CHAPTER 10

AUDITING THE EXPENDITURE CYCLE

REVIEW QUESTIONS

1. Differentiate between a purchase requisition and a purchase order.

Response: A purchase requisition is completed by the inventory control department when a need
for inventory items is detected. Purchase requisitions for office supplies and other materials may
also be completed by staff departments, such as marketing, finance, accounting, and personnel.
The purchasing department receives the purchase requisitions and, if necessary, determines the
appropriate vendor. If various departments have requisitioned the same order, the purchasing
department may consolidate all requests into one order so that any quantity discounts and lower
freight charges may be taken. In any case, the purchasing department prepares the purchase order,
which is sent to the vendor, accounts payable department, and the receiving department (blind
copy).

2. What purpose does a purchasing department serve?

Response: A purchasing department is able to research the quality and pricing of various
vendors. Its job is to monitor various supply sources and choose the highest quality good for a
given price, with reliable delivery. The purchasing department may also take advantage of
quantity discounts, especially when two or more manufacturing facilities are involved.

3. Distinguish between an accounts payable file and a vouchers payable file.

Response: An accounts payable file contains all source documents, including invoices,
organized by payment date. As the due dates come close to the current date, the invoices are
pulled from the file and paid. Under the voucher system, the accounts payable clerk prepares a
cash disbursements voucher upon receipt of all source documents. Each cash disbursements
voucher represents payment to one vendor. Multiple invoices may be paid with one voucher. The
voucher system allows better control over cash disbursements because cash vouchers are assigned
and tracked.

4. What are the logical steps of the cash disbursements system?

Response: The three logical steps of the cash disbursements system are
1. Identify liabilities due
2. Prepare cash disbursement
3. Update accounts payable record

5. What general ledger journal entries are triggered by the purchases system?
Response:
Accounts Payable:
Inventory Control Debit
Accounts Payable Credit

Cash Disbursements:
Accounts Payable Debit
Cash Credit

6. What two types of exposure can close supervision of the receiving department reduce?
Response: Large quantities of valuable assets flow through the receiving department on their way
to the warehouse. Close supervision here reduces the chances of two types of exposure: failure to
properly inspect the assets and the theft of assets.
7. What steps of independent verification does the general ledger department perform?
Response: The general ledger department receives journal vouchers from inventory control,
accounts payable, and cash disbursements. With these summary figures, the general ledger clerk
verifies that
a. total obligations recorded equal total inventories received.
b. total reductions in accounts payable equal total disbursements of cash.

8. What is (are) the purpose(s) of maintaining a valid vendor file?

Response: As a control against unauthorized payments, comparing the vendor number on the
voucher with a valid vendor file validates all entries in the voucher file. If the vendor number is
not on file, the record is presumed to be invalid and is diverted to an error file for management
review.

9. What is the purpose of the blind copy of the purchase order?

Response: A blind purchase order has all the relevant information about the goods being received
except for the quantities and prices. To obtain the information on quantities, which is needed for
the receiving report, the receiving personnel are forced to physically count and inspect the goods.
If receiving clerks were provided with quantity information through formal documentation (i.e.,
the purchase order), they may be tempted to transfer this information to the receiving report
without performing a physical count.

10. Give one advantage of using a vouchers payable system?

Response: Vouchers provide improved control over cash disbursement, and they allow firms to
consolidate several payments to the same supplier on a single voucher, thus reducing the number
of checks written.

11. How do computerized purchasing systems help to reduce the risk of purchasing
bottlenecks?
Response: Routine purchases can be automated, reducing the time lag between order, arrival and
recording of inventory. By freeing purchasing agents from routine work, such as preparing
purchase orders and mailing them to the vendors, attention can be focused on problem orders
(such as special items or those in short supply).

12. Which document is used by cost accounting to allocate direct labor charges to work-in-
process?
Response: Job tickets capture the time spent on each job during the day and are used to allocate
the labor charges to the work-in-process accounts.

13. Which department authorizes changes in employee pay rates?

Response: The personnel department, through the personnel action form authorizes changes to
employee pay rates.

14. Why should the employee’s supervisor not distribute paychecks?

Response: A form of payroll fraud involves a supervisor submitting fraudulent time cards for
nonexistent employees. The resulting paychecks, when given to the supervisor are then cashed by
the supervisor. This type of fraud can be reduced or eliminated by using a paymaster to distribute
paychecks to employees in person. Any uncollected paychecks are then returned to payroll.

