How to Test Internal Controls of an Organization

• Part 11.1 - Summary of Qualitative Characteristics of GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
• Part 11.2 - How and When to Recognize Revenues & Expenses in Accrual Accounting
• Part 11.3 - Functions in the Purchasing Process and how to Segregate Purchasing Duties
• Part 11.4 - Three Steps to Determining and Applying Materiality
• Part 11.5 - Assertions of Management about Economic Events in the Business
• Part 11.6 - Bank Accounting - Types of Bank Accounts, Cash Receipts & Disbursements, Disclosures Required for Cash Accounting
• Part 11.7 - Objectives of Internal Controls set by Management
• Part 11.8 - How to Test Internal Controls of an Organization
• Part 11.9 - Positive Accounting Theory (PAT)
• Part 11.11 - Accounting Information - Complex Commodity & Information Asymmetry

What are Testing Procedures of Internal Controls for Organizations?

• Procedures designed to evaluate the effectiveness of the design and operation of internal controls

• Auditor assesses whether the control has been properly designed to prevent or detect a material misstatement in the financial statements

• Auditor then assesses the operational effectiveness of the control, which determines whether the control is applied consistently through the period and by whom is it applied

Examples of tests of controls:

-Inspecting documents/reports for evidence the control has been performed. Example: HR manager signs the payroll as evidence of her/his review before the payroll is finalized and the cheques are issued.

-Observation of the application of specific controls. Example: auditor observes the cashier perform sales transactions and notes that the cash register will not open unless a sale has occurred.

-Walkthroughs – tracing a transaction from its point of origin to its inclusion in the financial statements. Involves several audit procedures: enquiry, observation, inspection. Example: the purchase of a capital asset is traced from the purchase order to the inclusion on the financial statements, ensuring required approvals, categorization of asset, and amortization policies are applied.

-Reperformance of the application of the control by the auditor – test ensures the integrity of the control. Example: recalculating the sales commissions paid on a sample of sales transactions.

Substantive Tests

Two Key Categories of Substantive Tests:

o Substantive Tests of Transactions – test for fraud or errors in individual transactions. Provides evidence on occurrence, completeness and accuracy assertions.

o Tests of Account Balances – establish whether there are any material misstatements in accounts or disclosures included in the financial statements by concentrating on the details in an account balance. Example – sending A/R confirmations to specific customers in the A/R listing to confirm the amounts outstanding.

Substantive Analytical Procedures

• Substantive analytical procedures include evaluating financial information made by studying plausible relations among financial and non-financial data.

• Requires knowledge of client’s business and industry

Key procedures used include:

• Trend analysis – examines changes in an account balance over time. Example: compare current year budgeted insurance expense to current year actual insurance expense.

• Ratio analysis – compares balances either across time or to a benchmark, of relationship between financial statement accounts or between an account and non-financial data. Example: compare current year inventory turnover to prior year inventory turnover.

• Reasonableness analysis – develops a model to form an expectation using financial data, non-financial data or both to test account balances or changes in account balances. Example: calculate average purchase price *number of units sold to estimate cost of goods sold.

Purposes of Analytical Procedures:

1. To assist auditor in planning the nature, timing and extent of other audit procedures

2. As a substantive test to obtain evidence about particular assertions

Steps:

a) Develop an expectations

b) Define an acceptable difference based on significance of the account, degree of reliance on the procedure, level of potential disaggregation in the amount being tested and precision of the expectation

c) Compare expectation to actual recorded amount

d) Investigate differences greater than acceptable difference threshold

a. Quantify portion of the difference that can be explained

b. Corroborate explanations of unexpected difference by substantiating the information supporting the explanation is reliable

c. Evaluation using professional skepticism

d. If the desired level of assurance is not obtained from the procedure, perform additional test of details or substantive analytical tests to achieve the required assurance levels

3. As an overall review of the financial statements in the final review stage of the audit

Dual-Purpose Tests

• Include both tests of controls, which assess errors in the design and application of controls, and substantive tests of transactions, which are concerned with monetary errors.

o Example: Check for agreement of a sample of purchase invoices to receiving documents and purchase order for approval signatures, product types, price and quantity. Recalculate the total purchase and ensure the purchase is recorded in the correct account (capitalized as an asset, vs expensed as operating expenditure).