Chapter 12

Audit of the Sales and Collection Cycle: Tests of Controls

Review Questions

12-1 a. The bill of lading is a document prepared at the time of shipment of goods
to a customer indicating the description of the merchandise, the quantity shipped, and
other relevant data. Formally, it is a written contract of the shipment and receipt of
goods between the seller and carrier. It is also used as a signal to bill the client. The
original is sent to the customer and one or more copies are retained.

b. A sales invoice is a document indicating the description and quantity of goods

shipped, the price including freight, insurance, terms, and other relevant data.
It is the method of indicating to the customer the amount owed for the sale and
due date of the payments. The original is sent to the customer and one or
more copies are retained. The invoice is the basic document for recording
sales in the accounting records.

c. The credit memo is a document indicating a reduction in the amount due from
a customer because of retained goods or an allowance granted. It takes the
same general form as a sales invoice, but it reduces the customer's accounts
receivable balance rather than increasing it.

d. The remittance advice is a document accompanying the sales invoice mailed

to the customer for return to the seller with the cash payment. It is used to
indicate the customer name, sales invoice number, and the amount of the
invoice when the payment is received. A remittance advice is used to permit
the immediate deposit of cash as a means of improving control over the
custody of assets.

e. The monthly statement to customers is the document prepared monthly and

sent to each customer indicating the beginning balance of that customer's
accounts receivable, the amount and date of each sale, cash payment
received, credit memo for sales returns and allowances, and the ending
balance due. It is in essence a copy of the customer's portion of the accounts
receivable master file.

12-2 Proper credit approval for sales helps minimize the amount of bad debts and
the collection effort for accounts receivable by requiring that each sale be evaluated for
collection potential.

Adequate controls in the credit function enable the auditor to place more reliance on the
client's estimate of uncollectible debts. Without these controls, the auditor would have to
make his or her own credit checks on the customers in order to assure him- or herself
that the allowance for bad debts is reasonable.

12-1
12-3 The charge-off of uncollectible accounts receivable is a process whereby the
company writes off receivables already in existence that it decides will not be collected.
This usually occurs after a customer files for bankruptcy or the account is turned over to
a collection agency. The bad debt expense is a provision for sales that the company will
be unable to collect in the future. It is an estimate used because of the matching
concept of accounting.

The uncollectible accounts write-off must be carefully audited to assure that accounts
that have been paid are not written off to cover up a defalcation. This is done by
examining the authorization for the write-off and the correspondence in the files
concerning that account, and possibly by circularizing accounts receivable
confirmations.

Bad debt expense is audited by examining past trends in uncollectibility, as it is a

projection of future uncollectibles.

12-4
Transaction-Related Audit Key Internal Controls
Objective

1. Recorded sales are for Recording of sales is supported by authorized

shipments actually made to
nonfictitious customers
(existence).
shipping documents and approved customer orders.
Monthly statements are sent to customers;
complaints receive independent follow ups.
Authorization of credit before shipment takes place.
Only customer numbers existing in the computer data
files are accepted when they are entered.
Shipping documents (that is, bills of lading) are
prenumbered and accounted for.

2. Existing sales transactions Sales invoices are prenumbered and accounted for.
are recorded Shipping documents are prenumbered and accounted
(completeness). for.

3. Recorded sales are for the
amount of goods shipped
and are correctly billed and
recorded (accuracy).
Determination of prices, terms, freight, and discounts
is properly authorized.
Internal verification of invoice preparation.
Approved unit selling prices are entered into the
computer and used for sales.
Batch totals are compared with computer summary
reports.

4. Sales transactions are Use of adequate chart of accounts.

properly classified Internal review and verification.
(classification).

12-2
 5. Sales are recorded on the Procedures require billing and recording of sales on a
correct dates. (timing). daily basis.
Internal verification.

6. Sales transactions are Regular monthly statements to customers.

properly included in the Internal verification of accounts receivable master file
subsidiary records and are or trial balance with general ledger balance.
correctly summarized
(posting and
summarization).

12-5 The most important duties that should be segregated in the sales and collection
cycles are:

1. Receiving orders for sales

2. Shipping goods
3. Billing customers and recording sales
4. Maintaining inventory records
5. Maintaining general accounting records
6. Maintaining detailed accounts receivable records
7. Processing cash receipts
8. Granting credit and pursuing unpaid accounts
Segregation of duties should be used extensively in the sales and collection cycle for
two reasons. First, cash receipts are subject to easy manipulation. Second, the large
number and nature of transactions within the cycle makes the procedure of cross-
checking, where one employee's duties automatically serve to verify the accuracy of
another's, highly desirable.

