After the auditor has learned about the design of a company’s internal controls, the auditor needs to test the operating effectiveness of the controls.

The auditor must determine whether each internal control:
• Is operating as designed
• Is being performed by an employee who has both the ability and authorization to perform the control

There are several ways for an auditor to test internal controls. These include:
• Inquiry
• Observing the client applying the control
• Inspecting the client’s documents
• Reperforming the control
• Walkthrough (this would include several of the steps listed above)

If an internal control is not operating effectively, the risk of material misstatement increases. This means the auditor will need to increase the amount of substantive testing to keep audit risk at an acceptable level.

When testing controls, the auditor should perform dual-direction tests (aka dual-purpose procedures). For example, to ensure that the client is checking for a 3-way match of the purchase order, receiving report, and invoice, the auditor should both:
• Test the existence assertion (did all recorded liabilities occur?) by vouching a sample of invoices back to the related receiving reports and purchase orders
• Test the completeness assertion (have all liabilities been recorded?) by tracing a sample of purchase orders to the related entries in the purchases journal

One of the most important controls for accounts payable is ensuring a 3-way match of the purchase order, receiving report, and invoice. The auditor should thus check for transactions where a 3-way match is missing. A list of unmatched vendor invoices, for example, could mean that:
• The goods were never received (perhaps the billing was fraudulent), or
• The goods were received, but the receiving report wasn’t matched to the invoice (there is an unrecorded liability)

After the tests of controls have been completed, the auditor should set the achieved level of control risk.
• If the achieved level of control risk is lower than the planned level, the amount of substantive procedures for account balances can be reduced. For example, the auditor might focus only on large-dollar accounts when confirming accounts payable.
• If the achieved level of control risk is higher than the planned level (e.g., if the auditor found that the company doesn’t review unmatched invoices), the amount of substantive procedures should be increased. For example, the auditor might send accounts payable confirmations to vendors that have a balance of zero.

0:00 Introduction
0:20 Effectiveness of internal controls
1:05 Techniques for testing effectiveness
1:46 Internal control NOT operating effectively
2:42 Dual-direction tests
5:20 Tests of controls related to purchase transactions
12:21 Tests of controls related to cash disbursement transactions
16:26 Tests of controls related to accounts payable balances
16:53 Comparing the achieved level of control risk to the planned level
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