(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.
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 orders
Production Order (P.O.) Support for P.O.
Prepare bill of materials and manpower needs
Bill of materials (B.M.) Manpower needs (M.N.)
Separation planning from production.
Tests of Controls 19-5
Assign job order and foreman
Note separation production supervisor from foreman duties. Job tickets and material
requisitions prepared
Job tickets (JT)
Material requisition (MR)
Production foreman duties separated from authorization. Raw material records
updated, issue slips prepared
Issue slip (IS) Materials not issued without MR. IS
prepared for all materials released.
Observe time entered and foreman approval on JT
Approval by foreman of hours.
Direct labor report prepared
Labor report (LR) Job tickets support L.R.
Observe timekeeping, compare job tickets to clock cards
Reconciliation hours per clock cards to hours per J.T.
Material used report prepared
Material used report (MUR)
Issue slips and requisitions support MUR.
Observe matching issue slips and material used report
Records from sources reconciled.
Observe matching job time tickets (or labor distribution) to labor report
Records from separate sources reconciled.
Enter costs in job cost sheets
Job cost sheets (JCS) Support for all entries in JCS.
Summary entry prepared.
Summary entry form Job cost sheets support summary entries. Trace summary entry to
General Ledger posting
Separation of duties; cost accounting and general ledger. Preparation of completion report Report of units completed (RUC) Independent report of production completed. Observe units compared
to RUC, post finished records
Independent check of RUC.
Products received report prepared
Products received report (PRR)
Independent records of units put into finished goods inventory. Observe comparison
RUC and PRR
Records from separate sources reconciled. Job sheets closed out,
summary entry prepared
Summary entry form Closed job sheets, RUC and PRR support summary entries. Trace summary entry to
General Ledger posting
Separation of duties; cost 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.
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
Tests of Controls 19-7
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
dept.
Personnel forms, employee authorization for 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.
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
Cases
1. 1. Controlled access to blank sales invoices.
a. Observation. Visit the storage location yourself and see if unauthorized persons could obtain blank sales invoices. Pick some up 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.
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.
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
Tests of Controls 19-9
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.
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.
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).
4. If the credit limits are set and entered incorrectly, the credit approval process will be systematically deficient.
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.
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.
Tests of Controls 19-11
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. 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. 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.