Professional Documents
Culture Documents
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The revenue/receipt cycle encompasses both the sale of goods or services to customers and the
collection of cash. The cycle is related to each of the other three transaction cycles since it:
a. Receives resources and information provided by the financing and conversion cycles, and
b. Provides resources and information to the expenditure/disbursement cycle.
2. Common activities:
- Customer order (the cycle begins at this point when the customer’s order is received by fax,
mail, e-mail, telephone, or EDI).
- Credit approval
- Inventory control
- Shipping
- Recording
- Cash collection
- Sales return
3. Common entries:
- Sales – a sales order is prepared by an employee of the Customer Order department. All
documents connected to sales should be prenumbered consecutively and, if paper, missing
forms should be accounted for.
- Sales returns and allowances – personnel independent of cash collection and recording
should review Customer requests for adjustments on returned goods.
a. An approved request is documented as a credit memorandum.
b. Returned goods are handled through the Receiving department and returned to the
warehouse along with a receiving report. Inventory Control personnel match the
receiving report with a copy of the credit memorandum.
- Cash receipts – the revenue/receipt cycle is completed for a transaction when cash is
collected. Personnel involved in cash collection are segregated from Accounts Receivable,
General Accounting, and Billing, since combining cash collection with any of these other
three functions provides opportunities to misappropriate cash.
- Allowance for uncollectible accounts – A/R personnel should review individual customer
accounts periodically as a check against unauthorized credit limits and prepare monthly A/R
trial balances for reconciliation with general ledger control accounts. Delinquent accounts
should be reviewed periodically by personnel who report to the treasurer and are
independent of recording functions.
- Write off of specific accounts – when an individual customer account is judged to be
uncollectible, written authorization to write off the account is sent to A/R and to General
Accounting.
4. Common forms:
- Customer order – request from a customer to purchase goods.
- Sales order – identifies goods ordered by a customer, including relevant information about
price, quantity, payment terms, etc.
- Shipping document – identifies goods shipped and represents a contract between the
seller and carrier.
- Sales invoice – identifies goods sold and represents formal notice to a customer about the
amount and terms of payment.
- Customer remittance advice – accompanies a sales invoice but is intended to be returned
with a customer’s payment; a returned remittance advice indicates the purpose of a cash
payment, facilitating handling and recording.
AT Lecture 8 “Tests of Transaction Cycles” 2
1. Control objectives are summarized in the following categories. If the control objectives are
not achieved error or fraud may occur:
c. Recording – all sales, cash receipts, and related transactions should be recorded at
correct amounts, in the proper period, and be classified properly within the accounts.
- Management can control the recording function by establishing written procedures,
reconciling control totals and periodically comparing actual results with budgets, if
available.
- Management should also establish procedures to assure that recorded receivables
balances fairly reflect the underlying transactions and events they represent.
- To control the recording of receivables, management could periodically substantiate
and evaluate individual customer balances and reconcile supporting detailed ledgers
to the general ledger.
The expenditure/disbursement cycle encompasses both the acquisition of goods and services and
the payment of cash for the goods and services acquired.
3. Common activities:
- Purchasing – involves the acquisition of goods and services from vendors.
o Goods include tangible resources, such as inventory, supplies, and equipment.
o Services include nontangible resources, such as advertising, repairs and maintenance,
utilities, and insurance.
o An employee of the department that requests the purchase prepares a purchase
requisition, which is submitted to a supervisor for approval.
o Approved purchase requisitions are forwarded to Purchasing, where the request is
reviewed, a vendor selected, and a purchase order prepared.
o A purchase order describes the goods or services requested, specifying the price,
quantity, shipping terms, and catalog numbers.
o Purchasing sends copies of purchase orders to the vendor and to the requisitioning
department, to Receiving, and to Accounts Payable.
- Receiving – goods ordered from vendors are delivered to the Receiving department, where
the goods are compared with the purchase order and a receiving report is prepared.
o The Receiving department maintains a receiving log cross-referenced to related
receiving reports.
o A copy of the receiving report is forwarded to Purchasing and to Accounts Payable.
