Auditing I (Acct 411)

Table of Contents

Contents Pages
Unit 1: Overview of Auditing 1

Unit 2: Internal Control 9

Unit 3: Internal Control Over Cash 18

Unit 4: Internal Control Over Purchase & Inventory 27

Unit 5: Internal Control Over Receivables & Credit Sales 34

Unit 6: Internal Control Over Payroll 40

Unit 7: Internal Control Over Fixed Assets 45

Unit 8: Internal Auditing 50

Unit 1: overview of auditing

Contents
1.0 Aims and Objective
1.1 Introduction
1.2 Over view of Auditing
1.2.1 Definition
1.2.2 Demand for Audit
1.2.3 Internal Auditing
1.3 Types of Auditing
1.3.1 Financial Statement Audits
 1.3.2 Compliance Audits
1.3.3 Operational Audits
1.4 Summary
1.5 Glossary
1.6 Answers to Check Your Progress
1.7 Model Examination Questions

1.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to:

- explain the meaning of Auditing
- explain the need for Auditing
- explain Internal Auditing, and
- identify the types of Audits.

1.1 INTRODUCTION

This unit deals with the definition of Auditing, why there is a demand for Auditing by
stock holders, managers, employees, and debt holders, what is the role of Internal
Auditing in an organization; and deals with description of types of Audits commonly
used by the professional Auditors.

The public accounting profession (CPA), as we knew it today grew mainly out of the
demand for financial statement Audits. Very specific auditing standards, referred to as
generally accepted auditing standards (GAAS), are provided for conducting financial
statement audits. How ever, In recent years, the profession has been asked to provide
services beyond the traditional financial Statement Audit. These include compliance and
operational Audits.

1.2. OVERVIEW OF AUDITING

1.2.1 Definition of Auditing

The American Accounting Association, committee on Basic Auditing concepts - Defined
Auditing as:

Auditing is systematic process of objectively obtaining and evaluating evidence regarding

assertions about economic actions and events to ascertain the degree of correspondence
between assertions and established criteria and communicating the results to interested
users.

The phrases in this definition require additional explanation. The phrase systematic
process implies there should be a well-planned approach for conducting an audit. This
plan involves objectively obtaining and evaluating evidence. The evidence gathered by
the auditor must relate to assertions about economic actions and events. For example.
Financial statements prepared by management contain numerous assertions. If the
Balance sheet contains amount of Br. 10million for property, plant and equipment,
management is asserting (declaring) that the company owns the assts, uses them in the
production of goods and services, and that this amount represents their un depreciated
historical costs. The Auditor compares the evidence gathered to assertions about
economic activity in order to assess the degree of correspondence between those
assertions and established criteria. Generally Accepted Accounting Principles (GAAP)
are normally used for measuring the degree of correspondence, for financial Audits. The
last Phrase, communicating the results to interested Users, is concerned with the type of
report the auditor provides to the intended users. (Banker, investors, stockholders,
Creditors, e.t.c ).

1.2.2 Demand for Audit

The essence of demand for audit refers to the question “why do organizations request an
audit?” the answer to this question can be described as follows:

(i) Control mechanism – audits whether important control mechanisms for

accountability. The auditors role is determining whether the reports prepared
by management are in conformity with the responsibility and duties provided
in the organization policies. The overall need for monitoring activities, need
demands (requests) Auditing to provide credible or Audited financial
 information, Audited performance reports, Audited implementation of rules,
& regulations.

(ii) To resolve conflict of interest between management and the owners. The
Agency relation ship that exists between the owner and manager produces a
natural conflict of interest. Because, the manager has more information about
the “True financial position and results of operations of the entity than the
owner who is absentee. It both parties seek to maximize their own self
interest, It is likely that the manager will not act in the best interest of the
owner. Example The manager may spend organizational funds to provide
excessive personal benefits or manipulate the reported earnings in order to
earn a larger bonus. Thus, the need for Independent (non-partian) opinions or
view is necessary to resolve such conflicts.

(iii) To reduce damaging Consequences – Even though, the function of

accounting is to provide information for economic decision making; this
information must be verified by auditors, before they are used for decisions
that have serious and subsequent factual economic consequences.

(iv) To simplify complexity – In our age, financial in formation & translation has
been come complex in preparation, content, and format. Therefore it demands
drippy specialized body of knowledge to prepare (compilation), verify and
interpret them.

(v) Regulatory requirements – many business laws, memo random of association

and government regulation, make requirements’ annual audits. For Example –
For renewal of license, or permit, (commercial code to Ethiopia), financial
Administration regulation proclamation tax, requires audited financial
statements.

1.2.3. Internal Auditing

Internal auditing is a managerial control activity performed with an organization as
service to management by an employee of the organization. It reviews operations through
the measurement and evaluation of other control mechanisms. Their primary activities are
to conduct compliance and operational audits within the organization. However, they
assist the external auditor with the annual financial statement audit. Internal auditors are
employed by Individual companies, partnerships, government agencies. The Institute of
Internal Auditors (IIA) has developed set of standards that should be followed by Internal
auditors and Established certification program – which Includes passing of uniform
writer examination. Like external auditors they must be Independent and objective.

1.3 TYPES OF AUDIT

While there are many types of audit based on the definitions previously provided,
generally they are discussed under three types: financial statement audits, compliance
audits and operational audits

1.3.1 Financial Statement Audits

The purpose of a financial statement audit is to determine whether the overall financial
statements present fairly in accordance with specified criteria. This type of audit usually
covers the basic set of financial statements (Balance sheet, Income statement, statement
of stockholders equity, and statement of cash flows); and Generally Accepted Accounting
principles (GAAP) serve as the criteria. However, certain financial statements audits may
use of other criteria, such as cash basis or Income tax basis.

1.3.2 Compliance Audits

The purpose of a compliance audit is to determine the extent to which rules, policies,
Laws covenants, or governmental regulation are followed by the entity being audited for
example, accompany may use auditors to determine whether the corporate rules, and
policies are being followed by departments within the organization. The corporate rules
and policies serve as the criteria for measuring the departments Compliance. Another
example is examination of tax returns (payment) of individuals and companies by the
Internal Revenue Service for compliance with Tax Laws.

1.3.3 Operational Audits

Operational Audit involves a systemic review of organizational activities, or apart of
them, in relation to the efficient and effective use of resources. The purpose of
operational audit is to assess performance, Identity areas of Improvement, and develop
recommendations. Sometimes this type of audit is referred to as a performance audit or
management audit. Operational audits are generally more difficult to conduct than
financial and compliance audits. Since the purpose of an operational audit is to assess
effectiveness and efficiency, it can be very difficult to Identify objective, measurable
criteria that can be used for that purpose.

Examples of such audit include – audit of government programs, Efficiency of the food
and Drug administrations procedures for Introduction of new Drugs, to market.
Assessment of the efficiency and effectiveness of organizations use of computer
resources. etc.

Check Your Progress Exercise

1. Discus what leads to the demand for auditing services in a free market economy.
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2. Define the three general types of audits.
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3. What does the phrase systemic process means in the Auditing definition?
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4. List the established criteria other than GAAP that can be used to measure
economic information.
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1.4. SUMMARY

The primary reason for development of Auditing profession is the need of attest
function. That is, the need of Independent assurance of the reliability, credibility and
quality of Information. When certified public accountants attest to information they issue
a report with a conclusion about the reliability of a written assertion by management. In
the case of financial statement Audits, the Audit report most frequently includes an
opinion about whether management is financial statements conform to generally accepted
accounting principles. Auditors also are being asked to assume more responsibility for
attesting to compliance with laws and regulations, and to the effectiveness and Internal
controls.

1.5. GLOSSARY

1. Assertion - are presentation or declaration, typically made by the management of

entity.
2. Certified public Accountant (CPA) – A person licensed by the state to practice
public accounting is a professions, based on having passed the uniform CPA
Examination and having met certain educational and experience requirements.
3. Compliance Audit- An audit to maser the compliance of the organization with
some established criteria, for example, Laws and regulation.
4. Operational Audit- An analysis of department or other unit of business or
governmental organization to masseurs the effectiveness and efficiency of operation.

1.6. ANSWERS TO CHEEK YOUR PROGRAM QUESTION

1. The demand for Auditing in the free market economy economy among other include:
- Control mechanism - to minimize bad consequences from the decisions
 - to resole conflict of interest - to simplify completive
- to meet the regulatory requirements
2. The three general types of Audit are
a) Financial statements Audit b) compliance Audit and c) operational Audits
3. Systematic process in Auditing means that fuere should be a well – designed audit
plan to conduct an actual Audit.
4. These measuring criteria Include Laws and regulations, for compliance Audit; Plans
and standards or policies, programs, budgets, for operational Audits.

1.7 MODEL EXAMINATION QUESTIONS

Instruction – choose the best answer for the following questions.

