Case Study

Auditing Theory

Submitted to:
Prof. Maria Luisa Oliveros

Submitted by:
GROUP 5

Aberca, Mary Cris

Apostol, Vernie Anne
Awa, Vergil
Basco, Angela
Celadeña Joyce
Diegor, Mary Joy
BSA 3-1
 Unit 3

INTERNAL CONTROL DOCUMENTATION

Harer & Jones Policy

The permanent file for all continuing engagements includes thorough documentation of the
system of internal control, facilitating audit planning and providing new staff members an opportunity
to familiarize themselves with the client’s system. The firm’s study and evaluation of the system of
internal control is addressed in three phases:

 System Review – for new engagements this is particularly important and involves obtaining a
knowledge and understanding of an entity’s prescribed procedures and methods.
 Compliance Testing – involves obtaining a reasonable degree of assurance that prescribed
procedures and methods are complied with and operating as planned.
 Evaluation – involves evaluating the system and reaching conclusions on the level of reliance to
place on controls relating to each transaction cycle.

This unit provides an overview of the firm’s first phase system review, and requires completing an
internal control questionnaire, flowcharting an understanding of the system, and documenting strengths
and weaknesses.

Firm policy requires that engagement working papers include a clear description of conclusions
reached concerning the client’s system of internal control and that documentation of the study and
evaluation be consistent with the conclusions.

System Overview

The following narrative describes your understanding of a subsystem of Lone Star’s expenditure
disbursement cycle: manufacturing asset purchasing and accounts payable. This evidence was gathered
by observation and inquiry of management and appropriate employees within the organization.

Requisitions. All raw material and plant asset acquisitions are initiated by Ross Crothers (VP –
manufacturing). He prepares and signs raw material requisitions following a weekly tour of the raw
material storage area and a review of perpetual inventory cards; as yet, the company has not developed
standard reorder points for raw material replenishment <In a continuous inventory system (also
referred to as a perpetual system and a fixed-order-quantity system), a continual record of the inventory
level for every item is maintained. Whenever the inventory on hand decreases to a predetermined
level, referred to as the reorder point, a new order is placed to replenish the stock of inventory. The
order that is placed is for a fixed amount that minimizes the total inventory costs. This amount, called
the economic order quantity, is discussed in greater detail later.>. Purchases of plant assets in excess of
$2,000 are approved by the board of directors, and the requisition is signed by Wiggins (president).< 10.
Certain control activities may depend on the existence of appropriate higher level policies established by
management or those charged with governance. For example, authorization controls may be delegated
under established guidelines, such as investment criteria set by those charged with governance;
alternatively, non-routine transactions such as major acquisitions or divestments may require specific
high level approval, including in some cases that of shareholders.>

Requisitions are prepared in duplicate on standardized printed forms which are sequentially pre-
numbered < A59. Internal control over safeguarding of assets against unauthorized acquisition, use, or
disposition may include controls relating to both financial reporting and operations objectives. The
auditor’s consideration of such controls is generally limited to those relevant to the reliability of financial
reporting.>; the original is sent to the purchasing agent, and a copy is forwarded to the accounts payable
clerk. For purchase returns, Crothers prepares a debit memo, forwarding copies to the purchasing agent
and accounts payable clerk. Due to the nature of the company’s sales, purchase returns have been
immaterial in the past.

Ordering. Ellwood Ray (purchasing agent) has the authority to negotiate raw material and plant
asset acquisition prices with individual vendors. Crothers has not approved an authorized vendor list or
reviewed the prices negotiated, since Ray, who was the purchasing agent employed by Western Hat Co.,
is experienced in the area and has good personal relationships with many of the vendors. < PSA 240
opportunities: Inadequate internal control over assets may increase the susceptibility of
misappropriation of those assets. For example, misappropriation of assets may occur because there is
the following:

• Inadequate segregation of duties or independent checks.

• Inadequate oversight of senior management expenditures, such as travel and other

reimbursements.

• Inadequate management oversight of employees responsible for assets, for

example, inadequate supervision or monitoring of remote locations.

