence to be
accounted for to help ensure completeness and occurrence and assists in matching
documents.
• Purchase requisitions require approval from an appropriate officer before a
purchase order is raised. This ensures that purchases are bona fide and for the
benefit of the entity.
• The receiving department checks goods received against the authorised purchase
order and supplier delivery dockets to ensure that all goods listed have been
delivered.
• The accounts payable clerk checks supplier invoices against the purchase order
and the receiving report before processing to ensure that only goods ordered and
received are paid for.
• Receiving reports and purchase orders are reviewed at month end and any items
received for which an invoice has not been received are accrued for to ensure that
all purchases for the period are recorded.
• The accounts payable clerk codes purchase invoices from a standard general
ledger code file and the coding is reviewed by the financial accountant prior to
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 6
processing the invoices to ensure that purchases are classified to the correct
general ledger account.
7.16
Impact on control risk Account Key assertion
affected
(a) Increase in control risk, as simply Inventory or Existence
making a notation that the order was accounts
received is not an adequate check on the payable
quantity and condition of goods
received. The receiving department
should count and inspect the goods
received. Failure to check the quantity
may result in failing to pick up short
deliveries.
Also, some goods received may be Valuation and
damaged. allocation
(b) Increase in control risk, as an important Cash at bank Existence
control over bank receipts and
payments—that is, monthly bank
reconciliations—does not exist.
(c) Increase in control risk, as there is no Inventory or Existence
control to ensure goods are actually accounts
received before inventory and accounts payable
payable are recorded.
(d) Increase in control risk, due to the Accounts Valuation and
absence of the previous control, receivable allocation
increasing the risk of bad debts.
7.17
(a) Internal control weakness (b) Internal control improvements
Other departments can raise Pre-numbered requisitions orders should
requisitions for goods and services be raised and signed by authorised
without proper authorisation. personnel. Requisitioning authority should
be related to authority and function. A
signed requisition order should be required
before raising purchase orders.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 7
Purchase orders are unnumbered Pre-numbered purchase orders should be
and unaccounted for. signed by an authorised purchasing
department staff member and a copy
forwarded to the requisitioner, goods
receiving and accounts departments. Pre-
numbered purchase orders should ensure
completeness.
Purchasing department obtains Orders should be placed with approved
goods and services as soon as the suppliers on the best terms and quality.
requisition is received, without
checking for the best deal.
Blank purchase orders are Blank purchase orders should be kept in a
accessible to all purchasing staff secure place to avoid misuse and should be
and open to theft and accounted for; that is, checked for
misappropriation. sequential continuity.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 8
supervisor/clerk, who may then destroy the picking slip and the returned delivery
docket (invoice).
(c) The control risk relating to Acid’s sales system will be assessed as medium, as
there are some controls that may be able to be relied upon, but also major weaknesses
around the dispatch clerk.
7.20 a)
(i) Control activity (ii) Explanation (iii) Key
assertion
Segregation of duties in The segregation of duties Completeness of
recording and handling cash makes the theft of cash cash
receipts (one employee difficult (unless there is
compares the cheque with collusion). Comparing the
the remittance advice and cheque received with the
forwards the cheque, a remittance advice ensures that
different employee prepares payments are complete.
a list of cash receipts).
Monthly bank Prompt attention to Completeness of
reconciliations by an reconciliation of cash records
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 9
employee who is not makes detection of errors or cash
responsible for receiving frauds easier.
cash.
Authorisation of sales All sales returns and Occurrence of
returns and allowances allowances must be sales
authorised by a person who
has an appropriate level of
authority (i.e. the financial
controller).
Authorisation of bad debt Bad debts can be written off Valuation and
write-off only by the financial allocation of
controller after discussion accounts
with the credit manager. receivable and
occurrence of bad
debt expense
b)
(i) Internal (ii) Account (iii) Assertion (iv) Justification
control balance at risk
weakness at risk
Sales orders Sales Occurrence There is no externally
may be received generated
orally. documentary evidence
Accounts Existence
of a customer order.
receivable
Hence fictitious sales
may be generated.
There is no Accounts Valuation and Sales staff can increase
credit approval receivable allocation sales by selling to
required for customers who may
customers prior not be able to pay their
Provision for Completeness
to sales being debts.
doubtful debts
processed.
Although sales Sales Completeness Accounting for a
orders are pre- sequence of sales
numbered, there orders can ensure that
is no sequence records are complete.
check Without this control,
completed. all sales may not be
recorded in the
accounts.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 10
(c) 9 Hash total
(d) 1 Limit test
(e) 8 Financial total
7.22 (a) There are a number of application input controls that could prevent, or detect this
situation, including the following.
• Control totals: A batch total of the sum of customer payments could be used to
test the accuracy of data input.