1. Independent Auditing can be best be described as:
A. A branch of accounting
B. A discipline which attests to the result ‘s of accounting and other functional
operations and data.
C. A professional activity that measures and communicates financial and business
data.
D. A regulatory function that prevents the issuance of Improper financial
information.
2. An Independent Audit aids in the communication of economic data because the
audit.
A. Confirms the accuracy of management of financial representations.
B. Lends credibility to the financial statements
C. Guarantees that financial data are fairly presented.
D. Assures the readers of financials that any fraudent activity has been corrected.
3. Operational auditing is oriented primarily toward:
A. Future improvements to accomplish the goals of management.
B. The accuracy of data reflected in managements financial records.
C. Verification that the company’s financial statements are fairly
presented.
D. Past protection provided by existing Internal control
4. A typical objective of operational Audit is to determine whether an entities.
A. Internal control is adequately operating as designed.
B. Operational Information is in accordance with generally accepted
governmental standards.
C. Financial statements present fairly the results of operations.
D. Specific operating units are functioning efficiently and
effectively.
5. Which of the following best describes the reason why an Independent auditor
reports an financial statements:
A. a management fraud may exist, and It is more likely to be
defected by Independent auditors.
B. Different Interest may exist between the company preparing the
statements and the persons using the statements.
C. A misstatement of account balances may exist, and It is generally
corrected as result of the Independent auditors work.

Unit 2: Internal Control

Contents
2.0. Aims and Objective
2.1 Introduction
2.2 Definition
2.3 Purpose and objective of Internal
2.4 Essential Elements of Sound (Effective) Internal Control
2.4.1 Competent, Trustworthy Personnel With Clear Lines of Authority
and Responsibility
2.4.2 Segregation of Duties
2.4.3 Documentation Procedures
2.4.4 Authorization Procedures
2.4.5 Physical Control Over Assets and Records
2.4.6 Internal verification (Independent Internal Verification or
Checking)
 2.5 Limitations of Internal Control
2.6 Summary
2.7 Answers to Check Your Progress
2.8 Model Examination question

2.0 AIMS AND OBJECTIVE

After studying thin unit , you should be able to

 define what is meant by internal control
 describe the purpose and objective of Internal control, and management
responsibility.
 explain the characteristics of effective Internal Control.
 explain the limitation of internal control.

2.1 INTRODUCTION

The Important consideration of internal control in this unit has three major objectives
first, to explain the meaning of internal control, second, the significance of purpose and
objective of internal control third, the characteristics of good internal control. In this
Unit, students should able to know the broad classification of internal control as
accounting and administrative control; and the major weakness of internal control. This
unit tries to show the internal control over cash, Accounts Receivable (credit sales),
payroll, and fixed assets.

2.2 DEFINITION

Internal Control is a process effected by an entity’s board of directors, management, and

other personnel that is designed to provide reasonable assurance regarding the
achievement of objectives in the following categories.

(1) effectiveness and efficiency of operations

(2) Reliability of financial reporting, and
(3) Compliance with applicable laws and regulations. alternative definition defined
by AICPA (American Institutes for certifications of public accountants) as:
 Internal control referees to all coordinate methods and measures within an
organization or within a system adopted to safeguard assets, cheek accuracy and
reliability of accounting data, promote operational efficiency and encourage
adherence to prescribed managerial policy.

Overall internal controls are also defined as operational checks and balances that prevent
loss due to fraud, waste, abuse, and management of resources. The resources include:
personnel, information, and capital.

2.3 PURPOSES AND OBJECTIVES OF INTERNAL CONTROL

The purpose of internal control can be explained in to two aspects:

a) The management (client) concern and
b) The Auditors concern

(a) The client concern – the reason an organization establishes a system of internal
control is to attain objectives (goals). Generally management has six purposes in
setting good system of internal control. These are to:
(i) achieve reliability of accounting records.
(ii) safeguard assets
(iii) increase profitability
(iv) prevent and defeat frauds and errors
(v) prepare financial statements timely
(vi) discharge laws, rules & regulations
(b) Auditors concern: The generally accepted auditing standard field work standard,
number, (3) three states that a sufficient understanding of internal control is to be
obtained to plan the audit and determine the nature, timing and extent of testes to
be performed. Thus, the primary purpose of studying and evaluating of internal
control system by external auditors is to determine the amount of audit work. It is
assumed that good internal control provides more reliable financial data and
statements.

The objectives internal control includes to:

 (i) control operations – to ensure efficiency and effectiveness
(ii) control financial reports – To ensure the preparation of reliable
financial statements
(iii) control compliance – To ensure compliance of laws, regulations.

2.4 ESSENTIAL ELEMENTS OF SOUND (EFFECTIVE) INTERNAL CONTROL

Essential elements are components of strong internal control. They are used to evaluate
the strengths and weakness of internal control system.

2.4.1. Competent, trustworthy personnel with clear lines of authority and

responsibility
The most important element of any internal control is personnel. If the employees are
component (well trained) and trustworthy (TRUST), some of other elements can be
absent and reliable financial information’s will still result. Specific responsibility for
performance of a given duties must be assigned to specific Individuals. Organizational
structure defines how authority and responsibility are delegated and monitored. It
provides a frame work for planning executing, and monitoring operations.

2.4.2. Segregation of Duties

It is Important for an organization to segregate (separate) the authorization of
transactions, recording of transactions, and custody of the related assets. Independent
performance of each of these functions reduces the opportunity for any one person to be
in apposition both to perpetrate and to conceal errors or Irregular in the normal course of
his or her duties. Example: first, if an employee can authorize the sale of marketable
securities and has access to the stock certificates, the assets can be misappropriated.
Second, If an employee receive payment from customers on account and has access to the
accounts receivable subsidiary ledger, It is possible for that employee to misappropriate
the cash and cover the shortage in the accounting records.

There are four guidelines for segregations of duties to prevent both intentional and
unintentional errors and frauds.
 (a) Separation of the custody of assets from accounting. For example, If one
person is responsible for store keeping (custody of inventory) and maintains
inventory records, it is possible to ship (dispatch) some Items for his /herself
and adjust the Inventory balance by recording a factious transaction.
(b) Separation of the authorization of transaction from the custody of related
assets – for example, If one person is assigned For authorization of payment
transaction, and handling of cash it in creases the possibility of frauds.
(c) Separation of duties within the accounting section function: Examples
include: The recording in journals and related subsidiary ledgers and then
keeping of control ledgers in principle should be separated. Recording in sales
journals and recording in cash receipts journal and Accounts Receivable
control Ledger keeping should be separated. Accounts payable control clerk
should not record cash payments journal.
(d) Separations of operational responsibilities from record – keeping. For
example, accounting functions should be separated from management
department activities.

2.4.3. Documentation Procedures

Documents provide evidence that transactions and events have occurred. Several
procedures should be established for documents. first, whenever, possible, document
should be pre – numbered and all documents should be accounted for pre numbering
accounting documents should be promptly forwarded to accounting to help timely
recording documents should be produced in copies, they should be simple to understand,
sufficient, and designed for multiple uses.

2.4.4. Authorization Procedures

Every transaction must be properly authorized. Properly authorization implies that
concerned personnel should authorize (approve) each transactions at each step where
transactions occurs. For example, the authorized person for paying cash is the cashier, for
receiving, it is the store clerk, for permitting the transaction it is the manager etc.

2.4.5. Physical Control Over Assets and Records

Physical control relates primarily to safeguard asset from theft, deterioration, spoilage,
etc. Accounting records and securities, (bonds, Debentures, Treasury stocks, cheeks,
notes,) should be in well locked custody. Inventories should be protected by constructing
from fire proof materials, well – ventilated room and locked doors, generally,
 Safes and vaults are necessary to store cash before the cash is deposited in a bank.
 Locked ware houses for inventories.
 Fencing of the organization.
 Locked storage cabinets for accounting records. etc; are necessary elements, of
physical control.

2.4.6. Internal verification (Independent Internal Verification or Checking)

This element of internal control refers to the need of Independent checking process.
Which involves, Reviewing, comparison, reconciliation of data, which are prepared by
the other personnel, and the findings (discrepancies) should be corrected.

2.5 LIMITATIONS OF INTERNAL CONTROL

An internal control system should be designed and operated to provide reasonable

assurance. That is an entity’s cost of internal control system should not exceed the
benefits that are expected to be derived. The necessity of balancing the lost of Internal
controls with the related benefits requires considerable estimation and judgment on the
part of management.

Therefore the idea of reasonable assurance arises from two concepts: cost – benefit, and
the inherent weakness: The cost – includes paying employees for implementing the
system, constructing and acquiring facilities (safes, stoves) printing of vouchers, forms,
etc. the benefits includes prevention of potential losses.

The inherent limitations include management override of internal control, personnel

errors, or mistakes, and collusion.

