MODULE 8: TESTS OF CONTROLS

A. Tests of controls in the revenue/receipt cycle: sales and cash receipts

transactions

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.

1. Business functions associated with this cycle:

- Resources are sold to customers in exchange for promises of future payment
- Cash is collected from customers.

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.
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- 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.

5. Internal control objectives and potential errors or frauds

1. Control objectives are summarized in the following categories. If the control objectives are not
achieved error or fraud may occur:
a. Transaction Authorization – before accepting a customer’s sales order, the customer’s
credit should be approved, guarding against shipments made to poor credit risk customers,
potentially resulting in uncollectible receivables.
- Management should establish unit prices and sales terms that are consistent with the
company’s revenue objectives and cash flow needs.
- Management should establish written policies for sales-related deductions and
adjustments. Forms should be numbered and controlled.

b. Transaction Execution – goods should be shipped on a timely basis. Management should

establish policies for scheduling prompt shipment and for verifying that ordered products
are in stock.
- Following shipment, customers should be billed promptly avoiding losses arising from
unbilled shipments or from delayed cash collections.
- Management should establish procedures to investigate unbilled shipments promptly.
- Management should require prenumbered shipping documents, periodically assuring
that all sequentially numbered documents result in timely billing.

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.

d. Access to Assets – within the revenue/receipt cycle, management attempts to safeguard

assets by restricting access to cash and cash-related records, controlling against loss or
diversion and against misstated cash balances.
- Management could establish procedures to prenumber and control remittance advices,
prepare separate lists of incoming mail receipts, and periodically reconcile cash receipts
records to deposit slips and bank statements.
- Management should also limit physical access within Shipping, Billing, and Inventory
Control, primarily to avoid the misappropriation of assets between or among related
departments.

6. Considering internal control in a financial statement audit

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:
1. Obtaining an understanding of the controls – an auditor’s objective when considering
internal control is to obtain an understanding of a client’s prescribed policies and procedures
sufficient to plan the audit.

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- Performing a preliminary review – an auditor begins considering a client’s internal
control by developing a general understanding of the control environment; the control
procedures; and how the entity identifies, captures, communicates, and monitors external
and internal conformation in a form and time frame that enables employees to discharge
their assigned responsibilities.
- Documenting the system – auditors typically document an entity’s internal controls with
flowcharts, questionnaires, and/or written narratives.
a. Questionnaires – are designed to detect control deficiencies and typically require one
of three responses for each question; yes, no or N/A
b. Narratives – describe in prose one or more phases of management’s controls.
. Flowcharts – provide concise, informative, and unambiguous descriptions of internal
controls and are used when an entity’s system is complex and processes large volumes
of transactions.
- Performing a transaction walk-through – an auditor tests his or her understanding of
a system by performing a transaction walk-through.
- Determining whether existing control procedures is potentially reliable in
assessing control risk below the maximum – once an auditor understands an entity’s
internal controls and determines that the controls are potentially reliable in assessing
control risk below the maximum, he or she continues to:
a. Identify the system’s control objectives
b. Consider the potential errors or frauds that might result if specific control objectives are
not achieved.
c. Determine what control procedures management uses to prevent or detect potentially
material errors or frauds.
d. Design tests of controls:
- Shipping – weaknesses in the Shipping department controls present two major
risks for errors or frauds: Goods may be shipped without authorization, or shipped
goods may not be billed and recorded at all. Tests of controls for Shipping are
intended to determine whether shipments are made only in accordance with
approved sales orders and whether shipments have been billed and recorded
properly.
- Billing – tests of controls for billing focus on whether billed goods have been
shipped and whether bills are accurate and have been prepared properly and
recorded.
- Recording – the objective of all three tests for recording is to determine whether
details are summarized, periodically reconciled, and accurately posted to sales
journals, to the accounts receivable ledgers, and to the general ledger.
- Cash Collection – an entity’s cash collection activities are particularity susceptible
to frauds. Tests of controls over cash collections are designed to detect
misappropriation of cash receipts and lapping.
 Lapping – a fraud that conceals cash shortages resulting from delays in
recording cash collections.
- Sales Returns and Allowances – an auditor’s tests of controls for sales returns
and allowances focus on whether credit memoranda are approved and recorded
properly.
- Uncollectible Accounts – an auditor’s tests of controls over uncollectible
accounts focus on whether write-offs are properly authorized and recorded.

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B. Tests Of Controls In The Expenditure/Disbursement Cycle:Purchases And Cash
Disbursements Transactions

The Expenditure/Disbursement Cycle

The expenditure/disbursement cycle encompasses both the acquisition of goods and services and
the payment of cash for the goods and services acquired.

