P7 THE CONTROL ENVIRONMENT OF A COMPANY(2)

5 Organisational structure

 ISA 315 describes a company’s organisational structure as being ‘the framework within which an entity’s activities for achieving its objectives are planned, executed, controlled and reviewed’. The appendix to the ISA then explains ‘that the appropriateness of an entity’s organisational structure depends, in part, on its size and the nature of its activities’. It follows from this that an international consulting company with offices and operations in several countries has different priorities in terms of organisational structure to a national car sales company with several offices and a number of sales branches in a single country. Similarly, the organisational structure deemed suitable for such a car sales company would not be appropriate for a single site manufacturing company. Generally, an auditor may reasonably expect

there to be a positive correlation between the level of inherent risk and the size and complexity of a company’s operations. In assessing, the level of the risk of material misstatement the auditor should consider as to whether the company’s organisational structure in terms of authority, responsibility and lines of reporting meet desired objectives.

 

6 Assignment of authority and responsibility

Normally, the larger a company’s scale of operations, then the larger the size of the workforce and, inevitably, the larger the amount of assignment of authority and responsibility that is required. Consequently, companies need to deal not only with ensuring that appropriate levels of authority and responsibility are assigned to appropriately qualified and experienced individuals. They also need to ensure that adequate reporting relationships and authorisation hierarchies are in place. Additionally, individuals need to be properly resourced and made fully aware of their responsibilities and of how their actions interrelate with the actions of others and contribute to the objectives of the company. If a company is not successful in meeting each of these needs, then there is an increased probability of ineffective decisions, errors and oversights by employees leading to an increased risk of material misstatement in its financial statements. For example, where a wages clerk is authorised to process the wages payroll and is then assigned the (inappropriate!) authority to enter new employee details into the wages master file.

 

7 Human resources policies and practices

As explained in ISA 315, ‘human resource policies and practices demonstrate important matters in relation to the control consciousness of an entity’. This implies that if human resources policies and practices are considered to be sound both in design and in implementation over a range of matters, then the risk of material misstatement will be reduced.

 

Examples of these matters include:

·           Recruitment policies and procedures. These should ensure that only competent individuals with integrity are employed by the company. Interview procedures should ensure that only candidates meeting the company’s criteria for recruitment are engaged.

·           There should be adequate induction procedures for new employees, such that they can carry out their assigned responsibilities effectively and efficiently soon after being engaged by the company.

·           Employees should be provided with ongoing training, support and mentoring as appropriate, such that they can continue to carry out their assigned responsibilities effectively and efficiently.

·           There should be regular formal appraisal, at least annually of an employee’s performance. Performance should be measured against standardised criteria authorised by senior management of the company, and there should be ongoing monitoring and feedback to employees about their performance and development needs.

 

 

·           The company should employ comprehensive and transparent employment grievance procedures, such that employees can be confident that grievances will be dealt with openly and impartially.

·           There should be open, transparent and equitable employee disciplinary procedures, such that employees can be confident they will not be treated unfairly by the company in the event that an action triggers its disciplinary process.

·           Employment termination procedures should incorporate provision for an exit interview so that the reason for the termination can be confirmed or clarified, all emoluments due to the employee can be settled and arrangements can be made for the return of all company assets prior to the termination date.

 

While each of the above measures will have a positive impact on the internal control of a company, to some extent they all have the effect of reducing the risk of material misstatement in the financial statements. For example, the existence of fair and robust grievance and disciplinary procedures reduce the possibility of a successful claim against the company for constructive or unfair dismissal, and the absence of a material provision in this respect. Significantly, the existence of human resources policies and practices that are the same or similar to those above should leave a favourable impression with the auditor, as to the directors’ attitude toward their company’s workforce. It is likely that such an attitude would foster good working relationships with employees, leading to an increased likelihood that individuals would reciprocate by carrying out their tasks diligently with integrity in the best interests of the company – resulting in a reduced risk of material misstatement.

 

Summary

As indicated at the beginning of this article, the purpose of it is to provide candidates with a more detailed appreciation of matters pertinent to an auditor, when evaluating the control environment of a limited liability/limited company. When asked to explain what is meant by the term ‘control environment’, they typically comment that it is a component of a company’s internal control and that it centres around how a company is operated by its management, reflecting such matters as their philosophy and operating style. While there is some merit in this answer, having now read the above commentary, candidates should be aware that the term has much more meaning than that.

 

Written by a member of the audit examining team

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