Figure 8.1 showed there are two broad levels of regulation and control relating to both external and internal environment. You are the auditor of an entity providing advice to clients on financial matters. You are aware that there have been serious reductions in the value of shares quoted on stock exchanges throughout the world and that this will have a negative impact on pensions in the future. Explain how management of the entity should react to this external factor. Consider the control environment of the entity and the auditor’s interest.

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TABLE 8.1 Potential limitations in internal control Limitation 1. Design of controls may be faulty or there has been inadequate consideration of changes in circumstances; human error can cause breakdown in controls. 2. Controls can be rendered ineffective if two or more people collude to circumvent a control, or if management is in a position to override controls. 3. Management may recognize that a risk exists but decides not to implement controls if they judge them to be too expensive in the circumstances. 4. An important internal control is segregation of duties to ensure that transactions cannot be completely processed by one person. Smaller entities often have insufficient num- bers of employees to make segregation of duties practicable. Comment For instance, controls, such as supervision by top management, might become inadequate as an entity grows. Or credit limits may not be reviewed as circumstances change. Or if staff do not understand the importance of timely review of exception reports to correct errors, they may not perform the procedure, making the control ineffective. Refer to 'A word about collusion' on page 317 of this chapter. In a small firm with an owner-manager, the latter may be more able to override controls because the system of internal control is weaker. For instance, auditors may suggest that inventories be counted at month ends to ensure inventory records are accurate on a continuous basis. Management may decide that this would be too costly and rely only on year end counts. We shall see later that in a small owner-managed entity the owner-manager may be able to exercise more effective oversight than in a larger entity (see Case Study 8.1). Owner- managers may have other controls, such as good information systems, to enable effective oversight.