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3 Revision of risk assessment, audit strategy and audit plan

3 Revision of risk assessment, audit strategy and audit plan

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In particular, if controls testing reveals that controls have not operated effectively throughout the year, the
auditor may have to extend substantive testing.
Revising the risk assessment and audit procedures will necessitate an update of the audit strategy, which
sets out the scope, timing and direction of the audit. For example, if tests of controls highlight that many
controls are not operating as expected, this may lead to an increase in the strategy's emphasis on
substantive procedures.
The new or changed procedures will need to be reflected on the audit plan, which, as we saw in Chapter 7,
details the nature, timing and extent of audit procedures to be performed.

3.4 Communication of deficiencies in internal control

Dec 10

Significant deficiencies in internal controls shall be communicated in writing to those charged with
governance in a report to management in accordance with ISA 265 Communicating deficiencies in
internal control to those charged with governance and management which states that the objective of the
auditor is to communicate appropriately to those charged with governance and management deficiencies
in internal control identified during the audit which the auditor considers are of sufficient importance to
warrant their attention.
We will look at an example report to management in more detail in Chapter 19, but in this section we will
discuss the requirements of ISA 265.

Key terms

A deficiency in internal control exists when:
(a)

A control is designed, implemented or operated in such a way that it is unable to prevent, or detect
and correct, misstatements in the financial statements on a timely basis; or

(b)

A control necessary to prevent, or detect and correct, misstatements in the financial statements on
a timely basis is missing.

A significant deficiency in internal control is a deficiency or combination of deficiencies in internal
control that, in the auditor's professional judgment, is of sufficient importance to merit the attention of
those charged with governance.
ISA 265 requires the auditor to determine whether one or more deficiencies in internal control have been
identified and, if so, whether these constitute significant deficiencies in internal control. The significance of
a deficiency depends on whether a misstatement has occurred and also on the likelihood of a
misstatement occurring and its potential magnitude. ISA 265 includes examples of matters to consider
when determining whether a deficiency in internal control is a significant deficiency.


The likelihood of the deficiencies resulting in material misstatements in the financial statements in
the future



The susceptibility to loss or fraud of the related asset or liability



The subjectivity and complexity of determining estimated amounts



The amounts exposed to the deficiencies



The volume of activity that has occurred or could occur



The importance of the controls to the financial reporting process



The cause and frequency of the exceptions identified as a result of the deficiencies



The interaction of the deficiency with other deficiencies in internal control

The ISA also lists examples of indicators of significant deficiencies in internal control, which include the
following:

184



Evidence of ineffective aspects of the control environment



Absence of a risk assessment process

9: Internal control ⏐ Part C Internal control



Evidence of an ineffective entity risk assessment process



Evidence of an ineffective response to identified significant risks



Misstatements detected by the auditor's procedures that were not prevented, or detected and
corrected, by the entity's internal control



Restatement of previously issued financial statements that were corrected for a material
misstatement due to fraud or error



Evidence of management's inability to oversee the preparation of the financial statements.

The auditor shall communicate any significant deficiencies in internal control to those charged with
governance on a timely basis. The auditor shall also communicate in writing to management on a timely
basis significant deficiencies in internal control that the auditor has communicated or intends to
communicate to those charged with governance and other deficiencies in internal control that have not
been communicated to management by other parties and that the auditor considers are of sufficient
importance to warrant management's attention. The communication to management of other deficiencies
in internal control can be done orally.
The auditor shall include the following in the written communication:
(a)

A description of the deficiencies and an explanation of their potential effects (but there is no need
to quantify the effects)

(b)

Sufficient information to enable those charged with governance and management to understand
the context of the communication, in particular that:
(i)

The purpose of the audit was for the auditor to express an opinion on the financial
statements.

(ii)

The audit included consideration of internal control relevant to the preparation of the
financial statements in order to design audit procedures appropriate in the circumstances,
but not to express an opinion on the effectiveness of internal control.

