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CHAPTER 23

TESTS OF CONTROLS

I. Review Questions

1. Directly. Higher levels of control risk induce auditors to audit larger samples of
receivables, with confirmation date closer to the fiscal year end date. As for
nature of the procedures: higher levels of control risk induce auditors to use
positive confirmations instead of negative confirmations, and to consider
vouching subsequent payments by the customers.

2. A “walk through” is the process of following a transaction from its initiation


(customer order in the Revenue Cycle) through all the various processing steps
until it is recorded in the formal accounting records (accounts receivable and
sales). Usually samples of all documents are collected (sales order, sales
invoices, sales return slip, credit memo, shipping document, remittance advice
and daily remittance report) and notes are made of procedures each person
performs.

The purpose of the “walk through” is to obtain an understanding of the


transaction flow, the control procedures and populations of documents that may
be utilized in test of controls auditing.

3. The review (obtaining an understanding) of the control structure is primarily a


process of identifying control procedures (strengths) and lack of controls
(weaknesses) which will affect subsequent substantive procedures.

4. The internal auditors should, through periodic checks, ensure that the control
account is periodically reconciled to the customer subsidiary accounts, bank
statements are reconciled and that all prenumbered documents, especially
invoices, have all numbers accounted for. Some internal auditors also confirm
accounts receivable. Internal auditors also might review and evaluate customer
complaints for signs of weaknesses in the procedures leading to errors in
accounts receivable.

5. The features of a cash receipts internal control system which would be expected
to prevent an employee from absconding with company funds and covering with
funds from the employee pension fund is the prohibition against one employee
having custody of company funds and noncompany funds. The auditor can
detect such transfers by controlling and counting both funds simultaneously.
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To prevent the cash receipts journal and recorded cash sales from reflecting
more than the amount shown on the daily deposit slip, the internal control
system should provide that receipts be recorded daily and intact. A careful bank
reconciliation by an independent person could detect such errors.

6. The evaluation after the review phase was to determine which controls appeared
adequate as a basis for justifying a low control risk assessment. The final
assessment after test of controls auditing is to determine if the controls are
actually operating as well as they appeared to be.

7. The objectives of internal control relate to transactions, and by category are:


validity, completeness, authorization, accuracy, classification, accounting and
proper period. The objectives expensed in general terms and specific terms
applied to cash receipts are as follows:
Example of Cash Receipts
General Objective Specific Objective
1. Recorded transactions are valid 1. Recorded cash receipts are
and documented. supported by remittance advices.
2. All valid transactions are recorded 2. All cash receipts are entered in the
and none omitted. daily remittance list, deposited
intact and recorded in the accounts
receivable control account.
3. Transactions are authorized by 3. Cash receipts for transactions other
company policy. than merchandise sales (scrap
sales, sales of fixed assets) are
properly authorized.
4. Transaction peso amounts are 4. Cash receipts are compared to
properly calculated. invoice terms to determine proper
cash discounts.
5. Transactions are properly 5. Cash receipts for nonmerchandise
classified in the accounts. sales are posted to proper accounts.
6. Transaction accounting is 6. All cash receipts for credit sales are
complete. posted to customer individual
accounts.
7. Transactions are accounted in the 7. Cash receipts are deposited daily
proper period. intact and recorded as of date
received.

8. If the credit limits are set and entered incorrectly, the credit approval process
will be systematically deficient.
Tests of Controls 23-3
9. The functions which should be separated to maintain internal control in a
purchasing system include (1) custody of the goods (receiving and stores
departments), (2) authority to initiate a transaction (purchasing department) and
(3) bookkeeping (accounts payable department, inventory record-keeping
department).

10. The “walk through” of a purchase transaction would begin with the preparation
of the requisition by the Stores department, through the bidding process and
preparation of the purchase order by the purchasing agent, to receipt of vendor’s
invoices and receiving report by the purchasing agent and finally to accounts
payable voucher preparation. Procedures would be observed and notations
made on document samples of procedures followed.

Documents are collected to note where documentary evidence exists or control


procedures being followed. The following documents would be collected:
requisition, purchase order, receiving report and voucher. The “walk through”
and sample documents would assist the auditor in understanding the flow of
transactions.