AT Lecture 8 “Tests of Transaction Cycles” 4
- Payment – cash disbursements should be authorized and executed by personnel who report
to the treasurer and are independent of purchasing and recording.
o Voucher packages in the unpaid voucher file are forwarded to the Treasury
department, prior to the date payment is due.
o The Treasury department reviews voucher packages for accuracy and authenticity
before approving vouchers for payment and submitting vouchers for check printing.
o Blank checks should be prenumbered and voided checks should be retained and
accounted for.
o Unused checks should be controlled physically; limiting access to authorized personnel
only.
o Drawn checks and approved supporting vouchers should be reviewed by an individual
not otherwise involved in either processing or recording payables.
o Signed checks should be mailed directly to the payee without intervention by
employees responsible for approving, recording, or processing the transaction.
o Paid voucher packages should be cancelled immediately. Cancellation prevents
duplicate payments and is often accomplished by perforating the voucher package or by
notation son a computer screen. Cancelled voucher packages, with check numbers on
the vouchers should be filed.
o A daily summary of all remittances should be prepared and forwarded to Accounts
Payable for posting to subsidiary payables ledger and to General Accounting for
recording in the voucher register.
Where applicable, competitive bids or formal price quotations should be obtained from suppliers.
- Transaction execution – goods should be inspected for quality when received, and quantities
should be verified by physical count and compared with purchase orders.
o Management should require that Receiving personnel inspect and count all received
goods before releasing the carrier.
o Management should institute policies to assure that cash is disbursed only for bona fide
liabilities, protecting against disbursements for goods not received, payment to
unauthorized parties, and duplicate payments.
o To control against improper disbursements, management could prenumber and control
vouchers and checks, require a second manual signature for checks exceeding pre
specified amounts, and cancel paid voucher packages immediately upon payment.
- Recording – after purchase transactions are executed, all goods and services received should be
reported promptly to Accounts Payable, indicating title has passed, and to Purchasing, indicating
ordered goods have been received.
o To protect against inaccurate account balances and against misstated financial
statements, management should institute policies to assure that all purchases and cash
disbursements are recorded properly and in the proper period.
o To control against inaccurate vendor accounts, management could establish validation
procedures to verify postings, and reconcile input totals to processed and output totals.
o Authorized personnel should investigate correspondence from vendors, particularly
collection notices.
AT Lecture 8 “Tests of Transaction Cycles” 5
For each of the categories, the types of errors or frauds that could occur if the control objective is not
met, and the control procedure designed to prevent or detect the error or fraud is described.
The focus of the internal control section of the chapter is on the application of audit procedures to the
tests of controls in the expenditure/disbursement cycle. This involves:
a. Perform a preliminary review – auditors will interview client personnel and review
accounting procedures manuals to develop a general understanding of the client’s control
environment, accounting system, and how the entity identifies, captures, communicates, and
monitors external and internal information in a form and time frame that enables employees
to discharge their assigned responsibilities.
- The preliminary review determines whether investing additional audit effort is likely to
support a decision to assess control risk below the maximum allowing the auditor to
assess detection risk above the minimum and restrict the extent of substantive tests for
the very account balances that are processed through the expenditure/disbursement
cycle.
If existing controls are inadequate to justify assessing control risk below the maximum,
then the auditor’s documentation of the system is limited simply to a memorandum in the
working papers that describes the reasons for not continuing to consider internal control.
b. Document the system – this can be accomplished with the use of flowcharts,
questionnaires, and/or narratives.
System documentation would be revised if the transaction walk-through revealed that the
auditor’s understanding of internal control is inaccurate.
In respect to high-volume transactions like purchases and cash disbursements, an auditor’s strategy
is to expend significant audit effort performing tests of controls, since evidence supporting the
assessment of control risk below the maximum would justify restricting substantive tests of account
balances at year end.
AT Lecture 8 “Tests of Transaction Cycles” 6
Business functions - the services of employees are acquired in exchange for obligations to pay and
those obligations are paid.
- Personnel and payroll are critical to most entries for at least three reasons:
I. Salaries and wages are a major expenditure for most service, manufacturing, and nonprofits
entities.
