Southwest Medical Center internal controls audit

1.
An auditor’s working papers include the following narrative description of the cash receipts and
billing portions of Southwest Medical Center’s internal control. Evaluate each condition following the
narrative as being either (1) a strength, (2) a deficiency, or (3) not a strength or a deficiency.
Southwest is a health care provider that is owned by a partnership of five physicians. It employs 11
physicians, including the five owners; 20 nurses; five laboratory and X-ray technicians; and four
clerical workers. The clerical workers perform such tasks as reception, correspondence, cash
receipts, billing, accounts receivable, bank deposits, and appointment scheduling. These clerical
workers are referred to as office manager, clerk #1, clerk #2, and clerk #3. Assume that the narrative
is a complete description of the system.
About two-thirds of Southwest’s patients receive medical services only after insurance coverage is
verified by the office manager and communicated to the clerks. Most of the other patients pay for
services by cash or check when services are rendered, although the office manager extends credit on
a case-by-case basis to about 5 percent of the patients.
When services are rendered, the attending physician prepares a prenumbered service slip for each
patient and gives the slip to clerk #1 for pricing. Clerk #1 completes the slip and gives the completed
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slip to clerk #2 and a copy to the patient.
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Using the information on the completed slip, clerk #2 performs one of the following three procedures
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for each patient:
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
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Clerk #2 files an insurance claim and records a receivable from the insurance company if the
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office manager has verified the patient’s coverage, or
 Clerk #2 posts a receivable from the patient on clerk #2’s PC if the office manager has
approved the patient’s credit, or
Clerk #2 receives cash or a check from the patient as the patient leaves the medical center,
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
and clerk #2 records the cash receipt.
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At the end of each day, clerk #2 prepares a revenue summary.
Clerk #1 performs correspondence functions and opens the incoming mail. Clerk #1 gives checks
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from insurance companies and patients to clerk #2 for deposit. Clerk #2 posts the receipt of patients’
checks on clerk #2’s PC patient receivable records and insurance companies’ checks to the
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receivables from the applicable insurance companies. Clerk #1 gives mail requiring correspondence
to clerk #3.
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Clerk #2 stamps all checks “for deposit only” and each day prepares a list of checks and cash to be
deposited in the bank. (This list also includes the cash and checks personally given to clerk #2 by
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patients.) Clerk #2 keeps a copy of the deposit list and gives the original to clerk #3.
Clerk #3 personally makes the daily bank deposit and maintains a file of the daily bank deposits.
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Clerk #3 also performs appointment scheduling for all of the doctors and various correspondence
functions. Clerk #3 also maintains a list of patients whose insurance coverage the office manager has
verified.
When insurance claims or patient receivables are not settled within 60 days, clerk #2 notifies the
office manager. The office manager personally inspects the details of each instance of nonpayment.
The office manager converts insurance claims that have been rejected by insurance companies into
patient receivables. Clerk #2 records these patient receivables on clerk #2’s PC and deletes these
receivables from the applicable insurance companies. Clerk #2 deletes the patient receivables that
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appear to be uncollectible from clerk #2’s PC when authorized by the office manager. Clerk #2
prepares a list of patients with uncollectible balances and gives a copy of the list to clerk #3, who will
not allow these patients to make appointments for future services.
Once a month, an outside accountant posts clerk #2’s daily revenue summaries to the general ledger,
prepares a monthly trial balance and monthly financial statements, accounts for prenumbered service
slips, files payroll forms and tax returns, and reconciles the monthly bank statements to the general
ledger. This accountant reports directly to the physician who is the managing partner.
All four clerical employees perform their tasks on PCs that are connected through a local area
network. Each PC is accessible with a password that is known only to the individual employee and
the managing partner. Southwest uses a standard software package that was acquired from a
software company and that cannot be modified by Southwest’s employees. None of the clerical
employees are able to write checks on the company’s account.
For each of the following conditions, indicate whether they represent an internal control “strength” or
“deficiency.” If the condition is not an internal strength or deficiency, respond that the condition is
“neither.”
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Conditions
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The bank reconciliation is prepared monthly by the outside accountant, who is independent of the
a. Strength
revenue-generating and revenue-recording functions.
o.
Insurance coverage for patients is verified and communicated to the clerks by the office manager before
b.
medical services are rendered.
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The physician who renders the medical services documents the services on a prenumbered slip that is
c. Strength
used for recording revenue and as a receipt for the patient.
d. Southwest is involved only in medical services and has not diversified its operations. Neither
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Cash collection is centralized in that clerk #2 receives the cash (checks) from patients and records the
e. Deficiency
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cash receipt.
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f. Southwest extends credit rather than requiring cash or insurance in all cases. Neither
Computer passwords are only known to the individual employees and the managing partner, who has no
g. Strength
duties in the revenue-recording functions.
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2. An auditor may use confirmations of accounts receivable. Reply as to whether the following statements are
correct or incorrect with respect to the confirmation process when applied to accounts receivable.
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Conditions
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a. Auditors may ignore individually immaterial accounts when confirming accounts receivable. Correct
Second requests are ordinarily sent for positive form confirmation requests when the first request is not
b. Correct
returned.
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Accounts receivable are ordinarily confirmed on a standard form developed by the American Institute of
c. Incorrect
Certified Public Accountants and the Financial Executives Institute.
d. The confirmation requests should be mailed to respondents by the CPAs. Correct
e. A combination of positive and negative request forms must be used if receivables are significant. Incorrect
3. Reply as to whether each of the following comments relating to the confirmation of accounts receivable
during a financial statement audit is correct or incorrect.
1. Confirmations address completeness more than they address existence. Incorrect
2. A combination of positive and negative requests may be used. Correct
Second requests are more frequently used for negative confirmation requests than for positive confirmation
3. Incorrect
requests.
Since they represent evidence obtained from an external source, confirmation replies from customers are
4. considered to provide more reliable information than the client's records and accepted as the proper audited Incorrect
balance.
5. Only material accounts need be confirmed. Incorrect
6. Confirmation replies should be addressed directly to the CPAs at the client's address. Incorrect
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Potential Misstatements in the Revenue Cycle
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Read the overview below and complete the activities that follow.
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The revenue cycle is a major cycle for most companies. Accounts receivable, revenue,
and other accounts are tested through this cycle. Often there are misstatements found,
including errors and/or fraud by the client.
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CONCEPT REVIEW:
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It is important in testing any cycle, especially revenue, to realize that misstatements will
occur and to try to distinguish between errors and fraud.
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Label each potential misstatement as either an error or fraud.

