Internal Control Review: Performing Audit and Evaluation in China

When foreign investors want to figure out whether internal control exists and is sufficient in their Chinese subsidiaries, an internal control review (ICR) might be the best and very first step to achieve that. In contrast to an annual statutory audit, which mainly focuses on maintaining reliable financial reporting, the ICR cares more about specific management processes.

The Internal Control Review is often seen as a plus, rather than a must, by those whose business models are relatively simple. But an ICR should be considered under certain circumstances

To put it simply, ICR is an overall assessment of the internal control system across various functions in a company. It tests whether the implemented internal control system works as designed, to evaluate whether it’s enough to manage the risks that the company may face in its day-to-day business, and to identify deficiencies in the internal control structure that could be strengthened  to maximize efficiency.

Generally, an ICR would generate the following benefits:

  • Encourage adherence to prescribed internal control policies and procedures
  • Improve effectiveness and efficiency of operations
  • Guarantee reliability of the companies’ financial reporting
  • Ensure compliance with applicable laws and regulations
  • Detect and prevent errors and irregularities in a timely manner
  • Help overseas headquarters and senior management to have a thorough understanding of their company’s internal control mechanisms

When is ICR needed?

Unlike listed companies that are required by law to conduct separate internal control audit and evaluation regularly, ICR is generally not mandatory for smaller private companies. The Internal Control Review is often seen as a plus, rather than a must, by those whose business models are relatively simple.

More often than not, these businesses may just combine the ICR into the annual statutory audit process. However, even SMEs should consider an Internal Control Review under certain circumstances, including:

  • When the key management of the company is changing
  • When there is internal reporting indicating fraud or corruption within the organization
  • When an acquiring company in an M&A knows nothing about the management situation of the acquired company
  • When a parent overseas company and its Chinese subsidiary have difficulties in reaching a mutual understanding on internal control mechanisms due to language or cultural barriers
  • When a company tries to figure out why irregularities, high costs, or low performance have occurred within its organization

Internal or external?

Many companies may also wonder whether they should do the review internally or use third party professional services. While the former might be preferred for cost-saving purposes, an ICR conducted by third party professionals can actually add more value to the process in the business context of China.

This is not only because they have the expertise needed to identify the unique risks and deficiencies in China, but also because they are usually in a more independent position to ensure the objectiveness of the ICR process, and thus better serves to improve the internal control operations.

Nevertheless, the advantages of external ICR can only be achieved when the third party professionals are reliable and qualified. Companies are advised to do at least basic due diligence into a potential third party to ensure it has compatible resources and experience to conduct an ICR that are customized to their needs.

For example, the qualified service provider should handle the ICR process in English, allowing headquarters or senior managements to monitor the process. The service provider should have adequate professionals with good understanding of ICR and necessary qualifications, such as CPA certificate or other certificates. The service provider should also have experience of conducting ICR for companies that have similar business operations and scope.

The Internal Control Review

Companies can get more from the ICR process by knowing how it works. Though the methodology and procedure of each review vary case by case, depending on the objectives and actual situation of the company, we summarize the full set of ICR process as follows:

How to Assess Internal Controls

Step 1: Identify business objectives

Since internal control is essentially designed to provide reasonable assurance that the company’s objectives are being achieved, identifying all these objectives is the starting point in improving the organization’s internal control system.

A walk-through test traces how the company authorizes, records, processes, and reports a sample transaction

If a third-party service provider is involved, the company and the service provider need to figure out the objectives before the service agreement is signed. By expressly identifying the business objectives, the service provider can better allocate resources to the most relevant business process and reduce the likelihood of key business risks being overlooked.

Step 2: Conduct walk-through tests

The walk-through test is a method commonly used to learn the key business processes and existing internal controls. A walk-through test traces how the company authorizes, records, processes, and reports a sample transaction.

For example, in a walk-through test for the purchase cycle of a manufacturing company, the auditor would go through the whole process, including order placing, good shipment, invoicing, good receipt and quality checking, monthly reconciliation and payment settlement, and quality dispute management, step by step.