Documents include:
Personnel records: includes information for each employee, including date of employment, job
classification, salary or hourly pay rate, promotions, payroll deductions, terminations, etc.
Time Record: hours worked by an employee during a pay period.
Payroll Register: a record of gross pay, withholdings, deductions, and net pay for each
employee for a pay period; the basis for preparing pay checks, recording payroll, and updating
employee earnings records.
Employee earnings record: a cumulative, year-to-date summary of total earnings, withholdings,
and deductions for each employee.
All action taken by management on behalf of an employee should be approved by both department
supervisors and by the Personnel department, and should be documented in an employee’s
personnel records. Personnel records include:
Salary or wage rates,
Payroll deductions,
Employee signatures,
Job classifications, and
Performance evaluations.
To minimize chance of fraud, personnel records should not be accessible to employees who are
responsible for preparing, approving, or distributing payroll.
When employees are terminated, the Personnel department should determine the nature and terms
of any related termination settlement and notify the Payroll department of the settlement and
termination.
-Transaction authorization – management should establish criteria for hiring line and staff
employees. Otherwise, unqualified employees may be hired, potentially resulting in excessive
training costs, unnecessary relocation costs, or penalties for violating equal opportunity laws, among
other things.
To control against unauthorized hiring, management should establish written hiring policies.
Verify all information included in employment applications.
Maintain updated personnel records for all employees.
Authorize compensation and payroll deductions.
Establish written policies for pay rate adjustments and communicating the policies to the
Personnel department and to operating department supervisors.
AT Lecture 8 “Tests of Transaction Cycles” 7
-Transaction execution – to control against disbursements for work not performed, all
disbursements for payroll should be based on a recognized liability.
Management can control unauthorized payroll disbursements by requiring a second, manual
signature for all unusual or excessive paycheck amounts.
Companies should establish personnel and payroll procedures manuals and advertise available
job openings widely throughout the company.
- Recording – all amounts owed to employees should be recorded at the properly amounts and in
the proper period, and should be classified properly.
To control against improper recording, management could establish account distribution, and
labor cost allocation procedures and reconcile appropriate ledgers, journals, and summaries.
- Access to assets – to control against misapplied cash and unauthorized labor costs, management
should institute policies that restrict access to personnel and payroll records to authorized personnel
only.
The focus of the internal control section of the chapter is on the application of audit procedures to the
tests of controls in the revenue/receipt cycle. This involves:
This involves:
Performing a preliminary review – when an auditor develops a general understanding of
a client’s control environment, the flow of transactions and records through the accounting
system, and the control procedures management has implemented to prevent and detect
errors or frauds.
Documenting the system – the process when auditors use narratives, flowcharts, and
questionnaires to describe the payroll system.
Performing a transaction walk-through – to confirm his or her understanding of the
system documented, the auditor could select a line item from a processed payroll register
and trace the information:
1. To time records summarized in the Payroll department and filed in the Inventory
Accounting department and
1. The conversion cycle–encompasses the production of finished products for sale, and relates
directly to two other cycles:
It uses resources and information provided by the expenditure/disbursement cycle
Provides resources and information to the revenue/receipt cycle
2. Business functions–the production of finished products for sale.
3. Common activities:
a. Inventory
- Maintaining perpetual records – Throughout the conversion cycle, journal entries are
made to process inventory costs through production, to record the cost of goods sold, and
to write down obsolete or damaged inventory. Paper or computer images documents
include:
Labor charge report: A summary of labor costs to be applied to work in-process
inventory.
AT Lecture 8 “Tests of Transaction Cycles” 8
b. Fixed assets – are related both to the conversion cycle and to inventory:
To the conversion cycle because fixed assets transform inventory from raw materials
to finished goods, and
To inventory because some depreciation is applied to products as overhead.
c. Throughout the conversion cycle, journal entries are made to record depreciation and to
apply overhead to inventory. Paper or computer image documents include:
Depreciate schedule: A spreadsheet computing and summarizing depreciation.
Overhead application report: A summary of overhead applied to work-in-process
inventory.
