ACCA Qualification

ISA330 THE AUDITOR’S RESPONSES TO ASSESSED RISKS

MODULE:
AUDIT & ASSURANCE
INTERNATIONAL STREAM

Chapter 10 –Transactional Cycle

Sales System, Purchase System, Payroll System, Inventory &
Cash System

Prepared by Steven Khor

Learning Outcome

In this lesson, you will learn the control procedures and tests of control over the following systems:-

1. Sales System 4.Inventory

2. Purchase System 5.Cash System
3. Payroll System 6. Trade Receivables.

SALES/REVENUE CYCLE (System)

Receipt of sales inquiry /orders

Record each inquiry/order in a

sequential number
Credit Limit File

Checking the credit limit of existing Contact the existing receivables to pay the o/s debts or
customers seek approval from credit controller to increase credit
limit or reject the order

If within Exceed credit limit

credit
limit Seek approval from credit controller/manager to
increase credit limit

Approved by Sales Manager

-Sales price are fixed, trade discount is given and
delivery date is set

-Delivery of goods & delivery order is issued.

-Dispatch order authorized by storekeeper

Customer rejects and returns the

damaged goods

Customer receives goods and acknowledges

the acceptance of goods.
Check for damaged goods from customer

Issues Invoice to customer and signed by

sales manager.
Issue credit note to customer (receivable)

Monitoring payment from receivables

Issues monthly statement to receivables

Receivables make payment Issue official receipt

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Risk Areas in Sales System

Order received • All orders received may not be executed resulting customers’ complaints.
• Enquiries received may not be recorded resulting company lost control over the
sales lead.
• Credit limits given to new customers without assessing their credit worthiness
resulting high bad debts.
• Credit limits given to new customers not authorized resulting bad debts.
• Request for materials to factory may not be authorized production manager.
• Sales price fixed is less than the rates specified in the standard price list.

Goods dispatched • Sales invoices may not be recorded resulting sales are not recognized.
• Dispatches made without approval resulting loss of revenue.

Invoice raised • Invoices not raised at standard rates since the price list was not updated
promptly.
• Standard price list not authorized.
• Master file containing price list updated by unauthorized persons.
• Items invoiced are of poor quality or incorrect items.
• Invoices can be incorrectly recorded into the accounting system.
• Delays in posting on cut off dates leading to non recognition of revenue.
• Invoice and dispatch order are not matched.

Receipt of payment • Incorrect recording of receipts.

from customers • Incorrect cash receipts.
• Bad debts in books due to insufficient follow up for due.
• Bad debts written off is not authorized.

Control objectives of revenue system (P2A2R2IS2 + Accuracy, Completeness, Validity, Properly

Recorded & Controlled)

No Control Explanation
Objectives

1 Company Sales are made in accordance with company objectives with

objectives agreements in place with all customers.

2 Customers’ Customers’ order should be authorized, controlled and recorded.

orders Sales are made to only valid customers.

3 Completed work Goods shipped and work completed should be controlled to ensure
and delivered that invoices are issued, and revenues are recorded.
goods

4 Returned goods Goods returned and claimed by customers should be controlled in

and customers order to determine the liability for goods returned and claims are
claims recorded.

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 5 Invoices and They should be properly checked for accuracy and proper
credits authorization before entering accounting records. Sales are
recorded accurately and completely.

6 Receivables Receivables should be validated for accuracy before entering the

accounts.

7 Procedures on There should be procedures to ensure that sales invoices are

invoices and subsequently paid. Debts are collected within a reasonable period.
doubtful debts Any doubtful debts should be identified and provide the appropriate
provision

Control procedures over sales & receivable (Describe and explain the internal controls procedures that
you might expect to see in the sales system)

How to write control procedures in the exam?

Control procedure- What/How to do + Why doing this (objective of control).

Examples 1. Credit limit should be checked by credit controller (what to do) by randomly select
a sample of large receivable account (how to do) to ensure no unauthorized excess
of credit limit (why doing this).

Use P2A2R2IS2 + Accuracy, Completeness, Validity, Properly Recorded & Controlled to guide you.

Areas of Explanation of the controls procedures of sales system

control

Orders i. The management will ensure the orders should be checked against the
customer’s account to ensure only valid customers with good credit records
are processed.

ii. Existing customers should be allocated a credit limit & it should consider
whether this limit is to be exceeded if the new order is accepted

iii. All orders should be recorded on numbering & properly authorized.

iv. Sales order should be used to produce a dispatch note for the goods
outwards department to ensure no unauthorised dispatch.

v. The computer system should apply the credit limits set by the credit
controller and the system should reject any orders that exceed customer credit
limits at the point at which the order is taken, so that the customer can be
advised. Any override of credit limits should be authorized by the credit
controller.

vi. From time to time, there should be an independent check to ensure that the
credit limits within the system are being properly calculated and properly

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 applied to individual transactions. Similar considerations apply to prices
maintained within the system.

vii. The computer system should also reject any order for which there is no
stock available so that orders cannot be taken for delivery.

Dispatch i. Dispatch notes should be pre-numbered and kept in proper sequent.

ii. They should be authorized as goods leave and checked periodically

Invoicing & i. Sales invoices should be authorized and cross check against original orders &
credit notes dispatch notes.

ii. All invoices & credit notes should be posted to various accounts such as daily
sales records, accounts receivable ledger, & receivable ledger control accounts.

iii. Sales invoices & credit notes should be checked for prices & casting by other
person

iv. Credit notes should be sequentially number and properly authorized by

someone unconnected with dispatch or account receivable department

v. Copies of cancelled invoices & other notes or documents relating to the

cancellation should be retained

vi. Cancelled and free of charge invoices should be signed by the authorized
person

vii. Each invoice should distinguish between different types of sales and any
sales taxes.

viii. All invoices should be posted to the sales daybook, the accounts receivable
ledger and the accounts receivable control account automatically by the
system and the accounts receivable ledger and the accounts receivable control
account should be reconciled each month for sales and receivables records to
be kept up to date.

Returned i. Any returned goods should be checked for damage & recorded to ensure the
goods validity of returns.

ii. All returned goods should be used to prepare appropriate credit notes.