• Inadequate job applicant screening of employees with access to assets.

• Inadequate record keeping with respect to assets.

• Inadequate system of authorization and approval of transactions (for example, in

purchasing).

Specific Responses—Misstatements Due to Misappropriation of Assets >

  Performing a computerized match of the vendor list with a list of employees to identify
matches of addresses or phone numbers.

 Obtaining evidence that contracts are being carried out in accordance with their terms.

PSA 265

A4. Also, smaller entities often have fewer employees which may limit the extent to which
segregation of duties is practicable. However, in a small owner-managed entity, the owner-manager
may be able to exercise more effective oversight than in a larger entity. This higher level of management
oversight needs to be balanced against the greater potential for management override of controls. >

Four copies of a sequentially pre-numbered purchase order form are prepared for each
purchase and include the unit price negotiated by Ray and the quantity of goods ordered. Ray computes
the extensions and sends the original copy of the purchase order to the vendor; one copy is filed by Ray
along with a copy of the requisition for comparison with the receiving report when the goods are
delivered. The other copies are sent to the accounts payable clerk in the accounting office and to the
receiving/storage manager for comparison with goods received. On a sample basis, Crothers examines
the sequential integrity of Ray’s purchase order file, since he is especially interested in any voided or
missing purchase orders.

Receiving. Goods arriving at the receiving dock are inspected, counted (or weighed), and
compared in quantity and description to the purchase order filed in the receiving/storage department;
any unordered, damaged, or otherwise unacceptable goods are returned to the vendor < Art. 1502.
When goods are delivered to the buyer “on sale or return” to give the buyer an option to return the
goods instead of paying the price, the ownership passes to the buyer of delivery, but he may revest the
ownership in the seller by returning or tendering the goods within the time fixed in the contract, or, if no
time has been fixed, within a reasonable time. (n)

When goods are delivered to the buyer on approval or on trial or on satisfaction, or other similar terms,
the ownership therein passes to the buyer:

(1) When he signifies his approval or acceptance to the seller or does any other act adopting the
transaction;

(2) If he does not signify his approval or acceptance to the seller, but retains the goods without giving
notice of rejection, then if a time has been fixed for the return of the goods, on the expiration of such
time, and, if no time has been fixed, on the expiration of a reasonable time. What is a reasonable time is
a question of fact. (n)>. For accepted goods, a receiving report is prepared in duplicate, numbered by
hand, and signed by the receiving/storage department manager the day the goods are delivered. Since
materials remain in the receiving/storage department until requisitioned for use in manufacturing, a
copy of the receiving report is used by the department manager to update the raw material inventory
cards. The original copy of the receiving report is sent to the purchasing agent, who compares the report
to his file copies of the purchase order and requisition and then forwards the receiving report to the
accounts payable clerk. The accounts payable clerk files the receiving report with the purchase order
initially received from the purchasing agent. When plant assets arrive, they are processed in the same
manner except that they are transferred to the appropriate department in the plant immediately upon
receipt.

Accounts Payable. All vendor invoices are received by the accounts payable clerk and compared
with the matching purchase requisition, purchase order, and receiving report. In addition, invoice
extensions are tested, and any discrepancies are discussed with the purchasing agent and reviewed with
the vendor. If invoices are received for goods which have no supporting documentation, they are
forwarded to the controller for review and resolution.