If the asset-handling activities (shipping goods and processing cash receipts) are
combined with their respective accountability activities (maintaining inventory, accounts
receivable, and general accounting records), a serious weakness with respect to
safeguarding those assets exists. It would be very easy for an employee, by either
omitting or adding an entry, to use the company's assets for his or her own purpose. If
the credit granting function is combined with the sales function, a weakness as to
adherence to management's policies exists, as the credit function checks the natural
tendency of sales to optimize volume even at the expense of high bad debt write-offs.
12-6 The use of prenumbered documents is meant to prevent the failure to bill or
record sales as well as to prevent duplicate billings and recordings. An example of a
useful control to provide reasonable assurance that all shipments are billed, is for the
billing clerk to file a copy of all shipping documents in sequential order after a shipment
has been billed. Periodically, someone can account for all numbers in the sequence and
investigate the reason for missing documents. The same type of control is also useful
for duplicate sales invoices. An example of a useful test in this area is to account for the
sequence of duplicate sales invoices in the sales journal, watching for omitted numbers,

12-3
duplicate numbers, or invoices outside the normal sequence. This test simultaneously
provides evidence of both the "existence" and "completeness" objectives.

12-7 1. Credit must be properly authorized before a sale takes place.

Test: Analyze the allowance for doubtful accounts and writeoffs of

accounts receivable during the period to determine the effectiveness of the
credit approval system.

2. Goods should be shipped only after proper authorization.

Test: Review physical inventory shortages to determine the effectiveness of

inventory control.

3. Prices, including payment terms, freight, and discounts, must be

authorized.

Test: Compare actual price charged for different products, including freight
and terms, to the price list authorized by management.

12-8 The purpose of footing and crossfooting the sales journal and tracing the
posting to the general ledger is to determine that all transactions are included in the
sales journal from which the auditor will make his or her sample selection for testing the
transactions and to determine that the general ledger balance results from the sales and
collection cycle.

12-9 The verification of sales returns and allowances is quite different from the
verification of sales for two primary reasons:

1. Sales returns and allowances are normally an insignificant portion of

operations and therefore receive little attention from the auditor.

2. The primary emphasis the auditor places on sales returns and

allowances is to determine that returns and allowances are properly
authorized and that sales are not overstated at year-end and
subsequently reversed by the issuance of returns.

12-10 Cash is the most liquid asset that the company owns and thus is the most
likely target of a fraud. The emphasis the auditor places on the possibility of fraud in
cash is not inconsistent with this responsibility, which is to confirm the fairness of the
presentation of the financial statements. If material fraud has occurred, and it is not fully
disclosed in the financial statements, those statements are not fairly presented.

12-4
12-11
Transaction -Related Audit
Objective
1. Recorded cash receipts
are for funds actually received
by the company. (existence)
2. Cash received is
recorded in the cash receipts
journal. (completeness)
3. Recorded cash receipts
are deposited and recorded at
the amount received.
(accuracy)
4. Cash receipts are
properly classified.
(classification)
5. Cash receipts are
recorded on the correct dates.
(timing)
6. Cash receipts are
properly included in the
subsidiary records and are
correctly summarized. (posting
and summarization)
Key Internal Controls
• Separation of duties between handling
cash and record keeping.
• Independent reconciliation of bank
account.
• Separation of duties between handling
cash and recordkeeping.
• Use of remittance advices, or a prelisting
of cash.
• Immediate endorsement of incoming
cheques.
• Internal verification of the recording of
cash receipts.
• Regular monthly statements to
customers.
• Same as 2 above.
• Regular reconciliation of bank accounts.
• Batch totals are compared with computer
summary reports.
• Use of adequate chart of accounts.
• Internal review and verification.
• Procedure requiring recording of cash
receipts on a daily basis.
• Internal verification.
• Regular monthly statements to
customers.
• Internal verification of accounts receivable
master file contents.
• Comparison of accounts receivable
master file or trial balance totals with general
ledger balance.
12-5
12-12 Audit procedures the auditor can use to determine whether all cash receipts
were recorded are:

1. Confirmation of accounts receivable.

2. Gain an understanding of and test internal controls over cash.
3. Reconciliation of bank account.
4. Tracing receipts listed by person opening mail to the deposit slip
validated by the bank.
5. Trace credits in accounts receivable to their source (i.e., cash receipts,
sales return, uncollectible account).