Receivables i. Receivable ledger control account should prepared regularly & checked
against individual sales ledger balances by an independent official

ii. Receivable ledger personnel should be independent of dispatch and cash

receipt functions

iii. Statements should be sent to customers regularly

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 iv. Formal procedures should be set out concerning overdue debts

v. Letters should be sent to customers for collecting overdue debts

Collection of i. At the end of each period, the system should produce a list of overdue
cash receivables. There should be procedures for chasing these customers and for
putting a ‘stop’ on accounts where amounts are significant in order to control
bad debts.

ii. When bank transfers are received from customers, they should be input into
the system and matched with individual transactions and controls should
ensure that the correct amounts are allocated to the correct customers and
transactions.

iii. An exception report should be produced for any unallocated bank transfers.
Exceptions should be promptly investigated. This will ensure that receivables
information is accurate and up to date and that customers are not chased for
amounts that have been paid.

iv. A bank reconciliation should be performed on a monthly basis in order to

ensure that the company’s cash records are complete, accurate and up to date.

Bad debts i. Authority should be assigned to write off or adjust bad debts.

ii. The use of court action or the writing off bad debts should be authorized.

Segregation of duty

To achieve these objectives, there should be good segregation of duties. There are 3 processes in
the sales system that should have segregation of duties.

Segregation of duties under the internal control has the basic 3 areas:

(i) Initiating a transaction

(ii) Custody or handling of the related asset & Remember: All the segregation
(iii) Recording the transactions. of duties control procedures
should have these 3 areas.

No Segregation of duties Individual control procedures (EXAM FOCUS)

1 Process 1: Accepting i) Sequent-controlled documents should be used to

customers’ orders acknowledge all orders received.
ii) Credit limit should be checked by credit controller
iii) Selling prices, special discounts and delivery dates
should be fixed by senior sales managers- never by
[INITIATING] accounts staff.

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 2 Process 2: Dispatch Sequent-controlled documents should be used for all goods
department leaving the premises. They should be completed by the
gatekeeper or dispatch department- not the account staff.
[CUSTODY]

3 Process 3: Invoicing the Sequential controlled invoices should be raised by the sales
goods department and then passed to the accounts department for
recording.
[RECORDING]

Test of Control / Audit Tests on the Sales System (EXAM FOCUS)

Format: AEIOU + CR to ensure P2A2R2IS2 & accuracy/completeness/validity/proper cut off

A= Analytical Procedure P=Physical access control

E= Enquiry P= Personnel
I= Inspection of documents and physical assets A= Authorization & Approval
O=Observation R= Recording and Reviewing
U=compUtation /recomputation I= Information and communication
C= Confirmation S= Supervision & Segregation of duty
R= Reperformance

Examples:

• Perform an analytical procedure by comparing the current year turnover

to previous year to ensure all the unusual items have been identified
and analysed by the existing control system.
• Enquire the management on the process of authorization and approval
to ensure the effectiveness of control system.
• Inspect the sales invoices to ensure the amount is accurately recorded.
• Observe the process of segregation of duty to ensure the sales process is
done by different persons.
• Recompute the amount of sales returns to ensure the amount is
accurately recorded.
• Confirm with the major customers to ensure the amount recorded in the
books is correctly recorded.

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Tests of control that an auditor would normally carry out on the despatch and sales system and explain the
reason for each test (2008 June)

Test of Control (What/How to do) Reasons for the test (Why do it)
Review a sample of goods despatch notes (GDN) Ensures that the goods despatched are accurately
for signatures of the goods despatch staff and recorded on the GDNs.
customer.

Review a sample of GDNs for signature of the Ensures that the GDN details have been completely entered
accounts staff. onto the computer system.

Observe despatch system ensuring Seeley staff Ensures that goods are only despatched to
have seen the customers’ identification card prior authorised customers.
to goods being loaded into customers’ vans.

Review the error report on numeric sequence of Ensures that the sequence of GDNs is complete.
GDNs produced in the accounts department and
enquire action taken regarding omissions.

Observe despatch process to ensure that the Ensures that goods are not despatched to poor/bad
customers’ credit limit is reviewed prior to goods credit risks.
being despatched.

Substantive Procedures –Sales transactions

When you write your substantive procedures, your procedures must have the element of what to do, how to
do and why you do it. It means you must use AEIOU + CR and the reason is to check the assertion of ACCA
COVER. For example:

Substantive Procedures Reasons

For a sample of order, trace details to the list of sales To check the completeness of transfer of information
invoices raised maintained in the receivable’s ledger between the order and invoice. (Completeness)
programme.

For a sample of sales invoices, agree the price To check for accuracy of charging for each individual
charged to the standard pricing. customer. (Accuracy)

Re-compute the list of invoices in the receivable To ensure the total sales are accurately recorded.
ledger and trace to the total sales to the GL (Accuracy)
programme.

Compare the price charge with stated sales income To satisfy the auditor that the price charge in the
and obtain explanations from management if the income statement is reasonable in relation to stated
figures do not appear reasonable. sales income. (Accuracy)

Select sales for 15 days before the year end and 15 This is to check that cut-off is properly done. The sales
days afterwards and compare with the dates of should only be recognized up to the cut-off date.(Cut
despatch notes. Off)

Select a sample of sales invoices and agree to the To ensure the accuracy of the goods been invoiced.
sales order

Cast the monthly sales figures in the GL and agree to The final cast and checking ensure that the financial
the financial statements. Investigate any discrepancy account figure is accurate.

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2.Substantive Procedures (for computerized Sales System)
Substantive Procedures/Audit Test Reason For procedures/test
Using test data, if necessary, access the To ensure that order details are completely and
company’s website site and input order details accurately recorded by the website software.
for specific goods. Trace those order details to (completeness)
the orders pending file.
To ensure that details recorded agree to those
input. (accuracy)

For a sample of items in the orders pending file,
– agree to the orders awaiting dispatch file,
ensuring that appliance details and quantities are
the same.
To ensure that details from the website
software are completely and accurately
transferred to the orders awaiting dispatch file.
(completeness & accuracy)

– agree sales details for that customer to the
monthly reimbursement from the credit card
company, checking amount received is the
product price less the appropriate commission
charged by the credit card company.
To confirm that amounts are received for each
appliance sold, and therefore that monies
received are complete and accurate.