A pre-numbered cover jacket < A93. Application controls are manual or automated procedures that
typically operate at a business process level and apply to the processing of individual applications.
Application controls can be preventive or detective in nature and are designed to ensure the integrity of
the accounting records. Accordingly, application controls relate to procedures used to initiate, record,
process and report transactions or other financial data. These controls help ensure that transactions
occurred, are authorized, and are completely and accurately recorded and processed. Examples include
edit checks of input data, and numerical sequence checks with manual follow-up of exception reports or
correction at the point of data entry.>, containing all supporting documentation is prepared for each
invoice. The accounts payable clerk is responsible for determining the appropriate account distribution
and recording the distribution and net amount payable on the front of the jacket. The jacket is then filed
by payment date. The file of unpaid jackets serves as an informal subsidiary ledger. A total of each day's
additions <Continuous accounting is a paradigm shift for finance professionals responsible for
closing the books and producing financial statements. The practice of keeping accounting systems
always up to date—ready for closing out at any time—is known as continuous accounting.> to the
file is forwarded to the general ledger clerk for posting to both the accounts payable control account
and the appropriate asset accounts (e.g., raw materials -fur, raw materials -chemicals, machinery, etc.)
One week prior to the payment date, the cover jackets are sent to the treasurer's office for review. On a
monthly basis, the accounts payable clerk totals the unpaid jackets file and forwards the balance to
general accounting for comparison with the control account. < Generally speaking, closing the month
entails the following major tasks: recording all financial transactions, reconciling balance sheet
accounts, review of income & expense accounts, preparing financial statements and finally the
review of all of this work, usually by the CFO or Director of Finance. In essence, the monthly
closing is a mini-audit that closes the books for the current month.>

Treasurer. After the treasurer reviews the contents and approves (signs) the cover jackets for
payment, they are stamped "Approved for Payment," and a clerk batches each day's approvals for
submission to the EDP control clerk for processing. The EDP department prints checks from data entered
on the jackets. Catherine Meyer (treasurer) notes that the EDP department and the controller are
developing an EDP system to completely automate the purchasing and accounts payable activities.
However, the system will not be implemented for another year or so. <A93. Application controls are
manual or automated procedures that typically operate at a business process level and apply to the
processing of individual applications. Application controls can be preventive or detective in nature and
are designed to ensure the integrity of the accounting records. Accordingly, application controls relate
to procedures used to initiate, record, process and report transactions or other financial data. These
controls help ensure that transactions occurred, are authorized, and are completely and accurately
recorded and processed. Examples include edit checks of input data, and numerical sequence checks
with manual follow-up of exception reports or correction at the point of data entry. >Upon receiving the
checks from the EDP department, the treasurer reviews them and sends a copy of the check listing
received from the EDP department to the general accounting clerk for posting to the general ledger. The
checks are then mailed, and the cover jackets are marked "Paid" and filed by jacket number.

Other Observations. With the exception of the receiving storage area, all departments safeguard
unused forms, such as purchase requisitions and purchase orders, thereby minimizing the likelihood of
inappropriate usage. However, in the receiving/storage department, stacks of receiving reports are
accessible both on the department manager's desk and at the receiving dock. Although formal purchase-
related manuals are available and used in the treasurer's and controller's area, no written procedures
exist in Crothers’ area. <Physical controls. Controls that encompass:

o The physical security of assets, including adequate safeguards such as

secured facilities over access to assets and records.

o The authorization for access to computer programs and data files.

o The periodic counting and comparison with amounts shown on control

records (for example comparing the results of cash, security and inventory

counts with accounting records).

The extent to which physical controls intended to prevent theft of assets are

relevant to the reliability of financial statement preparation, and therefore the

audit, depends on circumstances such as when assets are highly susceptible to

misappropriation.>
 REQUIREMENTS

1. Using the narrative provided in this unit, complete the purchasing & disbursements internal
control questionnaire to the Lone Star engagement.
2. Flowcharting a client's internal controls is an integral step in the study and evaluation of an
internal control system. Flowchart your understanding of the manufacturing asset purchasing
and accounts payable subsystem for Lone Star.
3. Harer & Jones requires the completion of a system analysis working paper for each of the
control subsystems upon which reliance is planned. Complete the working paper for this
phase of the Lone Star engagement. Be certain to complete the "potential risk" column for all
control objectives even though your assessment may indicate strength for a particular control
objective in the Lone Star subsystem.
4. Document all weaknesses detected in Lone Star's internal control system on the internal
control weaknesses summary. (Retain this working paper for future use in Unit 7 when
preparing a management letter.)
Unit 3 – Requirement 1 Prepared by:

