On a high level, the accounting processes of a business consist of internal controls, individual transactions, and account balances.

Question

Required:

A. Describe the relationship between internal controls, individual transactions, and account balances.
B. Discuss how evidence regarding each of these three areas can help an auditor determine if the financial statements are fairly stated

Answer 1

A. A company implements internal controls as a safeguard to ensure appropriate capturing and recording of individual transactions, which are then collected into ending account balances.
Ending account balances are then used to prepare the financial statements. The auditor
expresses an opinion on the financial statements, which are made up of ending account
balances and disclosures.
B. The auditor can obtain evidence from all three areas of the accounting process. For
instance, an auditor can directly test the account balance (e.g., by examining a bank statement reconciliation). This evidence is usually the highest-quality but costliest evidence. Alternatively,
the auditor can obtain indirect information by testing the individual transactions that make up an account balance. If transactions are handled properly, this provides indirect evidence that the ending balances are more likely to be fairly stated. The least direct method of obtaining evidence is to evaluate and test the company's internal controls, which are implemented to ensure that transactions are handled properly. If a company's system of internal control is effective, transactions are more likely to be handled properly, and thus the ending balances making up a set of financial statements are more likely to be fairly stated. Auditors usually collect evidence relating to all three areas: internal control, transactions, and ending balances.