11. a. Blank vouchers kept in secure location available only to authorized


personnel.
b. Blank supporting documents (invoices, receiving reports, requisitions,
purchase orders) kept in secure locations available only to authorized
personnel.
c. Supporting documents canceled by Cash Disbursement function when
checks are prepared.
d. Separation of duties of preparers of supporting documents, preparation of
vouchers, check preparation, and check signing.
e. Vouchers and other supporting documents reviewed by check signers.
f. Checks mailed directly by signer and not returned to accounts payable.

12. Authorization for vouchers payable recording mainly consist of an approved


purchase order, a receiving report, and an accurate vendor invoice. Auditors
should look for purchase approval signatures, receiving approval signatures, and
approval of the vendor invoice – checks by client for proper quantity, price, and
discount.

13. The point of this quotation is to generate discussion on the source of errors and
therefore the controls necessary when an accounting process is computerized.
Discussion items might include the following:
1. People have bad days and make mistakes; computers do not have bad days.
2. Murphy’s Law – If it is possible to make an error, someone will find a way
to do it.
3. People initiate the transactions and will make errors.
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4. All controls should be considered together (manual and computer).
Excellent computer controls cannot be relied upon if the related manual
controls are weak.
5. In computer systems, it is extremely important to establish extensive input
validation controls to prevent people errors from getting into the processing
(GIGO – garbage in, garbage out).
6. People can prevent a good computer system from working well if they are
not convinced it is in their best interests.
7. People will rarely question computer printed output, even though it may not
be correct.
8. Most computer controls are to prevent, detect, or correct errors made by
people.

14. The purpose of the auditor’s search for unrecorded liabilities is to gather
evidence as to whether the liability assertion is true. The same concern exists in
the internal control objective “all valid transactions are recorded and none are
omitted.” From an evidence gathering perspective, it is much more difficult to
gather evidence on unrecorded transactions than to gather evidence that recorded
transactions (and account balances) are proper.

The search for unrecorded liabilities includes procedures in other audit areas
such as questions on bank and insurance confirmations and vouching the source
of funds for asset additions. Specific audit procedures in the search for
unrecorded liabilities include:
1. Obtain vendor’s invoices (or accounts payable vouchers) recorded for
several days after the balance sheet date to determine if the liability relates
to the balance sheet period under audit.
2. Scan cash disbursements for several days subsequent to year-end and vouch
to support to determine if cutoff was proper. Scan all cash disbursements
until the end of field work for unusual amounts and payees to determine if
amounts paid represent liabilities of the balance sheet period.
3. Examine BIR tax reports and correspondence and the audit reports of tax
authorities and trace additional tax assessments to the accounts.
4. Confirmation of accounts payable.
5. Use analytical procedures such as trend comparisons of accounts payable to
sales, sales taxes to sales, payroll taxes to gross payroll and interest expense
to average notes payable.

15. A “walk through” involves following a transaction from initiation through the
various steps until the transaction is recorded in the formal accounting records.
In the conversion cycle, the following would constitute a complete “walk
through:”
Step Documents Collected Controls Noted
Prepare production Production Order (P.O.) Support for P.O.
Tests of Controls 23-5
orders
Prepare bill of materials Bill of materials (B.M.) Separation planning
and manpower needs Manpower needs (M.N.) from production.
Assign job order and Note separation
foreman production supervisor
from foreman duties.
Job tickets and material Job tickets (JT) Production foreman
requisitions prepared Material requisition (MR) duties separated from
authorization.
Raw material records Issue slip (IS) Materials not issued
updated, issue slips without MR. IS
prepared prepared for all materials
released.
Observe time entered Approval by foreman of
and foreman approval on hours.
JT
Direct labor report Labor report (LR) Job tickets support L.R.
prepared
Observe timekeeping, Reconciliation hours per
compare job tickets to clock cards to hours per
clock cards J.T.
Material used report Material used report Issue slips and
prepared (MUR) requisitions support
MUR.
Observe matching issue Records from sources
slips and material used reconciled.
report
Observe matching job Records from separate
time tickets (or labor sources reconciled.
distribution) to labor
report
Enter costs in job cost Job cost sheets (JCS) Support for all entries in
sheets JCS.
Summary entry Summary entry form Job cost sheets support
prepared. summary entries.
Trace summary entry to Separation of duties; cost
General Ledger posting accounting and general
ledger.
Preparation of Report of units Independent report of
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completion report completed (RUC) production completed.
Observe units compared Independent check of
to RUC, post finished RUC.
records
Products received report Products received report Independent records of
prepared (PRR) units put into finished
goods inventory.
Observe comparison Records from separate
RUC and PRR sources reconciled.
Job sheets closed out, Summary entry form Closed job sheets, RUC
summary entry prepared and PRR support
summary entries.
Trace summary entry to Separation of duties; cost
General Ledger posting accounting and general
ledger.