(i) Management override of internal control: an entity’s controls may be

overridden by management. For example, a senior – Level manager can
require a low – level employee to record entries into the accounting records
(because) that are not consistent with the substance of the transactions and are
in violation of the organization’s control. The lower – level employee may
record the transaction, even though he or she knows that it is a violation of
control, because of fear of losing he’s or her job.
(ii) Personnel errors or mistakes – The internal control system is only as
effective as the personnel who implement and perform the controls. For
example, employees may misunderstand instructions or make errors of
judgment. They may make mistakes because of personnel careless ness,
distraction, or fatigued.
(iii) Collusion – the effectiveness of segregation of duties lies in the Individuals
per forming only their assigned tasks or in the performance of one person
being checked by another. Collusion may occur, for example, an individual
who receives cash receipts from customers colide (agree) with the one who
records those receipts in the customers’ records order to steal cash from the
entity.

Check Your Progress Exercise

1. What is meant by reasonable assurance?
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2. Whose responsibility is to maintain (establish) Internal control?
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3. What important consideration is to be considered in establishing Internal Control.
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2.6 SUMMARY

Internal control is a process affected by the clients’ board of directors, management, and
other personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the categories of (1) effectiveness, and efficiency of operations, (2)
reliability of financial reporting (3) compliance with applicable laws and regulations.
The purpose of considering interval control in the auditors concern is to assess the audit
risk for each major financial statement assertions to determine the nature, timing and
extent of the substantive tests of that assertion. Whereas, in the managements concern,
the purpose of internal control is to increase profitability, safeguarding of assets and
accounting records, to produce reliable and accurate financial information, to adhere with
applicable rules and regulations. Thus, management of an organization should apply the
six elements of good internal control to achieve the above mentioned purposes and
objectives.
2.7 ANSWERS TO CHECK YOUR PROGRESS

1. Reasonable assurance of Internal describes that no internal control establishing

with out weakness.
2. The Responsibility of Internal control is given to the management.
3. The cost – benefit of Internal control should be taken into consideration.

2.8 MODEL EXAMINATION QUESTION

1. Which of the following statements about Internal control is correct?

A. a properly maintained Internal control reasonably ensures
that collusion among employees can not occur.
B. The establishment and maintaining of internal control is an
important responsibility of internal auditor.
C. An exceptionally strong internal control system is enough
for the auditor to eliminate substantive tests on significant account balances.
D. The cost benefit relationship is primary criterion that
should be considered in designing an interval control system,
2. An auditors primary consideration regarding an entity’s internal control is
whether they:
A. Prevent management override
B. Relate to the control environment.
C. Reflect the management’s philosophy and operating cycle.
D. Affect the financial statement assertion
3. Of the following statements about internal control, which one is not valid?
A. No one person should be responsible for the custody and recording of an asset.
B. Transaction must be properly authorized before such transactions are processed.
C. Because of the cost benefit relationship, a client may apply control procedure on
a test basis
D. Control procedures reasonably ensure that conclusion among employees cannot
occur.
4. Proper segregation of functional responsibilities cause for separation of the:
A. Authorization, record keeping, and custodian function.
B. Authorization, execution, and payment functions,
C. Receiving, shipping, and custodian functions.
D. Authorization, approval, and execution function.
5. The clients system of internal control must be sufficient to provide reasonable
assurance that:
A. transactions are properly valued.
B. transactions are properly authorized.
C. existing transactions are recorded.
D. recorded transactions are valid
E. all of the above

UNIT 3: INTERNAL CONTROL OVER CASH

Contents
3.0 Aims and Objectives
3.1 Introduction
3.2 Nature of Cash
3.3 Internal Control Objectives for Cash Receipts
3.4 Internal Control Over Cash Disbursements
3.5 Segregation of Duties
3.6 Limitation of Internal Control Over Cash
3.7 Summary
3.8 Glossary
3.9 Answers to Check Your Progress Exercise
3.10 Model Examination Questions

3.0. AIMS AND OBJECTIVE

After studying this unit, you should be able to:

  describe the nature of cash
 explain the nature of the cash receipts and disbursement cycles.
 identify and explain the fundamental internal controls over cash, receipts, and
disbursements
 describe the Auditors objectives for the audit of cash.

3.1 INTRODUCTION

This unit tries to describe the nature of cash, in general; the nature of cash receipts and
disbursements separately; and tries to Identify and explain the fundamental internal
controls over cash receipts and disbursements. Moreover, it tries to describe the
auditor’s objectives for the audit of cash –finally, some of the weakness of internal
control over cash is presented. This unit helps the students to understand and describe the
internal control over cash receipts and disbursements in relation to the important
documents and records used to control cash transactions.

3.2 NATURE OF CASH

The item cash reported in the financial statements represents currency on hand and cash
on deposit in Bank accounts, including certificate of deposit, time deposits, and saving
accounts. Certain “cash equivalents” are combined with cash for presentation in the
financial statements. FASB statement of financial accounting standards No 95, statement
of cash flow”, defines cash equivalents as short – term, highly liquid investments that are
readily convertible to cash or so near to their maturity that there is little risk of change in
their value. examples of such type include, Treasury bills, commercial paper and money
market funds.

Cash is affected in one or another, by all of the entity’s transaction cycles. Although the
main source of cash is revenue, other sources of cash include (1) the sale of property,
plant, and equipment and (2) the proceeds from issuing large – term debt or capital stock
- the main source of disbursements are the purchasing and payroll.

(i) Types of Bank accounts – the entity’s management must be concerned with
the control and safekeeping of cash. The use of different types of bank
 accounts keeps in controlling the entity’s cash. The following types of Bank
accounts all usually used.
(ii) General cash account – It is the principle cash account for most entity’s the
major source of cash receipts for this account is the Revenue cycle, and the
major sources of cash disbursements are the purchasing and payroll cycles.
- Impress cash account contains a stipulated amount of money, and the
account is used for limited purposes. This account is usually used for disbursing
of payroll checks and the account contains a minimum balance.
- Branch accounts-companies that operate with multiple branches located in
multiply Locations may maintain separate accounts at local banks. This provides
each branch with ability to pay local expenses. The Branch submits periodic cash
reports to head quarters, and the branch account receives check or transfer from
general cash account.
3.3 Internal control objectives for cash Receipts Transactions

There are seven detailed internal control over cash objectives that internal control over
cash receipts transactions must meet to prevent errors in journals and ledgers, as well as
to prevent International misstatements (frauds) the internal control over cash receipts
must be sufficient to provide reasonable assurance that.
i) Recorded transactions are valid (validity)
ii) Transactions are properly authorized (authority)
iii) Existing transactions are recorded (completeness)
iv) Transactions are properly valued (valuation)
v) Transactions are properly classified (classifications)
vi) Transactions are recorded at proper time (timeliness)
vii) Transactions are properly included in subsidiary ledger and correctly
summarized (posting and summarizations).

Internal control objective, (validity) prevents the possible misstatements of cash receipts.
That is cash receipts may be recorded but may not be received or deposited. The
completeness control objective helps to prevent misstatement of receipts such as cash
receipts may be stolen or lost before recording. The timeliness internal control objective
prevents cash receipts misstatements such as cash receipts may be recorded in the wrong
period. Authorization objective prevent, cash miss statements such as cash discounts
may not be properly taken. The valuation objective prevents cash receipts misstatements,
like, cash Receipts may be recorded as incorrect amount. The classification control
objective of cash receipts may prevent misstatements like cash receipts may be recorded
in wrong financial statement account. The posting and summarization objective prevent
misstatement such as cash receipts may be posted to wrong customer account, cash
receipts may not be properly posted to general ledger accounts.
3.4. INTERNAL CONTROL OVER CASH DISBURSEMENTS.

The Internal objectives for cash disbursements can be summarized as follows.

(i) Validity - It refers that segregation of duties must be made to

check possible misstatements such as cash disbursement recorded may not be
made (occurred).
(ii) Completeness – It refers that all transactions of the given period
which are made or occurred must be included or recorded in records. How ever
there night be cash disbursements made or occurred but mot recorded or included.
Auditors have to check numerical sequence of cheeks, daily cash disbursements
reconciled to postings to accounts payable subsidiary records.
(iii) Timeliness – It refers that all disbursement transactions must be
recorded in proper time then, the internal control objective helps to prevent cash
disbursements not to be recorded in a wrong period. In control procedure, there
would be daily reconciliation of checks issued with postings to cash disbursements
journal and accounts payable subsidiary records.
(iv) Authorization – It refers that there must be appropriate
authorization of disbursement transactions by concerned personnel. Control
procedure to insure this objective is segregation of duties; checks must be prepared
only after all source documents have been independently approved.
(v) Valuation – It refers that cash disbursements must be properly
determined. The balances of cash disbursements must be determined accurately.
There might be incorrect amount of cash disbursed and recorded in journal, there
fore, there must be a control procedure to check this misstatement. Daily cash
disbursements report must be reconciled to checks issued; vendor statements must
be reconciled to accounts payable records, and independently reviewed, monthly
bank statements must be reconciled and independently reviewed.
(vi) Classification - The cash disbursements must be properly
classified to in accord dance with chart of accounts. There fore, there might be cash
disbursements charged to wrong account. The control procedure includes that there
 must be well – prepared chart of accounts, independent approval and review of
general ledger account on voucher packet.
(vii) Posting and summarization – It refers that all cash disbursement
transactions must be posted and summarized. There might be cash disbursement
posted to the wrong vendor accounts, or cash disbursements journal may not be
summarized properly or not properly posted to general ledger accounts. Then, there
must be reconciled and independently reviewed, monthly cash disbursements
journal agreed must agree to general ledger postings, Accounts payable subsidiary
records must be reconciled to general ledger control account.