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5.
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Potential Misstatements in the Revenue Cycle
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The revenue cycle is a major cycle for most companies. Accounts receivable, revenue,
and other accounts are tested through this cycle. Often there are misstatements found,
including errors and/or fraud by the client.
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CONCEPT REVIEW:
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It is important in testing any cycle, especially revenue, to realize that misstatements will
occur and to try to distinguish between errors and fraud.
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1. Many instances of misstatement are based on the inappropriate recognition of ______. revenue
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2. One way to avoid misstatement of revenue is to ensure the client has proper ________. cutoff policies
Revenues are deemed to be earned when the company has ______ what it must do to fulfill its
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3. accomplished
obligation.
4. Side _________ can substantially alter the terms of a sale. agreements
5. ________ needs to be assured in order to recognize revenue. Collectibility
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Explanation
1. Misstatements often occur within the revenue cycle.
2. Cutoff policies are important to ensure proper classification of revenue.
For revenue to be recognized, it is important that companies accomplish what they
3.
are obligated to do.
4. When clients have side agreements with customers, the terms of the agreement
leading to the sale can be altered.
Companies need to anticipate collecting the amount billed to recognize the related
5.
revenue.
6.
Accounts Receivable Confirmations
Read the case and answer the questions that follow.
Audit standards require analytical procedures at two stages during the audit: at the risk
assessment (planning) phase and again at the end of the audit. They are optionally
used as a substantive procedure during the course of an audit.
CONCEPT REVIEW:
Often times it does not seem to be productive or effective for auditors to send accounts
receivable confirmations, yet the standards require it. It is important that auditors
understand how to maximize effectiveness and efficiency in this required audit
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procedure.
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Read the case. Then answer the questions based on it.
o.
BACKGROUND:
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Audit standards indicate that there is a presumption that auditors will confirm accounts
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receivable unless the balance is immaterial, confirmations are deemed ineffective, or
the auditors' assessment of risk is low and other procedures will achieve the same
objective. However, these instances are considered few and far between and current
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trends in auditing indicate that there is an expectation that accounts receivable will be
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confirmed. Auditors may stratify the population, use haphazard or judgmental sampling,
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and send positive or negative requests.
Jenner & Jenner CPAs are the auditors for the Leno Company. In reviewing the
accounts receivable aging, the auditors learn that there is a high number of accounts
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with balances, there are some very large and very small balances, and many
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customers' balances consist of multiple invoices.
a. Should Jenner & Jenner CPAs send accounts receivable confirmations?

