3.3 Assessing Control Risk
4 min read•august 13, 2024
Assessing is crucial for auditors to determine the extent of substantive testing needed. This process involves evaluating internal controls, considering factors like effectiveness and the . The assessment impacts the and shapes the overall audit strategy.
Control influences how auditors design their procedures. By understanding internal control components and effectiveness, auditors can identify potential misstatements and tailor their approach. This assessment helps balance efficiency and thoroughness in the audit process.
Control Risk and Audit Risk
Defining Control Risk
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- Control risk is the risk that a material misstatement could occur and not be prevented, detected or corrected by the entity's internal control on a timely basis
- It is a component of audit risk, along with and detection risk
- The level of control risk impacts the acceptable level of detection risk and influences the nature, timing and extent of audit procedures (substantive testing)
Control Risk in the Audit Risk Model
- Auditors assess control risk as part of the audit risk model to determine the amount of substantive testing required
- The higher the assessed level of control risk, the more audit evidence is needed from
- This assessment helps auditors design an appropriate audit response to address the risks of material misstatement in the financial statements
Factors Influencing Control Risk Assessment
Internal Control Effectiveness
- The effectiveness of the design, implementation and maintenance of internal controls by management influences the auditor's control risk assessment
- Factors considered in assessing control risk include the nature and of misstatements the controls are intended to prevent or detect, the inherent risk of the relevant assertion, and the competence and authority of personnel involved in the controls
- Results of tests of controls, including identified deviations and deficiencies, impact the auditor's assessment of control risk (deviations suggest higher control risk than planned)
Control Environment
- The control environment, including management's philosophy, operating style, and assignment of authority, influences the auditor's expectations about the operating effectiveness of controls
- A strong control environment can help mitigate risks arising from other areas, while a weak control environment may undermine the effectiveness of specific controls
- Auditors consider factors such as integrity and ethical values, commitment to competence, board of directors' oversight, and human resource policies when evaluating the control environment
Effectiveness of Internal Controls
Understanding Internal Control
- Auditors obtain an understanding of internal control relevant to the audit to identify types of potential misstatements, consider factors that affect risks of material misstatement, and design further audit procedures
- This understanding includes evaluating the design of controls and determining whether they have been implemented
- Auditors focus on controls that address significant risks or risks for which substantive procedures alone do not provide sufficient appropriate audit evidence
Key Components of Internal Control
- Control activities are policies and procedures that help ensure management directives are carried out (, authorizations, verifications, reconciliations, business performance reviews)
- Information and communication systems initiate, record, process and report transactions; relevant information must be identified, captured and communicated to enable personnel to carry out responsibilities
- Monitoring of controls involves assessing their effectiveness over time through ongoing monitoring activities, separate evaluations, or a combination of the two (management review, internal audit)
Risk Assessment Based on Internal Control
- Based on the understanding obtained, auditors identify and assess risks of material misstatement at the financial statement and assertion levels to provide a basis for designing and performing further audit procedures
- Risks are assessed in terms of likelihood and magnitude, considering both quantitative and qualitative factors
- Auditors consider the potential for fraud, changes in the entity's environment, and results of previous audits when identifying and assessing risks
Control Risk Assessment for Audits
Maximum vs. Below Maximum Assessment
- Auditors assess control risk at the maximum level when controls are unlikely to pertain to an assertion, are unlikely to be effective, or evaluating their effectiveness would be inefficient
- Assessing control risk below the maximum level involves identifying specific controls relevant to specific assertions that are likely to prevent or detect material misstatements, and performing tests of those controls
- Testing the operating effectiveness of controls provides evidence for assessing control risk below maximum (inquiry, observation, inspection of documentation, reperformance)
Documenting the Control Risk Assessment
- Auditors document their basis for conclusions about the assessed level of control risk, which should be supported by sufficient appropriate audit evidence
- Documentation includes the identified controls, the testing performed and results, and the auditor's conclusions about control effectiveness
- When control risk is assessed below maximum, auditors design substantive procedures to reflect the assessed level, considering the sufficiency and appropriateness of audit evidence from planned tests of controls
Responding to Assessed Control Risk
- If the assessed level of control risk is lower than expected, auditors may need to revise the overall audit strategy and audit plan to obtain more persuasive audit evidence or perform further tests of controls
- Conversely, if control risk is assessed higher than expected, auditors may need to increase the extent of substantive procedures or modify the nature and timing of planned procedures
- Auditors should communicate significant deficiencies and material weaknesses in internal control to management and those charged with governance in a timely manner
Key Terms to Review (18)
Audit Risk Model: The audit risk model is a framework used by auditors to assess the risks associated with an audit engagement, combining inherent risk, control risk, and detection risk. This model helps auditors determine the overall audit risk and plan the necessary procedures to ensure that the financial statements are free of material misstatements. By evaluating these components, auditors can make informed decisions about where to focus their efforts during the audit process.
Control Environment: The control environment refers to the overall attitude, awareness, and actions of an organization regarding the importance of internal controls. It sets the tone for the entire organization and forms the foundation for all other components of internal control. This environment influences how risks are assessed and managed, ultimately affecting the effectiveness of internal controls and the reliability of financial reporting.