12-13 Proof of cash receipts is a procedure to test whether all recorded cash
receipts have been deposited in the bank account. In this test, the total cash receipts
recorded in the cash receipts journal for a period of time, such as a month, are
reconciled to the actual deposits made to the bank during the same time period. The
procedure is not useful to discover cash receipts that have not been recorded in the
journals or time lags in making deposits, but it is useful to discover recorded cash
receipts that have not been deposited, unrecorded deposits, unrecorded loans, bank
loans deposited directly into the bank account, and similar errors or fraud.

12-14 Lapping is the postponement of entries for the collection of receivables to

conceal an existing cash shortage. The fraud is perpetrated by someone who records
cash payments in the cash receipts journal and then enters them into the computer
system. He or she defers recording the cash receipts from one customer and covers the
shortage with receipts from another customer. The shortage is in turn covered by the
receipts from a third customer a few days later. The employee must either continue to
cover the shortage through lapping, replace the stolen money, or find another way to
conceal the shortage.

This fraud can be detected by comparing the name, amount and dates shown on
remittance advices to cash receipts journal entries and related duplicate deposit slips.
Since the procedure is relatively time-consuming, auditors ordinarily perform the
procedure only where there is a specific concern with fraud because of a weakness
discovered in internal control.

12-15 The audit procedures most likely to be used to verify accounts receivable
charged off as uncollectible and the purpose of each procedure are as follows:

1. Examine approvals by the appropriate persons of individual accounts

charged off. The purpose is to determine that charge-offs are approved.

12-6
 2. Examine correspondence in client's files that indicates the
uncollectibility of the accounts for a selected number of charge-offs.
The purpose is to determine that the account appears to be
uncollectible.

3. Consider the reason for the charge-off as compared to the company

policy for writing off uncollectible accounts. Purpose is to determine
whether or not company policy is being complied with.

12-16 It is always acceptable to perform tests of controls at an interim date. The

auditor may decide it is necessary to test the untested period at year end especially if
the period is longer than a month or two. It is acceptable to perform tests of controls for
sales and cash receipts at an interim date and not perform additional tests of the system
at year end under the following circumstances:

The auditor feels internal control over the accounting system is effective.
1. The auditor does not anticipate significant changes in internal control
during the remaining period.
2. The transactions normally occurring between the completion of the
tests of controls and the end of the year are similar to the transactions
prior to the test date.
3. The remaining period is not too long in the circumstances; conventional
wisdom suggests three months or less.
4. Other matters of concern to the auditor indicate that the limitation of
transactions testing is appropriate.

Note that if the auditor decides not to test the controls for the interim period and there
are problems (for example, a material error or fraud) arising from transactions that took
place during that period, the onus would be on the auditor to prove that he or she was
not negligent by not testing for the interim period. The auditor must consider the
potential impact of such decisions in making the decisions.

12-17 Generally, a successful test of controls allows for a reduction of tests of details
of balances at year end. However, Deidre Brandt chose the month of March, which only
represents one-twelfth of the year, as her test period. With such a short test period,
Deidre cannot conclude that she has selected a representative sample from the total
population; therefore, without testing additional months (consensus of coverage), Deidre
cannot change the scope of her tests of details of financial balances at year end. By any
standard, she is being negligent in adopting such an audit approach.

12-18
a. In considering the appropriate TER the auditor uses judgement to determine
what exception rate would be material. It is deciding how important each

12-7
 attribute is. A tolerable exception rate of 3% leads to a larger sample size than a
6% TER.

b. In deciding the ARACR the auditor is considering if there are other controls in
place for this attribute that he/she may rely upon. A sample size based on a 10%
ARACR will be smaller than a sample size based on a 5% ARACR.

c. A sample of 100 invoices, an ARACR at 5% and three exceptions found would

indicate a CUER of 7.6. This is the computed upper exception rate based on the
actual number of deviations found in the sample. If this number exceeds the
TER then more deviations were found than the auditor decided was appropriate.

