STANDARD ON INTERNAL AUDIT (SIA) 12
INTERNAL CONTROL EVALUATION*
Contents
Paragraph(s)
Introduction ............................................................................1
Nature, Purpose and Types of Internal Controls....................2-6
Inherent Limitations of Internal Controls ..................................7
Role of the Internal Auditor in Evaluating
Internal Controls ............................................................... 8-14
Segregation of Duties ........................................................... 15
Control Activities for Information Technology .................... 16-19
Test of Controls ............................................................... 20-23
Monitoring Internal Audit Findings ......................................... 24
Communication of Continuing Internal Control
Weaknesses.................................................................... 25-29
Effective Date....................................................................... 30
The following is the text of the Standard on Internal Audit
(SIA) 12, Internal Control Evaluation , issued by the Council of
the Institute of Chartered Accountants of India. These
Standards should be read in conjunction with the Preface to
the Standards on Internal Audit, issued by the Institute.
In terms of the decision of the Council of the Institute of
Chartered Accountants of India taken at its 260 th meeting held
in June 2006, the following Standard on Internal Audit shall be
recommendatory in nature in the initial period. The Standards
shall become mandatory from such date as notified by the
Council.
Published in the February, 2009 issue of The Chartered Accountant.
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Standard on Internal Audit (SIA) 12
Introduction
1. The purpose of this Standard on Internal Audit is to establish standards
and provide guidance on the procedures to be followed by the internal
auditor in evaluating the system of internal control in an entity and for
communicating weaknesses therein to those charged with governance.
Nature, Purpose and Types of Internal Controls
2. Internal controls are a system consisting of specific policies and
procedures designed to provide management with reasonable
assurance that the goals and objectives it believes important to the
entity will be met. "Internal Control System" means all the policies and
procedures (internal controls) adopted by the management of an entity
to assist in achieving management's objective of ensuring, as far as
practicable, the orderly and efficient conduct of its business, including
adherence to management policies, the safeguarding of assets, the
prevention and detection of fraud and error, the accuracy and
completeness of the accounting records, and the timely preparation of
reliable financial information. The internal audit function constitutes a
separate component of internal control with the objective of determining
whether other internal controls are well designed and properly operated.
Internal control system consists of interrelated components as follows:
Control (or Operating) environment.
Risk assessment.
Control objective setting.
Event identification..
Control activities.
Information and communication.
Monitoring.
Risk response.
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Internal Control Evaluation
3. The system of internal control must be under continuous supervision by
management to determine that it is functioning as prescribed and is
modified, as appropriate, for changes in environment. The internal
control system extends beyond those matters which relate directly to
the functions of the accounting system and comprises:
a. "control environment" means the overall attitude, awareness and
actions of directors and management regarding the internal control
system and its importance in the entity. The control environment has
an effect on the effectiveness of the specific control procedures and
provides the background against which other controls are operated.
Factors reflected in the control environment include:
The entity's organisational structure and methods of assigning
authority and responsibility (including segregation of duties and
supervisory functions).
The function of the board of directors and its committees, in the
case of a company or the corresponding governing body in case
of any other entity.
Management's philosophy and operating style.
Management's control system including the internal audit
function, personnel policies and procedures.
Integrity and ethical values.
Commitment to competence.
Human resource policies and practices.
b. "control activities" (or procedures) which means those policies and
procedures in addition to the control environment which management
has established to achieve the entity's specific objectives. Control
activities include approvals, authorizations, verifications,
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Standard on Internal Audit (SIA) 12
reconciliations, reviews of performance, security of assets,
segregation of duties, and controls over information systems.
4. Internal controls may be either preventive or detective. Preventive
controls attempt to deter or prevent undesirable acts from occurring.
They are proactive controls that help to prevent a loss. Examples of
preventive controls are separation of duties, proper authorization,
adequate documentation, and physical control over assets. Detective
controls attempt to detect undesirable acts. They provide evidence that
a loss has occurred but do not prevent a loss from occurring. Examples
of detective controls are reviews, analyses, variance analyses,
reconciliations, physical inventories, and audits.
