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CHAPTER 6
Internal Control Evaluation: Assessing Control Risk
LEARNING OBJECTIVES
Review
Checkpoints
Exercises
and Problems
Cases
1. Write an essay or memo explaining
primary and secondary reasons for
conducting an evaluation of a
client's internal control
structure.
1, 2, 3
29, 39, 55
2. Distinguish between management's
and auditors' responsibility
regarding a company's internal
control structure.
4, 5, 6
48
55
3. Define and describe the three basic
elements of an internal control
structure, and specify some of
their component characteristics.
7, 8, 9, 10,
11, 12
51
57
4. Identify and give examples of seven
internal control objectives, and
associate them with the five
management assertions in financial
account balances.
10
52, 53
56, 57
5. List and explain the control
procedures companies use to
achieve control objectives.
10, 11, 12,
13, 14, 15,
16, 17
52
6. Explain the phases of an evaluation
of control and risk assessment and
the documentation and extent of
audit work required.
18, 19, 20
49
28, 30, 31,
32, 33
7. Write procedures for an audit
program, following the general
form of a detail test of control
procedure.
21, 22
50, 51, 54
33
8. Define and explain reasonable
assurance and cost-benefit in the
context of control risk
assessment.
23, 24, 25
48
9. Adapt the concepts and processes of
control risk assessment to small
businesses.
26, 27
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POWERPOINT SLIDES
PowerPoint slides are included on the website. Please take special note of:
*
Phases of Risk Assessment Diagram
SOLUTIONS FOR REVIEW CHECKPOINTS
6.1
The primary reason for conducting an evaluation of a client's existing
internal control system is to give the auditors a basis for finalizing the
details of the account balance audit program--to determine the nature, timing
and extent of subsequent substantive audit procedures.
A secondary purpose for conducting an evaluation of internal control is to be
able to make constructive suggestions for improvements. Officially, the
profession considers these suggestions a part of the audit function and does
not define the work as a MAS consultation.
Another purpose of the evaluation is to report to management and the board of
directors or its audit committee any discovery of "any reportable conditions"
of internal control deficiencies.
6.2
A "substantive audit procedure" is any action (resembling a specific variation
of one of the seven general audit procedures) undertaken for the purpose of
producing evidence about a dollar amount of a disclosure that appears in the
financial statements under audit.
The nature of a procedure is its description--usually associated with one of
the seven general audit procedures. For example, the nature of a procedure may
be confirmation, document, vouching, etc.
The timing of a procedure is the period during which it is performed--usually
distinguished as interim (before the balance sheet date), year-end (on or
close to the balance sheet date), and subsequent (after the balance sheet
date).
The extent of a procedure is the number of details audited with it, or another
measure of intensity or frequency. Oftentimes, extent is measured by the
sample size.
6.3
A reportable condition is a control deficiency in the design or operation of
the internal controls that could adversely affect the client's ability to
account for transactions properly.
A material weakness in internal control is an extreme type of reportable
condition defined in auditing standards as a condition in which the specific
control procedures or the degree of compliance with them do not reduce to a
relatively low level the risk that errors or irregularities in amounts that
would be material to the financial statements being audited may occur and not
be detected within a timely period by employees in the normal course of
performing their assigned functions.
Business managers can make estimates of benefits to be derived from controls
and weigh them against the cost. Managers are perfectly free to make their own
judgments about the necessary extent of controls. Managers can decide the
degree of business risk they are willing to tolerate (refer to SAS 30, AU
642.05).
6.4
Management is responsible not only for the control structure that supports the
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production of financial statements, but also responsible for the internal
control that achieves all the other objectives of the business.
Management is responsible for "managing" internal control to achieve these
control objectives over and above the objectives related to external financial
reporting:
1.
2.
3.
4.
5.
6.5
Significant, managerial, and operating information reported internally is
accurate, reliable, and timely;
The activities of the organization are in compliance with policies,
plans, standards, and procedures, and with applicable laws and
regulations;
Resources are adequately protected;
Resources are acquired economically and used efficiently (or costeffectively); and,
The organization's plans, goals, and objectives are achieved.
External auditors' communications of reportable conditions and material
weaknesses are intended to help management carry out its responsibilities for
internal control monitoring and change.
Accountants in public practice may undertake engagements to design and install
control structures as MAS engagements.
6.6
Control risk is the probability that the client's internal control procedures
will fail to detect material errors and irregularities, provided any enter the
data processing system in the first place.
The seven general types of errors and irregularities are:
1.
2.
3.
4.
5.
6.
7.
6.7
Invalid transactions are recorded.
Valid transactions are omitted from the accounts.
Unauthorized transactions are executed and recorded.
Transaction amounts are inaccurate.
Transactions are classified in the wrong accounts.
Transaction accounting is incomplete.
Transactions are recorded in the wrong period.
Some of the important characteristics of "tone at the top" and control
environment:
Management philosophy and operating style
Ethical values and moral guidance communicated
throughout the organization by word and deed.
Company organization structure
Functioning of board of directors and audit committee
Methods of assigning authority and responsibility
Management's monitoring methods
Functioning of internal audit department
Personnel (human resource) policies and practices
External influences (e.g. regulation)
6.8
An auditor can find client's documentation of the accounting system in the:
Chart of accounts
Accounting manual--definitions and instructions about measuring and
classifying transactions
Computer systems documentation
Computer program documentation
Systems and procedures manuals
117
Flowcharts of transaction processing
Various paper forms
6.9
The audit trail is the set of accounting operations from transaction analyses
to reports. It starts with the source documents, proceeds to data entry, then
to transaction processing and posting to ledger accounts, then from ledger
accounts to the financial reports.
Auditors often follow this trail frontwards and backwards! They will follow it
backwards from the financial reports to the source documents to determine
whether everything in the financial reports is supported by appropriate source
documents. They will follow it forward from source documents to reports to
determine that everything that happened (transactions) got recorded in the
accounts and reported in the financial statements.
6.10
A "control environment" may consist of many things, including management's
attitude and behavior related to concern about accuracy, carefulness, and
honesty, management's methods of communicating responsibility and authority to
accounting personnel. In general a "control environment" is a setting that
affects all accounting operations and all transaction subsystems (like
"general controls" in an EDP setting).
The "accounting system" is a specific set of directions and procedures for
keeping records. Various policies and procedures are specified for performance
in order to achieve some control over data preparation, data entry,
transaction processing and report preparation and distribution.
The control procedures are specific procedures in which people review,
reperform, or supervise the work of other people. Controls can, of course, be
automated in a computer system.
Control objectives ensure that financial statements assertions are correct.
6.11
Four kinds of functional responsibilities that should be segregated:
1.
2.
3.
4.
6.12
Authorization to execute transactions.
Recording of transactions (bookkeeping).
Custody of assets.
Periodic reconciliation (comparison) of existing (real) assets to
recorded amounts.
Examples of periodic comparisons:
Count of cash on hand.
Reconciliation of bank accounts.
Count of securities.
Confirmation of accounts receivable.
Confirmation of accounts payable.
Physical count of inventory.
6.13
A company control procedure is an action taken for the purpose of preventing,
detecting, or correcting errors and irregularities in transactions.
6.14
Typical duties of computer personnel:
1.
2.
Systems analysis. Personnel will design and direct the development of new
applications.
Programming: Other personnel will actually do the programming dictated by
the system design.
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3.
6.15
Operating: Other people will operate the computer during processing runs,
so that programmers and analysts cannot interfere with the programs
designed and executed, even if they produce errors.