Multiple Choice Questions

12-19 a. (2) b. (3) c. (1) d. (1)

12-20 a. (1) b. (3) c. (1)
12-21 a. (1) b. (1) c. (3)

Discussion Questions and Problems

12-22

1. a. Recorded sales are for the amount of goods ordered and are correctly
billed and recorded. (Accuracy)

b. Examine indication of internal verification on sales documents.

c. Incorrect prices may be charged, the customer may be billed for the wrong
quantity, or the total amount may be computed incorrectly.

d. Recompute information on the sales invoices. Trace details on sales

invoices to shipping records, price lists, and customers' orders.

2. a. Recorded sales and credit transactions are for shipments actually made
and existing sales transactions are recorded. (Existence and
Completeness)

b. Account for the numerical sequences of sales orders, invoices, and credit
memoranda.

c. Shipments or returns are not recorded. Orders from customers are

misplaced and not filled.

12-8
 d. Examine correspondence concerning credit memoranda to assure that
they were properly issued. Trace shipping documents to resultant sales
invoice and entry into sales journal and accounts receivable master file.
Send accounts receivable confirmations.

3. a. Existing transactions are recorded; recorded transactions are valid.

(Completeness and Existence)

b. The auditor should observe the employees and discuss the procedures
with personnel.

c. Sales could be made and not recorded, with the employee keeping the
proceeds of the sale.

d. Trace selected shipping documents to related duplicate sales invoices, the

sales journal, and accounts receivable master file.

4. a. Existing transactions are recorded. (Completeness)

b. The auditor should observe the activities of those employees and discuss
the procedures with personnel.

c. These unusual sales could be made but not recorded and the proceeds
kept from the company.

d. Examine sales documents for these sales and trace the entries into the
cash receipts books.

5. a. Existing transactions are recorded and recorded sales are for the amount
of goods ordered and are correctly billed. (Completeness and Accuracy)

b. The auditor should observe the activities of employees and discuss the
procedures with personnel.

c. A receivable might intentionally not be recorded, allowing the cash to be

kept from the company.

d. Trace from the shipping records to the sales invoice, to the accounts
receivable master file, and to cash receipts.

6. a. Sales and collection transactions are properly included in the subsidiary

records and are correctly summarized. (Posting and Summarization)

b. Observation of procedures and examination of indication of internal

verification.

12-9
 c. Unintentional misstatements could be posted in the control accounts and
left undetected for long periods of time.

d. Perform tests of clerical accuracy—foot journals and trace postings from

journal to general ledger and accounts receivable master file.

7. a. Existing cash receipts transactions are recorded. (Completeness)

b. Observation and discussion of procedures with employees.

c. Cash could be received, not recorded, and kept from the company by an
employee or lost prior to deposit.

d. Trace receipts recorded on a list—such as from a prelist of cash—to the

books of original entry; send accounts receivable confirmations.

8. a. Transactions are recorded at the proper time. (Timing)

b. Compare date per books to the date the deposit appears on the bank
statement.

c. Cash receipts might be recorded in the wrong accounting period, lost, or

stolen.

d. Trace cash recorded on a list, such as a prelist of cash, to the cash

receipts journal and to the bank statement.

12-23

1-a Error
1-b Print a list of all master file changes for independent verification.
1-c Compare approved master file change form to listing of master file.

2-a Error
2-b Sales invoices are prenumbered, properly account for in the sales journal, and a
notation on the invoice is made of entry into the sales journal.
2-c Account for numerical sequence of invoices recorded in the sales
journal, watching for duplicates. Confirm accounts receivable at year-end.

3-a Fraud
3-b All payments from customers should be in the form of a cheque payable to the
company. Monthly statements should be sent to all customers.

12-10
3-c Trace from recorded sales transactions to cash receipts for those
sales; confirm accounts receivable balances at year end.

4-a Fraud
4-b The listing of cash received should be compared to the postings in the
accounts receivable master file and to the validated bank deposit slip.
4-c Trace cash received from prelisting to cash receipts journal. Confirm
accounts receivable.

5-a Error
5-b Use of prenumbered bills of lading that are periodically accounted for.
5-c Trace a sequence of prenumbered bills of lading to recorded sales transactions.
Confirm accounts receivable at year end.

6.-a Error
6-b No merchandise may leave the plant without the preparation of a prenumbered
bill of lading.
6-c Trace credit entries in the perpetual inventory records to bills of
lading and the sales journal. Confirm accounts receivable at year end.

7-a Error
7-b Internal review and verification by an independent person.
7-c Test accuracy of invoice classification.