3.5. SEGREGATION OF DUTIES

Segregation of duties with regard to control over cash includes the following types. The
custody (possessing), recording, and Authorization of cash should be separated. That is,
the same person should not be entrusted to perform the two or three activities. The
reason is that if the custody and record keeping are done by the same person, that person
can steal money and they change the ledger to conceal the theft. If cashier has custody,
the bookkeeper makes entries, and the finance head authorizes payments, this is good
segregation of duty regarding to petty cash. If the Bank account is reconciled by one who
does not have access to cash, then it is good segregation of duties regarding to cash in
Bank the store keeper should not fill our receiving reports to control Inventory. The
person who authorizes salary for new employee should not be the one paying the salary.
The receiving of cash, depositing of the cash in the Bank, recording of cash and general
ledger should be segregated. Cash payment preparation, authorizing of cash payment,
cash payment, (disbursing), and recording of cash payments in cash disbursement journal
and general ledger such as Account payable ledger and cash control ledger should be
segregated; that is each activity should be performed by different persons.

3.6. LIMITATIONS (WEAKNESS) OF INTERNAL CONTROL OVER CASH

Weak internal control procedures would create opportunity for fraud or defalcation /theft/
of cash. The most common defalcation techniques of cash are:
a. Withholding of cash receipts – proceeds form cash sales are withheld at point of
sales recording and receiving of cash. For example, a cash register clerk can fail
to register sales or under register amounts, and pocketing full or partial amounts,
If the customer does not wait for his receipts and changes, or check amounts
charged, registered, and paid.
b. Lapping - refers to cash collection on account from credit customer may be
postponed (delayed). This is usually practiced as temporary borrowing, but in the
long run they lead to cover up by more elaborate means. This is possible if a
single person is responsible to receive cash from charge customers and keep
records for accounts receivable at the same time.
c. Sales discount – cash can be abstracted from sales discount not taken by
customers. i.e when customers pay the full amount, only amount net of discount
are recorded to customers and the difference would be pocketed by recording it to
discount account.
d. Writing off bad debts – Accounts Receivable could be written off as bad debts
when actually customers remittance is pocketed.
e. Fictions Accounts Receivable – Goods could be taken for private use or stolen
by charging fictions customers and writing off as bad debts later on.
f. Check – kiting – It refers to transferring of check from one back to another when
business has two bank accounts say in bank X and Y check is written to withdraw
an account from bank X account balance, and deposited into Bank Y account.
Because of lag (delay) of time for clearance, the amount deposited in bank Y is
immediately reflected, but is not reflected as deduction (withdrawal) from Bank X
account soon, Consequently such technique is practiced by casher to cover up
cash shortage which an auditor might uncover.
g. Window – Dressing – Cash Shortage or cash position could be improved by
holding the cash book open /unclosed) beyond the closing date to include
subsequent cash receipts.
h. Others includes as, cashier payable to self, check payable to others, petty cash
vouchers.
Check Your Progress Exercise

(1) Which of the following is relevant to the auditors objectives in audit of cash.
A. Evaluating internal control over cash transaction.
B. Substantiate the existence of recorded cash.
C. Establish the completeness of recorded cash.
D. To determine that the client has right to recorded cash.
E. All of the above F. None
(2) An auditor would consider a cashier job description to contain compatible
duties if the casher receives remittance from the mail room and also prepares:
A. the prelisting of individual checks. C. the daily deposit slip.
B. the monthly bank reconciliation. D. remittance advice.
(3) Cash receipts from sales on account have been misappropriated. Which of
the following acts would conceal this defecation and be least likely to be detected by
an auditor?
A. understating the sales journal
B. over stating the accounts receivable control
C. overstating the accounts receivable subsidiary ledger
D. understating the cash receipts journal
(4) One of the following internal controls would be most likely to detect the
lapping of collections from customers?
A. Independent internal verification of dates of entry in the cash receipts journal
with dates of daily cash summaries.
B. Authorization of write – off of uncollectible accounts by a supervisor
independent of the credit approval function.
C. Segregation of duties between receiving cash and posting the accounts
receivable ledger.
D. Supervisory comparison of the daily cash summary with the sum of the cash
receipts journal entries.
3.7 SUMMARY

This unit described the fundamental internal control over cash receipts and
disbursements. It also explained how the auditors design tests of controls for cash. To
summarize:
1. Since cash generally has high degree of inherent risk, more audit time is devoted
to the audit of the account than is indicated by its dollar amount.
2. Internal control over cash receipts should provide assurance that all cash received
is reported promptly and accurately, control over cash sales is strongest when two
or more employees participate in each transactions, or when collections are
controlled by a cash register.
3. Internal control over cash disbursements is best achieved when all payments are
made by cheek or well – controlled electronic fund transfers except for minor
payments.
4. The cash value and liquid nature of many investments makes the separation of the
authorization, custody, and record – keeping functions’.

3.8 GLOSSARY

1. Window dressing – Action taken by the client. Shortly connect it before the
balance sheet date to improve the financial picture presented in the financial
statements.
2. Voucher – A document authorizing a cash disbursement. A voucher usually
provides space for employees performing various approval functions to initial. (The
term voucher may also be applied to the group of documents that support a cash
disbursement.
3. Kiting – manipulations causing an amount of cash to be included simultaneously
in the balance of two or more bank accounts. Kiting schemes are based on the fleet
period the time necessary for a check deposited in one bank to clear two bank while it
was drawn.

3.9 ANSWER TO CHECK YOU PROGRESS

1. A 2. C 3. D 4. A
3.10 MODEL EXAMINATION QUESTIONS

1. Which of the following is the most effective control procedures to detect vouchers
prepared for the payment of goods that were not received?
A. Counting of goods upon receipt in storeroom.
B. Matching of purchase order, receiving report, and vendor in voice for each
voucher in accounts payable department.
C. Comparison of goods received with goods reqisioned in receiving
department.
D. Verification of vouchers for accuracy and payroll in internal audit
Department.
2. Which of the following procedures in cash disbursement cycle should not be
performed by the accounts payable department?
A. Cancellation of supporting documents after payment.
B. Comparison of the vendor invoice with the receiving report.
C. Verification of the mathematical accuracy of the vendor invoice
3. For Effective internal control purpose, which of the following individuals should
be responsible for mailing signed checks?
A. Receptionist B. Treasurer
C. Accounts Payable clerk. D. Payroll clerk
4. In museum, opened to public visiting assume that two clerks are assigned at
entrance to collect admission fees. What possible internal control should be installed
to prevent cash misuse?
A. The admission fee collectors should deposit daily collections.
B. The treasurer and the clerk should deposit the cash.
C. Cashier is responsible to receive daily cash collections and deposit the
cash.
D. The cash collection should be based on cash receiving in voice.
5. Which of the following is an internal control procedures that would prevent paid
vouchers from being presented for payment for the second time?
A. Vouchers should be prepared by individuals who are net responsible for signing
checks
 B. Vouchers should be approved by responsible official.
C. The person signing checks should compare the check with vouchers supporting
do comments.
D. All of the above

UNIT 4: INTERNAL CONTROL OVER PURCHASE AND INVENTORY

Contents

4.0. Aims and Objective

4.1. Introduction
4.2. Nature of Internal Control Over Purchase
4.3. Control Procedures and Tests of Controls of Purchases
4.4. Segregation of Duties
4.5. Inventory
4.6. Control Procedures and Tests of Controls of Inventory
4.7. Summary
4.8. Answer to Check Your Progress Exercise
4.9. Model Examinations Questions

4.0. AIMS AND OBJECTIVES

After studying this unit, you should be able to:

 describe the nature of purchases and inventories
 describe the documents, records and the amounts that comprise purchase and
inventories.
 identify and explain the fundamental Internal control policies and procedures for
purchase and inventories.
 describe the typical tests of controls used by the auditors to evaluate the
effectiveness of control.
4.1. INTRODUCTION

The relationship of inventories and purchase makes it logical for the two topics to be
considered together. The Internal control that assures the fair valuation of inventories are
found in the purchase (or acquisition) cycle. These procedures in clued procedures for
the selection of vendors, ordering merchandise or materials, inspecting goods, receive,
recording the liabilities to the vendor, and authorizing and making cash disbursements.

