Chapter 3: INTERNAL CONTROL

I.

RIGH/ WRONG - EXPLANATION

1. .While conducting an audit, auditors always pay attention to the control activities that aims to prevent
or detect mistatements in financial statements.
2. Establishing and maintaining internal control are the responsibility of shareholders.
3. .Internal control is generally not effective in preventing fraud from senior executives of the company.
4. Internal audit function is an important component of internal control.

II.
CASES
1. At a movie theater, a cashier has undertaken the task of collecting the money and selling the ticket by
using the ticket machine for continuous order. When entering the theater, viewers present the ticket for
a doorman staff far from ticket selling room about 30 meters. The doorman staff tear ticket in half, the
other half is put in a locked box.
a. Indicate which control procedures are implemented in the money collection phase?
b. Suppose the cashier and the doorman staff collusing to embezzling money, what behavior they could do?
c. With the same supposition above, suggest control activities can detect that embezzlement.
2. You are responsible for the audit of a Major Steel Fabrication Company. Most of the companys
customers are development or construction companies involved in the building of shopping centres, office
complexes, warehouses and other large scale building constructions.
During the planning stage, you observe that the building industry is in period of severe decline. You note that this
increase the risk associated with the misstatement of several material account balances, including the risk of not
identifying and appropriately accounting for potential bad debts. The companys credit manager, appointed near
the beginning of the financial year, regularly reviews the aged list of trade receivables. You have determined,
provided this procedure is effective, that it is the only internal control specifically addressing this significant risk
upon which you could place reliance.
Required:
a) List, in point form, all the tests of controls you consider nessesary to determine the likely effectiveness of
this control.
b) Recommend additional practical and effective internal control procedures the company could introduce to
mitigate this risk.
3. The following questions deal with deficiencies in internal control. Choose the best response.
a. Which of the following is an example of an operation deficiency in internal control?
(1) The company does not have a code of conduct for employees to consider.
(2) The cashier has online ability to post write-offs to accounts receivable accounts.
(3) Clerks who conduct monthly reconciliation of intercompany accounts do not understand the nature of
misstatements that could occur in those accounts.
(4) Management does not have a process to identify and assess risks on a recurring basis.
b. A material weakness in internal control represents a control deficiency that
(1) more than remotely adversely affects a companys ability to initiate, authorize, record, process, or report
external financial statements reliably.
(2) results in a reasonable possibility that internal control will not prevent or detect material financial statement
misstatements.
(3) exists because a necessary control is missing or not properly designed.
(4) reduces the efficiency and effectiveness of the entitys operations.
c. An auditor of a large public company identifies a material weakness in internal control. The auditor
(1) will be unable to issue an unqualified opinion on the financial statements.
(2) must issue a qualified or disclaimer of opinion on internal control over financial reporting.
(3) may still be able to issue an unqualified opinion on internal control over financial reporting.