16. Weaknesses (lack of control where auditors believe one is necessary) are not
audited because auditors do not rely upon weaknesses to prevent, detect or
correct material errors. Auditors must consider the financial impact of
weaknesses on financial statements and plan substantive tests accordingly.

A control strength may be identified in interviews during the review phase (or in
preparing the flowcharts or questionnaires), but during test of controls auditing,
found to be nonexistent or operating ineffectively. For example, in the
conversion cycle the production management may state that foremen approve
workers’ job time tickets. However, when a sample of job time tickets are
examined by auditors for evidence of approval, none is found. Thus, a weakness
is not found until the control is tested. Therefore, control risk should not be
assessed low until evidence is gathered that the control is operating effectively.

17. The purpose of this review question is to foster discussion toward what
information an independent auditor needs to know. Items relevant to the
quotation might include:
1. Reference to the standard regarding “adequate technical training and
proficiency as an auditor.”
2. Reference to the standard regarding “due professional care.”
3. Obviously, the auditor must be knowledgeable about cost accounting to
audit a manufacturing company.
4. In a manufacturing company, the inventories most likely will be a major
asset which will require substantial audit work.
Tests of Controls 23-7
5. A proficient auditor must be knowledgeable in all phases of the business,
including production, marketing, finance as well as accounting data
processing.

18. The surprise observation enables the auditor to see how the distribution system
really works and increases his chances of detecting fraud. Such an observation
involves taking control of paychecks, then accompanying a client representative
as the distribution takes place. The auditor checks to see that each employee is
identified and that only one check is given to each individual. Unclaimed
checks are controlled and examined to detect any fictitious persons on the
payroll.

19. A “walk through” of a personnel and payroll transaction would include


discussions with each person handling personnel and payroll records. The
following illustrates the steps and documents collected.

Steps Document(s) Collected


Hiring – personnel dept. Authorization to hire and rate assignment
Deductions – personnel Personnel forms, employee authorization for
dept. deductions
Timekeeping Clock card
Shops Job time ticket
Cost distribution Labor distribution sheet
Accounts payable Payroll voucher
Cash disbursement Payroll checks

If the payroll is processed by computer, the clock cards and job time tickets
would be traced to batch control in the timekeeping and production departments,
to data preparation (keying to machine sensible form), to edit and validation
error reports and other computer output indicating control and finally to
computer prepared checks, labor distribution reports and summary general
ledger entries.

II. Multiple Choice Questions

1. c 5. a 9. d 13. b 17. d
2. c 6. c 10. b 14. a 18. d
3. b 7. c 11. a 15. c 19. c
4. c 8. b 12. a 16. d 20. b

III. Comprehensive Cases

Case 1. 1. Controlled access to blank sales invoices.


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a. Observation. Visit the storage location yourself and see if unauthorized
persons could obtain blank sales invoices. Pick some up yourself to see
what happens.
b. Someone could pick up a blank and make out a fictitious sale.
However, getting it recorded would be difficult because of the other
controls such as matching with a copy from the shipping department.
(Thus a control access deficiency may be compensated by other control
procedures.)

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. 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).

4. 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.

Case 2. 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.”
Castro 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.
Tests of Controls 23-9
An identification of the potential irregularities will illustrate the misdeeds
he can perpetrate almost single-handedly.

2. Potential irregularities include:


a. Castro can collude with customers to rig low bids and take kickbacks,
thereby depriving the company of legitimate revenue.
b. Castro 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. Castro, through the control of physical inventory, can (i) remove
materials for himself, and (ii) manipulate the inventory accounts to
conceal shortages.
d. Castro can order truck shipping services for his own purposes and
cause the charges to be paid by the company.
e. Castro 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. Castro has authorization
and custodial responsibilities.
b. Authorization, Supervision. Castro is apparently subject to no
supervision or review. The accounting staff is probably powerless to
challenge transactions because of Samuel’s apparent approval of
Castro’s powers.
c. Controlled Access. The whole situation gives Castro 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.

Case 3. The purpose of this question is to get the student to consider where the
functions that are considered incompatible in a manual system occur in a
computer system.