15. Why should employee paychecks be drawn against a special checking account?
Response: A separate imprest account is established for the exact amount of the payroll based on
the payroll summary. When the paychecks are cashed, this account should clear leaving a zero
balance. Any errors in checks (additional checks or abnormal amounts) would result in a non-zero
balance in the imprest account and/or some paycheck would not clear. This will alert
management to the problem so corrective action can be taken.

16. Why should employees clocking on and off the job be supervised?
Response: A form of payroll fraud involves employees clocking the time cards of absent
employees. By supervising the clocking in and out process, this fraud can be reduced or
eliminated.

17. What is a personnel action form?

Response: The Personnel Action Form is prepared by the Personnel Department for the
authorization of new employees and changes in job class and pay rates. It enables the Payroll
Department to prepare a list of currently active employees. Any submission of time cards by
supervisors for fictitious or ex-employees should thus be detected

18. What tasks does a payroll clerk perform upon receipt of hours-worked data from the
production department?
Response:
The payroll clerk then performs the following tasks.
1. Prepares the payroll register showing gross pay, deductions, overtime pay, and net pay.
2. Enters the above information into the employee payroll records.
3. Prepares employee paychecks.
4. Sends the paychecks to the paymaster or other distribute-paycheck function.
5. Files the time cards, personnel action form, and copy of the payroll register (not shown).

19. What documents constitute the audit trail for payroll?

Response: Timecards, personnel action forms, job tickets, labor distribution summary.

DISCUSSION QUESTIONS

1. What is the importance of the job ticket? Illustrate the flow of this document and its
information from inception to impact on the financial statements.
Response: The job ticket is used to allocate each labor hour of work to specific WIP accounts.
These job tickets are very important for cost accounting. The job tickets are completed by
production workers as they capture the total amount of time that they spend on each production
job. Upon completion, these are routed to the cost accountants who use them to post the labor
costs to specific WIP accounts such as direct labor, indirect labor, and overhead. The cost
accountant prepares a labor distribution summary that contains the information for the general
ledger clerk to make the necessary entries to the general ledger accounts.

2. What documents support the payment of an invoice? Discuss where these documents
originate and the resulting control implications.
Response: The payment of an invoice may be supported by the purchase requisition, purchase
order, and receiving report (in addition to the invoice itself). The purchase requisition originates
from inventory control and represents the inventory requirements. The purchase order originates
from the purchasing department and represents an order placed. The receiving report originates
from the receiving department and represents the quantity and types of goods received. Thus, the
accounts payable must determine (a) that the goods ordered were requested by some department
(i.e., inventory control) other than purchasing, (b) that purchasing ordered the goods from a valid
vendor, and (c) that the goods were actually received. If all three of the conditions are met, then
and only then should the invoice be paid. Further, payments should be made for only those goods
received in good shape.

3. Discuss the time lags between realizing and recognizing economic events in the purchase
and payroll systems. What is the accounting profession’s view on this matter as it pertains
to these two systems?
Response: For accounts payable, a time lag exists between the time the good that is purchased is
received and the recording of the liability to the vendor. The receipt of an invoice is the event that
usually causes the liability to the vendor to be recorded. The time lag may range from virtually
nothing for fully integrated EDI systems to a few days. Thus, during this slight lag in the
recording process, liabilities are understated.
For payroll costs, wages to workers accrue each minute, hour, or day that they work. However,
these costs are not recorded as a liability during the time between when the workers earn their
wages and when they are paid. These time lags typically average from half a week to a week.
Neither of these time lags are of concern unless the firm is closing its books or preparing interim
financial statements. At these points, however, estimates or accruals of the amounts owed should
be made and the books adjusted.

4. Discuss the importance of supervision controls in the receiving department and the
reasons behind blind fields on the receiving report, such as quantity and price.
Response: The receiving clerks have access to many of the firm’s assets: its inventory. Two
exposures potentially exist: (a) the clerk failing to perform his or her duty and (b) the clerk
pilfering or stealing the inventory. Thus, the copy of the purchase order used for this inspection
should have the quantities and amounts covered so that they may not be read. If the quantity is
printed on the receiving clerk’s copy of the purchase order, he or she may be tempted to skip the
physical inspection and the company may pay for inventory it did not receive or that is damaged.
A supervisor must remove the packing slip that contains quantity information to make sure the
receiving clerk actually inspects the goods. If the value of the inventory is listed, the employee
may be tempted to steal some of the inventory. Close supervision should deter employees from
stealing.