(4) must issue an adverse opinion on internal control over financial reporting.
d. When a nonpublic company auditors tests of controls identify deficiencies in internal control over financial
reporting, the auditor
(1) must communicate to management all deficiencies identified.
(2) must communicate both significant deficiencies and material weaknesses to those charged with governance.
(3) may communicate orally or in writing to the board all significant deficiencies and material weaknesses
identified.
(4) must issue an adverse opinion on the financial statements.
4. The following questions deal with assessing control risk in a financial statement audit. Choose the best
response.
a. The auditors tests of controls revealed that required approvals of cash disbursements were absent for a large
number of sample transactions examined. Which of the following is least likely to be the appropriate auditor
response?
(1) The auditor will communicate the deficiency to those charged with governance.
(2) The auditor will increase the planned detection risk.
(3) The auditor will not select more sample items to audit.
(4) The auditor will perform more extensive substantive tests surrounding cash disbursements.
b. An auditor uses assessed control risk to
(1) evaluate the effectiveness of the entitys internal controls.
(2) identify transactions and account balances where inherent risk is at the maximum.
(3) indicate whether materiality thresholds for planning and evaluation purposes are sufficiently high.
(4) determine the acceptable level of detection risk for financial statement assertions.
c. On the basis of audit evidence gathered and evaluated, an auditor decides to increase assessed control risk from
that originally planned. To achieve an audit risk level (AcAR) that is substantially the same as the planned audit
risk level (AAR), the auditor will
(1) increase inherent risk.
(2) increase materiality levels.
(3) decrease substantive testing.
(4) decrease planned detection risk.
d. Which of the following statements about tests of controls is incorrect? Tests of controls
(1)must be done in every audit of an accelerated filer public companys financial statements.
(2) provide persuasive evidence that a material misstatement exists when the auditor determines that the control is
not being consistently applied.
(3) are often based on the same types of audit techniques used to gain an understanding of internal controls, except
the extent of testing is generally greater when testing controls.
(4) allow a reduction in the extent of substantive testing, as long as the results of the tests of controls are equal to
or better than what the auditor expects.
5. Each of the following internal controls has been taken from a standard internal control questionnaire
used by a CPA firm for assessing control risk in the payroll and personnel cycle.
1. Approval of department head or foreman on time cards is required before preparing payroll.
2. All prenumbered time cards are accounted for before beginning data entry for preparation of checks.
3. The computer calculates gross and net pay based on hours inputted and information in employee master files,
and payroll accounting personnel double-check the mathematical accuracy on a test basis.
4. All voided and spoiled payroll checks are properly mutilated and retained.
5. Human resources policies require an investigation of an employment application from new employees.
Investigation includes checking the employees background, former employers, and references.
6. The payroll accounting software application will not accept data input for an employee number not contained in
the employee master file.

7. Persons preparing the payroll do not perform other payroll duties (timekeeping, distribution of checks) or have
access to payroll data master files or cash.
8. Written termination notices, with properly documented reasons for termination, and approval of an appropriate
official are required.
9. All checks not distributed to employees are returned to the treasurer for safekeeping.
10. Online ability to add employees or change pay rates to the payroll master file is restricted via passwords to
authorized human resource personnel.
a. For each internal control, identify the type(s) of specific control activity (activities) to which it applies
(such as adequate documents and records or physical control over assets and records).
b. For each internal control, identify the transaction-related audit objective(s) to which it applies.
c. For each internal control, identify a specific misstatement that is likely to be prevented if the control
exists and is effective.
d. For each control, list a specific misstatement that could result from the absence of the control.
e. For each control, identify one audit test that the auditor could use to uncover mis statements resulting from the absence of the control.

Chapter 4: AUDIT METHODOLOGY

I.
REVIEW QUESTIONS
1. Identify the two factors that determine the persuasiveness of evidence. How are these two factors related to
audit procedures, sample size, items to select, and timing?
2. Identify the six characteristics that determine the reliability of evidence. For each characteristic, provide one
example of a type of evidence that is likely to be reliable.
3. List the eight types of audit evidence included in this chapter and give two examples of each.
4. What are the characteristics of a confirmation? Distinguish between a confirmation and external
documentation.
5. Distinguish between internal documentation and external documentation as audit evidence and give three
examples of each.
6. Explain the importance of analytical procedures as evidence in determining the fair presentation of the
financial statements.
7. Identify the most important reasons for performing analytical procedures.
8. List the purposes of audit documentation and explain why each purpose is important.
II.
CASES
1. The following are examples of documentation typically obtained by auditors:
1. Vendors invoices
2. General ledger files
3. Bank statements
4. Cancelled payroll checks
5. Payroll time records
6. Purchase requisitions
7. Receiving reports (documents prepared when merchandise is received)
8. Minutes of the board of directors
9. Remittance advices
10. Signed W-4s (Employees Withholding Exemption Certificates)
11. Signed lease agreements
12. Duplicate copies of bills of lading
13. Subsidiary accounts receivable records
14. Cancelled notes payable
15. Duplicate sales invoices
16. Articles of incorporation
17. Title insurance policies for real estate
18. Notes receivable
a. Classify each of the preceding items according to type of documentation: (1) internal
or (2) external.
b. Explain why external evidence is more reliable than internal evidence.
2. The following are examples of audit procedures:
1. Review the accounts receivable with the credit manager to evaluate their collectibility.
2. Compare a duplicate sales invoice with the sales journal for customer name and amount.
3. Add the sales journal entries to determine whether they were correctly totaled.
4. Count inventory items and record the amount in the audit files.
5. Obtain a letter from the clients attorney addressed to the CPA firm stating that the attorney is not aware of any
existing lawsuits.
6. Extend the cost of inventory times the quantity on an inventory listing to test whether it is accurate.