4.
Converting data: Since this is the place where misstatements and errors
can be made--the interface between the hardcopy data and the machinereadable transformation, people unconnected with the computer system
itself do the data conversion.
5.
Library-keeping: Persons need to control others' access to system and
program software so it will be used by authorized personnel for
authorized purposes.
6.
Controlling: Errors always occur, and people not otherwise connected with
the computer system should be the ones to compare input control
information with output information, provide for correction of errors not
involving system failures, and distribute output to the people authorized
to receive it.
The most significant separation of duties unique to computer systems are those
performed by the systems analyst, programmer, computer operator, and data base
administrator. The idea is that anyone who designs a processing system should
not also do the technical work, and anyone who performs either of these tasks
should not also be the computer operation when real data is processed.
6.16
A self-checking number is a two-part number consisting of a basic set of
digits followed by (or preceded by) a "check digit." The check digit is
determined by performing a mathematical calculation on the basic set of
digits, thus an erroneous basic number may be detected by a computer. A common
self-checking number is on every credit card number.
6.17
1.
Valid character tests
2.
Valid sign test
3.
4.
Missing data test
Sequence test
5.
Limit or reasonableness test
Customer name alphanumeric and customer
number numeric.
All amount fields positive, sales amount
greater than zero.
Bill of lading document number included.
Invoice numbers are in sequence and none
missing.
Total invoice less than $25,000.
6.18
Yes and no. The phase 1 understanding must always be followed by a control
risk assessment phase and documentation of control risk less than 100%
(compliance phase). However, compliance procedures are required only if an
auditor wants to lower the control risk assessment.
6.19
1.
Advantages of control questionnaire:
Easy to complete.
Checklist of questions.
Less chance of overlooking something important.
Disadvantages:
May contain numerous irrelevant questions.
Tendency to treat it like another form to fill out.
2.
Advantages of memorandum documentation:
Can explain the precise controls applicable to the particular
client. (precise tailoring)
Requires penetrating analysis.
Minimizes tendency toward perfunctory review.
Disadvantages:
Hard to write. Often lengthy.
Hard to revise in subsequent years.
3.
Advantages of flowchart:
119
Graphic presentation of systems.
Shows the steps required and the flow of forms and documents.
Easy to read and analyze.
Easy to update in subsequent years.
Disadvantages:
Takes some time to draw neatly.
6.20
A "bridge working paper" connects the control evaluation to the audit program
(subsequent procedures). It contains brief descriptions of control strengths
and weaknesses, implications for control or error related to accounts, and
statements of audit program procedures related to the strengths and
weaknesses. The procedures related to control strengths are test of control
procedures, and the ones related to control weaknesses are substantive
procedures.
6.21
A test of control procedure is an audit procedure designed to produce evidence
about the performance of a control procedure. A test of control procedure is a
two-part statement, consisting of:
Part One: Identification of a data population from which a sample of items
will be selected for audit.
Part Two: Expression of an action of either (1) determining whether the
selected items correspond to a standard or (2) determining whether the
selected items agree with information in another data population.
A test of control procedure may also consist of a direct observation of a
control activity that leaves no documentary trail.
6.22
"Inspection," in a test of control procedure, refers to auditors looking to
see whether client personnel stamped, initialed, or left other signs that
their assigned control procedures had been performed.
"Reperformance," in a test of control procedure, refers to auditors doing
again the control that was supposed to have been performed by the client
personnel (recalculating, looking up the right price, comparing quantities,
and so forth).
6.23
Reasonable assurance is closely related to cost-benefit analysis. By
definition, reasonable assurance recognizes that the cost of an organization's
internal control should not exceed the benefits obtained by the control.
Management is basically responsible for assessing the cost and benefit of
controls, hence their reasonable assurance. Auditors get into the act of
reasonable assurance assessment when they consider whether to make
recommendations about control improvement in a management letter.
6.24
Audit problems can arise when costly controls are necessary to prevent,
detect, and correct material misstatements in the accounts. Management may
believe the costs outweigh the benefits and appeal to "reasonable assurance"
to justify not having some controls. Nevertheless, control can therefore be
deficient, and the auditors will need to take the deficiency under
consideration when planning the substantive audit program.
6.25
A "dual-purpose test" serves the purposes of (1) obtaining evidence about a
client's control procedure performance [test of control compliance purpose],
(2) obtaining evidence to help detect material misstatements in account
balances and disclosures [substantive balance-audit purpose].
120
6.26
The general theory of internal control is applicable to both large and small
businesses as long as the underlying behavioral assumptions are met. However,
the fact that small businesses have only a few people usually means that the
general theory requirement of separation of duties is not satisfied, and the
general theory is less applicable as a practical matter.
The bureaucratic assumptions of strict separation of duties, a tight authority
structure, an extensive system of rules and files, and impersonality are
harder to satisfy in small businesses that have only a few employees operating
in an informal manner. When the assumptions cannot be observed to exist, then
an auditor must be careful not to rely blindly on the general theory.
6.27
The two main features of internal control in a small business are (1) the
small number of people engaged in the accounting and control systems, making
segregation of functional responsibilities very difficult, and (2) the active
involvement of the owner-manager in the accounting and control
responsibilities.
KINGSTON COMPANY CASE STUDY SOLUTIONS
6.28
6.29
6.30
Kingston Company Organization Chart
Kingston Company, Identification of Errors and Irregularities in Inventory
Issue and Sales Transactions.
and
Kingston Company: Specification of Controls to Handle these Errors and
Irregularities
NOTE TO INSTRUCTOR: THE SOLUTIONS TO THESE TWO QUESTIONS ARE COMBINED TO SHOW THE
SPECIFIC CONTROLS ALONGSIDE THE POSSIBLE ERRORS AND IRREGULARITIES. You may want to
tell students to combine the problems in this fashion.
6.29 and 6.30
Kingston Company
Possible Errors/Irregularities in Inventory Issues
and Sales Transactions
December 31, 2002
Transactions:
a.
Inventory issues (goods delivered to customers)
b.
Sales (sales invoices prepared)
1.
Invalid transactions may be recorded.
a.
Inventory issues: Goods may be shown as shipped/delivered to customers,
when in fact they have not been shipped.
CONTROL:
Prevention:
Detection:
Correction:
b.
Kingston shipping personnel are the ones who "show" shipment, and
they cannot get the goods until inventory stores gets invoice copy
authorization to move goods to shipping.
Shipping personnel can steal goods. If they show them as shipped,
the customer gets billed and can later complain about being
charged for goods not received. If shipping personnel do not
forward invoice Copy 4, the accounts receivable department will
investigate the status of old copies 1 and 2 held in the "pending
shipment file."
Customer complaints are handled by customer relations personnel
and not by shipping personnel.
Sales invoices may be prepared for goods no customer ordered.
121
CONTROL:
Prevention:
Detection:
Correction:
2.
Kingston's billing department controls the blank invoices and is
not supposed to make an invoice unless credit is approved or cash
is received and indicated on a customer order form. However, a
clerk could write a fictitious invoice.
Kingston's accounts receivable department should question and
investigate (using customer relations personnel) invoices with no
customer order attached. If the billing department destroys copies
1 and 2 (does not send them to accounts receivable, so no such
question will arise), then accounts receivable personnel should
still question the missing invoice when Copy 4 arrives from
shipping and there are no copies 1 and 2 in the "pending shipment
file."
Accounts receivable personnel, not billing personnel investigate
the missing documents.
Valid transactions are omitted from the accounts.
a.