5. Internal controls are generally concerned with achieving the following
objectives:
Transactions are executed in accordance with management's general
or specific authorisation.
All transactions and other events are promptly recorded in the correct
amount, in the appropriate accounts and in the proper accounting
period so as to permit preparation of financial statements in
accordance with the applicable accounting standards, other recognised
accounting policies and practices and relevant statutory requirements,
if any, and to maintain accountability for assets.
Assets and records are safeguarded from unauthorised access, use or
disposition.
Recorded assets are compared with the existing assets at reasonable
intervals and appropriate action is taken with regard to any differences.
Systems and procedures are effective in design and operation.
Risks are mitigated to a reasonable extent.
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Internal Control Evaluation
6. Internal control is a process. Internal control can be expected to provide
only reasonable assurance, not absolute assurance. Internal control is
geared to the achievement of objectives. Internal control is effected by
people and not by policy manuals and forms alone.
Inherent Limitations of Internal Controls
7. Internal control systems are subject to certain inherent limitations, such as:
Management's consideration that the cost of an internal control does
not exceed the expected benefits to be derived.
The fact that most internal controls do not tend to be directed at
transactions of unusual nature. The potential for human error, such as,
due to carelessness, distraction, mistakes of judgement and
misunderstanding of instructions.
The possibility of circumvention of internal controls through collusion
with employees or with parties outside the entity.
The possibility that a person responsible for exercising an internal
control could abuse that responsibility, for example, a member of
management overriding an internal control.
Manipulations by management with respect to transactions or
estimates and judgements required in the preparation of financial
statements.
Role of the Internal Auditor in Evaluating Internal Controls
8. The Internal auditor should examine the continued effectiveness of
the internal control system through evaluation and make
recommendations, if any, for improving that effectiveness. However,
the internal auditor is not vested with management's primary responsibility
for designing, implementing, maintaining and documenting internal control.
Internal audit function adds value to an organization's internal control
system by bringing a systematic, disciplined approach to the evaluation of
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Standard on Internal Audit (SIA) 12
risk and by making recommendations to strengthen the effectiveness of risk
management efforts. The internal auditor should focus towards
improving the internal control structure and promoting better
corporate governance. The role of the internal auditor encompasses:
Evaluation of the efficiency and effectiveness of controls.
Recommending new controls where needed or discontinuing
unnecessary controls.
Using control frameworks.
Developing control self-assessment.
9. The internal auditor's evaluation of internal control involves:
determining the significance and the sensitivity of the risk for which
controls are being assessed;
assessing the susceptibility to misuse of resources, failure to attain
objectives regarding ethics, economy, efficiency and effectiveness, or
failure to fulfil accountability obligations, and non-compliance with laws
and regulations;
identifying and understanding the design and operation of relevant
controls;
determining the degree of control effectiveness through testing of
controls;
assessing the adequacy of the control design; and
reporting on the internal control evaluation and discussing the
necessary corrective actions.
10. The broad areas of review by the internal auditor in evaluating the
internal control system, inter alia, are:
Mission, vision, ethical and organizational value-system of the entity.
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Internal Control Evaluation
Personnel allocation, appraisal system, and development policies.
Accounting and financial reporting policies and compliance with
applicable legal and regulatory standards
Objective of measurement and key performance indicators.
Documentation standards.
Risk management structure.
Operational framework.
Processes and procedures followed.
Degree of management supervision.
Information systems, communication channels.
Business Continuity and Disaster Recovery Procedures.
11. The internal auditor should obtain an understanding of the significant
processes and internal control systems sufficient to plan the internal
audit engagement and develop an effective audit approach. The
internal auditor should use professional judgment to assess and
evaluate the maturity of the entity's internal control. The auditor
should obtain an understanding of the control environment sufficient
to assess management's attitudes, awareness and actions regarding
internal controls and their importance in the entity. Such an
understanding would also help the internal auditor to make a preliminary
assessment of the adequacy of the accounting and internal control systems
as a basis for the preparation of the financial statements, and of the likely
nature, timing and extent of internal audit procedures. The internal auditor
assesses the `asis' internal control system within the organization.