(iii)

The matters being reported are limited to those deficiencies identified during the audit and
which the auditor has concluded are sufficiently important to merit being reported to those
charged with governance.

The auditor may also include suggestions for remedial action on the deficiencies, management's actual or
proposed responses and a statement as to whether or not the auditor has undertaken any steps to verify
whether management's responses have been implemented. In addition, the auditor may include the
following information:
(a)

A statement that if the auditor had undertaken more extensive procedures on internal control, more
deficiencies might have been identified or some of the reported deficiencies need not have been
reported.

(b)

The written communication is for the purpose of those charged with governance and may not be
suitable for other purposes.

3.4.1 Impact of deficiencies on the auditor's reliance on internal control
As we discussed in Section 1, if the controls are not adequately designed or not operating effectively, the
auditor needs to revisit the risk assessment and design sufficient substantive testing over that financial
statement area. Therefore, where significant deficiencies are identified, unless there are robust
compensating controls, the auditor will have no choice but to use purely substantive procedures to obtain
sufficient appropriate audit evidence. The auditor will not seek to place reliance on internal controls.
It may be that the deficiencies were not identified during planning and risk assessment, but only become
apparent later in the audit process. If this is the case, and the original audit plan was based on a reliance
on internal controls, that audit plan will need to be amended, with the likely result that further audit
procedures will need to be performed.

Part C Internal control ⏐ 9: Internal control

185

4 Internal controls in a computerised environment
FAST FORWARD

There are special considerations for auditors when a system is computerised. IT controls comprise
general and application controls.
The internal controls in a computerised environment include both manual procedures and procedures
designed into computer programs. Such control procedures comprise two types of control, general
controls and application controls.

Key terms

General IT controls are policies and procedures that relate to many applications and support the effective
functioning of application controls by helping to ensure the continued proper operation of information
systems. General IT controls commonly include controls over data centre and network operations; system
software acquisition, change and maintenance; access security; and application system acquisition,
development and maintenance.
Application controls are manual or automated procedures that typically operate at a business process
level. Application controls can be preventative or detective in nature and are designed to ensure the
integrity of the accounting records. Accordingly, application controls relate to procedures used to initiate,
record, process and report transactions or other financial data.

4.1 General controls
GENERAL CONTROLS

EXAMPLES

Development of
computer applications

Standards over systems design, programming and documentation
Full testing procedures using test data
Approval by computer users and management
Segregation of duties so that those responsible for design are not responsible
for testing
Installation procedures so that data is not corrupted in transition
Training of staff in new procedures and availability of adequate documentation

Prevention or
detection of
unauthorised changes
to programs

Segregation of duties
Full records of program changes
Password protection of programs so that access is limited to computer
operations staff
Restricted access to central computer by locked doors, keypads
Maintenance of programs logs
Virus checks on software: use of anti-virus software and policy prohibiting use of
non-authorised programs or files
Back-up copies of programs being taken and stored in other locations
Control copies of programs being preserved and regularly compared with actual
programs
Stricter controls over certain programs (utility programs) by use of read-only
memory

186

Testing and
documentation of
program changes

Complete testing procedures
Documentation standards
Approval of changes by computer users and management
Training of staff using programs

Controls to prevent
wrong programs or
files being used

Operation controls over programs
Libraries of programs
Proper job scheduling

9: Internal control ⏐ Part C Internal control

GENERAL CONTROLS

EXAMPLES

Controls to prevent
unauthorised
amendments to data
files

Password protection
Restricted access to authorised users only

Controls to ensure
continuity of
operation

Storing extra copies of programs and data files off-site
Protection of equipment against fire and other hazards
Back-up power sources
Disaster recovery procedures eg availability of back-up computer facilities
Maintenance agreements and insurance

The auditors will wish to test some or all of the above general IT controls, having considered how they
affect the computer applications significant to the audit.
General IT controls that relate to some or all applications are usually interdependent controls, ie their
operation is often essential to the effectiveness of application controls. As application controls may be
useless when general controls are ineffective, it will be more efficient to review the design of general IT
controls first, before reviewing the application controls.