12-24

Objective Dual-Purpose Test

1. Accuracy Match a sample of duplicate sales invoices to related

shipping documents checking quantity and
description.
2. Posting and summarization Not applicable.
3. Accuracy Compare unit selling prices on duplicate sales
invoices to the approved price list.
4. Classification Not applicable.
5. Completeness Accuracy Select a sample of customer orders and verify that
Timing shipping documents, vendor's invoices exist for each
one and that there is an entry in the accounts
receivable master file for each one.
6. Existence Completeness Procedure listed is a dual-purpose test.
Accuracy, Timing
7. Accuracy Recalculate the cash discounts for a sample of
remittances and determine if each one was consistent
with company policy.

12-11
12-25 a. The lack of segregation of duties was the major deficiency that permitted
the fraud for Appliance Repair and Service Corp. Gyders has responsibility for opening
mail, prelisting cash, updating accounts receivable, and authorizing sales allowances
and charge-offs for uncollectible accounts. It is easy for Gyders to take the cash before
it is prelisted and to charge off an accounts receivable as a sales allowance or as a bad
debt.

b. The benefits of prelisting cash are to immediately document cash receipts at the
time that it is received by the company. Assuming all cash is included on the
prelisting, it is then easy for someone to trace from the prelisting to the cash
receipts journal and deposits. Furthermore, if a dispute arises with a customer, it
is easy to trace to the prelisting and determine when the cash was actually
received. The prelisting should be prepared by a competent person who has no
significant responsibilities for accounting functions. The person should not be in a
position to withhold the recording of sales, adjust accounts receivable or sales for
credits, or adjust accounts receivable for sales returns and allowances or bad
debts.

c. Subsequent to the prelisting of cash, it is desirable for an independent person to

trace from the prelisting to the bank statement. That can be done by anyone
independent of whoever does the prelisting, or prepares or makes the deposit.

d. A general rule that should be followed for depositing cash is that it should be
deposited as quickly as possible after it is received, and handled by as few
people as possible. It is, ideally, the person receiving the cash that should
prepare the prelisting and prepare the deposit immediately afterward. That
person should then deposit the cash in the bank. Any unintentional errors in the
preparation of the bank statement should be discovered by the bank. The
authenticated duplicate deposit slip should be given to the accounting
department who would subsequently compare the total to the prelisting. When an
independent person prepares the bank reconciliation, there should also be a
comparison of the prelisting to the totals deposited in the bank.

Any money taken before the prelisting should be uncovered by the accounting
department when they send out monthly statements to customers. Customers are likely
to complain if they are billed for sales for which they have already paid.

12-26 a. Collections

Weakness Recommended Improvement

1. Treasurer exercises too much
control over collections.
2. Finance committee is not
exercising its assigned
responsibility for collection.
To extent possible, treasurer's responsibilities
should be confined to record keeping.
Finance committee should assume a more
active supervisory role.

12-12
3. The auditing function has been
assigned to the finance
committee, which also has
responsibility for the
administration of the cash
function. Moreover, the finance
committee has not performed
the auditing functions.
4. The treasurer has sole access
to cash during the period of the
count. One person should not
be left alone with the cash until
the amount has been recorded
or control established in some
other way.
5. The collection is vulnerable to
robbery while it is being
counted and from the church
safe prior to its deposit in the
bank.
6. The ushers do not count
collection but simply place it in
the church safe. If the church
were to be robbed (see 5.
above), there would be no
record of the amount stolen.
7. No mention is made of
bonding.
8. Written instructions for
handling cash collections
apparently have not been
prepared.
b. Record keeping
1. The envelope system has not
been encouraged. Control
features which it could provide
have been ignored.
Individuals should be appointed to perform
periodic auditing procedures or engage
verification procedures.
The number of counters should be increased to
at least two, and cash should remain under joint
surveillance until counted and recorded so that
any discrepancies will be brought to attention.
The collection should be deposited in the bank's
night depository immediately after the count.
Physical safeguards, such as locking and bolting
the door during the period of the count, should
be instituted. Vulnerability to robbery will also be
reduced by increasing the number of counters
The ushers should count the collection using
specially developed count sheets. One copy of
the count and the receipts should be placed in a
night depository at the bank; the second copy
should be left at the church.
Key employees and members involved in
receiving and disbursing cash should be
bonded.
Especially because much of the work involved in
cash collections is performed by unpaid,
untrained church members, often on a short-
term basis, detailed written instructions should
be prepared.
The envelope system should be encouraged.
Counters should indicate on the outside of each
envelope the amount contributed. Envelope
contributions should be reported separately and
supported by the empty collection envelopes.
Prenumbered envelopes will permit ready
identification of the donor by authorized persons
without general loss of confidentiality.
12-13
 2. The church has no record of
individual givings and thus
receipts are not based on the
amounts actually given. It may
be that some members are
receiving tax receipts that are
far in excess of their actual
givings. This weakness is
especially a problem because
the tax department may revoke
the church's status as a
charitable organization.
3. Because no records of
individual givings are
maintained, the church does
not know which members are
meeting their pledges. There
would be no way of knowing
who was causing the shortfall
Members should have to document their givings
by using envelopes or cheques payable to the
church. The counters should list the givings by
envelope number every Sunday and reconcile
total to the funds (cash and cheques) received
and deposited. The treasurer should use the
same list to update the individual member's
giving record which is used to prepare the
annual tax receipt for the member.
Each member should receive a statement
quarterly from the finance committee indicating
amount pledged and amount given to the end of
the quarter; this would assist delinquent
members in meeting their pledges.