This unit explains the essential control procedures and tests of controls used by the
auditors for purchase and inventory. Thus student should be able to understand these
procedures and Tests with relation to necessary do comments and records used for
control purposes.

4.2 Nature of internal control over purchase

Purchase transaction usually begins with a purchase reacquisition being generated by

department or support function. The purchasing department prepares a purchase order
for the purchase of goods or services from a vender when the goods are received or the
services hare been rendered, the entity records a liability to the vender. Finally, the entity
makes payment to the vender.

The three major types of transactions are processed through the purchasing cycle.
 Purchase of goods and services for cash or credit
 Payment of the liabilities arising from such purchases.
 Return of goods to suppliers for cash or credit.

The types of documents and records involved in the purchasing cycle Include.
1. Purchase requisitions – this document is a request for goods or services by
authorized individual department within the entity. Example of such requests
 include an order for raw materials for production from the production
management department, an order for newspaper advertising space from a
marketing manager.
2. Purchase order – this document Includes the description, quality and quantity of
and other information as date of delivery, credit terms means of transportation, the
purchase order also indicates the person who approved the acquisition and
represents the authorization to purchase the goods or services.
3. Receiving report - this document is used to record the receipts of goods.
Normally, the receiving report is a copy of the purchase order with the quantities
omitted. This procedure encourages receiving department personnel to make
adequate, independent count of the goods received. Receiving department
personnel records the date, description, quantity and other Information or this
document.
4. Vender invoice – this document is the bill from the vender. The Vender invoice
or purchase invoice includes the description and quantity of goods shipped or
services rendered the prices including freight costs, insurance the terms of trade
including cash discounts and date billed.
5. Voucher – this is a document that is frequently used by entities to control
payment for acquired goods and services. This document serves as basis for
recording a venders invoices into voucher register or purchase journal the voucher
is attached to the purchase reacquisition, purchase order, receiving report, and
vender invoices to create a voucher packet – this vouch example Include check
payment voucher,
6. Accounts payable – is an account used to record all vender invoices, cash
disbursements and adjustment in individual vender accounts.
7. General ledger – proper accumulation, classification and summarization of
purchases, cash disbursement and payable in the general ledger.

4.3 CONTROL PROCEDURES AND TESTS OF CONTROLS

There are seven control procedures applied for control of purchase Transactions.
a. Validity - the Auditors concern in testing of the validity of purchase transaction is
that factious or non-existent purchase may have been recorded in the clients
records. If fraudulent transactions are recorded, assets or expenses will be
overstated. A liability will also be recorded and a resulting payment made, usually
to the individuals who initiated the factious purchase transactions proper
segregation is the control test for preventing factious purchases. The critical
segregation of duties is the separation of the reacquisition, and purchasing
functions from the accounts payable and disbursement functions.
b. Completeness of purchase transaction- If the client fails to record a purchase
that has been made assets or expenses will be understated and the corresponding
accounts payable will also understated. Control Test that provides assurance that
the completeness objective is being met includes accounting or checking the
numerical sequence of purchase orders, receiving Reports, and Vouchers;
matching receiving vouchers with vender invoices, etc.
c. Timeliness of recording of purchase transaction - the client should have
controls to ensure that purchase transactions are recorded or timely basis (in a
proper time). For example, the client’s procedure should require that all receiving
reports should be forwarded to the accounts payable department or section on
daily basis.
d. Authorization of purchase transaction - possible misstatements due to improper
authorization includes the purchase of unauthorized goods and the purchase of
goods or services at unauthorized price or terms. The major control procedure to
prevent these misstatements is the use of authorization schedule or table which
shows the amount that different levels of employees (personnel) are authorized to
purchase.
e. Valuation of purchase transactions - The possible misstatements for valuation
of Internal control objective is that purchase transactions may be recorded at in
correct amounts due to improper pricing or erroneous calculation.
f. Classification of purchases - Proper classification of purchase transactions is an
important internal control objective for the purchasing cycle. If purchase
transactions are not properly classified, asset and expense accounts will be
misstated. A control test for this objective is proper documentation and records
for example having chart of accounts.
g. Segregation of duties – the major segregation of duties to control purchasing
transactions including the following
- The purchasing function should be separated from the
requisitioning and Receiving functions (that is separate Individuals should
involve in each functions.
 - The invoice (vender invoice) processing function should be
segregated from the accounts payable function.
- The account payable function should be segregated from the
general ledger function.

4.5. INVENTORY

The inventory cycle is affected by the control procedures previously discussed for cash
receipts review purchasing, and payroll cycles. The acquisition of and payment for raw
materials and overhead costs is controlled via the purchasing cycle. The cost of both
direct and indirect labor assigned to inventory is contro9lled through payroll cycle.
Family, finished goods are sold and accounted for as part of revenue cycle. Thus, the
cycle for Inventory in manufacturing company begins when goods are purchased and
stored as raw materials, proceeds to the processing of the goods through manufacturing
departments, and ends when the finished goods are shipped to customers.

4.6. CONTROL PROCEDURES AND TESTS OF CONTROLS OF

INVENTORY

1. Validity of inventory Transactions- the auditors main concern is that all

recorded inventory exists and actually belongs to the client. The major control
procedure for preventing factious inventory transactions form being recorded is
proper segregation of duties, in which the production management and inventory
stores functions are separated form the departments responsible for inventory and cost
– accounting records
2. Completeness – The Control procedure for completeness objective relate to
recording inventory which has been received. Typically, the control procedures for
this objective are contained within the purchasing cycle.
3. Authorization – unauthorized production activity that may lead to excess levels
of certain types of finished goods.
4. Valuation – Inventory transactions that are not properly valued result in
misstatement that directly affect the amounts reported in the financial statements for
 cost of goods sold and inventory. Proper valuation of inventory involves a accurately
determining the quantity of goods on hand and assigning the appropriate costs to
these goods.
5. Classification of inventory transactions – control procedures must insure that
inventory is properly classified as raw materials, work in process or finished goods.
Check Your Progress Exercise
1. When auditing merchandise inventory at a year-end, the auditor performs a
purchase cut - off test to obtain evidence that:
a. All goods purchased before year end are received before the physical
Inventory count.
b. No goods held on consignment for customers are included in the inventory
balance
c. No goods observed during the physical count are pledged or sold.
d. All goods owned at year – end are included in the Inventory balance
2. Inquiries of ware house personnel concerning possibly obsolete or slow - moving
inventory items provide assurance about management ‘s assertions of
a. Completeness c. Presentation
b. Existence d. Valuation
3. Auditor performs a test to determine whether all merchandise for which the client
was billed was received. The population for this test consists of all:
a. Merchandise received c. Cancelled cheeks
b. Vendors' invoices. d. Receiving reports.

4.8 SUMMARY

1. Effective control over purchases and inventory requires appropriate policies and
procedures for purchasing, receiving and Issuing supplies and materials.
2. The auditors’ objectives in the audit of purchase and inventories are to:
(1) Consider the validity, (2) Completeness
(3) Timeliness (4) authorization
(5) Valuation and (6) classification of purchases and
inventories.
 3. In the audit of inventories, auditors are primarily concerned about the existence
of the assets in the store room that is the possibility of over statement of year –
end balances. There for the test is the observation of the physical inventory, and
or other include test of price for valuation, completeness (cuff –off test), and the
like.
4. The auditors’ concern in the understanding of Internal control over purchase and
inventories is to design appropriate substantive tests of purchase and
Inventories.

4.9 MODEL EXAMINATIONS QUESTIONS

1. When goods are received, the receiving clerk should match the goods
with:
a. Vender invoices b. The vender invoice and the receiving
report
c. The vender shipping document and the purchase order
d. The receiving report and the vender shipping document.
2. Internal control is strengthened when the quantity of merchandise ordered
is omitted from the copy of the purchase order sent to the:
a. department that initiated the requisition c. purchasing agent
b. receiving Department. d. accounts Payable
department
3. To determine whether accounts payable are complete, an auditor performs
a test to verify that all merchandise received is recorded. The population of
documents for this tests consists of all.
a. Vender invoices c. Receiving reports
b. Purchase orders d. Cancelled checks
4. Which of the following control tests would be most effective in ensuring
that recorded purchases are free of material errors?
a. the receiving Department compares the quantity ordered on purchase
orders with the quantity received on Receiving reports.
 b. Vender invoices are compared with purchase orders by an employee who
is independent of the receiving department.
c. Receiving reports require the signature of the individual who authorized
the purchase
d. Purchase orders, receiving reports, and vendor invoices are independently
matched in preparing vouchers.
5. Purchase completeness (cuff – off) procedures should be designed to test
whether all inventory.
a. Purchased and received before the year end was paid for.
b. Ordered before the end of the year was received
c. Purchased and received before the end of the year was recorded.
d. Owned by the company is in the possession of the company at the end of the
year.