7. Obtain a letter from an insurance company to the CPA firm stating the amount of the fire insurance coverage on
buildings and equipment.
8. Examine an insurance policy stating the amount of the fire insurance coverage on buildings and equipment.
9. Calculate the ratio of cost of goods sold to sales as a test of overall reasonableness of gross margin relative to
the preceding year.
10. Obtain information about internal control by requesting the client to fill out a questionnaire.
11. Trace the total in the cash disbursements journal to the general ledger.
12. Watch employees count inventory to determine whether company procedures are being followed.
13. Examine a piece of equipment to make sure that a major acquisition was actually received and is in operation.
14. Calculate the ratio of sales commission expense to sales as a test of sales commissions.
15. Examine corporate minutes to determine the authorization of the issue of bonds.
16. Obtain a letter from management stating that there are no unrecorded liabilities.
17. Review the total of repairs and maintenance for each month to determine whether any months total was
unusually large.
18. Obtain a written statement from a bank stating that the client has $15,671 on deposit and liabilities of $500,000
on a demand note.
Classify each of the preceding items according to the eight types of audit evidence:
(1) physical examination, (2) confirmation, (3) documentation, (4) analytical procedures,
(5) inquiries of the client, (6) recalculation, (7) reperformance, and (8) observation.
4. The following are various audit procedures performed to satisfy specific transaction-related audit
objectives. The general transaction-related audit objectives are also included.
Audit Procedures
1. Trace from receiving reports to vendors invoices and entries in the acquisitions journal.
2. Add the sales journal for the month of July and trace amounts to the general ledger.
3. Examine expense voucher packages and related vendors invoices for approval of expense account
classification.
4. Observe opening of cash receipts to determine that cash receipts are promptly deposited and recorded.
5. Ask the accounts payable clerk about procedures for verifying prices, quantities and extensions on vendors
invoices.
6. Vouch entries in sales journal to sales invoices and related shipping documents.
General Transaction-Related Audit Objectives
Occurrence, Posting and summarization, Completeness, Classification, Accuracy, Timing
a. Identify the type of audit evidence used for each audit procedure.
b. Identify the general transaction-related audit objective or objectives satisfied by each
audit procedure.
5. The following audit procedures were performed in the audit of inventory to satisfy specific balancerelated audit objectives. The audit procedures assume that the auditor has obtained the inventory count
sheets that list the clients inventory. The general balance-related audit objectives are also included.
Audit Procedures
1. Test extend unit prices times quantity on the inventory list, test foot the list, and compare the total to the general
ledger.
2. Trace selected quantities from the inventory list to the physical inventory to make sure that it exists and the
quantities are the same.
3. Question operating personnel about the possibility of obsolete or slow-moving inventory.
4. Select a sample of quantities of inventory in the factory warehouse and trace each item to the inventory count
sheets to determine if it has been included and if the quantity and description are correct.
5. Compare the quantities on hand and unit prices on this years inventory count sheets with those in the preceding
year as a test for large differences.