Harer & Jones, CPAs

Internal Control Questionnaire
Purchasing & Disbursements

Client : Western Hat Apparel Co. Year ending

Answer: Performed
Question Yes or No Remarks by

1. Is a purchase Yes Prepared by Crothers (VP-manufacturing)

requisition required
for each purchase?
2. Are pre-numbered Yes Prepared in duplicate: the original is sent to the
requisitions used and purchasing agent and the copy to the accounts
accounted for? payable clerk.
3. Is a purchase order Yes Prepared by Elwood Ray. Four copies of a
required for each sequentially pre-numbered purchase order form are
purchase? prepared for each purchase; the original to the
vendor, one copy is filed and the other copies are
sent to accounts payable clerk and storage manager
for comparison
4. Are purchase limits Yes Purchases of plant asset in excess of $2,000 are
established requiring approved by board of directors and requisition is
approval? signed by Wiggins (president)
5. Are competitive bids No
obtained before
issuing purchase
order?
6. Are pre-numbered Yes Prepared in duplicate on standardized printed forms:
purchase orders used the original is sent to the purchasing agent, and a
and accounted for? copy is forwarded to the accounts payable clerk.
7. Is there an approved No
list of vendors?
8. Is purchasing Yes
independent of
accounting, receiving,
storing, and
shipping?
9. Are goods received at Yes At receiving dock
a central location?
10. Are goods inspected, Yes Any unordered, damaged, or unacceptable goods are
counted/weighed, returned to the vendor.
and compared with
purchase order upon
receipt?
Unit 3 – Requirement 1 (continued) Prepared by:

Answer: Performed
Question Yes or No Remarks by

11. Are pre-numbered Yes Prepared in duplicate, numbered by hand MJD

receiving reports used and and signed by the receiving/storage
accounted for? manager.
12. Is a receiving report Yes signed by the receiving/storage MJD
prepared and signed at department manager the day the goods
time of receipt? are delivered.
13. Are goods safeguarded and Yes MJD
transferred to storage
area?
14. Are purchase orders, Yes MJD
receiving report, and
vendor’s invoice matched
before cover jackets are
prepared?
15. Are invoices checked for Yes MJD
quantities, prices and
accuracy?
16. Are unmatched invoices Yes It is specifically reviewed by the MJD
reviewed by management? controller
17. Are unpaid cover jackets Yes MJD
held in an unpaid file?
18. Is accounts payable notified No MJD
of goods return to vendor?
19. Are purchases properly Yes MJD
distributed to accounts?
20. Are cover jackets verified Yes One week before the payment date, the MJD
for accuracy before cover jackets are sent to treasurer for
payment? review.
21. Are purchasing and No EDP Department prints checks from the MJD
accounts payable activities data entered on the jackets.
processed by EDP
Department?
Unit 3 – Requirement 3 Prepared by:_____________________

Harer & Jones, CPAs

System Analysis: Purchasing & Disbursements

Client: Western Hat Apparel Co. Year ending ________________

Purchasing Control Strengths Weaknesses Potential Risk

Objectives

1. Management Crothers does not a. Payment to

should authorize approve vendors used unauthorized party
vendors. by purchasing agent. b. Management may not
be aware of related
party transactions.

Crothers has not a. Order of materials

2. Management approved an and supplies from
should authorize authorized vendor list unauthorized
types, quantities, or reviewed the prices vendors, or at the
prices, and terms negotiated, since Ray, wrong prices or
of purchases who was the terms.
purchasing agent b. Goods purchased will
employed by Western not meet quality
Hat Co., is experienced standards.
in the area and has c. The approval
good personal signature may not
relationships with exist or forged so that
many of the vendors. unauthorized
purchases are made.
All vendor invoices are a. Inaccurate recording
3. Management received by the of a purchase or
should approve accounts payable clerk disbursement.
adjustments to
and compared with the
vendor accounts.
matching purchase
requisition, purchase
order, and receiving
report. Any
discrepancies are
discussed with the
purchasing agent and
received by the
vendors.
4. Management The EDP system that a. Purchases are made
should establish the EDP department without proper
procedures for approval.
and the controller are
processing b. Receipt of goods is
purchasing developing to not documented.
transactions. completely automate c. Accept materials and
the purchasing and supplies for which no
accounts payable authorized order has
activities will not be been placed.
implemented for d. Undetected errors in
recording
another year or so.
transactions.