To confirm that the amount of sales is not

– agree the sales amount to the sales ledger file. understated or overstated in the ledger, general
ledger or financial statements. (accuracy)

Review goods awaiting dispatch file for old items To ensure that reasons for orders not being
and inquire as to why those items are still on file. processed are being obtained. Many old items
may also indicate problems with the credit card
authorization systems which again will need to
be investigated to ensure the orders are
accurately recorded. (accuracy)

For a sample of days, cast the sales daybook file To check the numerical accuracy of the daybook
and agree the total sales to the general ledger and the accuracy of posting to the general
accounts for that day. ledger file. (accuracy)

For a sample of items in the goods awaiting To confirm that order details are completely
dispatch file, agree to the dispatch information and accurately transferred to the dispatch
held on the dispatch department computer. department.

For a sample of items on the dispatch
department computer,
– agree back to the goods awaiting dispatch file
ensuring details of product, quantity and
customer agree.
To ensure that the dispatch information is
accurate and that the despatch record itself
relates to a valid sale.
To ensures that the inventory system correctly
records the appliance ordered and that the

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– agree to the inventory records confirming that
the correct appliance record was updated.
– check customer signature is on file agreeing
receipt of goods.
inventory system remains accurate.
To confirm that evidence is available for receipt
of goods confirming that goods have been
delivered. (completeness)

3.Cut Off Procedures- Sales

No Audit procedures for sales

1 Check goods dispatched and returned inwards notes around year end to ensure invoices
and credit notes are date in the correct period and posted to the sales ledger and GL in
the correct period.

2 Reconcile entries in the sales ledger control account around the year end to daily batch
invoice totals ensuring batches are posted in correct year.

3 Review receivables ledger control account around year end for unusual items.

4 Review material after date invoices, credit notes and adjustments and ensure that they
are proper treated as following year’s sales.

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 PURCHASE System

Raises Purchase Requisition if purchase is necessary

Obtains approval from immediate superior of user dept

Forwards all the purchase requisitions to purchase

department if it has been approved by user dept

Transfers purchase requisitions to purchase order (PO)

Purchase manager/chief buyer approves the purchase

Approved
order. All purchase orders must be sequentially
Suppliers
numbered. Supplier is selected from the approved
Listing.
listing.

Sends the purchase order to approved vendor/supplier

Supplier delivers goods together with delivery order

(DO)

Storekeeper checks the quantity and condition of the

goods before accepting.
Goods rejected &
returned to vendor if
quantity & quality are
Goods Received Note (GRN)is raised if quantity & not agreed.
quality of goods receipt is agreed to the P.O.

Issues Goods Returned

Receives purchase invoice from vendor
Note

Makes payment to vendor

Receives credit note
from vendor

Receives official receipt and monthly statement.

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Risk areas in purchase system

General • Purchases made by unauthorized person.

• The purchases made are not according to the company’s procedures.
Purchase • Unnecessary purchases may be made.
Order • Purchases not made at the right prices.
• Purchases made from unauthorized vendors (suppliers)

Receipt of • Receipt goods that never being ordered.

materials • Quantity receipt is different from the purchase order.

Recording of • Inaccurate posting in the vendor ledger.

transactions • Delays in recording the vendor ledger.
• Purchase vouchers do not authorize and inaccuracy in purchase vouchers.

Payment • Inaccurate amount paid to vendors.

made • Payments are made to the wrong vendors.
• Delay in payment (after due date) resulting loss in discount for early
settlement.

Goods • Credit notes may not be recorded and inaccurate amount.

returned • Poor quality materials are consistently received from vendors.

Inventory • Goods received/arrived never being counted by storekeeper.

received • Inventory kept in unsafe environment.
• Slow moving or obsolete stock is never identified.

Control objectives of purchase

Objectives Explanation

Proper authorization To ensure purchases are ordered under proper authority & approval to
and approval. avoid unauthorized purchase.

Order as necessary Purchases are only ordered as necessary (requirements of materials are
genuine) and order from suitable suppliers

Price To ensure purchases are made at the most optimum prices.

Inspection of goods Goods/services received are effectively inspected for quality, quantity,
and conditions

Checking & approval Invoices & other docs are properly checked & approved before posting.

Accuracy in recording All purchases & trade payables transactions must be accurately recorded

Payments Payments are made according to agreed terms.

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Control procedures over purchases

Areas of Control Procedures

control

Requisition/ i. Requisition notes for purchases should be authorized to avoid unnecessary

Orders placed purchase.

ii. All orders should be authorized by identified authorized person. Major

purchases should be authorized by BOD to ensure the proper authorization.

iii. All orders should be recorded, retained & checked for accuracy. Details on
suppliers, pricing & quantity should be retained to ensure the purchases are
made on the right price.

iv. Re-order levels and quantities should be pre-set & preferably recorded in
advance on the requisition note to avoid unauthorised order.

Receipt of i. Procedures should be set to deal with receipt of goods.

goods
ii. All receipt goods should be checked & Goods Receipt Notes (GRN) should be
raised & authorized. GRNs should be checked against purchase order. GRNs
should be filed sequentially.

Invoicing i. Purchase invoices received should be stamped with an approval & with
sequential numbers to ensure (the purchase has been completely recorded).

ii. Purchase invoices should be matched with goods received notes to ensure (the
amount/quantity of order goods ordered are actually received).

iii. The invoices should be checked against the order & GRNs to ensure (the
liability is accurately recorded).

iv. The invoices should be signed as approved for payment to ensure (they are
properly authorised).

v. Invoice sequential numbers should be checked against purchase to ensure (all

the invoices are completely recorded)

vi. Any recoverable purchase tax should be separated to ensure (the accuracy of
tax payment to the regulator)

vii. Invoices should be properly allocated to the general ledger to ensure (the
purchase transactions are posted to the right account).

Goods i.A record of returned goods should be maintained to ensure completeness of

returned returns.

ii.Credit notes received should be checked against purchase invoices to ensure

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 the validity of returns.

Accounts i. An accounts payable ledger control account should be maintained & checked.
Payable
Ledger & ii. Payable ledger should be kept by persons independent of the receiving of
Suppliers goods, invoice authorization and payment

iii. Statements from suppliers should be checked against the purchase ledger
account.

Payment i. Payment must be checked against the vendor’s invoice and statement.
Cheques should be crossed before signed. Cheques should be sent
immediately. Returned cheques should be investigated.

ii. The person making the payment must be different from the persons
raising the purchase order, goods received note (GRN) and purchase
voucher.

iii. Bank transfers must be approved by an authorized person.