12-27 a. To test whether shipments have been billed, a random selection of

warehouse removal slips should be made and examined to see if they have the proper
sales invoice attached. The sampling unit will be the warehouse removal slip.

b. Assuming the auditor is willing to accept a tolerable exception rate of 3% at a

10% ARACR, expecting no exception in the sample, the appropriate sample size
would be 76, determined from Table 11-6:
c. A one-to-one correspondence is established between the warehouse removal
slip number and the 5 digits in the random number table.

The first ten random numbers selected are 30452, 35793, 21027, 29925, 31546, 17563,
34535, 35936, 28288, 24841.

d. Other audit procedures that could be performed are:

a. Test extensions on attached sales invoices for clerical accuracy.
(Valuation)
b. Test time delay between warehouse removal slip date and billing date
for timeliness of billing. (Timing)
c. Trace entries into perpetual inventory records to determine that
inventory is properly relieved for shipments. (Posting and
summarization)

e. The test performed in part c cannot be used to test the existence of sales
because the auditor already knows that inventory was shipped for these sales.
To test the validity of sales, the sales invoice entry in the sales journal is the

12-14
 sampling unit. Since the sales invoice numbers are not identical to the
warehouse removal slips it would be improper to use the same sample.

12-28 a. It would be appropriate to use attributes sampling for all audit procedures
except audit procedure 1. Procedure 1 is an analytical procedure for which the auditor is
doing a 100% review of the entire cash receipts journal.

b. The appropriate sampling unit for audit procedures 2-5 is a line item, or the date
the prelisting of cash receipts is prepared. The primary emphasis in the test is the
completeness objective and audit procedure 2 indicates there is a prelisting of
cash receipts. All other procedures can be performed efficiently and effectively by
using the prelisting.

c. The attributes for testing are as follows:

Audit Procedure Attribute

Procedure 2 Cash receipts in the prelisting are recorded in the
cash receipts journal.

Procedure 3 Customer name, date, and amount are equal to the

prelisting and cash receipts journal.

Procedure 4 Cash discounts were approved on the related

remittance advice.

Procedure 5 Cash included in the prelisting has been included on

the deposit slip.

d. The sample sizes for each attribute are as follows:

Audit Sample Size Sample
Procedure Size
ARACR TER EPER
2 5% 8% 2% 77
3 5% 8% 2% 77
4 5% 8% 2% 77
5 5% 8% 2% 77

12-15
12-29 a. Use professional judgement to come up with a reasonable sample.

b.
Sample Size Before Population Size Sample Size After
Population Size Adjustment Population Size
Adjustment Adjustment
1 88 none 88
2 127 none 127
3 181 none 181
4 127 n = 127 / 1 + 127 113
/1,000 = 112.7
5 25 none 25
6 18 none 18
7 149 none 149

c.
Change in Effect on Sample Size Illustration in Part a
Factors
1 Increase in Decrease Compare columns 2 to 1
ARACR.
2 Increase in Decrease Compare columns 3 to 2
tolerable exception
rate.
3 Increase in Increase Compare columns 5 to 6
estimated
population
exception rate.
4 Increase in Increase Compare columns 4 to 2
population size.

d. The difference in the sample size for column 3 and 6 result from the larger
ARACR and larger tolerable exception rate in column 6. The extremely large
tolerable exception rate is the major factor causing the difference.

e. The greatest effect on the sample size is the difference between tolerable
exception rate and estimated population exception rate. For columns 3 and
7, the differences between the tolerable exception rate and estimated population
rate were 3% and 2% respectively. Those two also had the highest sample size.
Where the difference between TER and EPER was great, such as columns 5 and
6, the required sample size was extremely small.