Control Risk: Control risk is the risk that a client’s internal controls will not prevent or detect material misstatements in the financial statements. Understanding control risk is essential for auditors as it helps them determine the extent and nature of audit procedures needed to assess the reliability of financial reporting and the effectiveness of internal controls.
COSO Framework: The COSO Framework, developed by the Committee of Sponsoring Organizations of the Treadway Commission, is a comprehensive model designed to improve organizational performance through effective internal control systems. This framework emphasizes the importance of risk management and internal control in achieving operational efficiency, reliable financial reporting, and compliance with laws and regulations.
Entity-level controls: Entity-level controls are broad controls implemented by an organization to manage risk and ensure compliance across the entire entity. These controls serve as a framework for more specific controls, helping to create an environment of accountability and integrity throughout the organization. Effective entity-level controls are essential for assessing the overall control environment, as they help mitigate risks and support the reliability of financial reporting.
GAAS: GAAS, or Generally Accepted Auditing Standards, refers to the framework of guidelines and principles that auditors must follow when conducting audits of financial statements. These standards are essential for ensuring the quality and consistency of audits, providing a foundation for evaluating an auditor's performance and the reliability of their findings.
Inherent Risk: Inherent risk refers to the susceptibility of an account balance or class of transactions to misstatement due to error or fraud, assuming there are no related internal controls. It highlights the natural level of risk that exists in the absence of any mitigating factors, such as the effectiveness of a company's internal controls, and is crucial in understanding audit processes and planning.
ISA 315: ISA 315 is an International Standard on Auditing that focuses on identifying and assessing the risks of material misstatement in financial statements. This standard guides auditors in understanding the entity's internal controls and evaluating their effectiveness, which is crucial for determining the appropriate audit approach. It emphasizes the importance of a thorough risk assessment process to ensure that auditors can design effective audit procedures tailored to the specific risks identified.
Materiality: Materiality refers to the significance of financial information and its impact on the decisions made by users of financial statements. It helps auditors determine which misstatements or omissions are likely to influence the economic decisions of users, guiding the scope and focus of an audit.
PCAOB Standards: PCAOB standards refer to the regulations and guidelines established by the Public Company Accounting Oversight Board to govern the audits of public companies. These standards are designed to enhance the accuracy and reliability of financial reporting and ensure that auditors perform their work with integrity and independence. They play a crucial role in assessing the effectiveness of internal controls, developing substantive testing procedures, and evaluating audit results for misstatements.
Reassessing Risk: Reassessing risk involves the continuous evaluation of identified risks throughout the auditing process to determine if their potential impact or likelihood of occurrence has changed. This practice ensures that auditors remain vigilant and responsive to new information or changes in the control environment that may affect the effectiveness of internal controls. The goal is to adapt the audit strategy to address any alterations in risk levels effectively, promoting a thorough and relevant audit approach.
Reconciliation: Reconciliation refers to the process of comparing two sets of records to ensure they are in agreement, identifying and correcting discrepancies, and confirming that financial data accurately reflects the true state of an entity's financial position. This process is essential for maintaining accurate financial reporting, ensuring that internal controls are functioning properly, and assessing the risk associated with those controls.
Risk Assessment: Risk assessment is the systematic process of identifying, analyzing, and evaluating potential risks that could adversely affect the achievement of objectives. This process is crucial in various contexts, as it enables organizations to prioritize risks and allocate resources effectively to mitigate them, ensuring compliance with standards and regulations.
Segregation of Duties: Segregation of duties is an internal control principle that aims to prevent fraud and errors by dividing responsibilities among different individuals for related activities. This concept ensures that no single person has control over all aspects of a financial transaction, thereby reducing the risk of unauthorized actions and increasing the accuracy of financial reporting.
Substantive Procedures: Substantive procedures are the audit processes undertaken to detect material misstatements in financial statements, whether caused by error or fraud. These procedures include tests of details and analytical procedures that auditors perform to gather evidence about the amounts and disclosures in the financial statements, ultimately helping to assess the overall integrity of the financial reporting process.
Test of Controls: A test of controls is an audit procedure designed to evaluate the effectiveness of an entity's internal controls in preventing or detecting material misstatements in financial reporting. These tests help auditors understand how well the internal control system functions, informing them about the level of control risk. They are crucial in assessing the reliability of financial statements and ensuring compliance with regulations.
Transaction-level controls: Transaction-level controls are specific procedures and policies implemented within an organization to ensure the accuracy, completeness, and validity of individual transactions. These controls focus on preventing, detecting, and correcting errors or fraud at the transactional level, making them critical in evaluating the effectiveness of overall internal controls. By addressing risks associated with specific transactions, these controls help organizations maintain reliable financial reporting and compliance with applicable regulations.
Walkthrough: A walkthrough is a step-by-step process that auditors use to understand and evaluate the design and implementation of a company's internal controls. This method allows auditors to trace transactions through various stages of processing, highlighting how controls are supposed to function in practice. By conducting a walkthrough, auditors can identify gaps or weaknesses in internal controls that may increase the risk of errors or fraud, which is essential for assessing control risk effectively.