Evaluation of

Internal Controls
Internal Control
Internal control (IC) – the process designed, implemented and maintained by those charged with
governance, management and other personnel to provide reasonable assurance about the achievement of
an entity‘s objectives.
Essential concepts of internal control:
a. Internal Control is a Process
b. Internal control is effected by those charged with governance, management and other personnel.
c. Primary purpose/reason for establishing internal control is to provide reasonable assurance about the
achievement of an entity’s objectives.
d. Internal control can be expected to provide reasonable assurance of achieving the entity's objectives
e. Internal control is designed to help achieve the entity's objectives.
Classification of internal control:
1. According to Objectives:
a. Financial Reporting Controls
b. Operational Effectiveness Controls
c. Compliance Controls
2. According to Functions:
d. Preventive Controls
e. Detective Controls
f. Corrective Controls

Benefits of strong internal control:

 Reduced cost of an external audit
 Availability of reliable data for decision-making purposes
 Protection of important documents and records
 Assurance of compliance with applicable laws and regulations
Internal Control
The auditor should obtain an understanding of the accounting and internal control systems sufficient to
plan the audit and develop an effective audit approach. Accounting system means the series of tasks and
records of an entity by which transactions are processed as a means of maintaining financial records.

Such systems identify, assemble, analyze, calculate, classify, record, summarize and report transactions
and other events.

Internal Control System means all the policies and procedures (internal controls) adopted by the
management of an entity to assist in achieving management’s objective of ensuring, as far as practicable,:
 orderly and efficient conduct of its business, including adherence to management
policies;
 safeguarding of assets;
 prevention and detection of fraud and error;
 accuracy and completeness of the accounting records; and
 timely preparation of reliable financial information.
Internal Control (Cont’n)
The internal control system extends beyond those matters which relate directly to the
functions of the accounting system. Internal Control Components

(a) The control environment;

(b) The entity’s risk assessment process;
(c) The information system, including the related business processes, relevant to
financial reporting, and communication;
(d) Control activities; and
(e) Monitoring of controls.
Control environment

The control environment includes the attitudes, awareness, and actions of management
and those charged with governance concerning the entity’s internal control and its importance in
the entity. The control environment also includes the governance and management functions
and sets the tone of an organization, influencing the control consciousness of its people. It is the
foundation for effective internal control, providing discipline and structure.

The control environment encompasses the following elements:

• Communication and enforcement of integrity and ethical values.
• Commitment to competence.
• Participation by those charged with governance.
• Management’s philosophy and operating style.
• Organizational structure.
• Assignment of authority and responsibility.
• Human resource policies and practices.
Entity’s risk assessment process
An entity’s risk assessment process is its process for identifying and responding to business risks and the results
thereof. For financial reporting purposes, the entity’s risk assessment process includes how management identifies
risks relevant to the preparation of financial statements that are presented fairly, in all material respects in
accordance with the entity’s applicable financial reporting framework, estimates their significance, assesses the
likelihood of their occurrence, and decides upon actions to manage them.

Risks can arise or change due to circumstances such as the following:

• Changes in operating environment. Changes in the regulatory or operating environment can result in changes in
competitive pressures and significantly different risks.
• New personnel. New personnel may have a different focus on or understanding of internal control.
• New or revamped information systems. Significant and rapid changes in information systems can change the risk
relating to internal control.
• Rapid growth. Significant and rapid expansion of operations can strain controls and increase the risk of a
breakdown in controls.
• New technology. Incorporating new technologies into production processes or information systems may change
the risk associated with internal control.
• New business models, products, or activities. Entering into business areas or transactions with which
an entity has little experience may introduce new risks associated with internal control.

• Corporate restructurings. Restructurings may be accompanied by staff reductions and changes in

supervision and segregation of duties that may change the risk associated with internal control.

• Expanded foreign operations. The expansion or acquisition of foreign operations carries new and
often unique risks that may affect internal control, for example, additional or changed risks from
foreign currency transactions.

• New accounting pronouncements. Adoption of new accounting principles or changing accounting

principles may affect risks in preparing financial statements.
Information system, including the
related business processes, relevant to
financial
reporting, and communication
An information system consists of infrastructure (physical and hardware components), software, people,
procedures, and data. Infrastructure and software will be absent, or have less significance, in systems that are
exclusively or primarily manual. The information system relevant to financial reporting objectives, which includes
the financial reporting system, consists of the procedures and records established to initiate, record, process, and
report entity transactions (as well as events and conditions) and to maintain accountability for the related assets,
liabilities, and equity.

