Solution manual aswers auditing theory by cabrera chapter 23 ans

CHAPTER 23 TESTS OF CONTROLS I Review Questions 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 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 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 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 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 23-2 Solutions Manual - Assurance Principles, Professional Ethics… 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 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 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 Recorded transactions are valid and documented All valid transactions are recorded and none omitted Transactions are authorized by company policy Transaction peso amounts are properly calculated Transactions are properly classified in the accounts Transaction accounting is complete Transactions are accounted in the proper period Recorded cash receipts are supported by remittance advices All cash receipts are entered in the daily remittance list, deposited intact and recorded in the accounts receivable control account Cash receipts for transactions other than merchandise sales (scrap sales, sales of fixed assets) are properly authorized Cash receipts are compared to invoice terms to determine proper cash discounts Cash receipts for nonmerchandise sales are posted to proper accounts All cash receipts for credit sales are posted to customer individual accounts Cash receipts are deposited daily intact and recorded as of date received If the credit limits are set and entered incorrectly, the credit approval process will be systematically deficient The functions which should be separated to maintain internal control in a purchasing system include (1) custody of the goods (receiving and stores Tests of Controls 23-3 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 b c d e f Blank vouchers kept in secure location available only to authorized personnel Blank supporting documents (invoices, receiving reports, requisitions, purchase orders) kept in secure locations available only to authorized personnel Supporting documents canceled by Cash Disbursement function when checks are prepared Separation of duties of preparers of supporting documents, preparation of vouchers, check preparation, and check signing Vouchers and other supporting documents reviewed by check signers 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: People have bad days and make mistakes; computers not have bad days Murphy’s Law – If it is possible to make an error, someone will find a way to it People initiate the transactions and will make errors All controls should be considered together (manual and computer) Excellent computer controls cannot be relied upon if the related manual controls are weak 23-4 Solutions Manual - Assurance Principles, Professional Ethics… 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) People can prevent a good computer system from working well if they are not convinced it is in their best interests People will rarely question computer printed output, even though it may not be correct 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: 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 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 Examine BIR tax reports and correspondence and the audit reports of tax authorities and trace additional tax assessments to the accounts Confirmation of accounts payable 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 orders Prepare bill of materials and manpower needs Bill of materials (B.M.) Manpower needs (M.N.) Separation planning from production Tests of Controls Assign job order and foreman 23-5 Note separation production supervisor from foreman duties Job tickets and material requisitions prepared Job tickets (JT) Production foreman Material requisition (MR) duties separated from authorization Raw material records updated, issue slips prepared Issue slip (IS) Observe time entered and foreman approval on JT Direct labor report prepared Approval by foreman of hours Labor report (LR) Observe timekeeping, compare job tickets to clock cards Material used report prepared Materials not issued without MR IS prepared for all materials released Job tickets support L.R Reconciliation hours per clock cards to hours per J.T 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 Preparation of completion report Observe units compared to RUC, post finished records Separation of duties; cost accounting and general ledger Report of units completed (RUC) Independent report of production completed Independent check of RUC 23-6 Solutions Manual - Assurance Principles, Professional Ethics… Products received report prepared Products received report (PRR) Observe comparison RUC and PRR Job sheets closed out, summary entry prepared Trace summary entry to General Ledger posting Independent records of units put into finished goods inventory Records from separate sources reconciled Summary entry form Closed job sheets, RUC and PRR support summary entries Separation of duties; cost accounting and general ledger 16 Weaknesses (lack of control where auditors believe one is necessary) are not audited because auditors 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: Reference to the standard regarding “adequate technical training and proficiency as an auditor.” Reference to the standard regarding “due professional care.” Obviously, the auditor must be knowledgeable about cost accounting to audit a manufacturing company In a manufacturing company, the inventories most likely will be a major asset which will require substantial audit work 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 23-7 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 Hiring – personnel dept Deductions – personnel dept Timekeeping Shops Cost distribution Accounts payable Cash disbursement Document(s) Collected Authorization to hire and rate assignment Personnel forms, employee authorization for deductions Clock card Job time ticket Labor distribution sheet Payroll voucher 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 c c b c a c c b 10 11 12 d b a a 13 14 15 16 b a c d 17 18 19 20 d d c b III Comprehensive Cases Case 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.) 23-8 Solutions Manual - Assurance Principles, Professional Ethics… 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) 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) 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 The discussion could take several directions, including some or all of the following: 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 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 Potential irregularities include: a b Castro can collude with customers to rig low bids and take kickbacks, thereby depriving the company of legitimate revenue Castro can direct purchases to favored suppliers, pay unnecessarily high prices and take kickbacks He might even set up a controlled Tests of Controls c d e 23-9 dummy company to sell overpriced materials to the company No competitive bidding control prevents these activities Castro, through the control of physical inventory, can (i) remove materials for himself, and (ii) manipulate the inventory accounts to conceal shortages Castro can order truck shipping services for his own purposes and cause the charges to be paid by the company Castro can manipulate the customer billing (similar to a above) to deprive the company of legitimate revenue while taking an unauthorized commission or kickback Almost every desirable characteristic of good internal control has been circumvented: a b c d Segregation of Functional Responsibilities Castro has authorization and custodial responsibilities 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 Controlled Access The whole situation gives Castro access to necessary papers, records, and assets to carry out his one-man show 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 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) Case If the credit limits are set and entered incorrectly, the credit approval process will be systematically deficient 23-10 Solutions Manual - Assurance Principles, Professional Ethics… Case Memorandum TO: FROM: DATE: SUBJECT: Board of Directors, The Potter Art League (Student’s name) 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 Case a b 23-11 The purposes of these audit procedures are: 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 To determine proper cash “cutoff”, i.e., to detect any unintentional errors overstating or understating cash between the current and the following accounting period To disclose “kiting” (if any), e.g., perpetrated by the home office cashier in collusion with one or more sales divisions employees Audit Program for Sales Divisions – Audit Steps 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 Compare dates of issue on canceled checks and of entries Trace and compare dates of perforation and dates of payment on the bank statement and the “cutoff” statement Compare dates of issue of checks to date of perforation looking for: a b unusual delays in payment discrepancy in accounting periods for the two dates Scan cancelled checks and cash disbursements records during the year for: a b names of payees, consecutive numbers of checks to determine whether any payments other than regular transfers to main office were made from this account Reconcile individually several transfers during the year to corresponding collections presumed to be transferred as of each individual date Reconcile total collections for the year to total transfers 23-12 Solutions Manual - Assurance Principles, Professional Ethics… Case a b Recorded payroll transactions are valid (no fictitious employees) 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 a b Recorded payroll deductions are valid Incorrect amounts might be deducted from pay a b Recorded payroll transactions are valid and authorized 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 a b Payroll and labor cost transactions are complete Cost accounting records might contain more or fewer pesos than actually paid (per payroll data) Simple errors in cost analyses might occur  ... controls should be considered together (manual and computer) Excellent computer controls cannot be relied upon if the related manual controls are weak 23-4 Solutions Manual - Assurance Principles, Professional... 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... shipping department (Thus a control access deficiency may be compensated by other control procedures.) 23-8 Solutions Manual - Assurance Principles, Professional Ethics… Sales invoices check