Tests of Control Over Purchases

Tests of control are those which seek to provide audit evidence that internal control procedures are
being properly applied throughout the period under review.
Areas of test Tests of controls
Receipts of 1.Inspect invoices for goods, raw materials to ensure they are:-
goods and
invoices -Supported by goods received notes and inspection notes.
-Entered in inventory records.
-Priced correctly by checking to quotations, price lists to see the price is in
order.
-Properly referenced with a number and supplier code.
-Correctly coded by type of expenditure.

2.Trace entry in record of good returned and see credit note duly received
from the supplier.

3.For invoices of all types:

-Re-perform calculations and additions to ensure accuracy.
-Inspect entries in purchase day book and verify that they are correctly
analyzed.
-Agree posting to purchase ledger to ensure accurately recorded.

4.For credit notes:

-Verify the correctness of credit received with correspondence.
-Inspect entries in inventory records and record of return.

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 5.Obtain explanation for items which have been outstanding for a long time
such as unmatched purchase requisitions and unprocessed invoices.

Recording of 1.Verify that invoices and credit notes recorded in the purchase day book are:
purchases -initialed for prices and calculation
-authorized for payment

2. Inspect the payable ledger by vouching the entries into the purchase day
book and test cast the additions and balances.

3.Inspect the control account for purchase for unusual entries.

5.Cut off procedures for purchase

No Cut off procedures

1 Review goods received notes with serial numbers before the year end to ensure that
invoices are either posted to purchase ledger prior to the year end or included on the
schedule of accruals
2 Review the schedule of accruals to ensure that goods received after the year end are not
accrued.
3 Check from goods returned notes prior to year end to ensure that credit notes have been
posted to the purchase ledger prior to the year end or accrued.
4 Review large invoices and credit notes included after the year end to ensure that they
refer to the following year.
5 Review outstanding purchase orders for indications of any purchases completed but not
invoiced
6 Reconcile daily batch invoice totals around the year end to purchase ledger control
ensuring batches as posted in the correct period
7 Review the control account around the year end for any unusual items.

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Payroll System

Risks Areas of Wages & Salaries

1. Invalid or unauthorized payments to staff including fraudulent payments or payments that staff
are not entitled to, resulting in financial loss.

2. Failure to make payments on a timely basis resulting in staff dissatisfaction

3. Delays or errors in arithmetic calculation

4. Corrupt data uploaded to or downloaded from, resulting discrepancies and errors

5. Unauthorized access to the payroll system

6. Unauthorized, inaccurate or delayed bonus or one off payments

7. Inaccurate or fraudulent payments to the leavers.

Control Objectives

Area Objectives
Setting of 1.The computation of wages and salaries should be given to the client’s employees
wages & and at authorized rates of pay.
salaries
2. Wages and salaries should be accordance with records of work performed

Recording of 1.Gross and net pay and deductions are accurately recorded on the payroll.
wages and
salaries 2.Wages and salaries paid are recorded correctly in the bank and cash records.

3.Wages and salaries are correctly recorded in the general ledger.

Payment of 1.Payrolls should be made to the correct employees

wages
Deduction 1. Liabilities to tax authority, social insurance should be properly recorded.

Control Procedures

Areas Controls

General 1. There should be separate records kept for each employee. The records should
contain such as matters as date of engagement, age, skills, next of kin and
specimen signature.

2. Procedures should be laid down for job responsibilities, promotion, changing of

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 rates of pay, retirements, dismissal etc

3.All overtime should be properly recorded and authorized.

4. The payroll should be prepared by personnel unconnected with other wages

duties. Special procedures should exist for dealing with advances, holiday pay,
layoff pay, bonuses etc.

5. The payroll should be checked by separate personnel. All work on the

preparation and checking of the payroll should be initiated. All such work should
be supervised and approved.

6. Payments by cheques and credit transfer should be subject to special

procedures such as maintenance of a separate bank account with regular
reconciliation.

7. Changes in rate of pay or salary should be authorized by official outside the

wage department.

8. The wages cheques should be signed by 2 signatories.

9. When employees have been absent for a significant period, their entitlement to
salary should be checked against personnel details.

10. Payroll should be prepared from clock cards, job cards, etc, and a sample
checked for accuracy against current rates of pay.

Access to 1. Employees should sign for their wages to acknowledge receipt of payment.
assets &
records 2. No employee should be allowed to take the wages of another employee to
avoid unauthorised claims.

3. When wages are claimed late, the employee should sign and acknowledge the
receipts in order to ensure payment is given to the right employee.

4. The wage system should allow the calculation of wages to be checked by the
employee before the packet is opened to ensure the accuracy of payment.

5. The wages department should be a separate department with their personnel

not involved with receipts or payment functions to segregate the duty.

6. The duties of wages staff should be rotated to minimize the risk of collusion.

7. A surprise check to be conducted regularly to implement unpredictable control

into the system.

8. Unclaimed wages should be recorded in a register and held by someone outside

wage department to minimize the risk of wages being stolen.

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 9. Control account of wage/salary should be maintained and regularly reconciled
to ensure the accuracy of amount.

Tests of control

Areas Test of control

Setting of 1. Test sample of personnel records for rates of pay, authorization of changes in
wages and rates, leavers’ and joiner’s personnel details to ensure that procedures are
salaries operating for authorizing changes.

2. A particular concern will be joiners and leavers. Auditor need to check the date of
engagement or leaving the company to ensure the validity of payment.

3.For salaries, verify gross salaries and bonuses are in accordance with personnel records,
letter of engagement to ensure the payments are properly authorized.

Payment of If wages are paid in cash:

wages and
salaries 1. Select payrolls and check to time records, test to personnel records, test casting
and calculation, check deduction to ensure the accuracy of payment.

2. Attend the pay out of wages to confirm that the official procedures are being followed
such as all workers must sign the acknowledgement of receipt.

3.Before the wages are paid, compare payroll with wage packets to ensure all employees
have a wage packet.

4.Observe whether any employee receives more than one wage packet to avoid any
incidence where worker takes the wage packet on behalf of others.

5.Inspect the unclaimed wages book entries with the entries on the payroll to ensure both
records are agreed.

6. For salaries, compare the payment records and the cheque records/bank transfer list to
ensure the correct amount and correct employees.

Recording of 1. Test posting of payrolls to GL accounts to ensure the accuracy of recoding.

wages and
salaries 2.If payroll control account is maintained, check against GL to ensure the amount is
agreed.

Deduction 1.Reperform the calculations of taxation and non statutory deductions to ensure they are
accurately deducted.