The acquisition of inventory is part of the expenditure/disbursement cycle, and the distribution of
finished goods is a part of the revenue/receipt cycle. The conversion cycle encompasses movement
of goods through the production process.
Inventory control
A materials requisition form is prepared by production personnel to request materials and
supplies for use in production.
o Requisitions should be approved by a supervisor and forwarded to Inventory Control.
o Inventory Control personnel should not release materials and supplies in the absence of an
approved requisition.
Inventory Control personnel not involved in purchasing, receiving, shipping, production, or
recording should control raw materials and finished goods.
o Access to storage areas should be limited to authorized personnel.
Inventory Control personnel should be responsible for controlling transfers in and out of storage
areas, and for monitoring inventory levels and for reporting slow-moving or damaged items.
o Inventory levels should be monitored to assure that they are neither too high, resulting in
needlessly high carrying costs, or too low, which could risk insufficient quantities on hand.
Inventory accounting – involves two major sets of records: perpetual inventory records and cost
records.
Perpetual Inventory Records – inventory quantities, physical locations, and selected unit cost
information usually are accumulated on perpetual inventory records maintained for a variety of
major inventory classifications, including supplies, raw materials, and finished goods.
o Work-in-process inventory should also be controlled on perpetual records.
o As inventory flows through the production process, perpetual records should be updated
continually, thereby providing a cumulative up-to-date record of quantities, physical location,
and selected unit cost information.
o Off-premises inventory should be accounted for and controlled by the outside parties
holding the goods. Periodically, a company should confirm off-premises inventory, physically
count quantities at off-premises locations, and reconcile confirmed or counted quantities with
internal perpetual records.
Cost records – An inventory accounting system must account for inventory costs, which may be
allocated on a FIFO, LIFO, average cost, or other acceptable basis.
o Like perpetual inventory records, cost accounting records and reports should be updated
continually, thereby providing an up-to-date record of accumulated costs.
o The updated information should be communicated to General Accounting personnel for
summarizing and for recording journal entries in general ledger control accounts.
o If updated information is not communicated to the Accounting department, accounts such as
Raw Materials, Work in Process, and Finished Goods could be misstated.
o To maintain segregation of duties, cost accounting records should be maintained by
personnel independent of perpetual records, general accounting, purchasing, production,
and inventory control.
1. Land, building, machinery, and equipment should be documented in detailed records that
account separately for each individual asset.
Detailed records might include the purchase date, historical cost, depreciation method,
estimated useful life, salvage value, and accumulated depreciation.
Personnel not responsible for physically controlling fixed assets should maintain the records.
Periodically, but no less than annually, detailed records should be reconciled with fixed asset
general ledger control accounts.
AT Lecture 8 “Tests of Transaction Cycles” 9
Responsible personnel independent of fixed asset recording and physical control should
periodically determine that recorded assets actually exist by observing machinery and
equipment and by comparing identification numbers and general descriptions with detailed
records.
Fixed assets should be insured against fire or other potential casualties. Assets should be
appraised periodically to determine that insurance coverage reasonably approximates
replacement cost.
2. Additions: Individual fixed asset additions are often material, necessitating specific authorization
by the board of directors or by senior management.
Formal authorization is required for major repairs or improvements; since the expenditures
may be large, management should assess the desirability of replacing, rather than
repairing and improving, existing assets.
Authorizations should be documented in writing.
Procedures should require that actual costs be compared with amounts authorized, and cost
overruns reported to senior management for authorization.
Constructed additions should also be authorized, and additional controls should be
implemented that allow the entity to inspect and approve both actual production and
detailed cost records as construction progresses.
3. Disposals: Senior management should authorize fixed asset disposals, such as sales or
retirements. Authorizations should be documented, and copies forwarded to accounting
personnel to assure that assets disposed of are subsequently removed from fixed asset
accounts.
Asset disposals should be reported to insurance companies and premiums adjusted
accordingly.
Controls should be established to assure that proceeds are deposited and gains or losses
are recorded.