During the test, auditors will use the email chains between the staff in charge and the suppliers, the invoices, and the paper records to demonstrate the process. By studying a single transaction, the auditor gets a sense of how the company handles other similar transactions.

Step 3: Document key processes

After the walk-through test, the auditors would document the key processes and controls narratives they observed, not only for the purpose of presenting the company’s current management situation to headquarters or the acquiring company, but also to streamline their own thoughts to facilitate the follow-up ICR processes.

Internal control documentation can take various forms, such as flowcharts, policy and procedure manuals, and narrative descriptions. Whatever the form it takes, the documentation should be of sufficient clarity to ensure that a reader will understand the detailed process.

Key Processes Are Different for Different Companies

Step 4: Identify key control points

Considering the time and cost required, it is impossible to test and analyze all control points. Auditors must decide which control points to further review. Here, the “materiality principle” is followed, i.e. only those points that could go wrong and thus impede the achievement of the company’s key objectives are subject to further test and review. The auditor’s professional judgement is essential during this preliminary assessment.

If an internal control is deemed very likely to be ineffective or non-existent, and there is no alternative controls existing, the auditor may directly report it as a significant deficiency or weakness in the ICR report.

Step 5: Test the effectiveness of key control points

Auditors will comprehensively apply different methods, such as interviewing, observing, inspecting, and re-performance, to test the effectiveness of the controls.

Different controls require different methods. For example, observation is appropriate when the control is a process and produces no product for inspection, such as when access to an area is restricted to authorized personnel only.

Inspection is suitable when documentation is available to check, such as authorization or contract compliance.

To get sufficient appropriate evidence for evaluating the effectiveness of the controls, the size of the tested sample is a key factor. Both the American Institute of Certified Public Accountants (AICPA) and Chinese Institute of Certified Public Accountants (CICPA) have standards on minimum sample sizes. However, the auditors may still need to use their expertise to determine if larger sample size is needed.

CICPA Sample Sizes for Manual Controls

Step 6: Analyze control deficiencies

Based on the materials acquired in the former steps, the auditors could analyze the deficiencies of the key control points and assess the corresponding effects to the companies businesses.

Generally, if a control is not implemented by personnel with proper authority and expertise as designed, then the control has deficiencies. If a control performs as designed but still could not achieve the intended objectives, then the control has deficiencies in design.

It’s not mandatory for most companies to do follow-up monitoring and review to see if the deficient controls are actually improved

One thing the auditors should bear in mind is that ICR is subject to cost-benefit constraints. No internal control system can absolutely avoid undesirable events from occurring. The control will be regarded effective so long as it can give reasonable assurance to the success of the business.

Another thing is that, when assessing the effects of the control deficiencies, significant risks include not only failures that threaten the survival of the group, or could seriously weaken it. The auditors should also focus on the risk of the controls impeding identification of significant opportunities.

Step 7: Generate ICR report

Finally, auditors would generate a complete report that will include, at the least:

  • Description of the key controls
  • Findings on control deficiencies
  • Assessment of the possible risks from the control weaknesses
  • Specific and feasible solutions to fix or improve the company’s control system

Step 8: Follow-up monitoring and review

It’s not mandatory for most companies to do follow-up monitoring and review to see if the deficient controls are actually improved, unless the company is regulated by Article 404 of the Sarbanes-Oxley Act in the US.

For those who just want to learn the control environment of their Chinese subsidiaries or their newly acquired companies, the ICR report is a good enough end-result of the ICR process.

However, if the company wants reasonable assurance in the long term, they should continuously monitor and regularly review their internal control system for maximum benefit.

About the Author                                                                                           

Dezan Shira & Associates is a specialist foreign direct investment practice that provides advisory services to multinationals investing in emerging Asia. This article first appeared in China Briefing, and was re-edited for clarity and conciseness. For further details or to contact the firm, please visit www.dezshira.com.

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