2. For voluntary deductions, inspect the authority completed by the relevant employees.

3.For income tax computation, agree the tax rate to the income tax authority schedule to
ensure the right tax rate is applied.

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Substantive Procedures for Payroll

Audit Procedures Reasons for the procedures

For a sample of employees chosen from To confirm that the individual exists and
payroll, check the existence of personnel therefore that liabilities in respect of them
records. exist.(existence)

Check for the existence of physical

security of cash by observing the
payment process for cash wages.

Perform a cash count of any amounts of

cash in hand especially the cash wages
have not been claimed to ascertain the
reasons for unclaimed money.

Check for evidence that bank To ensure the cash used to pay payroll
reconciliations are performed monthly exists. (existence)
which take into account bank transfers in
respect of wages.
For a sample of starters and leavers To ensure the completeness of payroll
agree the dates for which payments has transactions.
commenced/terminated per the payroll
with personnel records.

For a sample of employees agree hours To ensure that there is no unrecorded

worked per the payroll with hours payroll liabilities.(completeness)
recorded on the time sheets.

Perform the cut off tests. Hours worked To ensure all payroll transactions have
immediately before and after the year been recorded in the correct accounting
end should be traced from the payroll period. (cut off)
records and agreed to an authorized time
sheet specifying the period to which the
work related.

For a sample of employees agree To ensure the amounts relating to the

standing data to source documentation payroll transactions are accurately
such as pay rates to personnel records. recorded.

For a sample of payments re-perform the

payroll calculations.

Check the deductions from gross pay

have been calculated correctly.

Agree the accounting treatment and To ensure the financial information is

disclosure of income statement charges appropriately presented and described
and statement of financial position assets and disclosures are clearly expressed.

Audit & Assurance Page 19

and liabilities to the accounting standards (classification and understandability)
and legislations.

Perform substantive analytical procedure To ensure the reasonableness of payroll

by:- transactions (accuracy).

- compare total salaries cost this year to

total salaries cost last year

- ascertain how many shift managers are

employed by the company and the total
salary from the personnel department.

-calculate total salary and compare to the

salary disclosed in the financial
statements.

-obtain a listing of total salary payments

made each month

The Inventory System

Risk Areas

Inventory
• Inventory been stolen on arrival.
Received
• New purchase mixed up with returns.
• Poor quality inventory accepted.
• Inventory accepted that never ordered.
• No record made of its arrival

Storage of • Poor storage conditions lead to damaged inventory.

inventory • Inventory items not used before their useful life ends
• Inventory stolen from storage areas due to lack of physical access
control.

Issuance of raw • Materials over ordered to enable theft

materials • Unauthorized issuance of materials

Valuation of • Inappropriate valuation.

inventory • Non-provision of allowance for slow moving, obsolete and damage
inventory.

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Inventory Control Objectives

Areas Control Objectives

Recording
1.All inventory movements are authorised and recorded
2.Inventory records only include items that belong to the client
3.Inventory records include inventory that exists and is held by the client
4.Inventory quantities have been recorded correctly
5.Cut-off procedures are properly applied to inventory

Protection of 1. Inventory is safeguarded against loss, pilferage or damage.

inventory

Valuation of
1.The costing system values inventory correctly
inventory 2.Allowance is made for slow-moving, obsolete or damaged inventory

Inventory 1.Levels of inventory held are reasonable.

holding

Control Procedures
Control Procedures

Arrival of 1. All goods inward received must be set at a specific location and signed by store
inventory managers.

2. The quantity and quality of goods arrival must be checked to ensure the correct
amount and quality is received.

2. All returns of goods must be sent to returns department for checking.

Protection 1.Storage areas must be well conditioned to reduce the chance of deterioration.
of inventory
2. Security system is in place to safeguard the assets to avoid theft and misuse of
inventory.

3.Restriction on physical access to the third party stock held by entity to avoid
losses.

Issuance of 1. All requisitions from storages to have signed authorization from production
inventory manager to avoid excessive issuance.

2. Use of standard quantity requirement such Economic Ordering Quantity (EOQ)

to maximize the economy and efficiency.

3.Periodical checking on the quantity of stock against the record to ensure they
are agreed.

Audit & Assurance Page 21

Valuation of 1.Review the condition of inventory
inventory
2. Compute the inventory according to IAS2 on cost or NRV whichever is lower.

Tests of controls

Test of control
Inventory movement • Select a sample of inventory movements records and agree to
goods received and goods dispatched notes.
• Confirm that movements have been authorised as appropriate.
• Select a sample of goods received and goods dispatched notes
and agree to inventory movement records.
• Check sequence of inventory records.

Others • Test check inventory counts carried out from time to time (eg
monthly) during the period and confirm:

-All discrepancies between book and actual figures have been fully
investigated.
-All discrepancies have been signed off by a senior manager.
-Obsolete, damaged or slow-moving goods have been marked
accordingly and written down to net realisable value.

Observe security arrangements for inventories

Inventory
a) Why inventories and WIP important?

i. Because the inventory figure, particularly for manufacturing companies,

may be material to the balance sheet and income statement, both in the
current year and as a comparative figure.

ii. Inventories may be high risk if they are valuable, and/or easily being
stolen. The valuation of inventories is a matter requiring the exercise of
judgment, which means that inventories are sometimes used to
manipulate the appearance of both the income statement and the balance
sheet.

iii. Because in the income statement, there is a direct relationship between

the inventory figure and the profit for the period. If closing inventories are
overstated, profits will be overstated.

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 iv. Because many key accounting and performance ratios are calculated
using the inventory figure such as inventory turnover, inventory days, the
current ratio and working capital ratios.

v. Because poor inventory control will be reflected in inventory figures at the

period-end. For many companies, excess inventory is a sign of serious
problems.

vi. Because in some significant cases of litigation against auditors have

involved the alleged overstatement of inventories in financial statements of
companies where the auditors have issued an unqualified audit report
before the company has been taken over.

vii. Because there is sometimes relatively little audit evidence for the inventory
figure, particularly for small companies and it is therefore important for
auditors to scrutinize the evidence available carefully and consider the
scope for misstatement or deliberate manipulation of the inventory figure.

b) What factors that make inventories and WIP a focus point of audit work?

i. It is the easiest asset for management to manipulate it and thus profits.

ii. Some inventories can be very difficult for an auditor to identify
iii. The quantities of inventory held at a given moment may be difficult to
establish. Cut off may be hard to establish
iv. Valuation may be difficult especially it involves specialized inventory. Its
realizable values may be hard to establish.
v. Inventory losses from theft, wastage etc may be difficult to control
vi. Some very significant WIP balances may be intangible in nature (eg. film
production costs)

c) For disclosure, inventories are grouped under the following categories:

i. Raw materials and consumables
ii. Work in progress
iii. Finished goods and goods for resale
iv. Payments on account

d) IAS2 requires inventories to be measured at the lowest cost and net realizable value. Cost
should comprise all costs of purchase including all incidental costs. Net realizable value is
the estimated selling price less the estimated costs of completion of sale.