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Auditing standards require that they must be sent, so yes Jenner & Jenner CPAs
should follow proper auditing requirements.
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b. How should the auditors mitigate the risk associated with both very large and
very small balances?
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The sample should always be big enough to warrant the drawing of valid inferences
about the entire population of receivables. Auditors are able to stratify the population in
a manner that allows confirmation of a majority of the dollar amount of receivables.
c. Because so many customer balances consist of multiple invoices, what could the
auditors do to eliminate unnecessary reconciliation?
Putting the focus of the sampling on confirming invoices rather than balances could
eliminate the need for unnecessary reconciliations
d. What procedures can be performed on customers who do not respond?
Auditors should follow up with a second or third request to produce replies. When
replies still aren't received, the auditors should apply alternative procedures to the
accounts, unless (1) the amount is not significant when projected as a 100%
misstatement and (2) there are no unusual characteristics related to the nonresponses.
Explanation
1.
Yes, audit standards (AU 330) presume that auditors will send accounts receivable
confirmations.
2.
Stratification would mitigate the risks associated with a diverse population.
3.
Jenner & Jenner CPAs could base their sampling, and hence their confirmations, on
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confirming invoices, not balances. More confirmations will be sent, but they will be
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easier to follow up on and reconcile.
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4.
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Auditors can perform alternate procedures like examining subsequent collections of
cash receipts. rs e
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7.
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Accounts Receivable Confirmations

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Read the case and answer the questions that follow.
Audit standards require analytical procedures at two stages during the audit: at the risk
assessment (planning) phase and again at the end of the audit. They are optionally
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used as a substantive procedure during the course of an audit.

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CONCEPT REVIEW:
Often times it does not seem to be productive or effective for auditors to send accounts
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receivable confirmations, yet the standards require it. It is important that auditors
understand how to maximize effectiveness and efficiency in this required audit
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procedure.
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1. AR confirmations can be sent electronically or via ________. paper form

2. ______ communication with debtors is the most conclusive step in verifying accounts receivable. Direct
Confirmations are more persuasive than subsequent cash receipts as they help mitigate the risk of
3. lapping
_______.
4. Confirmations do not necessarily mitigate the risk of _________. bad debt
Explanation
1. Confirmations are either paper form (mailed) or sent electronically.
2. Direct communication (confirmations) is the best way to verify accounts receivable.
3. Lapping can still be a fraud risk if clients are intentionally misstating cash receipts.
Customers may confirm receivables that they are not able to pay; thus, these
4.
receivables should be written off as bad debts.
8.
Audit Assertions for Accounts Receivable
General audit objectives exist and help auditors design proper procedures. All audit
procedures include steps to test for each objective.
CONCEPT REVIEW:
In testing accounts receivable, auditors will design procedures to test for each general
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audit objective. Different procedures are designed for each general objective, and a
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well designed program includes tests for each objective
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Match each example audit procedure with its correct general audit objective related to accounts receivable.
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9.
Audit Assertions for Accounts Receivable