Accordingly, an information system encompasses methods and records that:

 Identify and record all valid transactions.
 Describe on a timely basis the transactions 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.
Information system, including
the related business
processes…..
Communication involves providing an understanding of individual roles and responsibilities pertaining
to internal control over financial reporting. It includes the extent to which personnel understand how
their activities in the financial reporting information system relate to the work of others and the means
of reporting exceptions to an appropriate higher level within the entity. Open communication channels
help ensure that exceptions are reported and acted on.
Control Activities

Control activities are the policies and procedures that help ensure that management directives are
carried out, for example, that necessary actions are taken to address risks that threaten the
achievement of the entity’s objectives. Generally, control activities that may be relevant to an audit
may be categorized as policies and procedures that pertain to the following:

 Performance reviews
 Information processing
 Physical controls
 Segregation of duties
Monitoring of controls

Management’s monitoring of controls includes considering whether they are operating as intended and
that they are modified as appropriate for changes in conditions. Monitoring of controls may include
activities such as management’s review of whether bank reconciliations are being prepared on a
timely basis, internal auditors’ evaluation of sales personnel’s compliance with the entity’s policies on
terms of sales contracts, and a legal department’s oversight of compliance with the entity’s ethical or
business practice policies.
Inherent Limitations of Internal Controls

1. Management’s usual requirement that the cost of an internal control does not exceed the expected
benefits to be derived.

2. Most internal controls tend to be directed at routine transactions rather than non-routine
transactions.

3. The potential for human error due to carelessness, distraction, mistakes of judgment and
the misunderstanding of instructions.

4. The possibility of circumvention of internal controls through the collusion of a member of

management or an employee with parties outside or inside the entity.

5. The possibility that a person responsible for exercising an internal control could abuse
That responsibility, for example, a member of management overriding an internal control.

6. The possibility that procedures may become inadequate due to changes in conditions,
And compliance with procedures may deteriorate.
Accounting and Internal Control Assessment

I. Understanding of accounting and internal control system

II. Plan the assessed level of control risk
III. Performance of tests of controls (if appropriate)
IV. Reassessment of control risk
V. Final assessment of control risk
Understanding of Accounting and
Internal Control Systems
In the audit of financial statements, the auditor is only concerned with those policies and procedures
within the accounting and internal control systems that are relevant to the financial statement
assertions. The understanding of relevant aspects of the accounting and internal control systems,
together with the inherent and control risk assessments and other considerations, will enable the
auditor to:

(a) identify the types of potential material misstatements that could occur in the financial statements;

(b) consider factors that affect the risk of material misstatements; and

(c) design appropriate audit procedures.

The nature, timing and extent of the procedures performed by the auditor to obtain an understanding
of the accounting and internal control systems will vary with, among other things:

 The size and complexity of the entity and of its computer system.
 Materiality considerations.
 The type of internal controls involved.
 The nature of the entity’s documentation of specific internal controls.
 The auditor’s assessment of inherent risk.
 Experience gained from prior audits.

Procedures in Obtaining Understanding

1. Make inquiries of appropriate company personnel
2. Inspect documents and records
3. Observe the company’s activities and operations
4. Walk-through
Documentation of Understanding

The auditor should document his understanding of internal control. The extent of documentation is a
matter of the CPA’s judgment and the form of documentation depends upon his preference and skills.

1. Narrative descriptions

2. Internal control questionnaires (ICQ)

3. Flowcharts

4. Checklists
Preliminary Assessment of Control Risk
The preliminary assessment of control risk is the process of evaluating the effectiveness of an entity’s
accounting and internal control systems in preventing or detecting and correcting material misstatements.
There will always be some control risk because of the inherent limitations of any accounting and internal
control system. After obtaining an understanding of the accounting and internal control systems, the auditor
should make a preliminary assessment of control risk, at the assertion level, for each material account
balance or class of transactions.

The auditor ordinarily assesses control risk at a high level for some or all assertions when:
(a) the entity’s accounting and internal control systems are not effective; or
(b) evaluating the effectiveness of the entity’s accounting and internal control systems would not be efficient.

The preliminary assessment of control risk for a financial statement assertion should be high unless the
auditor:
(a) is able to identify internal controls relevant to the assertion which are likely to prevent or detect and
correct a material misstatement; and
(b) plans to perform tests of control to support the assessment.
Test of Controls

If appropriate, tests of control are performed to obtain audit evidence about the effectiveness of the:

(a) design of the accounting and internal control systems, that is, whether they are suitably designed
to prevent or detect and correct material misstatements; and

(b) operation of the internal controls throughout the period.

Procedures for Performing Tests of Controls

1. Inspection
2. Inquiry
3. Observation
4. Reperformance
5. Walk-through
Required Documentation
Reassessment of control risk
Based on the results of the tests of control, the auditor should evaluate whether the
internal controls are designed and operating as contemplated in the preliminary assessment of
control risk. The evaluation of deviations may result in the auditor concluding that the assessed
level of control risk needs to be revised. In such cases, the auditor would modify the nature,
timing and extent of planned substantive procedures.
Final Assessment of Control Risk
Before the conclusion of the audit, based on the results of the substantive procedures
and other audit evidence obtained by the auditor, the auditor should consider whether the
assessment of control risk is confirmed.

As a result of obtaining an understanding of the accounting and internal control systems and tests of control, the
auditor may become aware of weaknesses in the systems. The auditor should make management aware, as soon
as practical and at an appropriate level of responsibility, of material weaknesses in the design or operation of the
accounting and internal control systems, which have come to the auditor’s attention.

The communication to management of material weaknesses would ordinarily be in writing. However, if the auditor
judges that oral communication is appropriate, such communication would be documented in
the audit working papers.

It is important to indicate in the communication that only weaknesses which have come to the auditor’s attention as
a result of the audit have been reported and that the examination has not been designed to determine the adequacy
of internal control for management purposes.