UNIT 5: INTERNAL CONTROL OVER RECEIVABLES AND CREDIT SALES

Contents
5.0. Aims and Objectives
5.1 Introduction
5.2 The Nature of Control Over Receivables and Sales
5.3 Steps and Procedures in Sales and Collection Cycle
5.4 Segregation of Duties
5.5 Summary
5.6 Answers to Check Your Progress Exercise
5.7 Model Examinations

5.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to:

- describe and under stand the three types of substantive tests used to Audit
accounts Receivable
- identify tests of accounts balance for auditing accounts Receivables, and
- identify the audit objectives of control over Receivable’ and sales.
5.1 INTRODUCTION

This unit is concerned with the audit of the accounts balances affected by the revenue
cycle. The numerous documents and records used by large companies in processing
credit sales transactions often include the following:
 Customer order
 Sales order
 Shipping documents
 Sales invoice
 Authorized price list
 Accounts Receivable subsidiary ledger or accounts receivable master file
 Sales transactions file
 Customer monthly statement

The processing of credit sales or credit sales functions involves a sequence of steps or
credit sales functions as follows:
 Accepting customer orders
 Approving credit
 Filing sales orders
 Shipping sales order
 Dealing with customers
 Recording the sales

Details of the controlling of Account Receivables and sales will be discussed in the
following titles of this unit.

5.2 THE NATURE OF CONTROL OVER RECEIVABLES AND SALES

The following control objectives and Test of controls are applicable in the accounts
Receivable and sales (Revenue) Transaction.
(i) Validity – the validity internal control objectives relates to management’s
assertion about existence or occurrence. Auditors are concerned about the
 validity objective for revenue from actions because clients are more likely to
overstate sales than to understate them. The possible misstatement including
sells to fictious customer, and recording of revenue when goods have not
been shipped or services have not been performed. The major control for
preventing such misstatement is segregation of duties between the shipping
function and the order entry and billing function. Requiring an approved
customer sales order and shipping document before revenue is recognized also
minimizes the recording of fictions sales in client’s records.
(ii) Completeness – the completeness objective relates to the completeness assertion.
The major misstatement that concerns both management and Auditor is that
goods are shipped or services are performed and no revenue is recognized
control procedures that provide assurance that accounting for numerical
sequences of shipping documents and sales invoices, matching shipping
documents with sales invoices, reconciling the sales invoices to daily sales
report, and minting and reviewing the open –order file.
(iii) Timeliness – timeliness internal control objective relates to the completeness
assertion. After client does not have adequate controls to ensure that revenue
transaction recorded on timely basis, sales may be recorded in the wrong
accounting period. The client should require that all shipping documents be
for warded to the billing function daily for processing on a timely basis. The
Auditor should test this control by comparing the date on a bill of lading with
the date on the respective sales invoice and the date the sales invoice was
recorded in the sales journal. All billing must occur with the minimum delay.
(iv)Authorization of revenue Transaction - this internal control objective relates to
the valuation assertion’ possible misstatements due to improper authorization
include shipping goods to or performing services for customers who are bad
credit risks and making sales at unauthorized prices or terms. Authorized
price lists and specified terms of trade, for shipping and credit must be
established.
(v) Valuation – This control relates to valuation assertion – Incorrectly valued
(determined) amount of Revenue results in misstatements that directly affect
 amounts reported in financial statements there must be authorized price, terms
of trade, type of goods shipped, a sales invoices should be verified for.
Mathematical accuracy before being sent. To recording.
(vi)Classification of Revenue Transaction - This control objective relates to the
presentation and disclosure assertion – the use of chart of accounts and proper
codes for recording transactions should provide adequate assurance about the
objective. The auditor can review the sales journal and general ledger for
proper classification.
(vii) Posting and summarization of revenue - This Internal control objective
relates to the presentation and disclosure assertion. There is possibility that
transactions are not properly summarized from source documents or posted
properly from journal to subsidiary and general ledgers. There fore, the
control test should include as, reconciling sales invoices to the daily sales
report (summary report) and the daily recordings in sales journal should be
reconciled with the posting to the accounts receivable subsidiary ledger, this
ledger should periodically be reconciled to the general ledger control account.

5.3 STEPS AND PROCEDURES IN SALES AND COLLECTION CYCLE

Selling the Goods and Billing the Customers

(a) Processing customer orders - the cycle begins when the customer
makes an order. The company may have preprinted order forms, or the
customer may make a verbal or informal written request.
(b) Credit approval – If the order is on account (on credit), credit
should be approved by producing credit approval form for approving credit,
limit, terms of credit and (credit worthiness of the customer).
(c) Shipping goods – this is a key part of the process, because this is
when the companies assets are actually given up. A shipping document (such as
bill of lading) is prepared giving the description, the quantity, the receivers,
freight costs, and other information the sales invoice is prepared of this stage. It
should show the description, quantity and prices including shipping charges –
Transport cash, Insurance, etc.
 (d) Bill customers and recording sales – the sales invoice is the most
important document in this activity – The sales invoice is the basis for recording
sales and for billing the customer. The monthly statement should be prepared
and sent to each customer who has an account. This monthly statement should
list the invoices and payments for the period, with the necessary information
about each transaction will used for confirmation by the auditor.
(e) Processing and recording cash receipts – A remittance advice
should be sent to the customer with the sales invoice. The customer should
return that advice which contains customers name invoice number, and amount
paid. When cash arrives, prelisting of cash receipts should be prepared. It
should be by some one with out access to cash, and with no knowledge of A/R.
All cash receipts should be prepared. And recorded in cash receive Journal.
(f) Charging off un collectible accounts – uncollectible authorization
form should be needed for charging –off uncollectible expenses.
5.4 SEGREGATION OF DUTIES

Authorization of sales, recording of sales, and custody of goods in the warehouse should
be separated. The people who are recording sales and cash receipt of have no access to
cash. Separate credit granting from sales. Separate posting to the cash receipts ledger
from posting to individual accounts receivable. Further, monthly statement should be
sent out by person with no responsibility for handling cash. Inquires or complaints about
the statements should be maintained for handling cash, recording sales or recording
accounts receivable.

Check Your Progress Exercise

1. Alpha company uses its sales invoices for posting perpetual inventory records, in
adequate control procedures over invoicing function allow goods that are not invoiced
to be shipped. The inadequate control. Procedures could cause an.
a. Understatement of revenues and receivables and inventory.
b. Overstatement of revenues and receivables and an understatement of
inventory
c. Understatement of revenues and receivable and over statement of Inventory.
 d. Overstatement of revenues, receivables, and Inventory.
2. Auditor selects a sample from the file of shipping documents to determine
whether invoices were prepared. This test is performed to satisfy the audit
objective of ;
a. Accuracy b. Completeness c. Control d. Existence

5.5 SUMMARY

An entity's revenue includes the activities pertaining to sales, cash receipts, and sales
adjustments transactions. These transactions affect several significant accounts in the
financial statements including cash, account receivables, inventories, and sales. The
nature of many of this activities in the cycle results in high inherent risk for several
significant financial statement assertions such as the existence or occurrence of accounts
receivable. Because of this, many companies have adopted extensive provisions within
their internal control structure to prevent or detect misstatements. In planning
substantative tests of Accounts Receivable, the auditor is particularly concerned with the
risk of overstatement of net receivables due to the inclusion of fictious receivables or
inadequate allowance for uncollectible accounts.

5.6 ANSWERS TO CHECK YOUR PROGRESS

1. A 2.A

5.7 MODEL EXAMINATION

1. An auditor’s purpose in reviewing credit ratings of customers with delinquent accounts

receivables is most likely to obtain evidence concerning management’s assertions about:
A. Presentation and disclosure. C. Rights and obligations
B. Existence or occurrence D. Valuation or allocation
2. For Internal control of credit sales, the correct procedure of transaction should be obtaining
orders approval of credit, billing of the sale, shipping merchandise, and recording revenue.
A. True B. False
3. What would you accept as satisfactory document evidence in support of entries in the sales
journal?
 A. Cash receipts invoices C. Customer order
B. Credit sales invoices D. All of the above
C. Cash sales invoices E. A and b only.
4. Which of the following procedures would ordinarily be expected to best reveal unrecorded
sales at the balance sheet date?
A. Compare shipping documents with sales records.
B. Apply gross margin rate to inventory dispossed of during the period.
C. Trace payments received subsequent to the balance sheet date.
D. Send accounts receivable confirmation requests
5. An auditor is testing sales transactions. One step to trace a sample of debit entries from the
accounts Receivable subsidiary ledger back to the supporting sales invoices. What would the
auditor intend to establish by this step.
A. All sales have been recorded.
B. All sales invoices have seen properly posted to customer accounts
C. Debit entries in the accounts receivable subsidiary ledger are properly supported by sales
invoices.
UNIT 6: INTERNAL CONTROL OVER PAYROLL

Contents
6.0 Aims and Objectives
6.1 Introduction
6.2 Nature of Control Over Payroll
6.2.1 The Types of Documents and Records Involved for Control of
Payroll
6.3 Control Procedures and Tests of Controls of Payroll Transactions
6.4 Segregation of Duties
6.5 Summary
6.6 Answer to Check Your Progress Exercise

6.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to:

 understand the payroll cycle.
 identify types of documents and records.
 understand and Identify the audit objectives of payroll
 understand the functions within the cycle.
 proper segregation of duties.