• Key verification: Duplicate keying of data to detect errors of entry.
• Multiple data entry: The computer could require a number of data items to be
entered by the keypunch operator. For example, the keypunch operator could be
required to enter the customer code, the invoice code and the payment amount.
The computer would then check whether the invoice whose invoice code was
entered was made out to the customer whose customer code was entered, and
whether the invoice amount of the invoice whose invoice code was entered is
equal to the payment amount entered.
Note: Neither reasonableness tests, range tests, nor limit tests will prevent nor detect
this error, because customer payments could be of any amount.
(b) Controls that could prevent or detect this situation include the following.
• The staff hiring policy of the entity should be reviewed. Computer operators
should not have knowledge of computer programming.
• There should be electronic access controls, such as staff ID numbers, passwords
and dedicated terminals, which restrict access to the computer software and data
files. There should be different levels of access controls (authorisation tables),
which allow particular computer users to access only the software and data files
required to perform their job, and prevent access to other software and data files
that are not required.
• An activity log that records each access to every software program and data file
should be maintained. The activity log should be regularly reviewed in order to
identify any unauthorised access.
7.23
Control Type of Explanation
control
(a) IT The restriction on processing transactions is performed
application automatically by the new accounting system. It
control ensures the complete and accurate processing of data.
(b) IT The restriction on changing any of the data fields
application relates to specific accounting applications and is
control performed automatically by the new accounting
system. It ensures the complete and accurate
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 11
processing of data.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 12
All IT systems are different and Staff not provided login access until they
staff have not been trained to use have completed appropriate training.
the new system and so may make
errors.
Data from the old system may not Data migration reconciliation completed
have been transferred properly to and signed off by user (to show all data
the new system (e.g. customer from the old system was correctly migrated
codes, rates, and history). to the new system).
b) Each time there is a version upgrade, the software changes of the previous
upgrades may be reversed, which means that the system will not operate correctly,
resulting in potential accounting (postings) errors and billing (customer accounts
receivable) errors.
7.25 (a)
Reasons why IT control risk assessment is Business risk
important
Many of the systems that are not integrated. Critical information may not be
IT control risk assessment is important to available to the business in order to
determine the likelihood of data being make decisions about performance,
incorrectly recorded when transferred to cash flow, etc.
GLI—especially as they are relying on an
interface routine (e.g. general ledger).
There is a variety of home-grown systems The operational requirements of the
and databases. An IT control risk assessment business may not be met. This could
is important in determining whether all the potentially lead to the loss of
systems are properly maintained or customers and suppliers, with a
supported. consequent impact on cash flow and
profit.
Smaller information transfers are done Individual fraud and the incorrect
manually, including payroll transactions. An transcription of information may lead
IT control risk assessment is important in to a loss of profit and impact on
determining the potential for fraud and the business performance as well as
incorrect transcription of the relevant reputational damage.
information.
Responsibility for fixing errors in large- Errors may remain in GLI or new
volume transactions lies with the respective errors created, which may lead to the
business process owners rather than the IT operational requirements of the
department. An IT control risk assessment is business not being met. This could
important to determine the likelihood of potentially lead to the loss of
errors remaining in the system as well as the customers and suppliers, with a
likelihood of new errors being introduced. consequent impact on cash flow and
profit.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 13
Several sensitive applications such as Non-functioning general and IT
inventory, payroll and purchasing have application controls may lead to
potential control weaknesses—they are used critical information not being
by business users who may not adhere to the available to the business, individual
IT general controls in place. As such, an IT fraud and the incorrect transcription
control risk assessment becomes important in of information, all of which may lead
order to determine whether general controls to the loss of customers and
are being adhered to and to assess the impact suppliers.
on the IT general controls.
There is no formal process for periodically A non-functioning backup system
testing the backup media in order to test the leads to the risk that business critical
recovery of information from backups. An IT files (i.e. customer records, etc.) will
control risk assessment is important in be lost in the event of an IT system
determining whether backup information is, problem.
in fact, recoverable.
(b)
Control that should be in place How the control functions
Password access to the IT area If the user does not have the correct password,
they will be unable to gain access to the IT area.
Password access to the software If the user does not have the correct password,
they will be unable to log onto the software.
Off-site storage of data/backup Backup data is saved at an off-site location so
tapes that power surges, data corruption etc. does not
permanently destroy information.
Firewall A firewall will prevent hacker access to IT
systems.
Anti-virus software Anti-virus software should prevent malicious
software from being installed on GLI and detect
and fix any viruses.
Segregation of duties between Independent review of work performed will
business process owners and IT prevent fraudulent manipulation of the IT
staff (e.g. access to systems, data system.
etc.)
There is a quality assurance Correct allocation of staff ensures that the IT
process to ensure that software is application controls of GLI work effectively.
supported by those who are expert
in the workings of GLI.