Inventory issues: Shipping personnel ship/deliver goods to customers but
fail to forward invoice Copy 3 to inventory records for entry to reduce
the inventory. (Inventory records also produces the cost report for the
general ledger cost of goods sold entry.)
CONTROL:
Prevention:
Detection:
Correction:
b.
Kingston's inventory records personnel should account for the
numerical sequence of sales invoices.
Inventory personnel should investigate missing invoices in the
numerical sequence by inquiry with accounts receivable personnel.
A copy from accounts receivable can then be used by inventory
records to produce the inventory entry and the cost of goods sold
report.
Sales: Shipping personnel ship/deliver goods to customers but fail to
forward invoice Copy 4 to accounts receivable.
CONTROL:
Prevention:
Detection:
Correction:
Depends on shipping department personnel care to forward all
papers.
Kingston's accounts receivable personnel should investigate old
invoices in the "pending shipment file."
Investigation done by accounts receivable and customer relations
personnel and not by shipping personnel. If invoice Copy 3 was
sent to inventory records, a copy can be recovered to produce the
final billing to the customer (completion of invoice copies 1 and
2).
(Note: Students may point out that the accounts receivable department can just
destroy invoice copies 1, 2, and 4 and the customer order "for a friend." The
control is a check on numerical sequence by the general ledger department that
eventually gets invoices, and utilization of the telltale copy 3 in inventory
records.)
3.
Unauthorized transactions are executed and recorded
a.
Inventory issues: Inventory storeskeepers can steal goods.
CONTROL:
Prevention:
Detection:
Integrity of inventory personnel.
Kingston's perpetual inventory records will not be reduced (no
invoice Copy 3 to inventory records). The annual inventory count
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Correction:
b.
Sales: Customer orders are forwarded without credit approval.
CONTROL:
Prevention:
Detection:
Correction:
4.
will show shortages. (No other information available about
specific physical inventory actions.)
Adjust inventory in the accounts to agree with the physical count.
Diligence of sales clerks and credit manager to follow company
policy.
Since Kingston's policy is credit approval or cash in advance, the
billing personnel should raise the question of no credit approval
with the credit manager (not with the sales clerks, who could have
sent forward the unapproved order).
Billing department personnel should get approvals in order before
preparing an invoice, not the sales clerks or credit manager.
Transaction amounts are inaccurate.
a.
Inventory issues: Shipping personnel alter invoice copies 3 and 4 to show
a lesser (or greater) quantity than actually shipped to customer.
CONTROL:
Prevention:
Detection:
Correction:
b.
Integrity and care for accuracy by shipping personnel.
Kingston has no accounting or control procedures for timely
detection of such accuracy errors. However, if the customer is
overbilled, a complaint to the customer relations office would be
expected. Customers who received more than billed ("friends" of
dishonest shipping department personnel!?) would not be expected
to complain. Tough luck, Kingston!!
Kingston's annual physical inventory should show shortages, and
the general ledger adjustment will throw these losses into cost of
goods sold. Thus, the financial statements may not be misstated,
except for not showing details of "inventory shrinkage."
Sales: Invoice amounts are computed incorrectly with inaccurate arithmetic
or improper unit prices.
CONTROL:
Prevention:
Detection:
Correction:
Care taken by Kingston's accounts receivable personnel who
complete the invoices.
Customers may complain about overcharges to the customer relations
office, not to accounts receivable personnel. Undercharges may
never be detected.
Overcharges can be handled by credit memo initiated by the
customer relations personnel and approved by someone other than
accounts receivable personnel, like the treasurer. (Undercharges
are "self correcting" since the understatement of sales revenue is
offset by the understatement of "clerical error loss.")
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5.
Transactions are classified in the wrong account.
[Note: These errors may seem strange, but remember that the part of the case
described so far does not include any journal or ledger entries in accounts.]
a.
Inventory issues: The wrong goods might get sent to customers. (Inventory
stores might release Product X instead of Product Y, and the shipping
department personnel might not alter the invoice copies 3 and 4 to show
Product X.)
CONTROL:
Prevention:
Detection:
Correction:
b.
Sales: The wrong customer name or number might get put on an invoice,
eventually causing the wrong customer to get billed.
CONTROL:
Prevention:
Detection:
Correction:
6.
Care and diligence by inventory stores and shipping department
personnel.
Kingston's perpetual inventory records will not agree with
physical quantities on hand. If quantities become negative,
inventory personnel records personnel should investigate by have a
count performed by someone other than the inventory storeskeeper.
Kingston's annual physical inventory and comparison and correction
of the perpetual records offers the only chance for correction.
Care and diligence by sales clerks, billing clerks, and accounts
receivable personnel.
Kingston's customer charged in error will complain to the customer
relations office.
Investigation should result in credit to the wrongfully charged
customer and, hopefully, charge made to the right customer.
Investigation is done by customer relations personnel, not by any
of the persons who could make the error.
Transaction accounting is incomplete.
[Note: This part of the case does not describe accounting entries that could be
incomplete. Students may have a hard time thinking of these errors, using the
case material as source reference.]
a.
Inventory issues: Inventory issues (invoice Copy 3) used in inventory
recordkeeping to reduce the perpetual inventory records may not get into
the cost of goods sold report to reduce the general ledger balance of
inventory and charge the cost of goods sold.
CONTROL:
Prevention:
Detection:
Correction:
b.
Care taken by Kingston's inventory recordkeeping personnel.
Kingston's physical inventory should show shortages relative to
the general ledger balance.
The inventory-taking process should include reconciliation of the
physical inventory to the general ledger account, and adjustment
to the physical-count based valuation. The adjustment will correct
the earlier error.
Sales: Accounts receivable personnel may fail to post charges to some
customers even though the proper total is posted to the general ledger
accounts receivable control account.
CONTROL:
Prevention:
Kingston should have procedures for daily comparison of the total
of charges to customers' individual accounts and the total posted
to the general ledger accounts receivable control account.
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Detection:
Correction:
7.
Periodically, someone should reconcile the total of customers'
accounts to the general ledger control account.
If the totals are not equal, someone other than the accounts
receivable personnel should investigate the difference and adjust
the proper account.
Transactions are recorded in the wrong period.
a.
Inventory issues: Shipping department personnel put the wrong shipping
date on the bill of lading.
CONTROL:
Prevention:
Detection:
Correction:
Correction:
b.
Care taken by shipping department personnel.
Accounts receivable personnel should check the shipping date in
comparison to the invoice date and the current day.
Accounts receivable personnel should inquire of shipping and
determine the proper date.
Accounts receivable personnel should change a date later than the
current day to the proper shipping date (e.g. shipment noted as
July 10, when the current day is July 6, when accounts receivable
receives invoice Copy 4). [Note: A backdated shipping date of July
6 for an invoice dated July 10 should raise an immediate question,
because it is not supposed to be possible for shipping to get
goods on a date before the invoice was prepared.]
Sales: Sales could be dated earlier or later than the shipping date.
CONTROL:
Prevention:
Care taken by personnel. The Kingston accounting manual directs
sales recording by the date of shipment.
Detection:
Kingston's general ledger personnel should check the shipping date
in comparison to the invoice recording date, invoice, and current
day.
Correction: General ledger personnel should investigate date discrepancies and
date sales on the proper shipment date for recording in the
general ledger. Special care should be taken at financial
statement reporting dates (monthly, quarterly, annual).