5. How does the procedure for determining inventory requirements differ between a basic
batch processing system and batch processing with real-time data input of sales and receipts
of inventory?
Response: A system that employs real-time data entry of sales will have the inventory levels
updated more frequently. Thus, when a sale depletes the inventory level to the reorder point, the
system will flag it for reorder more quickly than if it had to wait for a batch update of the
inventory records. The sooner the item is ordered, the sooner it will be received. With respect to
the real-time receipt of inventory, the inventory will be updated immediately to show the accurate
amount that is on hand. A customer wishing to know how soon an item will be shipped will
receive more accurate information regarding the status of the firm’s inventory levels. Thus, the
customer benefits from better stocking of inventory and better information regarding the
inventory levels.

6. What advantages are achieved in choosing?

a. a basic batch computer system over a manual system?
b. a batch system with real-time data input over a basic batch system?
Response:
a. The basic batch system provides the following benefits over a manual system: improved
inventory control, better cash management, reduction in time lag of inventory entries, increases in
the efficiency of the purchasing department, and a reduction in paper documentation.
b. The real-time data input system provides the following benefits over a batch system: reduction
in the time lag in record keeping, elimination of routine manual procedures, and an even greater
reduction in paper documentation.

7. Discuss the major control implications of batch systems with real-time data input. What
compensating procedures are available?
Response: The first control implication is that a fundamental separation between authorization
and transaction processing no longer exists. The computer programs both authorize and process
the orders and issue checks to the vendors. The compensating control is to provide transaction
listings and summary reports that describe the automated activities taken by the system to
management. In order for these controls to work, the managers must take the time to carefully
review these reports.
The second control implication is that the accounting records as well as the computer programs
reside on magnetic disks. These disks should not be accessed by any individuals not authorized to
access them in any fashion. The compensating control is to employ hardware, software, and
procedural controls over the data stores.

8. Discuss some specific examples of how information systems can reduce time lags that
positively affect an organization.
Response: One example is by reducing the time it takes to record the receipt of inventory into the
inventory records that are used to inform customers whether or not their requested item is
available. Also, the inventory levels are also reduced more quickly for those inventories that are
being shipped. With a reduced time lag, the risk of promising to ship an item to another customer
when it is not available is greatly reduced. Further, the automated system will be less likely to pay
an invoice too early, while at the same time not missing the discount period. Thus, cash
management is improved.

9. Discuss some service industries that may require their workers to use job tickets.
Response: Law firms require their employees to log the amount of time spent on each client for
billing purposes. Accounting firms also require their employees to keep job tickets for the time
they spend on each client. Car repair shops are another example. The mechanic must keep track
of how much time she or he spends working on each automobile.

10. Payroll is often used as a good example of batch processing using sequential files.
Explain why.
Response: Sequential files are appropriate because most if not all payroll records on the master
payroll file are updated during the payroll processing run.
MULTIPLE CHOICE

1. b
2. e
3. c
4. b
5. d
6. c
7. e
8. e
9. d
10. c
11. a
12. b
13. a
14. a
15. b

PROBLEMS

1. Inventory Ordering Alternatives

The flowchart for Problem 1 illustrates two alternative inventory ordering methods.
Required
a. Distinguish between a purchase requisition and a purchase order.
b. Discuss the primary advantage of alternative two over alternative one. Be specific.
c. Under what circumstances can you envision management using alternative one rather than
alternative two?

Response:
a. A purchase requisition is created when an item of inventory is needed (e.g., fallen below the
reorder point) and authorizes its purchase. A purchase order is created from requisitions to the
same vendor. Thus, one purchase order may contain many purchase requisitions.
b. The system shown in alternative two expedites the ordering process by distributing the
purchase orders directly to the vendors and internal users, thus bypassing the purchasing
department completely. This shortens the time between recognizing the need for inventory and
mailing the PO to the vendor. Consequently, inventory safety stock levels can be reduced, thus
reducing inventory carrying costs.
c. Alternative one provides additional control over the ordering process. For example, the
purchasing agent could manually detect unusual order quantities or frequency caused by a
computer error. Managers whose systems lack reliable computer controls, and who wish to
compensate with human independent verification, may prefer this alternative. The price of this
added control is excessive inventory carrying costs.