There is a quality assurance User driven sign-off procedures ensure that
process to ensure that user-driven users can use the system in a manner that is
sign-off procedures are in place. unlikely to lead to control breaches or
inadvertent errors.
There is a quality assurance Correctly trained users (with support) ensure
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 14
process to ensure that users of the that inadvertent control breaches will not occur
system have been correctly trained and that the system is used correctly.
and have access to support.
There is a quality assurance Employment of the correct software version
process to ensure that software ensures that the IT application controls function
development and production as intended and that there are no inadvertent
versions are controlled and system errors.
correctly managed.
7.26 The internal audit department is a part of internal control, as one of its key
responsibilities is to review the internal control policies and procedures to ensure they
are operating as intended. It is therefore part of the monitoring part of the internal
control system.
Where controls, such as an effective internal audit department, are in place and
working satisfactorily, the auditor can usually assess control risk as less than high, as
it is more likely that the client will have picked up and corrected any errors in the
accounting system before the financial report is prepared. This enables the auditor to
reduce the level of substantive testing and should result in a more cost-effective audit.
However, before the auditor can rely on internal audit, similar to any other control,
the auditor needs to evaluate it and test it.
7.27 Your review of internal audit should cover the following matters;
Objectivity
• IAD reports to the CEO, who is also the chairman, via a monthly report that is
presented to the board. It would have been preferable for objectivity if the report
to the board had been through an independent director or the audit committee if
they had one.
• Although the work program is based on internal requests, it appears that it is still
under Samantha’s control and the objectivity of IAD has not been affected.
• Although some resources were switched from the audit of Sydney office to a
suspected travel fraud in Perth, this seems reasonable under the circumstances.
Ninety per cent of the current year’s work program has been achieved and the
objectivity of IAD has not been affected.
• The CEO’s request of Samantha to set aside 20% of IAD time to carry out a
performance audit on administrative procedures to save costs, rather than focusing
on compliance matters, indicates that there is pressure for IAD to be cost-effective
and pay its way. While spending this amount of time on performance audits is not
unreasonable, any further reductions in time available for compliance matters may
hamper IAD in achieving its compliance goal objectively and effectively.
• The fact that the board has paid little attention to IAD in the past does not affect
the objectivity of IAD.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 15
Technical competence
• Although Samantha is not a member of IIA and does not have internal audit
experience, she has ‘Big 4’ audit experience. She is also aware of IIA standards
and so technical competence is not a problem.
• Graduate and assistant have little practical experience and are still completing
their studies. They will require close supervision.
• The ex-public sector auditors are not familiar with the industry or the company’s
systems and will require greater direction and supervision.
Systematic and disciplined approach
• Audit programs are being developed as each program is completed. It would be
more effective if the programs were written before the projects were undertake;,
however, this will be remedied over time.
Overall assessment
While the objectivity of the internal audit is not ideal, it appears that the work of IAD
could be used to reduce the auditor’s assessment of control risk. However, any
reliance would need to be supported by testing the work performed by IAD and
reviewing their working files.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 16
(b) Control weakness (c) Account Why account balance is (d)
balances at at risk Assertion
risk at risk
An accounts payable Inventory Clerks are manually Valuation
clerk does all the entering their calculations and
Accounts
calculations for of purchases of inventory allocation
payable
inventory stock and stock with multiple
accounts payable and currencies. Without an
their work is not independent party
confirmed or checked checking their
by an independent calculations, inventory
party. stock and accounts payable
may be recorded at
incorrect values.
General and accounts Accounts This may lead to Existence
receivables ledgers are receivable inaccurate general and
updated prior to the receivables ledgers, as Occurrence
Sales
dispatch of books to sales are recorded before
customers, with no the sales order is Cut-off
check that the order is dispatched. If print orders
correct. are incorrect, this may lead
to sales being recorded in
the incorrect period, as the
customer does not accept
liability until the goods are
received and are accepted
as being in accordance
with the purchase order.
7.29
(a) Audit risk Justification (b) Control activity
New system may not IT manager claims Running the two systems in
integrate properly that there was parallel until the new system can
with other existing insufficient time to be adequately tested.
systems or may do proper testing
contain bugs that need before going live.
to be worked out, Since installation IT
resulting in errors. manager has
identified cut-off
errors resulting from
problems interfacing
with an existing
software system.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 17
Data from the old IT manager claims Data migration reconciliation
system may not have that there was completed and signed off by
been transferred insufficient time to users to confirm that all data
accurately to the new do proper from the old system was
system. reconciliations. transferred correctly to the new
system.
Instructor Resource Manual t/a Auditing and Assurance Services in Australia 6e by Gay & Simnett
© McGraw-Hill Education (Australia) 2015
Chapter 7 18
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