Audit & Assurance Page 23

Physical inventory counts

a) Client’ s procedures. There are 2 methods of carrying out inventory counts.

Method 1: Periodical counting method- made at or close to the year end
count. Method 2: Perpetual counting method- on a continuous basis over the
whole year.

b) Perpetual Counting Method. If this method is used, it should ensure that

1) each item is physically inspected at least once a year and more frequently in
the case of items liable to loss;
2) adequate records are kept up to date;
3) the records are amended as a result of physical inspection and that there are
appropriate reports and investigation procedures for discrepancies.

There are several advantages of perpetual counting:

• there is not the disruption caused by an annual or periodical count

• there is more accurate and regular counting, earlier identification of errors and
slow moving stock
• there is increased discipline over storekeepers caused by the surprise
elements of random checks.
• Actual inventory balances are known at any time, allowing re-ordering of best
selling books to take place on a timely basis. There will also be fewer causes
of inventory reaching zero causing stock-outs with orders not being fulfilled.
• Increased control over storekeepers because inventory is being reviewed
regularly; this should decrease any pilferage.
• Auditors can rely on the computerized inventory system, reducing substantive
audit tests of inventory during the year and at the year end.

c) Periodical Counting Method (Year End Counting). (2003, June Q3). This
method will usually be undertaken on or around the financial year end. Importance of
having periodical counting are:

• Inventory counting is the best way to establish quantities for valuation

purposes and it assists management in making appropriate provisions against
obsolete, slow moving and damaged items.

• Inventory counting provides the only direct evidence in relation to the

existence of inventory. Performed properly, counting also provides evidence
on cut-off, certain frauds and on the quality of internal controls over inventory.

• Auditors should attend inventory counts where inventory is material to the

financial statements (balance sheet or income statement).

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d) Organizing the counting (How to organise the counting exercise?)

• Store organization. Goods are kept in bins or on rack with complete

description of each item. Goods should be protected from deterioration and
restriction of access to stores. Goods held for third party, obsolete and slow
moving stock should be identified and separated.
• Comprehensive instructions should be laid down. The instructions include :
appointment of competent supervisors ; marking of counted inventories;
standardized pre-numbered forms for recording the count, the issue and
return of goods; movement of inventories during the count should be
monitored; any discrepancies should be investigated and adjusted.

e) The client’s counting Instructions should include:-

• appointment of competent supervisors to supervise the counting;

• marking of counted inventories (after counting, the stock must be marked);

• standardized pre-numbered forms for recording the count, the issue and
return of goods;

• movement of inventories during the count should be monitored;

• any discrepancies should be investigated and adjusted.

The auditor’s presence in the inventory count

a) ISA 501 states that when inventory is material to the financial statements, the
auditor should obtain sufficient appropriate audit evidence regarding its existence
and condition by attendance at physical inventory counting unless impracticable.

b) The physical attendance on stock count enables auditor to inspect inventory and
observe compliance with the operation of management procedures. It is not the
auditor’s responsibility to count inventory, but the client’s.

c) Audit Procedures for Physical Count (EXAM FOCUS)

Audit Procedures for Physical Count Reason for procedure

Perform an overall review with client Check that client’s physical count
staff – ensure that they are following instructions are being followed as this
the client’s physical count instructions. will help to ensure that the count is
Specifically ensure that: complete and accurate.

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a. Inventory is divided into appropriate a. Confirms a clear layout of inventory
sections for recording – perhaps by ensuring items are not missed
type of goods
b. Prevents collusion and provides a
b. Staff are counting in pairs with one check over security of inventory and
person that the count sheets are not falsified.
checking the inventory and another
recording details c. Check to ensure that inventory is not
double counted.

c. Appropriate checks are in place to d. To ensure that there is no confusion

ensure that each item of good is only regarding which items are sold.
counted once.
e. To ensure that no count sheets are
d. The shop is closed during the count lost

e. Count sheets are pre-numbered

Obtain a sample of inventory items Check to ensure that the inventory

already recorded on the inventory recorded on the inventory and agree to
sheets the sheets actually exists

For a sample of inventory in the shop, Check to ensure that all inventory is
agree to the count sheets.. recorded on the inventory sheets –
check for completeness of recording
Obtain a sample of count sheets, To check that details on the count
photocopy and place on the audit file. sheets are not amended post physical
count and for agreement to the final
inventory sheets to ensure quantities
are recorded correctly
Check all count sheets are returned Ensures that all sheets are accounted
after the physical inventory count.. for and inventory is therefore not
understated
Obtain last inventory receipt note and To ensure that cut off is correct.
sales invoice number Subsequent checking should show that
goods received
notes post physical count are not
included in payables for the year, and
sales invoices after the physical
inventory are not included in sales for
the year
Review the condition of the inventory To check that any inventory which is
with the independent valuer. Ensure damaged or unsaleable is correctly
that there are no reasons why the valued
inventory could be obsolete (e.g.
due to changes in fashion) or
damaged.

Form an opinion regarding the overall To confirm that inventory quantities

accuracy of the physical count have been correctly recorded

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14.Audit procedures prior to inventory count attendance

Past Year Question

List FOUR audit procedures that an auditor will normally perform prior to attending the client’s premises on
the day of the inventory count. (2 marks)

Procedure
– Review prior year working papers
– Contact client to obtain stocktaking instructions
– Book audit staff to attend the inventory counts
– Obtain copy of inventory count instructions from client
– Ascertain whether any inventory is held by third parties
– Obtain last year’s inventory count memo
– Prepare audit programme for the count

d) Audit procedures on inventory at the year-end

(i) Perform an analytically review the year-end records to establish the overall quantities and costs of
inventories and the quantities and costs of raw materials and finished goods.