6. Examine sales invoices and contracts with customers to determine whether any goods are out on consignment
with customers. Similarly, examine vendors invoices and contracts with vendors to determine whether any goods
on the inventory listing are owned by vendors.
7. Send letters directly to third parties who hold the clients inventory and request that they respond directly to the
auditors.
General Balance-Related Audit Objectives
Existence, Cutoff, Completeness, Detail tie-in, Accuracy, Realizable value, Classification, Rights and obligations
a. Identify the type of audit evidence used for each audit procedure.
b. Identify the general balance-related audit objective or objectives satisfied by each audit procedure.
6. The following are nine situations, each containing two means of accumulating evidence:
1. Confirm receivables with consumers versus confirming accounts receivable with business organizations.
2. Physically examine 3-inch steel plates versus examining electronic parts.
3. Examine duplicate sales invoices when several competent people are checking each others work versus
examining documents prepared by a competent person on a one-person staff.
4. Physically examine inventory of parts for the number of units on hand versus examining them for the likelihood
of inventory being obsolete.
5. Discuss the likelihood and amount of loss in a lawsuit against the client with clients in-house legal counsel
versus discussion with the CPA firms own legal counsel.
6. Confirm the oil and gas reserves with a geologist specializing in oil and gas versus confirming a bank balance.
7. Confirm a bank balance versus examining the clients bank statements.
8. Physically count the clients inventory held by an independent party versus confirming the count with an
independent party.
9. Obtain a physical inventory count from the company president versus physically counting the clients inventory.
a. Identify the six factors that determine the reliability of evidence.
b. For each of the nine situations, state whether the first or second type of evidence is
more reliable.
c. For each situation, state which of the six factors affected the reliability of the evidence.
7. Following are 10 audit procedures with words missing and a list of several terms commonly used in
audit procedures.
Audit Procedures
1. _____ the unit selling price times quantity on the duplicate sales invoice and compare the total to the amount on
the duplicate sales invoice.
2. _____ whether the accounts receivable bookkeeper is prohibited from handling cash.
3. _____ the ratio of cost of goods sold to sales and compare the ratio to previous years.
4. _____ the sales journal and _____ the total to the general ledger.
5. _____ the sales journal, looking for large and unusual transactions requiring investigation.
6. _____ of management whether all accounting employees are required to take annual vacations.
7. _____ all marketable securities as of the balance sheet date to determine whether they equal the total on the
clients list.
8. _____ the balance in the bank account directly with the East State Bank.
9. _____ a sample of duplicate sales invoices to determine if the controllers approval is included and _____ each
duplicate sales invoice to the sales journal for agreement of name and amount.
10. _____ the agreement between Johnson Wholesale Company and the client to determine whether the shipment
is a sale or a consignment.
Terms
a. Examine e. Recompute
i . Count
b. Scan
f . Foot
j. Observe
c. Read
g. Trace
k. Inquire
d. Compute h. Compare
l . Confirm

a. For each of the 12 blanks in procedures 1 through 10, identify the most appropriate
term. No term can be used more than once.
b. For each of the procedures 1 through 10, identify the type of evidence that is being used.
7. Here are the audit procedures drawn from an audit program:
a. Check and calculate the total of detailed liabilities and reconcile with the general ledger.
b. Check the seller's invoice to verify the ending balance of payable accounts.
c. Compare this year's depreciation expense with the year before s depreciation expense. Thereby detect that
depreciation rate this year increase as compared to last year.
d. Discuss with a book-keeper of cash receipts and expenditures on his responsibilities. Observe whether this
employee is a treasurer or prepare the reconciliation with bank for bank deposits or not.
e. Directly send a confirmation letter to the supplier to confirm the final payable balance
f. Check the continuity of the cheques on fund-spending diary to see if they have missed it?
g. Check the signature of the internal auditors on the statement reconciling the bank deposit balances between the
auditee and the bank each month as evidence that the statement has been examined by the internal auditors.
h. Check the seller's invoices and other documents as the basis for recording in the purchases journal.
i. Multiply commission rate with sales revenue and then compare the results with commission expense in the
period.
j. Check the seller's invoice with full signature of staff assigned to check the price, and calculate the amount of the
invoice.
Requirements:
a. Indicate that which procedure is tests of controls, which procedure is substantive test. For substantive
test, indicate whether it is analysis procedure or test of detail.
b. For each procedure, indicate the evidence that auditors can gather and assess its reliability. Also
indicate the related management assertions.
8. Answer each of the following independent questions and explain the computations:
a. During the year, Hoa Binh Trading Company purchases goods valued 21.567.345.000 VND, cost of goods sold
during the year is 22.543.234.000. The value of inventories at the end of the year is 4.567.657.000. Calculate
the inventory turnover ratio for the year.
b. At the beginning of the year, the Royal Company's receivable account is 5.000.000.000d, at the end of the year,
it increases by 1.000.000.000d. Sales revenue for the year is 2.000.000.000d cash. Receivable turnover ratio for
the year was 5 rounds. Calculate net sales of the year.
c. During the year, the Roses Company's gross profit is 970.000.000d and costs of finished products which were
stored in warehouse is 3.400.000.000d. Production costs in the period is 3.700.000.000d. Opening balance of
unfinished products and finished products are 280.000.000d and 450.000.000d. Closing balance of unfinished
products and finished products are 380.000.000d and 520.000.000d. Calculate the sales revenue in the period.
d. Information about the product A:
Sales revenue: 300 billion
Cost of goods sold: 240 billion
Cost of sales and administrative costs: 40 billion
If the consumption of the product A increase by 20%, how much the gross profit margin will increase? Suppose
this company only trades this product.
e. Company D wrote off a bad debt of 100 million by provision for doubtful debts (total provision is 1,200
million). X and Y respectively, is the current ratio before and after writing off that bad debts. Choose the
correct statement:
i. X> Y
iii. X <Y
ii. X = Y
iv. Not identified