6.31 Kingston Company Internal Control Questionnaire
(Note: Blank copy for handout copies is on following pages)
Internal Control Questionnaire--Sales Transaction Processing
Client
Kingston Company
Audit Date
Dec 31, 2002
Client Personnel Interviewed___________________________________
_______________________________________________________________
Auditor________________________ Date Completed_________________
Reviewed By____________________ Date Reviewed__________________
Answers
Environment:
1. Is the credit department independent of the sales
department?
2.
Are sales of the following types controlled by the
same procedures described below? Sales to
Yes. Sales in
marketing. Credit
in treasurer
department.
125
employees, COD sales, disposals of property, cash
sales and scrap sales.
Validity Objective:
3. Is access to sales invoice blanks restricted?
4. Are prenumbered bills of lading or other shipping
documents prepared or completed in the shipping
department?
Yes
Yes
Completeness Objective:
5. Are sales invoice blanks prenumbered?
6. Is the sequence checked for missing invoices?
7. Is the shipping document numerical sequence
checked for missing bills of lading numbers?
Yes
Yes
No.
Authorization Objective:
8. Are all credit sales approved by the credit
department prior to shipment?
9. Are sales prices and terms based on approved
standards?
10. Are returned sales credits and other credits
supported by documentation as to receipt,
condition and quantity, and approved by a
responsible officer?
Yes. Sales orders
are approved.
Yes. Approved
price list.
Yes, Treasurer,
customer
relations.
Accuracy Objective:
11. Are shipped quantities compared to invoice
quantities?
12.
Are sales invoices checked for error in
quantities, prices, extensions and footing,
freight allowances and checked with customers'
orders?
13. Is there an overall check on arithmetic accuracy
of period sales data by a statistical or productline analysis?
14. Are periodic sales data reported directly to
general ledger accounting independent of accounts
receivable accounting?
Classification Objective:
15. Does the accounting manual contain instructions
for classifying sales?
Yes. In shipping
area and by acct
receivable clerks.
Yes, But acct
receivable
accounting.
Yes. Marketing
Vice-Pres.
No.
Yes. Two product
lines, lumber and
hardware.
Accounting Objective:
16. Are summary journal entries approved before
posting?
Yes.
Proper Period Objective:
17. Does the accounting manual contain instructions to
date sales invoices on the shipment date?
Yes.
126
Internal Control Questionnaire--Sales Transaction Processing
(Blank Form for Students)
Client__________________________
Audit Date_________________________
Client Personnel Interviewed_________________________________________
Auditor_____________________________ Date Completed__________________
Reviewed By_________________________ Date Reviewed___________________
Answer
Question
Environment:
1.
Is the credit department
independent of the marketing
department?
2.
Are sales of the following types
controlled by the same procedures
described below? Sales to
employees, COD sales, disposals of
property, cash sales, and scrap
sales.
Validity Objective:
3.
Is access to sales invoice blanks
restricted?
4.
Are prenumbered bills of lading or
other shipping documents prepared
or completed in the shipping
department?
Completeness Objective:
5.
Are sales invoice blanks
prenumbered?
6.
Is the sequence checked for
missing invoices?
7.
Is the shipping document numerical
sequence checked for missing bills
of lading numbers?
Authorization Objective:
8.
Are all credit sales approved by
the credit department prior to
shipment?
9.
Are sales prices and terms based
on approved standards?
NA
Yes
No
Remarks
127
10.
Are returned sales credits and other credits supported by documentation as to
receipt, condition and quantity, and approved by a responsible officer?
Accuracy Objective:
11. Are shipped quantities compared to invoice quantities?
12.
Are sales invoices checked for error in quantities, prices, extensions and
footing, freight allowances and checked with customers' orders?
13.
Is there an overall check on arithmetic accuracy of period sales data by a
statistical or product-line analysis?
14.
Are periodic sales data reported directly to general ledger accounting
independent of accounts receivable accounting?
Classification Objective:
15. Does the accounting manual contain instructions for classifying sales?
Accounting Objective:
16. Are summary journal entries approved before posting?
Proper Period Objective:
17. Does the accounting manual contain instructions to date sales invoices on the
shipment date?
6.32
Kingston Company System Flowchart Documentation
The solution flowchart is Exhibit 6-11 in Chapter 6.
6.33
Kingston Company Control Evaluation: Bridge Working Paper
Relation to Problems 6.29 and 6.30: These problems required students to think
of possible errors and irregularities and specify controls to prevent, detect,
and correct them. The bridge working paper should coordinate with the control
strengths and weaknesses. The solution presented next relates to 6.29/6.30
through the errors and irregularities, as follows:
1a.
1b.
2a.
2b.
3a.
3b.
4a.
4b.
5a.
5b.
6a.
6b.
7a.
7b.
S-3 covers by requiring existence of an invoice Copy 4.
S-1 covers by requiring existence of a sales order.
not covered in the bridge working paper because it involves invoice copy
3 and files kept in inventory records department which is not in the case
description in this chapter
S-3 covers with procedure to scan the pending shipment file.
not covered in bridge W/P because it involves eventual physical inventory
observation, and inventory records are not in the case material in this
chapter
S-1 covers by procedure to look for credit approval
W-3 covers by expanding inventory observation substantive procedures.
S-2 covers with procedures to recalculate the math and vouch to the
authorized price list.
S-3 covers by including comparison of product descriptions on documents.
S-1 covers by including comparison of customer name on documents.
not in this bridge W/P
not in this bridge W/P
S-3 covers proper period recording.
S-3 covers proper period recording.
128
Bridge Working Paper
Index
By__________ Date__________
Reviewed__________ Date__________
Kingston Company
Credit Approval, Sales Processing, Shipment, and Delivery Control
December 31, 2002
Strength/Weakness
Audit Implication
Audit Program
S-1
Credit
approval on
sales order.
Credit authorization
reduces risk of bad debt
loss and helps check on
validity of customer
identification.
Select a sample of recorded
sales invoices, and look for
credit manager signature on
attached sales order. Make note
of missing sales orders, ones
not approved and compare to
customers' accounts receivable
for evidence of payment in
advance. Note correspondence of
customer name on papers.
S-2
Unit prices
are taken from
an authorized
list. (Later
personnel
recalculate
and check the
invoice
arithmetic.)
Prices are in accordance
with company policy,
minimizing disputes.
(Invoices are
mathematically accurate.)
Using the S-1 sample of sales
invoices, vouch prices used to
the price list. Recalculate the
math.
S-3
Sales are not
recorded until
goods are
shipped.
Invoices are
checked for
correct
product
descriptions
(by accounts
receivable
personnel).
Cutoff will be proper and
sales will not be
recorded too early. Sales
will describe products
accurately for later
inventory and sales
classification
accounting.
Using the S-1 sample of sales
invoices, compare the recording
date to the shipment date on
attached bill of lading and
invoice Copy 4. Compare ship
date to customer order date.
Compare the product descriptions
billed and shipped. (Also, scan
the "pending shipment" file for
old invoices that might
represent unrecorded shipments.)
W-1
Shipping
personnel have
transaction
alteration
(initiation)
authority to
change the
quantities on
invoices, as
well as
custody of the
Dishonest shipping
personnel can alone let
accomplices receive large
quantities and alter the
invoice to charge them
for small quantities. In
this system, sales and
accounts receivable would
be understated, and
inventory would be
understated.
The physical count of inventory
will need to be observed
carefully (extensive work) to
detect material misstatement, if
any.
129
goods.
SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS
6.34
a.
b.
c.
d.
Incorrect.
Correct.
Incorrect.
Incorrect.
Management letter suggestions are a secondary purpose.
