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Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 5 (AS5), "An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements", was issued in order to increase the likelihood that material misstatements would be discovered by auditors. The top-down approach focuses on the auditing of the internal controls of a publicly traded company. Beginning at the largest, the financial statement level of a company, an auditor must use certain procedures to narrow the focus of the audit in order to discover the accounts, disclosures, and assertions that would lead to material misstatements located in the financial statements and footnotes.
Initially the auditor must look at the entire company as a whole. In this portion the controls are known as entity-level controls. By gaining an understanding of these controls, the auditor may primarily begin to determine whether he or she will need to apply more or less measures to test the effectiveness of the entities internal controls, and therefore the possibility of material misstatement. Most entity level controls deal with the larger scope of the company's internal controls.
Another important part of the top-down approach deals with the board of directors, audit committee, and management's role with respect to the internal controls and environment of a company. The internal environment of the company relies heavily on these contributors. These contributors determine the philosophical style and operations of a company. Without an effective philosophical style of operation, the internal controls of a company will not be as effective, and therefore allow for the increased likelihood of material misstatement.
Once an overall understanding of the entity-level controls and the control environment are understood the auditor must begin to look more closely at the financial reports, specifically the procedures and transactions related to these reports. The internal controls related to the transactions and manner in which they are recorded are of specific interest to auditors. AS5 lists the procedures that must be analyzed by an auditor in order to assure that the internal controls of the company are functioning properly. Aspects that the auditor must also focus on include management's role in the procedures related to the financial statements, information technologies role in the process, various journal entries, as well as management, the board of directors, and audit committee's role in the oversight of these processes.
Most specifically the auditor will use all the information previously gained to identify certain accounts and disclosures, and their related assertions, in order to assess the possibility of the existence of a material misstatement. The PCAOB lists the assertions with which an auditor would be working. Also the auditor must analyze the risk factors related to the financial statements that are tied to the significant accounts and disclosures. An important area, which PCAOB focuses on in AS5, deals with understanding the likely sources of misstatement.
AS5 provides four objectives for auditors to focus on in their evaluation of internal controls. The auditor must understand the transactions related to significant accounts and disclosures. An understanding of the company's processes where a material misstatement could occur must also be attained. The internal controls that management has implemented to mitigate possible material misstatements must be understood. Finally the auditor must understand all controls that deal with the company's assets and any action in which these assets are involved. In evaluating internal controls the PCAOB recommends that the auditor walk through the company and question personnel to help further understand and identify possible problems.
The main focus of the top-down approach starts at an entity level understanding of the company. Once a broad overview of the company has been established, the auditor can begin to focus on certain areas of the company's internal controls that are most venerable to material misstatement because of material weaknesses. This begins with an evaluation of the internal environment set by the board of directors, audit committee, and management. Overall the top-down approach looks to take the focus of an auditor from a large-scale view of the internal controls of a company, and narrow them to specific accounts, disclosures, and relevant assertions.
Significant Deficiency and Material Weakness
A significant deficiency relates to a problem within the internal controls of the financial reporting. Although the significant deficiency must be brought to the attention of those responsible for the oversight of the company's financial reporting, it will not lead to a material misstatement within the financial statements. A material weakness on the other hand has a reasonable possibility of resulting in a material misstatement within the financial statements. A material weakness is a single or multiple deficiencies in the internal controls of financial reporting that would lead to this material misstatement. A significant deficiency is a problem within the financial statements, which could eventually evolve into a material misstatement in the future, while a material weakness is a problem that will most likely lead to a material misstatement of the financial statements.
In AS5 the PCAOB lists the indicators of some major indicators of material weaknesses in the internal controls of financial reporting. The first indicator states that any fraud at the management level is a strong indicator that there are material weaknesses present. Also when a material misstatement occurs within the financial statements, a restatement of those statements must be issued, and would be a result of material weaknesses within the restated sections. Another indicator would be when an auditor finds a material misstatement within the current period that otherwise would not have been detected, in a timely manner by the company's internal controls. When the audit committee does not exercise the proper oversight of the internal controls relating to financial reporting, this becomes another indicator that a material weakness may be present. While considering the existence of material weaknesses, an auditor must look at the whether the deficiency would affect the actions or decisions of prudent officials, based on their reasonable assurance that the financial statements are free of material misstatement.
Communication with Audit Committee
When an auditor discovers a material weakness, he or she must communicate this information, in writing, to the audit committee and management prior to the issuance of the audit report. Similarly, with the discovery of a significant deficiency the auditor must also communicate this to management and the audit committee. In both cases this information would be communicated throughout the process of the audit. The audit report on the other hand includes a statement that includes an understanding of the internal controls of financial reporting within the company, as well as assessing the risk that there weaknesses exist. Throughout the process the auditor must communicate with management and the audit committee concerning material weaknesses and significant deficiencies, while an audit report includes a summarization of the internal controls of financial reporting.