Section 3 - Internal Control - Concepts & Standards

Question 1

In planning an audit of certain accounts, an auditor may conclude that specific procedures used to obtain an understanding of an entity’s internal control structure need not be included because of the auditor’s judgments about materiality and assessments of what type of risk?

Answer 1

Inherent Risk.

If the auditor has concluded that an account is immaterial and that inherent risk is low, the auditor might decide to skip the procedures used to obtain an understanding of the related internal controls because the risk of a material misstatement occurring is low.
This is really a rather tricky question because GAAS require the auditor to obtain an understanding of the internal control structure sufficient to plan the audit. In the case of immateriality combined with low inherent risk, the auditor does not need to understand the internal controls specifically related to the account in order to plan the audit.

Question 2

What is a decision table?

Answer 2

A decision table presents in tabular form the conditions and alternative actions related to making a particular decision. It emphasizes logical relationships (decision rules) among the conditions and actions.

Question 3

List the advantages of Internal Control Questionnaires (ICQs) to document the auditor’s understanding of internal controls

Answer 3

1. Can have a standard form for many clients;

2. Deficiencies are easily indicated by “no” answers.

Question 4

Identify 3 ways auditors might document their understanding of internal controls?

Answer 4

1. Flowcharts of transaction cycles;
2. Internal control questionnaires;
3. Narrative write-ups (memos).

Question 5

List the advantages of narratives (memos) to document the auditor’s understanding of internal controls.

Answer 5

1. Tailored to client;
2. Can be as detailed or as general as desired;
3. Easy to prepare;
4. Easy to read.

Question 6

What is the purpose of performing a walkthrough?

Answer 6

Obtain some feedback as to whether the way the auditor has understood (and documented) the entity’s internal controls is consistent with the way the entity is actually processing such transactions

Question 7

List the advantages of using flowcharts to document the auditor’s understanding of internal controls.

Answer 7

1. Systematic approach with emphasis on important accounting records
2. Tailored to client
3. Fairly easy for others to review and understand
4. Easy to update from year to year

Question 8

Define transaction cycle.

Answer 8

A group of essentially homogeneous transactions, that is, transactions of the same basic type

Question 9

List the disadvantages of flowcharts to document the auditor’s understanding of internal controls.

Answer 9

1. Tedious and time consuming to initially prepare;

2. Might fail to recognize deficiencies by getting overly absorbed in details.

Question 10

Identify 3 procedures an auditor might perform to obtain an understanding of internal controls?

Answer 10

1. Inquiry of appropriate personnel
2. Observation of client’s activities
3. Review entity’s documentation of internal controls.

Question 11

List the disadvantages of Internal Control Questionnaires (ICQs) to document the auditor’s understanding of internal controls.

Answer 11

1. These are generic and not tailored to any client specifically;
2. Irrelevant questions may annoy clients;
3. Client might conceal deficiencies by incorrect answers.

Question 12

List the disadvantages of narratives (memos) to document the auditor’s understanding of internal controls.

Answer 12

1. Writing such a memo is rather unstructured, lacking a systematic approach;
2. It may be rather easy to overlook relevant internal control issues

Question 13

Significant deficiencies previously communicated by management are not corrected. Is this a basis for the auditor to consider whether material misstatements exist in the financial statements?

Answer 13

No. The presence of uncorrected significant deficiencies would not necessarily cause the auditor to consider whether material misstatements exist. Management is able to apply cost-benefit considerations when deciding whether to correct internal control weaknesses.

It seems deficiencies means “deficiencies in internal control” as opposed to uncorrected accounting entries.

Question 14

List some techniques an auditor uses to assess control risk

Answer 14

Inquiries

Inspections of documents

Observation

Reperformance of the application of a control

Question 15

In gaining an understanding of internal control, does the auditor need to obtain knowledge about the operating effectiveness of the internal control structure?

Answer 15

NO. Gaining an understanding of internal control does not require TESTING controls, which would provide information about the operating effectiveness. This would occur AFTER gaining an understanding of internal control.

Question 16

What is a procedure that an auditor is most likely to perform to test controls relating to completeness of cash receipts for cash sales at a retail outlet?

Answer 16

Observe the consistency of the employees’ use of cash registers and tapes.

Question 17

What is a control performed by person who lacks the necessary authority or competence to perform the control effectively?

Answer 17

Deficiency in operation.

The control is designed correctly but is implemented incorrectly.

Question 18

When should the auditor assess the operating effectiveness of internal control?

Answer 18

Whenever the auditor contemplates a reliance strategy (which means the same thing as “assessing control risk at less than the maximum level”) and only after performing the appropriate tests of control.

Question 19

When should the auditor assess the design effectiveness of internal control?

Answer 19

In planning every audit under GAAS, as a basis for determining the nature, timing, and extent of further audit procedures.

Question 20

Identify 3 inherent limitations of internal controls?

Answer 20

1. Cost of controls should not exceed expected benefits
2. Mistakes may occur due to carelessness, fatigue, misjudgments, etc.
3. Segregation of duties may break down due to collusion or management override of internal controls.

Question 21

Identify 2 reasons for assessing control risk at the maximum level.

Answer 21

1. The auditor believes that the design of internal control is ineffective; or
2. The auditor believes that reliance on internal control (and performing applicable tests of control) is not an efficient audit strategy compared to a wholly substantive audit approach.