Second GAAS field work standard.
This is a paraphrase of the third GAAS field work standard.
Communication of control-related matters is a secondary
purpose.
6.35
a.
b.
c.
d.
Incorrect.
Incorrect.
Correct.
Incorrect.
This
This
This
This
6.36
a.
Correct.
b.
c.
d.
Incorrect.
Incorrect.
Incorrect.
Segregation of functional responsibilities can be viewed as a
control procedure in general.
This is an environment characteristic.
This is an environment characteristic.
This is an environment characteristic.
a.
b.
Incorrect.
Correct.
c.
d.
Incorrect.
Incorrect.
a.
Incorrect.
b.
Incorrect.
c.
Incorrect.
d.
Correct.
a.
Incorrect.
b.
Correct.
c.
Incorrect.
d.
Incorrect.
6.40
a.
b.
c.
d.
Incorrect.
Incorrect.
Correct.
Incorrect.
The
The
The
The
6.41
a.
b.
c.
d.
Correct.
Incorrect.
Incorrect.
Incorrect.
The control group monitors error report.
Systems analyst designs systems.
Supervisor of operations is a computer room employee.
Programmer writes code.
6.42
a.
b.
c.
Incorrect.
Correct.
Incorrect.
Record totals suggest dollar amounts.
Hash totals involve nondollar totals.
Data totals suggest dollar amounts.
6.37
6.38
6.39
is not a primary IC objective.
is not a primary IC objective.
relates to the primary objective of safeguarding assets.
is not a primary IC objective.
This describes an audit procedure.
This is one general way to define the purpose of control
procedures.
This is a definition of an accounting system.
This is a description of one of the elements of the control
environment.
The completeness objective deals with recording all valid
transactions.
The authorization objective deals with seeing that
transactions are authorized.
The proper period objective deals with recording transactions
in the correct accounting period.
The validity objective deals with the valid, documented
nature of recorded transactions.
The validity objective deals with the valid, documented
nature of recorded transactions.
The classification objective deals with getting accounting
entries in the right accounts.
The accuracy objective deals with whether the numbers in
transactions are correct.
The completeness objective deals with recording all valid
transactions.
programmer creates the code.
DP manager is the executive.
systems analyst designs systems.
internal auditor monitors systems.
130
d.
Incorrect.
Field totals suggest dollar amounts.
6.43
a.
b.
c.
d.
Incorrect.
Incorrect.
Incorrect.
Correct.
Wrong arithmetic, see d.
Wrong arithmetic, see d.
Wrong arithmetic, see d.
Cash deposits + discounts = payments credit to receivables.
6.44
a.
Incorrect.
b.
Correct.
c.
Incorrect.
d.
Incorrect.
The absolute amount of cost is irrelevant. Year-end
substantive work usually costs more than control evaluation
work.
The year-end cost savings exceeds the control evaluation
cost.
Whether the cost of control work exceeds (or does not exceed)
the cost of year-end work is irrelevant. Efficiency relates
to the cost that can be saved as a result of control
evaluation work.
Efficiency is not achieved by cost reductions being less than
control work cost.
a.
Incorrect.
b.
Correct.
c.
Incorrect.
d.
Incorrect.
a.
Correct.
b.
Incorrect.
c.
Incorrect.
d.
Incorrect.
a.
Incorrect.
b.
Incorrect.
c.
Incorrect.
d.
Correct.
6.45
6.46
6.47
The narrative is the documentation result of obtaining
evidence.
The ICQ is a device for collecting evidence in the form of
answers to control questions.
A flowchart is the documentation result of obtaining
evidence.
(This is the throwaway!) The working papers are the
documentation of the evidence obtained.
The bridge working paper connects control evaluation findings
of strengths to compliance procedures for testing the
strengths, and control evaluation findings of weakness to
suggestions for substantive procedures.
Control objectives are only implicit in the bridge working
paper.
Control objectives are only implicit in the bridge working
paper.
Assertions are related directly to substantive procedures and
not to compliance procedures.
Substantive procedures produce evidence about financial
statement assertions.
Company control procedures accomplish company control
objectives.
Analytical review is not accomplished with compliance
procedures.
Compliance procedures produce the evidence about actual
operation of company control procedures.
SOLUTIONS FOR EXERCISES AND PROBLEMS
6.48
Costs and Benefits of Control
A.
Porterhouse management may hesitate because its expected loss from bank
accounting errors may be less than $10,000, or the expected benefit
(reduction of the expected loss) by $10,000 or more might be in doubt.
Bank accounting is generally very accurate and further analysis might
confirm management's hesitation.
131
B.
Josh Harper should install the steel doors and burglar bars but not hire
the armed guards.
Cost-Benefit of Doors and Bars
Benefit $500,000 loss x 90% elimination
Qualitative benefit--The company is no longer a
"push-over target" for thieves
Direct cost
Direct cost-subsequent maintenance
Qualitative costs
$450,000
Unknown
($25,000)
small
none (?)
Net benefit estimated
$425,000
Cost-Benefit of Armed Guards
Benefit
Qualitative benefit--no longer a "push-over
target" for thieves
Direct cost
Direct cost--subsequent inflation
Qualitative cost--possibility of someone
being killed or wounded in robbery attempt;
social and insurance costs
$500,000
Unknown
(75,000)
some expected
remote, but high
Net benefit estimated
$425,000
Marginal Analysis (Measurable Information)
1.
If armed guards are hired, no more loss reductions (benefit) is
available to justify the additional $75,000 direct cost.
2.
Doors and
Bars Only
Loss expected without
control
Remaining expected loss
with control
Benefit (expected loss
reduction)
Cost of control
Net benefit
Guards
Only
Both
Neither
500,000
500,000
500,000
500,000
50,000
-0-
-0-
500,000
450,000
25,000
500,000
75,000
500,000
100,000
-0-0-
425,000
425,000
400,000
-0-
The armed guards control has two adverse factors not expected with the
doors/bars control: (1) Inflation in guard costs will probably outpace
the doors/bars maintenance costs and (2) The possibility of a shooting
incident on company property is not very appealing.
C.
Both of the manager's assertions are justifiable.
1.
Cost-Benefit of the New Arrangement
Benefits
4 meals @ $6 x 260 days
10 meals @ $6 x 104 days
Customer satisfaction
Possible reduction of exposure to theft loss to
collecting cashier at end of food line (former
arrangement)
6,240
6,240
some
*
132
12,480
*
The control is cost-beneficial without considering whether theft of
cash had occurred.
Costs
New salary, annual
New adding machine, 5-year life
Employee dissatisfaction
10,000
500
none expected
TOTAL COST
Net benefit, first year
Net benefit, succeeding years
**
10,500
1,980
2,480**
Assuming inflation in food prices tends to offset future salary
increases.
2.
D.
6.49
The control is better because
(i)
The recording duty and cash custody are separate. Running the
cash register amounts to authorizing and recording
transactions for all practical purposes, and under the former
arrangement this person also handled the cash. The cashier
could have failed to ring up a sale and just pocketed the
money.
(ii) The manager can compare the internal adding machine cumulative
total to the cash register total for correspondence of
amounts. A theft would require collusion of both persons.
The accountant should not express any opinion on management's statement.
You could disclaim any opinion about the statement. You could give advice
to the manager about the analysis. Still, the manager is responsible for
risk analysis and cost-benefit decisions.
Cash Receipts Control
a.
See the System Flowchart on the next page.
Students could be asked to prepare a bridge working paper for parts b and
c.
b.