6.1 INTRODUCTION

Payroll transaction usually begins with an employee performing some job and recording
the time spent on a time card. The time card is approved by a supervisor before being
forwarded to the payroll department. Finally, payment is made directly to the employee
or deposited in the employee’s bank account. The reader should focus on the basic
concepts so that they can be applied to the specific payroll cycles encountered. The
following topics are related to the payroll cycle.
6.2 NATURE OF CONTROL OVER PAYROLL

There are two major types of transactions that are processed through the payroll cycle.
(i) Payments to employees for services rendered
(ii) Accrual and payment of payroll – related liabilities arising from employees
services, including liability for social security and unemployment Taxes. The
discussion of Internal control focuses on payments to employees, including a
description of how such transactions are processed and the key control
procedures that should be present to ensure that no material misstatements
occur.

6.2.1 The Types of Documents and Records Involved for Control of Payroll
The following documents and records are Important for the control of payroll
transactions.
(a) Personnel Records, including wage – Rate or salary authorizations – The
personnel records contain information on each employees work history,
including hiring date, wage rate, or salary, payroll deduction, authorization
forms, wage –rate and salary adjustment authorizations performance evaluations,
and termination notice, are applicable.
(b) Time card – This document is used to record the hours worked by the employee
including the time the employee has started and stopped work.
(c) Payroll Register – this document whishing also referred to as the payroll journal,
is a summary of all payroll checks is used to employees. Of indicated,
employee’s gross pay, deductions, and net pay.
(d) Periodic payroll reports – at the end of each week or month, a number of
summary payroll reports may be prepared one such report would be a summary
of payroll for various job classifications or departments.

6.3 Control procedures and Tests of controls of payroll transactions

The following control procedures &Tests of control are used to prevent possible
misstatements.
 (i) Validity of payroll Transactions – the auditor wants assurance that payments
for payroll related services are being made to valid employees for time actually
worked. Thus, the client needs to have control procedures that prevent payments
to fictitious employees and to valid employees who have not worked. It also
needs to assure that payroll payment stop once. An employee is terminated.
Proper segregation of duties provides the main control against payments to
fictious employees.
(ii) Authorization of payroll transactions – The client should have authorization
procedures for hiring and Terminating employees, setting pay rates, making with
holdings, awarding benefits, and Issuing payroll checks. Supervisor should
approve the amount of time reported by an employee on his or her time card.

Similarly, hiring and termination of employees and changes in pay rates should be
authorized by the office of human resources consistent with union contract or
corporate policies. A payroll check should not be issued unless an employees
time card has been approved and that employee has a valid employee number on
the payroll master tile.
(iii) Valuation of payroll Transactions - The main concern related to the valuation
objective is that an employee with gross Pay and payroll deductions maybe
incorrectly computed. For example, employee may be paid at higher rate than
authorized or payroll deductions may be incorrectly computed. The client should
maintain verification procedures to ensure that payroll expense is charged to
wrong accounts; the financial statements may be misstated. It has to be classified
into direct, and indirect labor, inventory and cost of goods sold. The use of
adequate chart of accounts is one control mechanism.

6.4 SEGREGATION OF DUTIES

Proper segregation of duties provides the main control against payments to fictious
employees. Proper segregation of duties among operating departments, the office of
Human Resources, and the payroll department minimizes the possibility of fictious
employees existing with in the system. Further, imitation of wage or salary changes
should be performed by operating department, initiation of employee living and firing by
operating department, approval of wage or salary changes by personnel department, up
dating of personnel records by personnel department; approval of time cards and job
classification by operating department; review of time data and payroll distribution by
time keeping department; preparation of payroll department; preparation and signing of
payroll checks by financial department, distribution of payroll checks, by payroll taxes by
payroll department and the other activities related to payroll transactions must be
properly segregated.

Check Your Progress Exercise

1. Which of the following control procedures could best prevent direct labor
from being changed to manufacturing overhead?
A. Composition of daily journals entries with factory labor summary.
B. Examination of routine tickets from finished goods on delivery.
C. Reconciliation of work –in-process inventory with cost records.
D. Re computation of direct labor based on inspection of time cards
2. For appropriate segregation of duties, Journalizing and posting summary
payroll transactions should be assigned to:
A. The Treasurer’s Department C. Payroll accounting
B. General Accounting D. The time keeping Department
3. The auditor may observe the distribution of pay checks to ascertain
whether:
A. Pay-rate Authorization is properly separated from the operating function.
B. Deductions from gross pay are calculated correctly and are properly
authorized.
C. Employees of record actually exist and are employed the client
4. Which of the following departments should have the responsibility for
authorizing payroll rate changes?
A. Personnel C. Treasurer
B. Payroll D. Timekeeping
5. Tracing selected items from payroll register to employee time cards that
have been approved by supervisory personnel provides evidence that.
A. Internal controls relating to payroll disbursement were operating
effectively.
B. Payroll checks were signed by an appropriate officer independent of the
payroll preparation process.
C. Employees worked the number of hours for which their pay was
computed.
6.5 SUMMARY

Internal control over payroll includes accounts as accrued liabilities for salaries,
wages, commission, bonuses, employee benefits, and payroll taxes, and related
expense accounts. Although the auditor's primary concern for payroll expenses for
the year is with overstatement, for the year-end accruals the primary concern is
with understatements. In obtaining evidence concerning the reasonableness of
management's accruals, the auditor should review management's calculations or
make independent calculations accruals for payroll taxes should be compared with
amounts shown on payroll tax returns. Evidence obtained from these tests pertains
primarily to objectives related to the valuation or allocation assertion.

6.6 ANSWER TO CHECK YOUR PROGRESS EXERCISES

1. D
2. C
3. D
4. A
5. B
UNIT 7: INTERNAL CONTROL OVER FIXED ASSETS

Contents:
7.0 Aims and Objectives
7.1 Introduction
7.2 Nature of Internal Control Over Fixed Assets
7.2.1 Validity and Authorization
7.2.2 Completeness
7.3 Segregation of Duties
7.4 Summary
7.5 Answer to Check Your Progress Exercise

7.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to:

 describe the nature of property, plant and equipment, and depreciation.
 explain the fundamental Internal control policies and procedures for property,
plant, and equipment.
 design typical tests of controls used by Auditors to evaluate the effective ness of
controls over property, plant, and equipment.
 Identify the auditors objectives for the audit of property, plant, and equipment.

7.1 INTRODUCTION

The term property, plant, and equipment include all tangible assets with a service life of
more than one year that is used in the operation of the business and are not acquired for
the purpose of resale. Three major subgroups of such assets are generally recognized and
the concepts are given in the glossary part of this unit.

For most entities, property, plant and equipment represent a material amount in the
financial statements. When the audit is on going engagement, the auditor is able to
focus his or her efforts on the current year’s activity since the assets acquired in
earlier years were subjected to audit tests at the time of acquisitions.

There are four types of property, plant, and equipment transactions in fixed assets.
 Acquisition of capital assets for cash, or other non monetary considerations
(exchange by other fixed assets)
 Disposition of capital (fixed assets) through sale, exchange, retirement, or
abandonment.
 Depreciation of capital assets over their useful economic life
 Leasing of capital assets

The property, plant and equipment subsidiary ledger is are record of all capital assets
owned by the entity. It contains information of the cost of the asset, the date acquired,
the method of depreciation, and accumulated depreciation. The subsidiary ledger also
includes the calculation of depreciation expense for both financial statements and income
tax purposes. The subsidiary ledger should be reconciled to the general ledger control
account on a monthly basis.