1. Two major business functions are associated with the cycle:

- Resources (goods and services are acquired from vendors and employees in exchange for
obligations to pay.
- Obligations to vendors and employees are paid.
2. Paper or computer image documents affecting the expenditure/disbursement cycle include:
- Purchase requisition – a request from an employee or department supervisor that goods be
purchased.
- Purchase order – a request issued by the Purchasing department to a vendor to purchase
goods.
- Receiving report – identifies information about goods received from a vendor.
- Vendor’s invoice – identifies goods purchased and represents formal notice about the amount
and terms of payment (often called the bill).
- Voucher package – the purchase requisition, purchase order, receiving report, and invoice.
(Often includes a summarizing document, the voucher.)
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.

- Recording – Accounts Payable compares purchase requisition, purchase order, receiving

report, and vendor’s invoice.
o Accounts Payable prepares the voucher upon receipt of a vendor’s invoice.
o A voucher package is filed in an unpaid vouchers file by due date.
o A copy of the daily summary of vouchers is forwarded to General Accounting for recording
in a voucher register.
o Column totals in the voucher register are posted to general ledger accounts.

- Payment – cash disbursements should be authorized and executed by personnel who report to
the treasurer and are independent of purchasing and recording.

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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.

INTERNAL CONTROL OBJECTIVES AND POTENTIAL ERRORS OR FRAUDS

Control objectives are summarized in the following categories:

- Transaction authorization – effective control over an entity’s purchasing activities requires that
purchases be made only in accordance with general or specific authorization.
o All purchases should be initiated by user departments and approved by authorized
supervisors.
o Goods or services should not be ordered in the absence of authorized purchase requisitions.
o Management should approve vendors before Purchasing executes an order.
o Management should also establish policies for the types, quantities, payment terms, and
prices of good and services purchased.
o Management should maintain current price lists and actively seek suppliers whose goods or
services optimize price and quantity.
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.

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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.

- Access to assets – management should establish procedures to safeguard assets by restricting

access to purchasing and cash disbursement records and forms.

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.

Considering internal control in a financial statement audit

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:

1. Obtaining an understanding of the controls – an auditor obtains an understanding of internal control

in four steps.

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.

c. Perform a transaction walk-through – to confirm an auditor’s understanding of the system

of internal control, the auditor can select a cancelled voucher package and compare the
purchase requisitions, purchase order, receiving report, and invoice for compliance with
company policies and with documents filed in Purchasing, Receiving, and Accounts Payable.

System documentation would be revised if the transaction walk-through revealed that the
auditor’s understanding of internal control is inaccurate.

d. Determining whether existing control procedures are potentially reliable in

assessing control risk below the maximum – following system documentation, and
assuming that controls are potentially reliable in assessing control risk below the maximum, an
auditor:
- Identifies the system’s control objectives.

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- Considers potential errors or frauds that might result if specific
control objectives are not met.
- Determine what control procedures management uses to prevent
or detect potentially material errors or frauds.
- Design tests of controls.

Those control procedures relevant to management’s financial statement assertions about

accounts payable, prepaid expenses, and accrued liabilities are subjected to tests of
controls.
TESTS OF CONTROLS: PURCHASING AND CASH DISBURSEMENTS

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.

TESTS OF CONTROLS OF PERSONNEL AND PAYROLL

THE PERSONNEL AND PAYROLL FUNCTION (AN EXTENSION OF THE

EXPENDITURE/DISBURSEMENTS CYCLE)

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.
II. In manufacturing companies, labor is an important component in valuing inventory and, if
misclassified, both inventory and cost of goods sold could be misstated materially.
III. Payroll typically includes several categories of employee compensation and bonuses, overtime,
vacation pay, and employee benefits such as pensions, health care, and profit sharing.

Personnel and payroll activities include:

 Hiring and terminations,
 Payroll preparation and recording, and
 Distribution of payroll checks to employees.

Journal entries are made for:

 Wage and salary payments,
 Account distributions, and
 End of period accruals.

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.

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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.

INTERNAL CONTROL OBJECTIVES AND POTENTIAL ERRORS OR FRAUDS

Control objectives are summarized in the following categories:

-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.

-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.

- Segregation of duties – to assure adequate segregation of duties, Personnel department

responsibilities should be separated from cash disbursements and operating departments.

CONSIDERING INTERNAL CONTROL

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:

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MODULE 8- “Tests of Controls of Transaction Cycles: 9

1. Obtaining an understanding of the controls – when an auditor attempts to determine how

the system is supposed to work and whether control procedures have been prescribed by
management to assure that the system is functioning as planned.

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
2. To records maintained in the Personnel department.
 Determining whether existing controls are potentially reliable in assessing
control risk below the maximum.
 Identify the systems control objectives
 Consider the potential errors or frauds that right result if specific control
objectives are not met.
 Determine what control procedures are used by the entity to prevent or detect
potentially material errors or frauds.
 Design the tests of controls.

C. Tests Of Controls In The Conversion Cycle: Inventory And Fixed Assets

The Conversion Cycle

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.
 Materials requisition: An operating department’s formal request for materials.
 Perpetual inventory record: A cumulative record of quantities on hand for an
item or a class of inventory.

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.

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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.

Inventory and Internal Control

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.