The main "material weakness" lies with Sue Kenmore's cash handling
duties. She could allow more discount than the customer actually took or
approve a credit for a return that was not made in order to (1) take cash
for herself and (2) keep the customer's account properly stated. This
weakness is magnified by the fact that no one reviews the amount or
pattern of discounts and return allowances for accuracy or
reasonableness.
An auditor might suspect that Sue has taken cash in this manner from a
review of the sales statistics. Observe the following percent
relationship of discounts and allowances:
Recorded
1996
1997
1998
1999
2000
2001
Percent of Sales
3.03%
2.96
2.95
3.10
3.97
5.02
$
Amount
500
550
520
570
950
1,480
@ 3%
$ 495
557
528
551
719
884
Difference
$
5
( 7)
( 8)
19
231
596
133
2002
5.99
2,230
1,117
1,113
The normal discount of 3% is exceeded by 2000 (when Sue was first
employed). The increasing amount of return credits could account
legitimately for the difference, but it looks like $1,940 may have been
stolen since 2000.
Also, Sue seems to enjoy an expensive automobile, which might be
considered beyond the normal means of someone who can't afford to go to
college.
c.
This is a small business, a fact that should be considered when making
recommendations.
1.
Sue Kenmore has an improper combination of duties--custody of cash
plus a major record-keeping responsibility. Someone else (Janet
Bundy) should receive cash in the store, prepare the remittance list
and prepare the bank deposit, especially if Sue continues to keep
the cash receipts journal.
Sue can post the cash receipts journal from a copy of a remittance
list or daily cash report (including sales not on account) prepared
by Janet. Then Sue will not have access to the cash. Sue also has
authority to approve discounts and allowances. There may be a
question of whether she is competent (qualified, experienced) to do
so. This function may be left with Sue so long as Janet is
responsible for the remittance list. If Sue is embezzling money, her
motivation to approve erroneous discounts will be removed because
she no longer can handle the money.
FIGURE 6.49
SYSTEM FLOWCHART--SALLY'S CRAFT CORNER on next page
134
135
2.
3.
6.50
David Roberts should be assigned the duty (supervisory) of reviewing
discounts and allowances for reasonableness and proper approval. He
is experienced and is in charge of supervising the record keeping.
The cash receipts journal appears to be a superfluous record. A
daily cash report of over-the-counter sales and collections on
account (mail and in the store) could serve in its place.
Tests of Control Procedure Specification
1.
Credit approval
Control Objective: Authorization of credit sales transactions.
Test of Control Procedure: Select a sample of recorded sales invoices
from the sales journal. Note the date, number, amount and customer name.
Find the Copy 2 in the accounts receivable department chronological
(date) file and read (vouch) the customer order to see if credit was
approved according to company policy.
2.
Sales transaction recording
Control Objective: Validity of recorded sales.
Proper period recording of sales.
Test of Control Procedure: Select a sample of recorded sales invoices
from the sales journal (same sample as in a). Note the date, number,
physical quantity and customer name. Find the Copy 3 in the billing
department file for the recording date. Compare (vouch) the quantities
noted in Copy 3. Note the shipping document number. Find the bill of
lading in the shipping department numerical file. Compare (vouch) the
quantity shipped, date and customer name.
3.
Pricing and mathematical accuracy
Control Objective. Mathematical accuracy of recorded sales.
Authorized prices used on invoices.
Test of Control Procedure: Select a sample of recorded sales invoices
from the sales journal. (Same sample as in a and b). Note the date,
invoice number, amount and customer name. Find Copy 2 (because it is the
copy used in the accounting entry) in the accounts receivable department
file (same copy as found in a). Look up the correct unit price in the
catalog and recalculate the invoice arithmetic.
4.
Classification of sales.
Control Objective. Classification of sales.
Test of Control Procedure. Select a sample of recorded sales from the
sales journal (same sample as in a, b, and c). Find Copy 2 (same as a and
c). Knowing the names of the subsidiary companies, determine whether
Copies 2 with those names are coded "9" and so entered in the sales
journal, and that none are not coded "9" and entered as sales to
outsiders.
6.51
Test of Control Procedures and Errors/Fraud
1.
Controlled access to blank sales invoices.
a.
Observation. Visit the storage location yourself and see if
unauthorized persons could obtain blank sales invoices. Pick some up
136
b.
sale.
of the other
department.
other
2.
Sales invoices check for accuracy.
a.
Vouching and Recalculation. Select a sample of recorded sales
invoices and vouch quantities thereon to bills of lading, vouch
prices to price lists, and recalculate the math.
b.
Errors on the invoice could cause lost billings and lost revenue or
overcharges to customers which are not collectible (thus overstating
sales and accounts receivable).
3.
Duties of accounts receivable bookkeeper.
a.
Observation and Inquiry. Look to see who is performing bookkeeping
and cash functions. Determine who is assigned to each function by
reading organization charts. Ask other employees.
b.
4.
6.52
yourself to see what happens.
Someone could pick up a blank and make out a fictitious
However, getting it recorded would be difficult because
controls such as matching with a copy from the shipping
(Thus a control access deficiency may be compensated by
control procedures.)
The bookkeeper might be able to steal cash and manipulate the
accounting records to give the customer credit and hide the theft.
(Debit a customer's payment to Returns and Allowances instead of to
cash, or just charge the control total improperly.)
Customer accounts regularly balanced with the control account.
a.
Recalculation. Review the client's working paper showing the
balancing/reconciliation. Do the balancing yourself.
b.
Accounting entries could be made inaccurately or incompletely and
the control account may be overstated or understated.
Control Objectives and Procedures Associations
Required:
a.
Opposite the examples of transaction errors lettered a-g, write the name
of the control objective clients wish to achieve to prevent, detect, or
correct the error.
b.
Opposite each numbered control procedure, place an "X" in the column that
identifies the error(s) the procedure is likely to control by prevention,
detection, or correction.
137
EXHIBIT 6.52-1
a.
"Validity"
b.
"Completeness"
c.
"Authorization"
d.
"Accuracy"
e.
"Classification"
f.
"Accounting"
g.
"Proper period"
Sales recorded, goods not shipped
Goods shipped, sales not recorded
Goods shipped to a bad credit risk customer
Sales billed at the wrong price or wrong quantity
Product A sales recorded as Product line B
Failure to post charges to customers for sales
January sales recorded in December
CONTROL PROCEDURES
1.
Sales order approved for credit
X
2.
Prenumbered shipping doc prepared, sequence checked
3.
Shipping document quantity compared to sales invoice
4.
Prenumbered sales invoices, sequence checked
X
5.
Sales invoice checked to sales order
X
6.
Invoiced prices compared to approved price list
7.
General ledger code checked for sales product lines
X
8.
Sales dollar batch totals compared to sales journal
X
9.
Periodic sales total compared to same period
X X
X
X
accounts receivable postings
10.
X X
X
Accountants have instructions to date sales on the
date of shipment
X
11.
Sales entry date compared to shipping doc date
X
12.
Accounts receivable subsidiary totaled and
reconciled to accounts receivable control account
13.
X X
X
Intercompany accounts reconciled with subsidiary
company records
14.
Credit files updated for customer payment history
15.
Overdue customer accounts investigated for collection
X
X
X
X X
X
138
6.52
a.
EXHIBIT 6.52-1 Blank form for Students
Sales recorded, goods not shipped
b.
Goods shipped, sales not recorded
c.
Goods shipped to a bad credit risk customer
d.
Sales billed at the wrong price or wrong quantity
e.