4.2 Application controls
The purpose of application controls is to establish specific control procedures over the accounting
applications in order to provide reasonable assurance that all transactions are authorised and recorded,
and are processed completely, accurately and on a timely basis.
Application controls include the following.
APPLICATION CONTROLS

EXAMPLES

Controls over input:
completeness

Manual or programmed agreement of control totals
Document counts
One-for-one checking of processed output to source documents
Programmed matching of input to an expected input control file
Procedures over resubmission of rejected controls

Controls over input: accuracy

Programmes to check data fields (for example value, reference
number, date) on input transactions for plausibility:







Digit verification (eg reference numbers are as expected)
Reasonableness test (eg sales tax to total value)
Existence checks (eg customer name)
Character checks (no unexpected characters used in reference)
Necessary information (no transaction passed with gaps)
Permitted range (no transaction processed over a certain value)

Manual scrutiny of output and reconciliation to source
Agreement of control totals (manual/programmed)
Controls over input:
authorisation

Manual checks to ensure information input was:

Controls over processing

Similar controls to input must be in place when input is completed; for
example, batch reconciliations

• Authorised
• Input by authorised personnel

Screen warnings can prevent people logging out before processing is
complete

Part C Internal control ⏐ 9: Internal control

187

APPLICATION CONTROLS

EXAMPLES

Controls over master files and
standing data

One-for-one checking
Cyclical reviews of all master files and standing data
Record counts (number of documents processed) and hash totals
(for example, the total of all the payroll numbers) used when master
files are used to ensure no deletions
Controls over the deletion of accounts that have no current balance

Controls over input, processing, data files and output may be carried out by IT personnel, users of the
system and a separate control group and may be programmed into application software. The auditors may
wish to test the following application controls.
TESTING OF APPLICATION CONTROLS
Manual controls exercised by the
user

If manual controls exercised by the user of the application system are
capable of providing reasonable assurance that the system's output is
complete, accurate and authorised, the auditors may decide to limit
tests of control to these manual controls.

Controls over system output

If, in addition to manual controls exercised by the user, the controls to
be tested use information produced by the computer or are contained
within computer programs, such controls may be tested by examining
the system's output using either manual procedures or computers.
Such output may be in the form of magnetic media, microfilm or
printouts. Alternatively, the auditor may test the control by performing
it with the use of computers.

Programmed control procedures

In the case of certain computer systems, the auditor may find that it is
not possible or, in some cases, not practical to test controls by
examining only user controls or the system's output. The auditor may
consider performing tests of control by using computers,
reprocessing transaction data or, in unusual situations, examining the
coding of the application program.

As we have already noted, general IT controls may have a pervasive effect on the processing of
transactions in application systems. If these general controls are not effective, there may be a risk that
misstatements occur and go undetected in the application systems. Although weaknesses in general IT
controls may preclude testing certain IT application controls, it is possible that manual procedures
exercised by users may provide effective control at the application level.

Exam focus
point

188

The examining team expects you to be comfortable with a computerised scenario so it's important that
you understand the use of IT controls within an organisation. The August 2009 edition of Student
Accountant contains a very useful article on auditing in a computerised environment. You can also access
this article on the ACCA's website in the students' area.

9: Internal control ⏐ Part C Internal control

Chapter Roundup


The auditors must understand the accounting system and control environment in order to determine
their audit approach.



The auditors shall assess the adequacy of the systems as a basis for the financial statements and shall
identify risks of material misstatements to provide a basis for designing and performing further audit
procedures.



The auditors must keep a record of the client's systems which must be updated each year. This can be
done through the use of narrative notes, flowcharts, questionnaires or checklists.



If the auditors believe the system of controls is strong, they may choose to test controls to assess whether
they can rely on the controls having operated effectively.



There are special considerations for auditors when a system is computerised. IT controls comprise
general and application controls.