(ii) Ask management about any problems experienced with the system at, or close to, the period-end
and about how they had been dealt with to ensure that they had been appropriately resolved.

(iii) Ask management about the likely level of write-down of either raw materials or finished goods.
Compare this with prior years and form an opinion as to its appropriateness. Check the calculation of
the provision and review exception reports close to the period-end.

(iv) Obtain schedules of the costs and quantities to be included in the financial statements and trace
these back to the output of the inventory system noting and substantiating any significant
adjustments.

(v) Enquire as to how accurate cut-off had been achieved. I would perform cut-off tests on the
records by tracing samples of goods received and despatch notes just before and just after the year-
end to the inventory, sales and purchases systems in order to ensure that costs had been correctly
allocated to the correct accounting period. I would also perform this test in reverse, from the sales
and purchases systems through to goods received and despatch notes.

(vi) Ensure that the valuation method used by the client was in accordance with IAS 2 Inventories
and that, for example, the system was adequate to ensure that finished goods included an
appropriate element of labor and overhead costs.

e) Cut off procedures for inventory

Audit & Assurance Page 27

Cut Off Procedures

1.During stock count, note the series numbers of the last sales invoices, dispatch note and goods
received note generated before the inventory count

2. After the inventory count, check the year end dispatch notes to sales invoices and sales day
book.

3. Ensure year end goods receipts notes and purchase invoice are correctly recorded in the
current period

4. Take a sample of goods received and goods dispatched just after the year end and ensure that
the related inventory was not included in the count in the case of good received.

5.Take a sample of delivery notes for sales and purchases on either side of the year end and trace
these to invoices and ledgers and inventory records to ensure that sales and purchases have
been included in the correct period and that inventory is accounted for where appropriate..
6. Once it is determined whether this delivery should count as this year's inventory, the delivery
information should be traced to purchase invoices and ledgers to ensure that the purchase is
recorded in the year and that the creditor is accounted for in the year.

7. If inventory returns are material, the inventory returns after the year end should be reviewed to
ensure that items are not included as sales in the year and that the inventory is added to the
inventory figure unless it is now obsolete, whereupon it should be written off.

e) Inventory valuation procedures- The inventory should be valued at the lower of

cost and net realizable value.

Valuation procedures

Raw materials 1. Ascertain all the incidental costs are included

2. Ascertain the method used in valuing the inventory

3. If standard costs are used, enquired the basis of standards

4.Test check cost price with purchase invoices received

5. Test check quantities with inventory records

6.Follow up valuation of all damaged or obsolete inventory

Work in progress 1. Ascertain the elements of costs are included.

2. Ascertain various stages of process are measured and if

estimation is made, based on what basis

Audit & Assurance Page 28

 3. Inquiry into the reliability of cost system

4. Enquiry into any old ,obsolete or damaged items and

ensure that these are valued at a reasonable estimated NRV

Finish goods 1. Enquire into what cost elements are included.

2. Test check the prices on inventory lists

3. Follow up those slow moving stock to ascertain its possible

realizable value.

4. For a sample of goods on the final inventory sheets, trace

the cost of those items to the original purchase invoice,
ensuring that the description of goods on the invoice matches
the number.

5. For goods sold after the end of the year, check a sample of
sales invoices back to the final inventory sheets ensuring that
the sales value exceeds the cost. Where sales value is less
than cost, ensure that the jewellery is stated at the realizable
value on the inventory sheet.

6. Review the report of the professional valuer. Ensure that

the inventory is genuine. For the items checked by the valuer,
agree the valuation to the items of jewellery on the inventory
statements. Where there is a difference, for example due to
age of the inventory or where it is unlikely to be sold due to
changes in fashion, discuss with the client and agree a
realistic valuation.

7. Follow up those obsolete stock and ensure that they are

valued at a reasonable estimated realizable value.

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The Cash System

Risk Areas

• Cash been stolen if no proper control.

• Misuse of cash for personal usage.
• Misappropriation of cash to purchase unauthorized goods/assets.

Objectives of controls

• All monies received are recorded and banked in

• Cash and cheques are safeguarded against loss or theft
• All payments are authorised, made to the correct payees and recorded
• Payments are not made twice for the same liability

Control Procedures

Recording of • Safeguards to prevent interception of mail between receipt

receipts by post and opening.
• Appointment of responsible person to supervise mail.
• Protection of cash and cheques (restrictive crossing).
• Amounts received listed when post opened.
• Post stamped with date of receipt

Recording of cash • Restrictions on receipt of cash (by cashiers only, or by

sales and salesmen etc).
collections • Evidencing of receipt of cash:-
-Serially numbered official receipt.
-Cash registers incorporating sealed till rolls.
• Agreement of cash collections with till rolls.
• Agreement of cash collections with bankings and cash and
sales records
• Investigation of cash shortages and surpluses

General controls • Prompt maintenance of records (cash book, ledger accounts)

over recording • Limitation of duties of receiving cashiers to ensure accuracy of
recording the transactions.
• Compulsory holiday arrangements and disallow employees
who are on leave to come back to the office.
• Giving and recording of official receipts with retained
copies. All the receipts books must be serially numbered.
• Compare the official receipt to the bank paying slips.

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Banking • Having daily bankings to minimize the cash been stolen.
• Make-up and comparison of paying-in slips against initial
receipt records and cash book
Safeguarding of • Restrictions on opening new bank accounts
cash and bank • Limitations on cash floats held.
accounts • Restrictions on payments out of cash received
• Restrictions on access to cash registers and offices
• Independent checks on cash floats
• Surprise cash counts
• Custody over supply and issue of cheques
• Preparation of cheques restricted.
• Safeguards over mechanically signed cheques/cheques
carrying printed signatures
• Perform frequent bank reconciliation.

Tests of controls
Tests of control: Receipts received by post

• Observe procedures for post opening are being followed

• Observe that cheques received by post are immediately crossed in the company's favour of the
company
Tests of control: Cash sales

• For a sample of cash sales summaries/branch summaries from different locations:

 Verify with till rolls or copy cash sale notes
 Check to paying-in slip date-stamped and initialled by the bank
 Verify that takings are banked intact daily
 Vouch expenditure out of takings

Tests of control: payments

• For a sample of payments:

 Compare with paid cheques to ensure payee agrees
 Note that cheques are signed by the persons authorised to do so within their authority
limits
 Check to suppliers' invoices for goods and services. Verify that supporting documents are
signed as having been checked and passed for payment and have been stamped 'paid'
 Check to suppliers' statements
 Check to other documentary evidence, as appropriate (agreements, authorised expense
vouchers, wages/salaries records, petty cash books etc)

Tests of control: Bank Reconciliation

• Examine evidence of regular bank reconciliations at least once per month. Large organizations
should prepare the reconciliation daily or weekly.