7.2 NATURE OF INTERNAL CONTROL OVER FIXED ASSETS

Key control procedures, and tests of controls that relate directly to property, plant, and
equipment were discussed as part of the purchasing cycle. More over, the following
control procedures are discoursed as follows:

7.2.1 Validity and Authorization

The control procedures for the validity and Authorization objectives are normally part of
the purchasing cycle. Purchase reacquisition are initiated in relevant departments and
authorized at the appropriate level within the entity. How ever large capital asset
transactions may be subject to control procedures out side the purchasing cycle for
example, highly specialized equipment may require skilled engineers approval for the
technical specifications for the equipment, for such transactions, the auditor may need to
examine more than the vendors invoices to test validity; review of additional
documentations, such as capital – budgeting documents and engineering specifications
may be needed.
7.2.2 Completeness
The control procedures used in the purchasing cycle for ensuring completeness provide
some assurance that all capital asset transactions are recorded in the property, plant, and
equipment subsidiary ledger and general ledger. One procedure that helps to ensure that
this objective is met is reconciliation of the property, plant and equipment subsidiary
ledger to the general ledger one procedure that helps to ensure that this objective is met is
reconciliation of the property, plant and equipment subsidiary ledger to the general ledger
control accounts on monthly basis. Another control procedure that on entity may use to
ensure that all capital assets are recorded is periodic comparison of the detailed records in
the subsidiary ledger with the existing capital assets. The client may take a complete
physical examination of property, plant, and equipment on periodic or rotating basis and
compare the physical asset to the subsidiary ledger.

7.3 SEGREGATION OF DUTIES

The existence of adequate segregation of duties for property, plant and equipment within
an entity depends on the volume and significance of the transaction processed. For
example, If an entity purchases large quantities of machinery and equipment, or if it has
large capital projects under construction, there is a likely to be a formal internal control
system. On the other hand, if an entity has few capital purchases, the entity will
generally not have formal control system.

The following notes show the key segregation of duties for property, plant, and
equipment transactions and examples of possible errors or irregularities that can result
form conflicts in duties.
(a) If one individual is responsible for initiating a capital asset transaction and
also has final approval, it is possible for fictitious or unauthorized purchases
of assets to occur. This can result in purchases of unnecessary assets, assets
that do not meet the company’s quality control standards, or illegal payments
to suppliers or contractors. Thus, there must be final approval functions.
 (b) If one individual is responsible for the records and also for the general ledger
functions, It is possible for that individual to conceal (fraud) any defalcation
that world normally be detected by reconciling subsidiary records with the
general ledger control account. Thus, the recording function should be
segregated from the general ledger function.
(c) If one Individual is responsible for the records and also has custodian
responsibility for the related assets, it is possible for tools and equipment to be
stolen and for the theft to be concealed by adjustment of the accounting
records. Thus, the recording functions should be segregated from the
custodian function.
(d) If the individual who is responsible for the periodic physical inventory fixed
assets, is also responsible for the custodian and record – keeping functions, it
is possible for theft of the entity’s capital assets to be concealed. Thus,
individual responsible for the inventory should be independent of the
custodian and record – keeping functions.

Check Your Progress Exercise

1. To strengthen internal control over the custody of heavy mobile

equipment, the client would most likely institute a policy requiring a period.
a. Increase in insurance coverage
b. Inspection of equipment and reconciliation with accounting
records.
c. Verification of liens, pledges, and collateralizations.
d. Accounting for work orders.
2. A weakness in internal control over recording retirement of
equipment may cause an auditor to.
a. Trace additions to the “other assets” account to search for equipment that is
still on hand but no longer being used
b. Select certain items of equipment from the accounting records and locate them
in the plant.
 c. Inspect certain items of equipment in the plant and trace those items to the
accounting records.
d. Review the subsidiary ledger to ascertain whether depreciation was taken on
each item of equipment during the year.
3. Which of the following procedures is most likely to prevent the
improper disposition of equipment?
a. Separation of duties between those authorized to dispose of equipment and
those authorized to approve work orders.
b. The use of serial numbers to identify equipment that could be sold
c. Periodic comparison of removal work orders to authorizing do
documentation.
d. Periodic analysis of the scrape sales and the repairs and maintenance
accounts
4. Which of the following combinations of procedures would an
auditor be most likely to perform to obtain evidence about fixed asset additions?
a. Inspection of documents and physical examination of assets.
b. Re computation of calculations and obtaining of written
management representations
c. Observation of operating activities and comparison of balances to
prior period balances.
d. Confirmation of ownership and corroborating of transaction
through inquiries of client personnel.

7.4 SUMMARY

In the audit of plant assets, the auditors should give emphasis on the addition, disposals
and repairs and maintenance. Evidence of sales, retirements and trade-in should be
available to the auditor. The three procedures involved in substantive tests of plant assets
include:
- inspecting
- examining title documents and contracts, and
- review provisions for depreciation.
In such tests, auditors can prove the completeness, and existence or occurrence and
valuation or allocation, as well as the presentation, ad rights obligations objectives.

7.5 ANSWER TO CHECK YOUR PROGRESS

1. A 2. C 3. A 4. A

UNIT 8: INTERNAL AUDITING

Contents
8.0 Aims and Objectives
8.1 Introduction
8.2 Function of Internal Auditing
8.3 Responsibility and Authority
8.4 Internal Control and Internal Audit
8.5 Summary
8.6 Answer to Check Your Progress

8.0 AIMS AND OBJECTIVES

After studying this chapter, you should be able to:

 define internal auditing and describe its objectives
 identify the functions of internal Auditing
 the Authority and Responsibility Understand and,
 distinguish the relationship of Internal auditing and internal control

8.1 INTRODUCTION

Most Auditing courses or Topics on Auditing concentrates only “Independent /External

auditing” Some times to the neglect or point of marginalizing the other types of audit,
that is internal auditing. However, since 1950’s and 1960’s in particular with the
development of management theory and management controls (management accounting),
the importance and scope of internal auditing has been gaining greater emphasis.
The development of internal auditing is tied with the advance of better management
decision making internally.

8.2 FUNCTIONS OF INTERNAL AUDITING

The internal auditing function includes verification, evaluation and compliance of

operations. Among others the following are specifiable. These are :-
(i) Review and appraise internal control procedure;
(ii) Ascertain effectiveness and efficiency of operations
(iii) Verify compliance to policies and procedures;
(iv) Ascertain reliability of data and documents
(v) Evaluate quality of performance;
(vi) Recommend improvements in better management controls.
Thus, the internal auditor can perform his work either through functional
approach, operational, or financial approach.

8.3 RESPONSIBILITY AND AUTHORITY

Internal Auditing is a staff function; there fore, the auditor ideally is not in disposition of
line function. This position and place in the organization is determined by the scope of
the function he performs and extent of responsibility entrusted to him by management. It
is desirable that he should be placed as high as possible in the organization structure of he
is truly to be of “service to management” without intimidation, and be in position of
surveillance over all the organizations activity.

The independence of internal auditor again depends on his place in the organization, the
extent of responsibility and authority required for performing his function, and the desire
to enhance his competence and independence in reporting to whom. Here it must be
appreciated that the desire to have Independence in the internal Auditing function may
not necessarily be attainable or be as high as in the external auditing function. The matter
of qualification for the Internal auditor is also dependent on the alone factors. Of course,
these factors one definitely much more clearly demarcated in a large organization than in
small.

8.4 INTERNAL CONTROL AND INTERNAL AUDIT

Internal audit as we have studied in some detail in the previous discussion is means of
management control mechanism established internally and arising out of need for
verification, evaluation and compliance of internal operation. It is designed for
management internal purposes. As such internal Audit is part of the internal control
system in the organization, while at the same time internal audit (or auditor), is
responsible for the surveillance (monitoring) of the effectiveness of the internal control
system and involve in its weakness and strength.

Check Your Progress Exercise

1. Internal Auditing can be best described as:

a. an accounting function
b. a compliance function
c. an activity primarily to detect fraud
d. a control structure function
2. The major responsibility of internal auditing is to:
a. Install sound accounting, financial and operating controls at reasonable cost.
b. Ascertain the extent of compliance with established policies, plans, and
procedures,
c. Account for the entity’s assets and safeguard them from losses.
d. Develop reliable management data.
e. All of the above.
3. The Independence of Internal auditing department will most likely be assured of it
reports to the :
a. President
b. Controller
c. Treasurer
d. Audit committee of Board of directors
e. Vice – President of finance.

4. The purpose of an opinion in an internal audit report would be to:

a. describe the audit findings.
b. make audit recommendations.
c. present audit conclusion
d. All of the above.

8.5 SUMMARY

Internal auditing is an important part of monitoring component of an entity's

internal auditing issued by the Institute of Internal Auditors (IIA) defines Internal
Auditing as an independent appraisal function established within an organization to
examine and evaluate its activities as a service to the organization. Difference
between Internal and External Auditors include:

Internal Auditors External Auditors

- employer of companies or gov't - CPA firms
organizations - AICPA
- national organization - CPA
- certifying designation – Certified internal
auditor - Yes
- license to practice - No - To third parties
- primary responsibility – to board of - Primarily financial
directors statements
8.6 ANSWER TO CHECK YOUR PROGRESS EXERCISE

6. D
7. B
8. D
9. B