Scope of the independent auditor's review of internal control; Statements on auditing procedure, No. 29

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Scope of the independent auditor's review of internal control; Scope of the independent auditor's review of internal control;

Statements on auditing procedure, No. 29 Statements on auditing procedure, No. 29

American Institute of Accountants. Committee on Auditing Procedure

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Statements on Auditing

Procedure

Issued by the

Committee on Auditing Procedure,

American Institute of

Certified Public Accountants

270 Madison Avenue, New York 16, N. Y.

American Institute of Certified Public Accountants

No. 29

October 1958

Scope of the

Independent Auditor's

Review of Internal Control

1. The purpose of this statement is to clarify previous pronouncements

relating to the scope of the independent auditor's review of internal con-

trol as it pertains to his examination leading to an expression of opinion

on the fairness of financial statements. No attempt is made in this state-

ment to consider the scope of reviews of internal control by the indepen-

dent auditor for other purposes, such as special engagements involving

systems surveys, revisions, etc.

BACKGROUND AND DISCUSSION

2. The standard short-form report

includes the following sentence:

"Our examination was made in accordance with generally ac-

cepted auditing standards, and accordingly included such tests

of the accounting records and such other auditing procedures

as we considered necessary in the circumstances."

3. The generally accepted auditing standard relating to internal control

is summarized in the standards of field work

follows:

"There is to be a proper study and evaluation of the existing

internal control as a basis for reliance thereon and for the deter-

mination of the resultant extent of the tests to which auditing

procedures are to be restricted."

Codification of Statements on Auditing Procedure, page 16.

Generally Accepted Auditing Standards, page 13.

Statements on Auditing Procedure

It is generally recognized that

a by-product of this study and evaluation,

the independent auditor is frequently able to offer constructive suggestions

to his client on ways in which internal control may be improved.

4. In practice, certain questions arise concerning the scope of the in-

dependent auditor's review of internal control because of the broad defini-

tion set forth in the Special Report on Internal Control issued by the com-

mittee on auditing procedure in 1949. The definition reads as follows:

"Internal control comprises the plan of organization and all of

the coordinate methods and measures adopted within a business

to safeguard its assets, check the accuracy and reliability of its

accounting data, promote operational efficiency, and encourage

adherence to prescribed managerial policies. This definition pos-

sibly is broader than the meaning sometimes attributed to the

term. It recognizes that a 'system' of internal control extends

beyond those matters which relate directly to the functions of the

accounting and financial departments. Such a system might in-

clude budgetary control, standard costs, periodic operating re-

ports, statistical analyses and the dissemination thereof, a

training program designed to aid personnel in meeting their

responsibilities, and an internal audit staff to provide additional

assurance to management as to the adequacy of its outlined

procedures and the extent to which they are being effectively

carried out. It properly comprehends activities in other fields as,

for example, time and motion studies which are of an engineer-

ing nature, and use of quality controls through a system of in-

spection which fundamentally is a production function."

5. Internal control, in the broad sense, includes, therefore, controls

which may be characterized as either accounting or administrative

, as

follows:

(a) Accounting controls comprise the plan of organization and all

methods and procedures that are concerned mainly with, and

relate directly to, the safeguarding of assets and the reliability

of the financial records. They generally include such controls

as the systems of authorization and approval, separation of

duties concerned with record keeping and accounting reports

In one sense all controls may be characterized as "administrative," even the accounting

controls. The division being made here is tor the purpose of distinguishing the account-

ing controls, with which the independent auditor is primarily concerned, from all other

controls.

Internal Control

from those concerned with operations or asset custody, physi-

cal controls over assets, and internal auditing.

(b) Administrative controls comprise the plan of organization and

all methods and procedures that are concerned mainly with

operational efficiency and adherence to managerial policies

and usually relate only indirectly to the financial records.

They generally include such controls as statistical analyses,

time and motion studies, performance reports, employee train-

ing programs, and quality controls.

The extent to which organizational plans and control methods and proce-

dures may be classified as accounting controls or administrative controls

will, of course, vary in individual circumstances.

CONCLUSIONS

6. In the ordinary examination, the selection of auditing procedures,

their timing, and the determination of the extent to which they should be

followed will depend largely upon the auditor's judgment of the adequacy

and effectiveness of the internal controls. This judgment is arrived at as

the result of his study and evaluation (which may involve testing, observa-

tion, investigation and inquiry) of those internal controls which, in his

opinion, influence the reliability of the financial records. In the course of

his examination the auditor obtains appropriate knowledge of his client's

organization and operations, on which he bases his selection of the internal

control areas he proposes to evaluate. Accounting controls, as described in

paragraph 5(a), generally bear directly and importantly on the reliability

of financial records and would, therefore, require evaluation. Administra-

tive controls, as described in paragraph 5(b), ordinarily relate only in-

directly to the financial records and thus would not require evaluation.

However, if the auditor believes that certain administrative controls, in a

particular case, may have an important bearing on the reliability of the

financial records, he should consider the need for evaluating such controls.

For example, statistical records maintained by production, sales or other

operating departments may be considered by the auditor as requiring

evaluation in a particular instance.

38 Statements on Auditing Procedure

7. The committee has considered whether the part of the definition of

internal control concerning the safeguarding of assets and the auditing

standard concerning study and evaluation of internal control, taken to-

gether, are inconsistent with the statement in the Codification

to the effect

that, in the ordinary examination, the auditor does not assume responsi-

bility for the detection of defalcations and other similar irregularities. The

committee sees no conflict in this regard since the objective of the audit

program (which is designed, in part, as a result of the evaluation of in-

ternal control) is to provide a basis for the expression of an opinion on

the financial statements, taken as a whole, and not to detect defalcations

or similar irregularities. In developing such a program, the auditor has a

responsibility for evaluating internal controls designed to safeguard assets,

and when such controls are weak or lacking his program should take this

condition into consideration. This consideration might lead either to the

extension of audit tests, or to the shifting of emphases or timing of the

audit procedures; for example, counts, reconciliations, confirmations, or

observations of certain assets (such as cash, receivables or inventories)

might be made at the balance-sheet date rather than at an interim date.

Codification of Statements on Auditing Procedure, "Responsibilities and Functions of

the Independent Auditor," pages 11-13.

COMMITTEE ON AUDITING PROCEDURE (1957-58)

HORACE G. BARDEN, Chairman

MARSHALL S. ARMSTRONG

THOMAS L. HOLTON

R. A. LILE

C. R. MILLER

SAMUEL PIVAR

JOHN WINSTON SHELTON

HAROLD M. SOLSTAD

W. D. SPRAGUE

CHARLES A. STEWART

JOSEPH F. SULLIVAN

EDWARD P. TREMPER

J. CARLTON UPDIKE

B. A. WILSON

CHARLES R. DALE

PHILIP L. DEFLIESE

M. M. DEVORE

CHARLES A. ZARINI

JOSEPH DRANGUET

EARL W. HAMMILL

CARMAN G. BLOUGH,

Director of Research

JOHN H. HANSON, JR.