5. The receiving Goods arriving at the a. Incur additional costs

department should receiving dock are to return or store
accept only inspected, counted (or these goods.
ordered goods and weighed), and b. Unauthorized
services. compared in quantity individuals will order
and description to the and receive materials
purchase order filed in and supplies.
the receiving/storage c. Goods may be
department; any accepted that have
unordered, damaged, not been
or otherwise ordered/wrong
unacceptable goods quantity /inferior
are returned to the quantity.
vendor.

6. Goods received For accepted goods, a a. Receiving will reject

should be reported receiving report is deliveries because
on a timely basis. there is no valid
prepared in duplicate,
purchase order.
numbered by hand, b. Unable to determine
and signed by the unfulfilled purchase
receiving/storage commitments.
department manager c. Lose purchase orders.
the day the goods are d. Goods received may
delivered. not have good quality
as ordered.

7. Amounts due A pre-numbered cover a. Fraudulent/inaccurate

vendors and jacket, containing all payments are made.
 account supporting b. Late payments are
distributions documentation is made, incurring
should be accurate prepared for each penalties
and timely. invoice. The accounts c. Purchases are not
payable clerk is recorded for the
responsible for proper amounts.
determining the
appropriate account
distribution and
recording the
distribution and net
amount payable on the
front of the jacket. The
jacket is then filed by
payment date.

8. Each cash All vendor invoices are a. Payment to incorrect

disbursement received by the vendor, which it may
should be based accounts payable clerk not be possible to
upon documented and compared with the recover.
liabilities. matching purchase b. Liabilities paid may be
requisition, purchase incorrect or paid
order, and receiving twice.
report.

9. Cash EDP system will not be a. Amounts

disbursements implemented for recorded/paid do not
should be another year. match the approved
accurately invoices.
reported.

10. Recorded balances The accounts payable a. Payment is not

of accounts clerk totals the unpaid recorded in the
payable and jackets file on a proper period.
related monthly basis. b. Debits to accounts
transactions and credits to cash
should be may not be valued at
reviewed proper amounts.
periodically.
11. Access to purchase All departments a. Unauthorized
requisitions, safeguard unused versions of files
purchase orders, forms such as purchase and/or programs will
and receiving requisitions and be used to process
reports should be purchase orders. In the transactions.
protected. receiving/storage b. Unauthorized use of
department, stacks of cheques and
receiving reports are recording of
accessible both on the transaction.
department manager's c. Inappropriate access
desk and at the to the accounts
receiving dock. payable system
Unit 3 – Requirement 4 Prepared by:_____________________

Harer & Jones, CPAs

Internal Control Weakness Summary

Client: Western Hat Apparel Co. Year ending ________________

Weaknesses Potential Risk Effect on Year-End

Scope

a. Payment to unauthorized party

Crothers does not b. Management may not be aware of related
approve vendors used by party transactions.
purchasing agent.

The company has not a. Invalid or incorrect orders made or recorded. Materiality
developed standard b. Orders are made in wrong quantity/inferior misstatements will
reorder points for raw quantity. occur.
material replenishment.

a. Purchases are made without proper

The EDP system that the approval. If the system is
EDP department and the b. Receipt of goods is not documented. determined to be
controller are developing c. Accept materials and supplies for which no unsatisfactory and
to completely automate authorized order has been placed. unreliable, it will
d. Undetected errors in recording transactions.
the purchasing and suppress the evidence
accounts payable developed and obtained
activities will not be under the system of
implemented for another internal control.
year or so.
 a. Unauthorized versions of files and/or
All departments programs will be used to process Disappearance of
safeguard unused forms transactions. relevant evidentiary
b. Unauthorized use of cheques and recording matter will hinder the
such as purchase
audit team to render a
requisitions and purchase of transaction.
clear opinion.
c. Inappropriate access to the accounts
orders. In the
payable system
receiving/storage
department, stacks of
receiving reports are
accessible both on the
department manager's
desk and at the receiving
dock.