2. Payroll Controls
Refer to the Problem 2 flowchart in the text.
Required:
a. What risks are associated with the payroll procedures depicted in the flowchart?
b. Discuss two control techniques that will reduce or eliminate the risks.
Response:
a. The payroll department has no independent information as to changes in an employee’s status.
For example, the foreman may continue to submit timecards for terminated employees. Because
the foreman also distributes paychecks, he could steal and forge the uncollected checks.
b. i. An employee action report from the personnel department should list all current employees.
Timecards for terminated or nonexistent employees should be identified when reconciled with the
personnel report.
ii. An independent paymaster should distribute the paychecks to the employees. If an employee
is not present to receive the paycheck, it will be returned to the payroll department.

3. System Flowchart Analysis

Using the Flowchart labeled Problem 3, answer the following questions:

a) What are the names of Departments X and Y?

b) What are the names of the documents that are identified by letters in the system? Use the
following format:
Doc A = (Name of document here), etc.
c) What are the processes that are represented by letters in the system?
d) What are the files that are represented by letters in the system?
e) What is represented by the terminal labeled “Z”?

Response:

a) Department X is Cash Disbursements, Department Y is General Ledger

b) Doc A = Purchase Order

Doc D = Journal Voucher
Doc H = Vendor Check
Doc K= Check Copy
Doc G = Journal Voucher

c) Process B = Set Up Liability (Post to AP)

Process E = Disburse cash (discharge liability)
Process I = Post to GL

d) File C = AP Sub ledger (vendor Invoice file)

File F = Check register (Cash Disbursements Journal)
File J = General Ledger

e) Terminal Z = Vendor (Supplier)

4. System Flowchart Analysis

Refer to the system flowchart labeled Problem 4.
Required:
a. Discuss the uncontrolled risks associated with the systems as currently configured.
b. Describe the controls that need to be implemented into the system to mitigate the risks in the
given scenario.
Response:
Part a. and b. below:
1) Risk: Unnecessary purchases of inventory may occur and the potential for kick-back fraud
exists under the current system.

Control: A purchase requisition should originate from the inventory control function to authorize
the creation of a purchase order.

2) Risk: The organization may receive and accept incorrect item types and /or quantities of items.

Control: Use of a blind copy of the PO will force the receiving clerk to count and inspect
receipts. The clerk should not have access to the packing slip, which contains details.

3) Risk: The organization may pay for items that it did not order. The liability is set up based
only on the Invoice and the Rec Rept.

Control: Perform a three-way-match (PO, Rec Report, and Invoice).

4) Risk: The potential for vendor fraud exists because the AP department sets up the liability and
also pays it.

Control: AP should authorize Cash Disbursements to may payment on the due date.

5. Payroll Fraud
John Smith worked in the stockyard of a large building supply company. One day he
unexpectedly and without notice left for California never to return. His foreman seized the
opportunity to continue to submit timecards for John to the payroll department. Each week, as
part of his normal duties, the foreman received the employee paychecks from payroll and
distributed them to the workers on his shift. Because John Smith was not present to collect his
paycheck, the foreman forged John’s name and cashed it.

Required:
Describe two control techniques to prevent or detect this fraud scheme.

Response:
a. An employee action report from the personnel department should list all current employees.
Time cards for terminated or nonexistent employees should be identified when reconciled with
the personnel report.
b. An independent paymaster should distribute the paychecks to the employees. If an employee is
not present to receive the paycheck, it should be returned to the payroll department.

6. Source Documents Identification

Refer to the Problem 6 figure presented in the text, which shows typical expenditure cycle files
and attributes. Explain, in detail, the process by which these data are obtained and used in the
requisition, purchase, and payment to inventory.

