One of the major revisions of ISA 315 relates to the inquiries made by external

auditors of the internal audit function since internal auditors have better
knowledge and understanding of the organisation and its internal control. This
article addresses and highlights the components of internal control

The International Auditing and Assurance Standards Board (IAASB) issues International
Standard on Auditing (ISA) for international use. From time to time, ISAs are revised to
provide updated standards to auditors. In order to enhance the overall quality of audit,
IAASB published a consultation draft on a proposed revision to ISA 315. The objective
in revising ISA 315 is to enhance the performance of external auditors by applying the
knowledge and findings of an entity’s internal audit function in the risk assessment
process, and to strengthen the framework for evaluating the use of internal auditors
work to obtain audit evidence.

In March 2012, ISA 315 (Revised) was approved and released. One of the major
revisions of ISA 315 relates to the inquiries made by external auditors of the internal
audit function since internal auditors have better knowledge and understanding of the
organisation and its internal control. This article addresses and highlights the
components of internal control.

Objectives in establishing internal controls

Generally speaking, internal control systems are designed, implemented and

maintained by the management and personnel in order to provide reasonable
assurance to fulfil the objectives – that is, reliability of financial reporting, efficiency and
effectiveness of operations, compliance with laws and regulations and risk assessment
of material misstatement. The manner in which the internal control system is designed,
implemented and maintained may vary with the entity’s business nature, size and
complexity, etc. Auditors focus on both the audit of financial statements and internal
controls that relates to the three objectives that may materially affect financial reporting. 

In order to identify the types of potential misstatements and to determine the nature,
timing and extent of audit testing, auditors should obtain an understanding of relevant
internal controls, evaluate the design of the controls, and ascertain whether the controls
are implemented and maintained properly.

The major components of internal control include control environment, entity’s risk
assessment process, information system (including the related business processes,
control activities relevant to the audit, relevant to financial reporting, and
communication) and monitoring of controls.
Control environment

The control environment consists of the governance and management functions and the
attitudes, awareness and actions of the management about the internal control. Auditors
may obtain an understanding of the control environments through the following
elements.

1. Communication and enforcement of integrity and ethical values

It is important for the management to create and maintain honest, legal and ethical
culture, and to communicate the entity’s ethical and behavioural standards to its
employees through policy statements and codes of conduct, etc.

2. Commitment to competence
It is important that the management recruits competent staff who possess the required
knowledge and skills at competent level to accomplish tasks.         

3. Participation by those charged with governance

An entity’s control consciousness is influenced significantly by those charged with
governance; therefore, their independence from management, experience and stature,
extent of their involvement, as well as the appropriateness of their actions are extremely
important.

4. Management’s philosophy and operating style

Management’s philosophy and operating style consists of a broad range of
characteristics, such as management’s attitude to response to business risks, financial
reporting, information processing, and accounting functions and personnel, etc. For
example, does the targeted earning realistic? Does the management apply aggressive
approach where alternative accounting principles or estimates are available?  These
management’s philosophy and operating style provide a picture to auditors about the
management’s attitude about the internal control.

5. Organisational structure
The organisational structure provides the framework on how the entity’s activities are
planned, implemented, controlled and reviewed.
6. Assignment of authority and responsibility
With the established organisational structure or framework, key areas of authority and
reporting lines should then be defined. The assignment of authority and responsibility
include the personnel that make appropriate policies and assign resources to staff to
carry out the duties. Auditors may perceive the implementation of internal controls
through the understanding of the organisational structure and the reporting
relationships.

7. Human resources policies and practices

Human resources policies and practices generally refer to recruitment, orientation,
training, evaluation, counselling, promotion, compensation and remedial actions. For
example, an entity should establish policies to recruit individuals based on their
educational background, previous work experience, and other relevant attributes. Next,
classroom and on-the-job training should be provided to the newly recruited staff.
Appropriate training is also available to existing staff to keep themselves updated. 
Performance evaluation should be conducted periodically to review the staff
performance and provide comments and feedback to staff on how to improve
themselves and further develop their potential and promote to the next level by
accepting more responsibilities and, in turn, receiving competitive compensation and
benefits.

With the ISA 315 (Revised), external auditors are now required to make inquiries of the
internal audit function to identify and assess risks of material misstatement. Auditors
may refer to the management’s responses of the identified deficiencies of the internal
controls and determine whether the management has taken appropriate actions to
tackle the problems properly.  Besides inquiries of the internal audit function, auditors
may collect audit evidence of the control environment through observation on how the
employees perform their duties, inspection of the documents, and analytical
procedures.  After obtaining the audit evidence of the control environment, auditors may
then assess the risks of material misstatement.

Entity’s risk assessment process

Auditors should assess whether the entity has a process to identify the business risks
relevant to financial reporting objectives, estimate the significance of them, assess the
likelihood of the risks occurrence, and decide actions to address the risks. If auditors
have identified such risks, then auditors should evaluate the reasons why the risk
assessment process failed to identify the risks, determine whether there is significant
deficiency in internal controls in identifying the risks, and discuss with the management.
 The Information system, including the relevant business processes,
relevant to financial reporting and communication

Auditors should also obtain an understanding of the information system, including the
related business processes, relevant to financial reporting, including the following areas:

 The classes of transactions in the entity’s operations that are significant to the
financial statements. The procedures that transactions are initiated, recorded,
processed, corrected as necessary, transferred to the general ledger and reported in
the financial statements.

 How the information system captures events and conditions that are significant to
the financial statements.

 The financial reporting process used to prepare the entity’s financial statements.

 Controls surrounding journal entries.

 Understand how the entity communicates financial reporting roles,

responsibilities and significant matters to those charged with governance and external –
regulatory authorities.

Control activities relevant to the audit

Auditors should obtain a sufficient understanding of control activities relevant to the

audit in order to assess the risks of material misstatement at the assertion level, and to
design further audit procedures to respond to those risks. Control activities, such as
proper authorisation of transactions and activities, performance reviews, information
processing, physical control over assets and records, and segregation of duties, are
policies and procedures that address the risks to achieve the management directives
are carried out.

Monitoring of controls

In addition, auditors should obtain an understanding of major types of activities that the
entity uses to monitor internal controls relevant to financial reporting and how the entity
initiates corrective actions to its controls. For instance, auditors should obtain an
understanding of the sources and reliability of the information that the entity used in
monitoring the activities. Sources of information include internal auditor report, and
report from regulators.
Limitations of internal control systems

Effective internal control systems can only provide reasonable, not absolute, assurance
to achieve the entity’s financial reporting objective due to the inherent limitations of
internal control – for example, management override of internal controls. Therefore,
auditors should identify and assess the risks of material misstatement at the financial
statement level and assertion level for classes of transactions, account balances and
disclosures.

Conclusion

As internal auditors have better understanding of the organisation and expertise in its
risk and control, the proposed requirement for the external auditors to make enquiries of
internal audit function in ISA 315 (Revised) will enhance the effectiveness and efficiency
of audit engagements. External auditors should pay attention to the components of
internal control mentioned above in order to make effective and efficient enquiries. An
increase in the work of internal audit functions is also expected because of such
proposed requirement.

Raymond Wong, School of Accountancy, The Chinese University of Hong Kong,

and Dr Helen Wong, Hong Kong Community College, Hong Kong Polytechnic
University

Reference
ISA 315 (Revised), Identifying and Assessing the Risks of Material Misstatement
Through Understanding the Entity and Its Environment