12. The internal auditor should obtain an understanding of the internal
control procedures sufficient to develop the audit plan. In obtaining this
understanding, the internal auditor would consider knowledge about the
presence or absence of control procedures obtained from the
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Standard on Internal Audit (SIA) 12
understanding of the control environment, business processes and
accounting system in determining whether any additional understanding of
control procedures is necessary. The internal auditor should understand
and document the design and operations of internal controls to
evaluate the effectiveness of the control environment. The important
procedures to be adopted by the internal auditor for this purpose include:
Narratives
Flowcharts
Questionnaires
13. When obtaining an understanding of the business processes, accounting
and internal control systems to plan the audit, the internal auditor obtains a
knowledge of the design of the internal control systems and their operation.
For example, an internal auditor may perform a "walk-through" test that is,
tracing a few transactions through the accounting system. When the
transactions selected are typical of those transactions that pass through the
system, this procedure may be treated as part of the tests of control.
14. The internal auditor should consider the following aspects in the
evaluation of internal control system in an entity:
Ascertaining whether the entity has a mission statement and
written goals and objectives.
Assessing risks at the entity level.
Assessing risks at the activity (or process) level.
Completing a Business Controls worksheet for each significant
activity (or process) in each function or department with
documentation of the associated controls and their degree of
effectiveness (partial or full); prioritizing those activities (or
processes) which are most critical to the success of the function
or department.
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Internal Control Evaluation
Ensuring that all risks identified at the entity and function or
department level are addressed in the Business Controls
worksheet along with the consolidated documentation of the
operating controls.
Ascertaining from the Business Controls worksheet, those risks
for which no controls exist or existing controls are inadequate.
This process is the stage of `controls gap' analysis.
Segregation of Duties
15. Segregation of duties is critical to effective internal control; it reduces the
risk of both erroneous and inappropriate actions. The internal auditor
should ensure that in general, the approval function, the
accounting/reconciling function, and the asset custody function is
separated among employees of the entity. When these functions
cannot be separated due to small department size, the internal auditor
should ensure that a detailed supervisory review of related activities
is in practice, as a compensating control activity.
Control Activities for Information Technology
16. In a computer information systems environment, the objectives of tests of
control do not change from those in a manual environment; however, some
audit procedures may change. The internal auditor may find it necessary, or
may prefer, to use computer-assisted audit techniques. The use of such
techniques, for example, file interrogation tools or audit test data, may be
appropriate when the accounting and internal control systems provide no
visible evidence documenting the performance of internal controls which
are programmed into a computerised accounting system. There are two
broad categories of information systems controls - general controls and
application controls. General Controls apply to all information systems-
mainframe, minicomputer, network, and end-user environments. Application
Controls are designed to cover the processing of data within the application
software.
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Standard on Internal Audit (SIA) 12
17. While evaluating the information technology controls in a system-
driven environment, the internal auditor should determine whether the
entity, inter alia, uses:
encryption tools, protocols, or similar features of software
applications that protect confidential or sensitive information
from unauthorized individuals;
back-up and restore features of software applications that reduce
the risk of permanent loss of data;
virus protection software; and
passwords that restrict user access to networks, data and
applications.
18. The nature, timing and extent of the procedures performed by the internal
auditor to obtain an understanding of the internal control systems will vary
with, among other things:
Size and complexity of the entity and of its information system.
Materiality considerations.
Type of internal controls involved.
Nature of the entity's documentation of specific internal controls.
Internal auditor's assessment of inherent risk.
19. Ordinarily, the internal auditor's understanding of the internal control
systems significant to the audit is obtained through previous experience
with the entity and is supplemented by:
a. inquiries of appropriate management, supervisory and other
personnel at various organisational levels within the entity, together
with reference to documentation, such as procedures manuals, job
descriptions, systems descriptions and flow charts;
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Internal Control Evaluation
b. inspection of documents and records produced by the accounting and
internal control systems; and
c. observation of the entity's activities and operations, including
observation of the organisation of computer operations, personnel
performing control procedures and the nature of transaction
processing.