Product line A sales recorded as Product line B
f.
Failure to post charges to customers for sales
g.
January sales recorded in December
CONTROL PROCEDURES
1.
Sales order approved for credit
2.
Prenumbered shipping doc prepared, sequence checked
3.
Shipping document quantity compared to sales invoice
4.
Prenumbered sales invoices, sequence checked
5.
Sales invoice checked to sales order
6.
Invoiced prices compared to approved price list
7.
General ledger code checked for sales product lines
8.
Sales dollar batch totals compared to sales journal
9.
Periodic sales total compared to same period
accounts receivable postings
10.
Accountants have instructions to date sales on the
date of shipment
11.
Sales entry date compared to shipping doc date
12.
Accounts receivable subsidiary totaled and
reconciled to accounts receivable control account
13.
Intercompany accounts reconciled with subsidiary
company records
14.
Credit files updated for customer payment history
15.
Overdue customer accounts investigated for collection
139
6.53
Control Objectives and Assertions Associations
For each error/control objective, identify the financial statement assertion
most benefited by the control. (Based on Exhibit 6-5 in Chapter 6.)
Assertions
a. "Validity"
Sales recorded, goods not shipped
Existence/occurrence
Rights/obligations
b. "Completeness"
Goods shipped, sales not recorded
Completeness
Rights/obligations
c. "Authorization"
Goods shipped to a bad credit
risk customer
Valuation
d. "Accuracy"
Sales billed at the wrong price
or wrong quantity
Valuation
e. "Classification"
Product A sales recorded as
Product line B
Presentation/
disclosure
f. "Accounting"
Failure to post charges to
customers for sales
Presentation/
disclosure
also Valuation OK
g. "Proper period"
January sales recorded in December
Existence/occurrence
6.54
Client Control Procedures and Audit Test of Control Procedures
For each client control procedure numbered 1-15, write an auditor's test of
control procedure that could produce evidence on the question of whether the
client's control procedure has been installed and is in operation.
Sales Invoice Sample:
Select a sample of random numbers representing
recorded sales invoices, and
1(a). Inspect the attached sales order for credit approval signature.
1(b). Trace customer to up-to-date credit file/information underlying the
credit approval.
14.
Note whether credit files are updated for customer payment history.
2.
Inspect the attached shipping document for (i) existence, and (ii)
prenumbering imprint.
3.
Compare billed quantity on sales invoice to shipped quantity on shipping
document.
4.
Find the sales invoice associated with the random number (failure to
find means an invoice wasn't recorded). Alternatively, use computer to
add up the recorded sales invoice numbers and compare to a sum of digits
check total.
5.
Compare sales invoice to sales order for quantity, price, and other
terms.
6.
Compare prices on sales invoice to approved price list.
7.
Check product line code for proper classification compared to products
invoices.
11.
Compare invoice date to shipping document date.
140
Other
2.
2.
2.
2.
8.
9.
10.
12.
13.
14.
15.
Count the number of shipping documents (subtract beginning number from
ending number) and compare to same-period count of sales invoices (to
look for different number of documents).
Select A sample of random numbers representing shipping documents and
look for them in the shipping document file.
Computer-scan the shipping document file for missing numbers in
sequence.
Use computer to add the shipping document numbers entered in the files
and compare to a computed sum of digits check total.
Find client's sales dollar batch totals, recalculate the total, and
compare to sales journal of the relevant period.
Use the same sales dollar batch totals for comparison to separate total
of accounts receivable subsidiary postings, if available.
Study the accounting manual and make inquiry about accountants'
instructions to date sales on date of shipment.
Obtain client's working papers showing A/R subsidiary total reconciled
to A/R control account. Alternatively, add up the subsidiary and compare
to the control account.
Obtain client's working papers showing reconciliation of intercompany
receivables and payables for sales and purchases. Alternatively, confirm
balances with subsidiaries or other auditors.
Select a sample of credit files and trace to customers' accounts
receivable, noting extent of up-date for payment history.
Study client correspondence on investigation and collection efforts on
overdue customer accounts, noting any dispute conditions. If no effort
is made, follow up overdue accounts with audit procedures (confirmation,
determine existence of debtor, directories, etc.)
SOLUTIONS FOR DISCUSSION CASES
6.55
Obtaining a "Sufficient" Understanding of Control
Martin is not correct in asserting that GAAS requires reviews and tests of
control in all audits. Reviews and obtaining and documenting an understanding
are necessary, and Jones may not be suggesting that no work at all be done on
becoming acquainted with the clients' control structures. Martin has
overlooked the common-sense (and GAAS) idea that tests of controls need to be
done only on those controls on which the auditor believes to be strong to
reduce the initial control risk assessment.
Martin appears to be proposing that if a partner wishes to extend the
substantive procedures and "act as if the control risk were high," he should
be free to do so. Under GAAS, this is OK.
This is a common problem in practice. Many small-client audits may be
accomplished through extensive substantive procedural work, making up for
little or no work on control structures. The trade-off is the time and cost
involved in performing test of control work against the reduction in
substantive procedure work. If the latter cannot be reduced much under any
circumstances, then a lot of work on internal control may be uneconomical.
6.56
Starting the "Logical Approach"
Identification of errors or irregularities and specification of accounts
affected.
141
For each of the classes of transactions, the possible errors or irregularities
can be expressed in general in terms of the seven control objective
categories. Here's an expression of them, and you can guide students'
suggestions to fit the list.
Possible
1.
2.
3.
4.
5.
6.
7.
Errors and irregularities
Invalid transactions are recorded.
Valid transactions are omitted from the accounts.
Unauthorized transactions are executed and recorded.
Transaction amounts are inaccurate.
Transactions are classified in the wrong accounts.
Transaction accounting is incomplete.
Transactions are recorded in the wrong period.
Students might need to think more specifically about which accounts could be
affected.
a.
Credit sales transactions
*
Sales revenue
*
Sales discounts
*
Accounts receivable
*
Inventory/Cost of Goods Sold
b.
Raw materials purchase transactions
*
Purchases
*
Inventory
*
Cost of goods sold
*
Accounts payable
c.
Payroll transactions
*
Payroll expense
*
Labor and overhead in inventory/cost of goods sold
*
Accrued payroll liabilities
*
Pension, profit sharing-based expenses and liabilities
d.
Equipment acquisition transactions
*
Fixed assets
*
Accumulated depreciation
*
Depreciation expense
*
Overhead in inventory/cost of goods sold
*
Gain on disposition
e.
Cash receipts transactions
*
Cash
*
Accounts/notes receivable
*
Sales
*
Other income
f.
Leasing transactions
*
Property, plant and equipment
*
Depreciation expense
*
Overhead in inventory/cost of goods sold
*
Interest expense
*
Accrued interest payable
*
Long-term debt (lease obligation)
*
Current portion of long term debt
g.
Dividend transactions
*
Liability for dividends declared
*
Retained earnings
*
Dividends declared/paid
h.
Investment transactions (short term)
*
Cash
*
Marketable securities
*
Dividend, interest income
*
Accrued interest receivable
142
*
6.57
Gain/loss on disposition
Simon Blfpstk Construction Company--Material Weakness in Internal Control
The discussion could take several directions, including some or all of the
following:
1.
Material Weakness. The facts seem to suggest "a condition in which
specific control features (few or none are described) or the degree of
compliance with them do not reduce to a relatively low level the risk
that errors or irregularities in amounts that could be material to the
financial statements may occur and not be detected within a timely period
by employees in the normal course of performing their assigned
functions." Gault has authority and influence over too many interrelated
activities. Nothing he does seems to be subject to review or supervision.