Audit & Assurance Page 31

• Examine evidence of independent checks of bank reconciliations such as signature.
• Examine evidence of follow up of outstanding items on bank reconciliation. Pay particular
attention to old outstanding unpresented cheques.

Tests of control: petty cash

• For a sample of payments:

 Check to supporting vouchers
 Check whether they are properly approved
 See that vouchers have been marked and initialled by the cashier to prevent their re-use
• For a sample of weeks:
 Trace amounts received to cash books
 Check additions and balances carried forward
 Check postings to the nominal ledger

Revenue & Capital Expenditure

Control 1. All expenditure is authorized.
objectives
2. All expenditure is classified correctly in the financial statements as capital or
revenue expenditure.

Control 1. Orders for capital items should be authorized

Procedures
2. Order should be requisitioned on appropriate (different to revenue)
documentation

3. Invoices should be approved by the person who authorized the order. They
should be marked with the appropriate general ledger code

4. All the standard controls over purchases are relevant here.

5. Capital items should be written up in the non-current asset register

6. The non-current asset register should be reconciled regularly to the general

ledger

Tests of Analytical procedures

controls 1. General review between current and prior year figures to ascertain any
unexplained differences
2. Review of sensitive codes in the general ledger such as repairs or maintenance
3. Review of the movements on the non-current asset codes
4. Compare budgeted capital purchases with actual capital purchases
Enquiry and review
1. Discuss the level of capital purchases in the year with the purchasing manager
2. Review the board minutes for authorisation of capital purchases

Audit & Assurance Page 32

Trade Receivables

7.Substantive Procedures for trade receivables, bad debts & prepayments

With receivables, the main exam area is customer balances (trade receivables). The only other receivable likely
to be tested is the audit of prepayments.

The main assertions

● Existence – balances may not represent genuine sales transactions

● Valuation – balances may be wrongly valued due to a failure to accurately account for bad/doubtful debts, a
failure to record discounts or refunds, or errors in the original recording of sales invoices

● Cut-Off – if sales transactions near the year-end are recorded in the wrong accounting year, then receivables
could be over or under-stated.

Assertions Substantive Procedures

Existence Select a sample of receivable balances at year-end and agree entries back to invoices

● With client permission, circularize a selection of client’s customers, requesting a

direct confirmation that their balance is accurate.

o POSITIVE METHOD – involves either:

▪ Sending balance to customer and asking them to agree / disagree with the figure ▪
Sending a request for the customer to tell you the balance they think they owe

o NEGATIVE METHOD – involves sending balance to customer and asking them to

respond only if they disagree with the balance.

Valuation ●For a sample of year-end balances, agree to post year-end cash received from
customer

● Obtain aged receivables analysis and identify the oldest year-end balances that
remain uncollected
● Inspect correspondence between client and customers who have old balances, to
identify any disputes
● If necessary, obtain management representations confirming that the oldest
balances are believed to be collectible
● If there is a doubtful debt provision, re-perform the calculation that created it

● Inspect credit notes issued to customers since the year-end, and trace back to the
original invoices. If these invoices are for pre year-end sales, ensure that there is a
provision at the year-end to recognize that these receivables are not “receivable”!

● Analyse year-end receivables ledger for any negative balances (i.e. credit balances)
and obtain explanations for these (many of them may indicate that a customer was
owed money back, which makes them a liability, rather than a negative receivable)

Audit & Assurance Page 33

 ● Compare Receivables Days ratio with prior year and with similar companies, to
assess reasonableness.

Cut off Matching up GDNs and sales invoices either side of the year-end.

Presentation If any receivables are due to be collected more than 1 year after the year-end, ensure
& disclosure that this fact is disclosed in the Financial Statements

Other Areas
Substantive Procedures
Bade debts 1.Review the company’s previous bad debt experience to know the reasonableness of bad
debt (accuracy)

2. Obtain confirmation from debtors to ensure the amount recorded is the same as the
confirmation. (accuracy)

3.Analyse the debtor ageing to ensure any long outstanding bad debts have been recognized
and classified as bad debt (classification)

4.Review post balance sheet events to check any amount of bad debt recovered in oreder to
disclose properly in financial statement. (completeness of disclosure)

Returns 1.Review the internal control system of issuance of returns inwards and credit notes to prevent
Inwards fraudulent cancellation of debts

2. Check whether there is no window dressing by examine post balance sheet events. No large
number of issuance of credit note after year end to cancel the sales made previous year.

Goods on 1. Ensure goods on sales or return are not included in sales or receivable until the right to
sales or return the goods expires.
return

Prepayment 1. Review internal control for prepayment

2. Obtain a schedule of prepayments, ensure correct casting and perform analytical review to
compare the previous year

3 Compare list of prepayments with prior year, seeking explanations for any unexpected
differences

4 For a sample of prepayments, agree items back to invoices and re-perform any pro-rata
calculations.

8.Confirmation of accounts receivable

a) ISA505: External Confirmation states that where accounts receivables are material, the auditors
should obtain direct confirmation of accounts receivable.

Audit & Assurance Page 34

b) When management requests the auditor not to contact a customer, the auditor should obtain a
valid ground for such a request. Client rarely refuses to such a confirmation. Disputes are normally
solved through negotiation. If no other evidence is available, the auditor might have to consider
qualifying the audit opinion.

c) Confirmation procedures

Step 1: Auditor should select the customers from a sales ledger listing . Particulars attention should
be given to old unpaid accounts, accounts written off, accounts with credit balances, account with
nil balance and account which have been paid by the date of the examination.

Step 2: The dispatch of request letters should be sent by auditor and addresses should be checked.

Step 3: Response. The auditor should send a reminder letter to those customers that have not
responded within a reasonable time.

d) Some customers will disagree. All such disagreements must be followed up until the auditor is
satisfied.

e) After the completion of the confirmation, the auditor will need to evaluate the results in terms of
i. percentage response; ii) number of disagreement; iii) outcome of follow up of disagreements; iv)
the materiality of the amounts involved.

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