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General audit objectives exist and help auditors design proper procedures.
All audit procedures include steps to test for each objective.
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CONCEPT REVIEW:
In testing accounts receivable, auditors will design procedures to test for
each general audit objective. Different procedures are designed for each
general objective, and a well designed program includes tests for each
objective
1. Management may have fraudulently overstated revenue by making __________ journal entries. inappropriate
2. Receivables that have been sold should not remain as a(n) _____ on the company's books. asset
3. Overstatement may occur when sales for the next period are recorded in the _______ period. current
To test collectability of receivables, auditors may consider credit ratings for debtors of
4. large
_____receivables.
Testing the reconciliation for accounts receivable to the general ledger ensures that the software is
5. correctly
programmed _________.
Explanation
1. Inappropriate journal entries can be made to overstate revenue.
Receivables that have been sold are converted to cash and are no longer an asset of
2.
the company, since the customer has to pay the bank instead.
Overstatement can occur when sales for the next period are recorded in the current
3.
period.
When a company has large receivables, it may be valuable for auditors to look at
4.
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credit ratings for those customers to help determine collectability.
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5. Testing that the system works helps to ensure the software is programmed correctly.
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10. A summary of the controls for the revenue and cash receipts cycle of Keystone Computers &
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Networks, Inc., appears in this appendix.
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a. For the following three controls over sales, indicate one type of error or fraud that the
control serves to prevent or detect. Select your solution as follows: (Each of the "Error
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or Fraud Controlled" may be used only once.)

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Error or Fraud Controlled

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1.Controls the recording of sales to ensure completeness.

2.Controls errors in the delivery and billing of sales
transactions.
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3.Controls the recording of fictitious sales and inaccurate

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sales to customer accounts.

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Error or Fraud
Control
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Controlled
Application controls are applied when customer orders are entered by the sales order
1. 2
clerk.
2. The computer assigns numbers to sales invoices when they are prepared. 1
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3. Monthly statements are mailed to customers. 3
b. For the following three controls over cash receipts, indicate one type of error or fraud
that the control serves to prevent or detect. Select your solution as follows: (Each of
the "Error or Fraud Controlled" may be used only once.)
Error or Fraud Controlled

1.Controls the abstraction of cash and the incorrect recording of
cash receipts and cash sales.
2.Controls the embezzlement of cash receipts and errors in and
incomplete postings to accounts receivables records.
3.Controls errors in the recording of cash and controls the
abstraction of cash.
Error or Fraud
Control
Controlled
1. Cash receipts are prelisted by the receptionist. 3
The accounting manager reconciles control totals generated by the accounts
2. 2
receivable computer program.
The computer summaries of cash collections and cash sales are reconciled to
3. 1
prelisting’s of cash receipts and cash deposits by the accounting manager.
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1.

At the end of each day, clerk #2 prepares a revenue summary.

2. A combination of positive and negative requests may be used. Correct

5. Only material accounts need be confirmed. Incorrect

Label each potential misstatement as either an error or fraud.

Accounts Receivable Confirmations

Read the case and answer the questions that follow.

and send positive or negative requests.

customers' balances consist of multiple invoices.

a. Should Jenner & Jenner CPAs send accounts receivable confirmations?

Accounts Receivable Confirmations

Read the case and answer the questions that follow.

used as a substantive procedure during the course of an audit.

1. AR confirmations can be sent electronically or via ________. paper form

Audit Assertions for Accounts Receivable

Audit Assertions for Accounts Receivable

or Fraud Controlled" may be used only once.)

Error or Fraud Controlled

1.Controls the recording of sales to ensure completeness.

3.Controls the recording of fictitious sales and inaccurate

sales to customer accounts.

3. Monthly statements are mailed to customers. 3

Error or Fraud Controlled

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