4. Depreciation: Due to the significant impact depreciation expense can have on reported net
income, an entity should maintain formal policies for determining depreciation methods,
estimated useful lives and salvage values.
Periodically, the policies should be reviewed to determine whether they reasonably
approximate actual experience.
5. Control objectives, potential errors or frauds, and control procedures are summarized in the
following categories:
- Transaction Authorization – Fixed asset additions, disposals, and retirements should be
authorized in accordance with management’s criteria.
To control unauthorized transactions, management could develop written procedures for
all additions, disposals, and retirements, and periodically compare scrap sale prices with
published price lists.
- Access to Assets – To control against stolen or lost fixed assets, access should be restricted
to personnel authorized by management.
Management should establish physical controls over unused assets, maintain
adequate insurance coverage, and segregate the physical custody of fixed assets
from recording and general accounting.
To control fixed assets records, management should establish controls over unused
forms and records or could perform periodic compliance audits, reconciling recorded
assets with existing assets.
AT Lecture 8 “Tests of Transaction Cycles” 10
For each of the categories, the types of errors or frauds that could occur if the control objective is not
met, and the control procedure designed to prevent or detect the error or fraud is described.
1. The focus of the internal control section of the chapter is on the application of audit procedures
to the tests of controls in the conversion cycle as applied to inventory and fixed assets. This
involves:
Preliminary review – An auditor performs the preliminary review for inventory by reading
the client’s procedures manuals and by interviewing client personnel who are responsible for
perpetual inventory records, cost records, and inventory accounting.
o Assuming that existing controls appear potentially reliable in assessing control risk
below the maximum, an auditor proceeds by documenting the system.
Documenting the system – An entity’s inventory control and inventory accounting
procedures can be documented with flowcharts, questionnaires, and/or narratives, although
detailed flowcharts are less common in practice.
Performing a transaction walk-through – To confirm his or her understanding of the
system, the auditor could trace one or several materials transfers from raw materials to work
in process, to finished goods perpetual records, and to entries and postings in cost records,
inventory accounting, and general accounting.
Determining whether existing control procedures are potentially reliable in assessing
control risk below the maximum
o Identify the system’s control objectives.
o Consider the potential errors or frauds that might result in specific control objectives are
not met.
o Determine which control procedures are used by the entity to prevent to detect
potentially material errors or frauds.
o Design tests of control.
2. Tests of controls over inventory focus on whether transfers of inventory through the production
process are authorized and recorded.
Perpetual Records – tests of controls over an entity’s perpetual records focus on physical
transfers of inventory to and from raw materials, work in process, and finished goods.
Inaccurate recording of transfers could suggest that control procedures are neither compiled
with, nor operating as planned, casting doubt on the reliability of the records.
Inaccurate recording could suggest the possibilities of double-counted inventory quantities.
Cost Records: tests of controls must be performed for the flow of inventory costs from raw
materials to work in process, finished goods, and cost of goods sold.
3. Assess Control Risk – an auditor reviews system documentation and the results of tests of
controls to determine whether existing control procedures can be relied on to assess control
risk below the maximum, assess detection risk above the minimum, and to restrict
substantive tests of inventory. The evaluation is based on four issues:
The types of errors or frauds that could occur,
Necessary control procedures that should prevent or detect the errors or frauds,
Whether the necessary procedures exist and are followed, and
Any deficiencies in internal control.
2. Tests of Controls: Fixed Assets – when the number of fixed asset transactions is limited, an
auditor may forego or limit tests of controls, electing instead to assess control risk at the
maximum, assess allowable detection risk at the minimum, and rely on substantive tests of
details. If the number of transactions is large, an auditor may elect to perform tests of controls
over an entity’s recording, addition, disposal, and depreciation activities.
Fixed Asset Records – tests of fixed asset records focus on the relationship between
detailed records and the general ledger and on the existence of, and insurance coverage for,
recorded assets.
Additions – an auditor’s predominant concern in tests of fixed asset additions is that the
related transactions are authorized and properly recorded.
Disposals – like additions, an auditor is concerned that fixed asset disposals are authorized
and properly recorded.