He even is able to exclude the internal auditor.
An identification of the potential irregularities will illustrate the
misdeeds he can perpetrate almost single-handedly.
2.
Potential irregularities include:
a.
Gault can collude with customers to rig low bids and take kickbacks,
thereby depriving the company of legitimate revenue.
b.
Gault can direct purchases to favored suppliers, pay unnecessarily
high prices and take kickbacks. He might even set up a controlled
dummy company to sell overpriced materials to the company. No
competitive bidding control prevents these activities.
c.
Gault, through the control of physical inventory, can (i) remove
materials for himself and (ii) manipulate the inventory accounts to
conceal shortages.
d.
Gault can order truck shipping services for his own purposes and
cause the charges to be paid by the company.
e.
Gault can manipulate the customer billing (similar to a above) to
deprive the company of legitimate revenue while taking an
unauthorized commission or kickback.
3.
Almost every desirable characteristic of good internal control has been
circumvented:
a.
Segregation of Functional Responsibilities. Gault has authorization
and custodial responsibilities.
b.
Authorization, Supervision. Gault is apparently subject to no
supervision or review. The accounting staff is probably powerless to
challenge transactions because of Simon's apparent approval of
Gault's powers.
c.
Controlled Access. The whole situation gives Gault access to
necessary papers, records, and assets to carry out his one-man show.
d.
Periodic Comparison. No one else apparently has any access to the
materials inventory in order to conduct an actual count for
comparison to the book value (recorded accountability) of the
inventory.
6.58
The question requires one to think about the reasons audit standards are created and
evaluate them critically. Points that can be raised include:
a) Financial statements are management’s responsibility, but the auditor uncovers
facts and knowledge that can be relevant to management is discharging this
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responsibility so it is beneficial to communicate these. This might be viewed as
closing an aspect of the ‘expectation gap’, since management can correct these
deficiencies while auditors cannot
b) Issues that can be discussed include auditor’s liability, confidentiality,
internal politics at the client organization, etc.
c) See part (b). Also one can discuss costs, responsibility for the comments, lack
of privilege in a potential lawsuit, etc.
6.59
The case raises a number of corporate governance issues in a small, private
corporation.
Some of the issues to analyze and advise R. Liu on include:
-her responsibilities concerning the prior year’s financial statements distributed
to shareholders, use of her review engagement report
-her role in corporate governance in protecting the interest of the minority
shareholders
-various events that require professional skepticism, such as the consultant’s
report supporting the executive compensation and the compensation ultimately paid
-legal liability of the PSI executives should the minority shareholders take action
-potential fraud and definite lack of control over the salary amount paid to the
CFO, reporting to the President
-concern about the President’s knowledge and complicity in these payments, creating
questions about management’s good faith and her ability to provide assurance,
especially at the audit level
-other valid points
6.60
The question asks one to distinguish the objective of internal vs. external auditor
regarding internal control. Perspectives that can be taken are that internal control
is a part of management and thus its main concern is to promote the successful
operation of the company, such as meeting cash flow and profit targets, while
external auditors have the objective of providing an independent opinion on whether
management’s report of its operating results is fair and in accordance with
generally accepted accounting principles.
6.61
The purpose of the question is to consider how accounting arises from the operating
realities of the business and the kinds of information the business need to track to
ensure its success, how errors in tracking information can occur and how errors can
be controlled procedurally.
a) This part requires one to envision the revenue generating activities and the
procedures that would need to be followed to capture revenue data for managing the
business successfully.
b) This part requires one to consider a list of various error types and how these
might occur in a specific business’s transactions and recording.
c) This part requires one to create control procedures by considering the kinds of
error that can occur, what business factors make these errors possible and determine
how likely they are to occur, and what practical procedures could be implemented
that would cost-effectively reduce the risk of them occurring or going undetected
A variety of valid responses can be generated for each of the business models given
in the question.
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6.62
The case sets out the parameters of a new business and requires one to design the
sales and delivery systems. This can be done is a major project, or a full class
discussion.
Various approaches can be taken to designing the systems and reports. A general
approach is outlined as follows.
Consideration needs to be given to the nature of the transactions and the critical
success factors of the business in identifying information needs. Consideration
needs to be given to risks - what can go wrong, how can money be lost or stolen, how
can customer service fail to meet customers’ expectations, etc. - and controls need
to be designed to reduce these risks to protect the business assets and ensure its
success as a sales operation. The control procedures described in the chapter
provide a rich menu of choices of control techniques to draw from. The new company’s
strategic focus of creating a ‘destination shop’ marketing web portal is an
important aspect of designing effective systems, controls and financial reports.
6.63
This question reinforces the purpose of internal controls by linking control
objectives to financial statement assertions. It may be a helpful exercise to think
of the assertions in terms of an error that has occurred, for example incompleteness
of sales arising from delivering books to a customer on credit and failing to enter
the sale and issue an invoice.
6.64
a) The question requires identifying or generating a periodic comparison procedure
that matches the accounting records listed to independent evidence of their
existence and valuation
b) Frequency recommendations require assumptions to be stated about costs and
benefits of the available comparison procedure, which depend on availability of
independent evidence (nature and timing, e.g. bank statements are usually available
monthly, T-4 summaries are prepared annually), how time consuming the comparison is,
whether it can be automated, how critical the control is to the business assets,
etc.
6.65
The question requires one to apply an understanding of the nature and timing of
performing audit work, or the ‘Phases’ as defined in the chapter, to predict in
which audit Phase various types of knowledge, evidence, errors or problems might
most likely be uncovered. Various responses are possible, so reasons to support
one’s responses are integral to assessing their validity.
A possible response, assuming three Phases are used to assess control risk:
1. Phase 1 - system documentation
2. Phase 2 - control risk assessment
3. Phase 2 - control risk assessment
4. Phase 2 - control risk assessment
5. Phase 3 - control testing or assessing material control weaknesses
6. Phase 3 - control risk assessment or assessing material control weaknesses
7. Phase 1 - system documentation
Assumptions and rationales for these responses would also be required
6.66
The case raises control issues that arise in not-for-profit organizations. It
requires one to think beyond the standard profit and loss accounting issues to
consider a situation where the goal is a social service. Some possible response
points are as follows:
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a) CHS’s system of recording donations on pre-numbered receipts, control over
issuing blank receipts and reconciliations of receipts issued to cash received can
be described. The CHS financial statements would be reviewed by CHS’s boards of
governors who take responsibility for the propriety of CHS’s financial transactions.
Some charitable organization also make their financial statements public. Also,
there are government requirements for charities to file information documents
provide governance over the organization’s activities.
b) Identification, documentation and testing of the types of procedures noted above
can be described in detail and consideration given to their impact on auditing
procedures
6.67
The case sets out details of a capital asset recording system
a) Requires a ‘walk-through’ procedure to be designed and its role in documenting
the system to be explained.
b) Various control tests can be created based on the case facts.
6.68
The question raises issues of whether external audits are an aspect of internal
control. A thought exercise that might be useful here would be to consider the
difference between identical companies where one has an external audit and the other
does not. What differences would it make? One point is that knowing one’s work is
going to be verified provides more incentive to do the work properly and thus
strengthens control. From management and corporate governance perspective, this can
be a value provided by an external audit. From the external auditor’s perspective,
however, this value is not relevant to the audit plan. The external auditor must
assess controls, which needs to be based on documentation of systems and assessment
of the adequacy of controls.