Exam 8: Evaluating Internal Control Over Financial Reporting

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All financial reporting systems are composed of four components:
i) Source documents and transactions. Source documents, whether paper or electronic, are generally generated by accounting transactions.. Some examples include: sales order, bill of lading, sales invoice, picking ticket, purchase order, requisition, etc.
ii) Journals. Transactions are initially recorded in journals, otherwise known as books of original entry. Journals include a general journal or a specific journal, such as a sales journal, cash disbursements journal, purchases journal or cash receipts journal which have large numbers of transactions of a particular type.
iii) General and subsidiary ledgers. Ledgers aggregate the transaction activity on an account basis and indicate the current balance at a point in time. Ledgers include a transaction summary for all authorized accounts. In a manual system, ledgers will indicate the final balance of each account after all current journal entries are posted. For automated systems, ledgers are the summation of master files organized by account balance. The ledger utilized most by auditors is the general ledger, which summarizes activity for all accounts contained in the chart of accounts at a point in time
iv) Financial statements. Financial statements consist of line items that summarize related account balances conditional on account type, materiality, and GAAP requirements.

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a. The primary purpose of the accounting system is to provide relevant and reliability information useful in making economic decisions.
b. The quality of the information and communication that occurs will have a direct impact on management's ability to effectively and efficiently manage the resources and activities of the organization. It will also affect the financial statements distributed to external constituents, thus affecting external users' decisions which in turn affect the organization's ability to obtain resources.

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a. Control risk is maximum: The auditor will not use evidence about internal control to reduce audit risk; therefore, detection risk must be reduced using very extensive substantive tests. However, the auditor will still need to gain sufficient knowledge of internal control to evaluate the design effectiveness of the control system.
b. Control risk is slightly reduced from maximum: Results from tests of control suggest the appropriateness of placing some reliance on controls. Although detection risk is allowed to rise slightly, extensive substantive tests will still be performed.
c. Control risk is reduced to a moderate or low level: The auditor will rely heavily on the quality of internal control to reduce audit risk and perform minimal substantive tests to reduce detection risk.