Part C Internal control ⏐ 9: Internal control

189

Quick Quiz
1

Complete the definition taking the words given below.
The …………. …………………. includes the governance and management functions and
the…………….., ………………… and …………. of those charged with …………… and management
concerning the entity's internal ……… and its ………………. in the entity.
attitudes importance

2

3

control

environment

1

………………………………………………

2

………………………………………………

control

General controls

One-for-one checking

Virus checks

Hash totals

Segregation of duties

Passwords

Program libraries

Review of master files

Training

Controls over account deletions

Back-up copies

Record counts

Back-up power source

Which of the following is not a test of control?
Inspection of documents
Reperformance of control procedures
Observation of controls
Verification of value to invoice

After the controls have been assessed, the audit plan may be modified.
True
False

190

actions

Put the controls below in the correct category.

A
B
C
D
5

governance

Name two key inherent limitations of an internal control system.

Application controls

4

awareness

9: Internal control ⏐ Part C Internal control

Answers to Quick Quiz
1

Control environment, attitudes, awareness, actions, governance, control, importance

2

Human error
Possibility of staff colluding in fraud

3
Application controls

General controls

One-for-one checking
Hash totals
Review of master files
Record counts

Virus checks
Program libraries
Segregation of duties
Passwords
Controls over account deletion
Training
Back-up power source
Back-up copies

4

D

5

True

Now try the question below from the Practice Question Bank

Number

Level

Marks

Time

Q15

Examination

10

20 mins

Part C Internal control ⏐ 9: Internal control

191

192

9: Internal control ⏐ Part C Internal control

Tests of controls

Topic list

Syllabus reference

1 The sales system

C3

2 The purchases system

C3

3 The inventory system

C3

4 The bank and cash system

C3

5 The payroll system

C3

6 Revenue and capital expenditure

C3

Introduction
We discussed tests of controls in the last chapter. In this chapter we will look
at how tests of controls might be applied in practice. We will examine each
major component of a typical accounting system.
We have already stated that the auditors must establish what the accounting
system and the system of internal control consist of. The auditors will then
decide which controls, if any, they wish to rely on and plan tests of controls to
obtain the audit evidence as to whether such reliance can be warranted. For
each of the major transaction systems we will look at the system objectives the
auditors will bear in mind while assessing the internal controls and give
examples of common controls. We shall then go on to look at a 'standard'
programme of tests of controls.

193

Study guide
Intellectual level
C3

Tests of control

(b)

Describe control objectives, control procedures, activities and tests of
control in relation to: the sales system; the purchases system; the payroll
system; the inventory system; the cash system; non-current assets.

2

Exam guide
Questions on tests of control are likely to come up in scenario-based situations, often in conjunction with
the topics we discussed in Chapter 9. One typical question requirement would ask you to identify and
explain internal control deficiencies, recommend suitable controls and describe the related tests of control.
You are likely to be asked to identify or describe controls that should be in place over a particular system
or explain the control objectives for a given system. Questions on internal controls and tests of controls
are very common and likely to come up, both in the form of written questions and in the form of OTQs in
Section A. You need to be familiar with the major transaction cycles so that you can answer such
questions competently.

1 The sales system
FAST FORWARD

The tests of controls in the sales system will be based around:




Exam focus
point

194

June 08, June 09, June 11, Dec 13, Dec 15,
Specimen exam

Selling (authorisation)
Goods outwards (custody)
Accounting (recording)

The pages that follow contain control objectives, the controls themselves and possible tests of controls. It
is very important to realise that the controls themselves should be thought of as distinct from the tests of
controls. If you are asked for tests of controls in a scenario-based question, be careful not to just state
control procedures managers should adopt. Instead you should focus on testing existing or potential
controls. When formulating tests of controls based on information in a scenario, the best approach is to
identify those controls present before considering how these controls can be confirmed. Make sure your
explanations are not vague – not starting with the word 'check' should help you to avoid this.

10: Tests of controls  Part C Internal control