12-16
Population size also had a relatively small effect on sample size. The difference in
population size in columns 2 and 4 was 99,000 items, but the increase in sample size
for the larger population was only 14 items.

f. The sample size is referred to as the initial sample size because it is based on an
estimate of the sample exception rate. Once the test is performed, the actual
sample exception rate is used to calculate the final upper exception rate. The
auditor can then decide whether the sample size is adequate.

12-30 a. and b. The sample sizes of CUERs are shown in the following table:

Actual Initial Sample Sample exception Rate CUER

Sample Size Size From Table (SER) From
12-7 Table
12-8
1. 100 127 2.0% 6.2%
2. 100 99 0.0 3.0
3. 60 65 1.7 6.3
4. 100 93 4.0 8.9
5. 20 18 5.0 18.1
6. 60 60 13.3 >20.0

a. The auditor selected a sample size smaller than that determined from the tables
in population 1 and 3. The effect of selecting a smaller sample size than the initial
sample size required from the table is the increased likelihood of having the
computed upper exception rate exceed the tolerable exception rate. If a larger
sample size is selected, the result may be a sample size larger than needed to
satisfy tolerable exception rate. That results in excess audit cost. Ultimately,
however, the comparison of CUER to tolerable exception rate determines
whether the sample size was too large or too small.

b. The sample exception rate and computed upper exception rate are shown in
columns 4 and 5 in the above table.

c. The population results are unacceptable for populations 4 and 6. In each of those
cases, the CUER exceeds tolerable exception rate.

The auditor's options are to change tolerable exception rate or ARACR, increase the
sample size, or perform other substantive tests to determine whether there are actually
material errors in the population. Increasing sample size would not likely result in
improved results for either population 4 or 6 because the CUER exceeds tolerable
exception rate by a large amount.

d. Analysis of exceptions is necessary even when the population is acceptable

because the auditor wants to determine the nature and cause of all exceptions.

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 If, for example, the auditor determines that an error was intentional, additional
action would be required even if the CUER was less than tolerable exception
rate.

e.
Term Nature of Term
1. Estimated population Nonstatistical estimate made by
exception rate auditor.
2. Tolerable exception rate Audit decision.
3. Acceptable risk of assessing Audit decision.
control risk too low
4. Actual sample size Audit decision (determined by
other audit decisions).
5. Actual number of exceptions Sample result.
in the sample
6. Sample exception rate Sample result.
7. Computed upper exception Statistical conclusion about the
rate population

Cases
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(a) CA did not consider anything other than the fact that he had the time to do the audit.
Before accepting an engagement the CA should have obtained more information
about the client including reviewing a copy of the previous financial statements,
communication with the predecessor accountant, and exploring the possibility of
unusual risks. The CA did not mention checking to ensure the firm was independent
of the prospective client nor whether the firm had the expertise required to fulfill this
engagement.

(b) CA’s preparation, conduct and evaluation did not comply with generally accepted
auditing standards. There is no mention of CA assessing audit risk or of doing any
verification that policies and procedures are followed. CA would need to investigate
this first before deciding and defining what test of controls or substantive procedures
were necessary and assigning someone to carry them out. CA was aware that
Smith Wholesalers Ltd. had inadequate segregation of duties; accounting duties,
data entry and handling cash all carried out by the same person. As well, the Sales
Manager was also responsible for credit approval and volume discounts, special
sales prices and the writing-off of uncollectible accounts. The receiver was in
charge of inventory control. This auditing engagement should have been assigned a
maximum risk level and the audit should have been designed accordingly. GAAS
states that a sufficient understanding of internal control should be obtained to plan
the audit. CA was aware there was a lack of controls from reading the company’s
formal sales policy and the list of employees and their duties. CA did no
investigating and the audit program CA designed does not reflect this knowledge.

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 GAAS states that if assistants are employed they are to be properly supervised. CA
gave the assistant free reign and no supervision. As well CA did not use all the
means described in the GAAS examination guidelines to gather sufficient
information: inspection, observation, enquiry, confirmation, computation and
analysis. CA’s evaluation of the results was inadequate. CA should have seen red
flags and done further investigating himself. CA knew the company’s formal sales
policies and was now aware they were not always followed. GAAS states that the
examination should be performed and the report prepared by a person having
adequate technical training and proficiency in auditing and is to be performed with
due care.

