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In this video, we will continue our discussion of
what how an auditor jusitifies their reliance on
internal controls by testing them.
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The methods we can use to test controls vary.
Inquiry of client personnel is one possible way to
test a control,
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but it’s generally not a very strong source of
audit evidence.
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Inspecting documents and records along the
audit trail for evidence of performance of the
internal control procedure...
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is a much stronger source of evidence.
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Keep in mind that with a test of control, we are
looking for evidence that the control procedure
has been performed.
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We are not trying to substantiate a balance or
an amount per se.
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So if the key control is that a payables clerk
matches a receiving report, a purchase order
and a purchase invoice...
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prior to preparing the payment, then we would
be looking at a sample of these documents
looking for h evidence of the three way match.
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A third way to test controls is to observe the
control activity be performed.
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If a control is undocumented and there is no
evidence, this may be the only way we can test
it.
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However, it harder to verify that the control
operated throughout the period using this
method.
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Test data is a way of testing computer controls
by feeding dummy data into the computer
system,
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and ensuring that it processes the data
according to the controls documentation
gathered.
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And lastly, we can reperform the client’s control
procedures.
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In our earlier example of the three way match,
we may look for evidence such as a stamp on
the invoice indicating that the clerk...
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performed the three way match was done;
however, using the reperformance method,
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we can reperform the three way match
ourselves.
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The extent of tests of the client's internal
controls depends on the our assessment of
control risk.
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The lower this assessment, the greater the
reliance,
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and the greater the amount of testing and
evidence required to support that reliance.
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Make sense?
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The results of our control testing are fed back
into our risk assessment.
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If the tests support our initial assessment we
continue executing the audit plan as scripted.
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However, if the tests do not support the control
risk assessment, then we will need to circle
back and reformulate our audit approach.
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When this happens, there is often a deficiency
in the internal controls noted.
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Our first step might be to consider whether a
compensating control exists.
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A compensating control is another control that
exists elsewhere in the process that offsets the
weakness.
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If there is not compensating control and we
legitimately have a control gap,
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we will document the weakness on a separate
working paper.
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This working paper will discuss the potential
misstatement that can arise, and any effects on
collection of substantive evidence.
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This is often referred to as a control matrix
working paper.
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Significant internal control deficiencies are
communicated in an internal control letter to the
audit committee or its equivalent in the company
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Management letters are a similar
communication;
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however, the control deficiencies identified and
discussed are less significant,
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and would be communicated to management to
point out areas for improvement.
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The common way of communicating deficiencies
is to identify the deficiency, talk about the
implication,
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and then propose a recommendation to close
the gap.
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So there you have it.
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What you need to do before you can rely on
internal controls.
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Now a couple of finishing points before we close
off this lesson.
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First, sometimes we will purposely assess
control risk at maximum for efficiency purposes.
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For example, if a balance or a transaction cycle
can be more easily audited using a substantive
procedure than testing controls,
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then we can limit our work on internal controls to
gaining an understanding.
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We then immediately move into the substantive
procedures.
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And finally, let’s put a bow around this whole
group of lessons by reviewing the overall
approaches to an audit,
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of which there are two- a combined or a
substantive approach.
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Under both approaches we need to obrtain an
understanding the control environment and
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system of internal controls to enable us to make
our assessment of control risk.
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This is done on an overall basis and also on a
transactional cycle basis.
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Under a combined approach, we believe there
are efficiencies to be gained by relying on the
strength
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of the client’s system of internal controls.
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If this is our approach, we must test the controls
to support our reliance.
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The results of our tests of control may or may
not impact the rest of the audit depending on the
results of our findings.
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Then we move on to do substantive audit
procedures, which would hope would be
generally less because of our reliance on control
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Under the substantive approach, we assess
control risk as maximum.
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This takes us right into the substantive audit
procedures,
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which will generally be greater than had we done
more work on the internal controls.
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It has taken a while to get to this point in the
course where you begin to see how all the
pieces of the audit fit together.
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This won’t be the last time we review the
different audit approaches,
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so if your understanding is still a bit fuzzy, hang
in there and remember…
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Don’t stop until you get to the top and when you
get to the top, don’t stop.