Depreciation – tests of depreciation involve calculations and the review of recorded
amounts, useful lives, and salvage values. Similar tests are performed for the amortization of
intangible assets and the depletion of wasting assets.
Assess Control Risk: an auditor reviews system documentation and the results of tests of
controls to determine whether existing control procedures can be relied on to assess control risk
below the maximum, assess detection risk above the minimum, and to restrict substantive tests
of inventory. The evaluation is base on four issues:
The types of errors or frauds that could occur,
Necessary control procedures that should prevent or detect the errors or frauds,
Whether the necessary procedures exist and are followed, and
Any deficiencies in internal control.
The financing cycle processes transactions and events that generate capital funds, and is directly
related to two other cycles:
It uses resources and information provided by the expenditure/disbursement cycle, and
Provides resources and information to the revenue/receipt cycle.
If securities are maintained internally, at least two officials should be held jointly responsible,
thereby minimizing the likelihood of unauthorized sales.
Employees who do not otherwise have custody or access should count securities maintained
by internal parties periodically on a surprise basis.
An employee independent of the custodial function should maintain detailed records for
securities held. Compiling information such as certificate numbers and quantities.
If maintained externally, securities listings should be prepared by the custodian at least
monthly, mailed to the company, and reconciled with internal records.
AT Lecture 8 “Tests of Transaction Cycles” 12
Acquisitions, Sales, and Income: all acquisitions and sales of current and non current
securities should be authorized by the board of directors or an authorized investment
committee.
Recorded acquisition and selling prices should be compared with published price quotations
assuring that transactions were recorded at accurate prices.
Dividend income should be recognized when declared, interest income accrued when earned,
and employees not otherwise responsible for the custody, acquisition, or sale of securities
should recalculate gains and losses.
Debt – debt incurrence and retirement transactions are relatively few in number but are usually
accompanied by extensive supporting documents, such as SEC filings and bond issuance
authorizations from shareholders and the board of directors.
The board of directors should authorize all long-term debt. Authorizations should be expressly
documented in the board’s minutes, clearly indicating maximum indebtedness and the names
of officers authorized to negotiate each transaction.
Debt instruments such as loan agreements contain restrictive covenants that, if violated, could
result in the debt becoming due immediately.
Unissued bonds and notes should be prenumbered consecutively and controlled by an
employee who neither maintains detailed debt records nor has access to general accounting
records. Periodically, an independent employee should physically inspect unissued debt
instruments and account for the numerical sequence.
Retired debt instruments should be either cancelled or destroyed. Records should be kept for
cancelled instruments, and affidavits from witnesses should be kept for destroyed instruments.
Periodically, an independent employee should reconcile bond or note register with the general
ledger. An authorized employee should calculate interest expense in accordance with the
terms of each instrument, and the resulting payments should be processed through the
expenditure/disbursement cycle.
Equity – the financing cycle processes equity issuance and retirement transactions, directing
resources through the revenue/receipt and expenditure/disbursement cycles, respectively.
All transactions relating to equity securities should be authorized by the board of directors and
documented.
All issuances and retirements should be approved both in price and in quantity by the board of
directors either specifically or generally, as in the case of authorized stock option plans.
Stock certificate should be pre numbered consecutively, signed by authorized officers when
issued, and promptly cancelled when surrendered for retirement.
Unissued certificates should be physically safeguarded with access limited to authorized
individuals.
Treasury shares that have not been retired and cancelled should be accounted for and
controlled.
Periodically an independent employee should reconcile the shareholder’s ledger with the
transfer journal.
An independent employee not otherwise responsible for maintaining shareholder records or
processing dividend payments should reconcile the dividend bank account periodically.
Internal Control Objectives and Potential Errors or Frauds: Investments, Debt, and Equity
Management could control access by establishing physical barriers over pre numbered
forms and records and by carrying insurance and fidelity bonds.
Officials responsible for unissued, issued, and retired securities should not be responsible
for physically controlling securities or for performing accounting or cash activities.
For each of the above categories, the types of errors or frauds that could occur if the control
objective is not met, and the control procedure designed to prevent or detect the error or fraud is
described.
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