The functions should be separated in a manual or computer accounting system


such that different people authorize the sales transactions, record the
transactions, have custody to the assets (inventory) and reconcile the books to
the assets.
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Different people should: indicate the sales order source document (authorize),
prepare the computer program (authorize and record), operate the computer
(record), have custody of inventory and correct errors (reconciliation).

Case 4. If the credit limits are set and entered incorrectly, the credit approval
process will be systematically deficient.

Case 5. Memorandum

TO: Board of Directors, The Potter Art League


FROM: (Student’s name)
DATE:
SUBJECT: Control weaknesses related to Cash Admission Fees

You requested a report which identifies the weaknesses in the


existing system of cash admission fees and my recommendations.
Below are the weaknesses that exist and my recommendations for
procedures that overcome these weaknesses. I will be pleased to
discuss these at the next board meeting and offer further
explanations that may be necessary.

Weakness: There is no segregation of duties between persons


responsible for collecting admission fees and persons responsible
for authorizing admission.
Recommendation: One clerk (hereafter referred to as the
collection clerk) should collect admission fees and issue
prenumbered tickets. The other clerk (hereafter referred to as the
admission clerk) should authorize admission upon receipt of the
ticket or proof of membership.

Weakness: An independent count of paying patrons is not made.


Recommendation: The admission clerk should retain a portion of
the prenumbered admission ticket (admission ticket stub).

Weakness: There is no proof of accuracy of amounts collected by


the clerks.
Recommendation: Admission ticket stubs should be reconciled
with cash collected by the treasurer daily.

Weakness: Cash receipts are not promptly prepared.


Tests of Controls 23-11
Recommendation: The cash collections should be recorded by the
collection clerk daily on a permanent record that will serve as the
first record of accountability.

Weakness: Cash receipts are not promptly deposited. Cash should


not be left undeposited for a week.
Recommendation: Cash should be deposited at least once each
day.

Weakness: There is no proof of accuracy of amounts deposited.


Recommendation: Authenticated deposit slips should be compared
with daily cash collection records. Discrepancies should be
promptly investigated and resolved. In addition, the treasurer
should establish a policy that includes an analytical review of cash
collections.

Weakness: There is no record of the internal accountability of


cash.
Recommendation: The treasurer should issue a signed receipt of
all proceeds received from the collection clerk. These receipts
should be maintained and should be periodically checked against
cash collection and deposit records.
Case 6. a. The purposes of these audit procedures are:
1. To substantiate the validity of the asset “cash” in the balance sheet, as it
may substantially consist of “cash in transit” from several sales
divisions.
2. To determine proper cash “cutoff”, i.e., to detect any unintentional
errors overstating or understating cash between the current and the
following accounting period.
3. To disclose “kiting” (if any), e.g., perpetrated by the home office
cashier in collusion with one or more sales divisions employees.

b. Audit Program for Sales Divisions – Audit Steps


1. Prepare a schedule of transfer payments made by the branch for a
period covering two weeks prior and two weeks after the end of the
fiscal period showing:
Check number
Date of entry in cash disbursements book
Amount of check
Date of perforation by paying bank
Transfer checks outstanding at the date of cutoff
Transfer checks outstanding at the date of reconciliation.
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2. Compare dates of issue on canceled checks and of entries.
3. Trace and compare dates of perforation and dates of payment on the
bank statement and the “cutoff” statement.
4. Compare dates of issue of checks to date of perforation looking for:
a. unusual delays in payment
b. discrepancy in accounting periods for the two dates.
5. Scan cancelled checks and cash disbursements records during the year
for:
a. names of payees,
b. consecutive numbers of checks to determine whether any payments
other than regular transfers to main office were made from this
account.
6. Reconcile individually several transfers during the year to
corresponding collections presumed to be transferred as of each
individual date.
7. Reconcile total collections for the year to total transfers.

Case 7. 1. a. Recorded payroll transactions are valid (no fictitious employees).


b. Paychecks might be delayed and terminated workers might continue to
be “paid” (with theft of check by someone else) if payroll is not
promptly notified of new hires and terminations.

2. a. Recorded payroll deductions are valid.


b. Incorrect amounts might be deducted from pay.

3. a. Recorded payroll transactions are valid and authorized.


b. If payroll department personnel were also responsible for time records,
they would have effective control over transaction authorization (i.e.,
hours worked approval) and could overpay themselves or friends.

4. a. Payroll and labor cost transactions are complete.


b. Cost accounting records might contain more or fewer pesos than
actually paid (per payroll data). Simple errors in cost analyses might
occur.