(c) Investigate and confirm the aged accounts receivables.

• Sales are up but cash is low could indicate that accounts receivables are not
being collected in a timely manner or at all.

Check how the company accounts for uncollectible accounts receivables. What
happens to bad debts? How many write-offs have there been?

• Are bad debts, write-offs and uncollectible accounts being deducted from the
gross sales?

Check the extent of volume discounts and special discounts granted by Zee.

• Overgranting discounts would decrease the profit margin, decreasing cash.

Investigate how the company calculates gross sales. Is it reasonable?

• Zee’s bonus is based on gross sales if it is not adjusted based on GAAP then
Zee would be receiving a larger bonus that he should. Perhaps CA should
recommend Zee’s bonus be paid on net sales.

Investigate the controls in place with regard to cash and do substantive testing to
verify controls are working. Is all cash being deposited in the bank?

• With the same person performing the accounting duties, the data entry and
handling cash, theft of cash would be relatively easy to do.

d) The principle difference between test of controls and substantive procedures is

their objective. Test of controls are used to assess and evaluate the effectiveness
of policies and procedures to prevent or detect material misstatements and to
assess the control risk range, from maximum to low for the audit. Substantive
procedures are used to acquire evidence as to the accuracy of the information
produced by the entity. Both tests of controls and substantive procedures use the
same methods to gather evidence: inspection, observation, enquiry, confirmation,
computation and analysis.

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12-32
a. Programmed controls
1. Check digit on the following fields:
• clerk code
• stock number

2. Limit check on maximum and minimums on the following fields:

• quantity sold
• unit price
• total sale
• sales tax
• amount tendered

3. Field check on the following fields:

• clerk code
• transaction code
• stock number
• quantity sold
• unit price
• amount tendered

4. Logical relationship
• total sale cannot exceed amount tendered
• return transaction should not have amount tendered

5. Programmed routine to identify error or potential error condition for the following:
• Unusual transaction or large value transaction should require a correction
procedure with a restricted use clerk code. The code would be issued only to the
store manager.
• A casual input error would simply be reentered by the clerk.
• A limited number of reentries for the same error would require correction by the
restricted clerk.
• A program routine should flag transactions left open after a certain period of time
(e.g., “END” key not activated).

6. Numeric test on stock number to ensure that only numeric items are processed.

7. Validity checks (program subroutine) against a table of valid codes (or against the
master inventory file for CD codes) on the following:
• transaction code
• clerk code
• inventory master details

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8. Set up control totals so that cashier can count cash at the end of the shift, enter, and
receive an error message if control does not equal cash count.

9. Anticipatory control to ensure that sequence of data entered is correct, e.g., data,
correct operation, data, etc.

10. Control to report on a sale against or generating a negative inventory quantity.

11. Other valid programmed controls.

b. Test transactions
1. Put through transactions
• to test that the system correctly handles valid transactions

2. Use an invalid check digit

• verify the existence of the check digit

3. Use field overflow

• field check

4. Omit data in critical fields to create an incomplete transaction

• field check

5. Use unreasonable data

• to verify limit checks

6. Use an invalid transaction code

• to verify the existence of the table of valid codes
• to assess the system response to invalid codes

7. Enter several valid transactions and enter an incorrect cash count

• to assess the system response to control totals being out of balance

8. Use of amount tendered less than total sale

• To verify the logical relationship test and to review the system response

9. Use an alpha numeric code for the stock number

• to assess the numeric test and to assess the system reaction

10. Withhold “END” key

• to ensure that open transaction is flagged by the system

11. Enter data out of proper sequence

• anticipatory control over sequence of input data

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12. Enter a sale which creates a negative balance in inventory
• error flag for credit balance in inventory

Note: Each transaction should contain only one error to facilitate follow-up by the
auditor.

c. Integrity of inventory master file

1. Use of copy of the client’s inventory master file for processing the test transactions
• Ideally, the copy should be made under conditions controlled by the auditor.

2. Create dummy stock numbers and quantities in a dummy master file and have all
test transactions processed against this dummy file.

OR

3. Use reversing transactions to remove the effects of any tests that affect the master
file (more risky and less desirable).

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