Test of Controls
20. Tests of control are performed to obtain audit evidence about the
effectiveness of the:
a. design of the internal control systems, that is, whether they are
suitably designed to prevent or detect and correct material
misstatements;
b. operation of the internal controls throughout the period; and
c. cost of a control vis-a-vis the benefit obtained from the same.
21. Tests of control normally include:
Inspection of documents supporting transactions and other events to
gain audit evidence that internal controls have operated properly, for
example, verifying that a transaction has been authorised.
Inquiries about, and observation of, internal controls which leave no
audit trail, for example, determining who actually performs each
function and not merely who is supposed to perform it.
Re-performance of internal controls, for example, reconciliation of bank
accounts, to ensure they were correctly performed by the entity.
Testing of internal control operating on specific computerised
applications or on the overall information technology function, for
example, access or program change controls.
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Standard on Internal Audit (SIA) 12
22. Based on the results of the tests of control, the internal auditor should
evaluate whether the internal controls are designed and operating as
contemplated in the preliminary assessment of control risk. The
evaluation of deviations may result in the internal auditor concluding that
the assessed level of control risk needs to be revised. In such cases, the
internal auditor would modify the nature, timing and extent of planned
substantive procedures.
23. The internal auditor should consider whether the internal controls
were in use throughout the period. If substantially different controls were
used at different times during the period, the auditor would consider each
separately. A breakdown in internal controls for a specific portion of the
period requires separate consideration of the nature, timing and extent of
the audit procedures to be applied to the transactions and other events of
that period. The internal auditor would obtain audit evidence as to the
nature, timing and extent of any changes in the entity's accounting and
internal control systems since such procedures were performed and assess
their impact on the auditor's intended reliance.
Monitoring Internal Audit Findings
24. The internal auditor should identify internal control weaknesses that
have not been corrected and make recommendations to correct those
weaknesses. The internal auditor should document the rationale in
deciding which audit recommendations should be followed up on and
when, in contrast with recommendations where no follow-up is
needed. The internal auditor should also inquire from the
management and document that either audit recommendations have
been effectively implemented or that senior management has
accepted the risk of not implementing the recommendations.
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Internal Control Evaluation
Communication of Continuing Internal Control
Weaknesses
25. When internal controls are found to contain continuing weaknesses,
the internal auditor should consider whether:
Management has increased supervision and monitoring;
Additional or compensating controls have been instituted; and/or
Management accepts the risk inherent with the control weakness.
26. The internal auditor should evaluate identified control deficiencies
and then determine whether those deficiencies, individually or in
combination, are significant deficiencies or material weaknesses. The
auditor should communicate significant deficiencies and material
weaknesses to management and those charged with governance. This
communication includes significant deficiencies and material weaknesses
identified and communicated to management and those charged with
governance in prior audits but not yet remediated.
27. Some examples of common weaknesses in internal controls are:
Corporate philosophy is understood but not written exposing it to
misinterpretation.
Organizational roles and responsibilities are not explicitly defined.
Lack of performance appetite and understanding of the entity's appetite
for risk taking.
Management or board of directors do not receive the right information
at the right time.
Disincentives exist which lead employees to behave in a dysfunctional
manner.
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Standard on Internal Audit (SIA) 12
28. As a result of obtaining an understanding of the internal control systems
and tests of control, the internal auditor may become aware of weaknesses
in the systems. The internal auditor should make management aware,
as soon as practical and at an appropriate level of responsibility, of
material weaknesses in the design or operation of the internal control
systems, which have come to the internal auditor's attention. The
communication of material weaknesses to management would ordinarily be
in writing, as part of the internal audit report. However, if the internal auditor
judges that oral communication is appropriate, such communication would
be documented in the audit working papers. It is important to indicate in the
communication that only weaknesses which have come to the internal
auditor's attention as a result of the audit have been reported and that the
examination has not been designed to determine the adequacy of internal
control for management purposes.
29. The internal auditor in his report to the management, should provide:
A description of the significant deficiency or material weakness in
internal control.
His opinion on the possible effect of such weakness on the
entity's control environment.
Effective Date
30. This Standard on Internal Audit is applicable to all internal audits
commencing on or after ______. Earlier application of the SIA is
encourage.
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