114 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, 27 115 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 116 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. 118 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 122 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.") 123 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. 124 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 143 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. 144 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: 145 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.