Chapter 5: ORGANIZATION OF AN AUDIT AND THE AUDIT APPARATUS

1. In the situations below, indicates (by ) when an auditor still is "independent" in relations with his/her
audit client.
independence
a.
b.
c.
d.

Auditors son has insignificant financial benefits in the client that he is

perfoming the audit.
Auditors brother is the manager of HR department in the client that he is
performing the audit.
Auditors father is a merchant doing business with the audit client.
Auditors mother has significant benefits in the client that he is
performing the audit.

2. While conducting the financial statements audit for Libra company, the auditor Nam has met the
following situations:
a. Two months before the fiscal year end 31/12/2011, the genearl accountant of Libra has ceased working and
up to the date of creating financial statements, the company has not yet found a replacement. Therefore, the
transactions and events arising in two months last year have not been recorded in the books yet. As the
auditor Nam audited financial statements for the company in 2010, so Libra has asked Nam to create
financial statements and then to audit those financial statements for the year end 31/12/2011.
b. Known that Nam is auditor in-charge for the audit of Libra, Ngc, who is Nams close friend, is an
economist conducting a study entitled, "the financial operations of joint-stock companies". She has
suggested Nam to provide Libras information or to comment on the financial activities of Libra. Ngoc
promised to be confidential the information Nam supplied.
c. After the inventory stocktake of Libra, workshop Manager gave auditor Nam a fishing produced by Libra.
Required: In each situation, consider that if the auditor Nam accepted the suggestion, would he violate
professional ethics?
8. Consider each of the following independent situations:
a. Inventory on hand at year end has been valued at cost in the financial statement of your client. However,
net realizable value is 10% below cost according to the audit findings. The difference is a material amount.
b. You are auditing a charity where net income is generally about 50% of gross revenues. Due to the small
size of the charitys staff, there is a lack of control over completeness of revenue. Dispite your best efforts,
you feel that you do not have enough evidence to conclude that revenue is complete.
c. Management of WER Limited has decided not to disclose directors fees in the accounts as they are not
material. You cannot convince management to change its decision. However, you do agree that the
amounts are not material.
d. Management of JKL Limited has estimated that allowance for doubtful debts should be $ 540,000. As
auditor you believe that the allowance should be $650,000. Management will not change its estimate. Profit
before tax for the year is $ 440,000.
e. Your client has several bank accounts one of which is in a foreign country. Cash balances total $740,000
with the account maintained in the foreign country totalliing some $528,750. You have been unable to
obtain a bank audit certificate or any third party confirmation with respect to the foreign bank account. The

client has been unable to supply you with bank statements or other supporting documentation in relation to
this bank account. Materiality for the client has been set at $480,000. All cash balances are classified as
current assets in the clients financial statements.
For each of the above situation, determine the appropriate audit opinion to be issued in each situation. Give
reasons.