FIXED ASSETS AND INTERNAL CONTROL

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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.
 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.

- Transaction Execution – Management should establish procedures for operating, using,

physically moving, and restricting access to movable fixed assets.

- Recording – To avoid unreported transactions, fixed asset additions, disposals, and retirements
should be recorded at the correct amount, be recognized in the proper period, and be classified
properly. Unrecorded or improperly recorded transactions could result in misstated fixed asset
accounts and misstated financial statements.

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 Management can control the recording function by establishing procedures for processing
and recording fixed asset transactions and for identifying fixed asset eligible for sale or
retirement.
 Detailed fixed asset records should be maintained and periodically reconciled with existing
accounts.
 The expiration of future service potential – depreciation and amortization – should be
calculated in accordance with management’s authorization and be recorded in the proper
period.
 Managements should establish polices for determining depreciation methods and for
calculating depreciation on all fixed assets.

- 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.

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.

CONSIDERING INTERNAL CONTROL: INVENTORY & FIXED ASSETS

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.

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 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.

CONSIDERING INTERNAL CONTROL: FIXED ASSETS

1. Obtain an Understanding – compared to inventory, fixed asset transactions are considerably less
numerous and individual transactions usually involve considerably larger dollar amounts. An
auditor’s focus is different, since any one transaction alone could exceed the auditor’s tolerable
error for fixed assets.
 Preliminary Review – an auditor performs the preliminary review for fixed assets by reading
the client’s procedures manuals and by interviewing client personnel who are responsible for
fixed assets additions, disposals and retirements, and recording.
 Assuming that existing controls appear potentially reliable in assessing control risk below the
maximum, an auditor proceeds by documenting the system.
 Documenting the System – flowcharts are seldom used to document fixed assets systems
because the number of transactions is not likely to justify extensive flowcharting. Auditors use
internal control questionnaires to identify apparent deficiencies and narratives to document
procedures for fixed asset additions, disposals and retirements, and recording.
 Performing a Transaction Walk-Through – to confirm his or her understanding of the
system, the auditor could trace an addition transaction, a disposal transaction, and a retirement
transaction through the system and examine depreciation schedules for conformity with
prescribed procedures.
 Determining whether existing control procedures are potentially reliable in
assessing control risk below the maximum
 Identify the system’s control objectives.
 Consider the potential errors or frauds that might result in specific control objectives are not
met.
 Determine which control procedures are used by the entity to prevent to detect potentially
materials errors or frauds.
 Design tests of 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.

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 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.

D. Tests Of Controls In The Financing Cycle: Investments, Debt & Equity

The Financial Cycle

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.

Two major business functions are associated with the cycle:

 Capital funds are received from investors and creditors.
 Capital funds are used for operations or temporarily invested until needed for operations.

Throughout the financing cycle, journal entries are made for the issuance and retirement of debt and
capital stock and the acquisition and sale of investments. Common forms and documents include:
 Bond certificate – a debt security document representing a stated amount of corporate debt.
 Commercial paper – a general category of commercial loan instruments, due and payable in
accordance with terms described on the instrument.
 Stock certificate – an equity security document representing ownership of a stated number of
shares of capital stock.
 Treasury bill – a debt instrument issued by the Philippine Government
 Investments – the financing cycle processes current and non current investments, directing
resources into other private- and public-sector equity and debt instruments, with the objective of
optimizing financial return on idle cash.
 Custody, Recording, and Valuation: an entity’s investment securities are held in the custody
of either internal officials or independent external custodians, such as stock brokerage firms.
 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.
 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.

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 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

Control objectives are summarized in the following categories:

 Transaction Authorization & Execution – all investment acquisitions and sales should be
authorized in accordance with management’s criteria. Lacking authorization, investments could be
made in violation of company policies.
 Management could establish polices for selecting and approving investment transactions and for
obtaining capital funds, and prepare lists of authorized investments if necessary.
 Journal entries that adjust investment carrying values and debt obligations should be authorized
in accordance with management’s criteria.
 To control adjustments, management could establish processing procedures, pre number and
control adjustment forms, and require specific authorization for adjustments exceeding pre
established amounts.

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 Recording – all investment, debt, and equity transactions should be recorded at the correct
amounts, in the proper period, and classified properly,
 Management could control against inaccurate records by establishing processing and recording
procedures, regularly reviewing board minutes for financing cycle resolutions, and preparing
schedules of interest and loan payment due dates.

 Access to Assets – access to securities should be restricted to personnel and authorized by

management.
 Personnel responsible for approving investments should not be responsible for recording or for
maintaining custody of securities.
 Access to accounting records and forms should be restricted to personnel authorized by
management.
 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.

Considering Internal Control in the Financing Cycle

The focus of the internal control section is on the application of audit procedures to the tests of controls
in the financing cycle. This involves
- Obtaining an understanding of the controls
- Documenting the system
- Performing a transaction walk-through
- Determining whether existing control procedures are potentially reliable in assessing control risk
below the maximum

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