Response: First, the Inventory Master file is searched to determine if the Quantity on Hand is
less than or equal to the Reorder Point, which is a predetermined point at which the firm orders
more inventory. If it is less than or equal to the reorder point and the Quantity on Order is not
flagged as true, then the EOQ (a predetermined optimal order amount) is used to order the
Inventory Number item, which is an assigned number and described by the Description field.
The item is ordered from a specified Vendor in the Vendor file, and this information is stored in
the Inventory Master file. A purchase requisition is filled out and a Purchase Requisition
Number is assigned to the requisition. The Inventory Number, Quantity on Order, Vendor
Number, and Unit Standard Cost are recorded. The vendor Address, Terms of Trade, and
Lead Time are obtained from the Vendor file. If the Lead Time is too long, a different vendor
may need to be chosen or the price paid may be higher than the predetermined Standard Cost for
the item. At this point, the Date of Last Order field in the vendor file is updated.
The purchasing department then completes a purchase order and places it into the Open
Purchase Order file until the order is completed. First, the purchasing clerk assigns a
Purchase Order Number and fills in the corresponding Purchase Order Number. The
following information is also copied to the purchase order file from the above-mentioned records:
Purchase Requisition Number, Inventory Number, Quantity on Order, Vendor Number,
Vendor Address, and Standard Cost. The Expected Invoice Amount is determined by
multiplying the expected price times the quantity ordered.
When the inventory is received, the Inventory Master File is updated: the Quantity on Hand is
increased by the number of units received, and the Total Inventory Cost is updated. In the Open
Purchase Order file, the field Rec Flag is checked to indicate that the goods have been received.
When the vendor’s invoice is received, the Invoice Flag field in the Open Purchase
Order file is checked to indicate that the invoice has been received. Further, the accounts payable
department adds a new record to the Voucher Register. This voucher register record is assigned a
Voucher Number, and the following information is recorded in it: Purchase Order Number,
Purchase Requisition Number, Inventory Number, Quantity on Order, Vendor Number,
Address, Standard Cost, and Expected Invoice Amount. The invoice Due Date is also noted
so that the disbursement may be made as close to the due date as possible without missing any
discounts offered.

7. IT Controls
Using the flowchart for Problem 7, describe the IT application controls that would apply to the
system. Be specific as to the role each control plays.

Response:
IT APPLICATION CONTROLS:
a. Automated Purchase Approval. Computer logic, not a human being, decides when to
purchase, what to purchase, and from which vendor. The key attributes needed to execute this
logic come from the purchase requisition file and the valid vendor file. The objective is to
prevent unauthorized purchases from unapproved vendors.

b. Automated Three-Way Match and Payment Approval. When the AP clerk receives the
supplier’s invoice, the clerk accesses the system and adds a record to the vendor invoice file.
This act prompts the system to automatically create a virtual AP packet by linking the vendor
invoice to the associated purchase order and receiving report records, using the PO number as
a common attribute. The application then reconciles the supporting documents, using
programmed criteria for assessing discrepancies. Discrepancies in excess of the threshold are
submitted to management for review and manual approval.

c. Multilevel Security. Multilevel security is a means of achieving segregation of duties in an

integrated data processing environment where multiple users simultaneously access a
common central application. Two methods for achieving multilevel security are the access
control list (ACL) and role-based access control (RBAC). Through these techniques,
purchasing, receiving, accounts payable, cash disbursements, and general ledger personnel
 are limited in their access based on the privileges assigned to them.

d. Automated Posting to Subsidiary and GL Accounts. All of the record keeping functions are
automated in the advanced technology system. In the advanced technology system, a
computer application, which is not subject to human failings such as yielding to situational
pressures and/or lacking ethical standards, decides which accounts to update and by how
much. By eliminating the human element from accounting activities, the potential for errors
and opportunities for fraud are significantly reduced. Also, since these are labor intensive
activities, automating them greatly improves efficiency of operations.

8. Physical Controls
Using the flowchart of a purchases system for Problem 8, identify six major physical control
weaknesses in the system. Discuss and classify each weakness in accordance with the COSO
internal control framework.

Response:
Transaction Authorization. Purchases are not authorized by inventory control.

Accounting Records. Inventory records are updated based on the purchase order rather than the
Receiving Report or Invoice.

Accounting Records. The Accounts Payable Subsidiary ledger is updated based only on the
Invoice. There is no reconciliation with supporting documents (purchase order and receiving
report).

Accounting Records. There is no Cash Disbursements Journal or Check Register in use.

Accounting Records/Segregation of Functions. The receiving department prepares the Receiving

Report directly from the Packing Slip. A blind copy of the Purchase Order should go to the
receiving clerk to control this activity. A supervisor should take possession of the packing slip
that contains relevant data and oversee the inspection process.

Accounting Records/Independent Verification. The General Ledger department should receive

Journal vouchers or batch totals from Inventory Control, Cash Disbursements, and Accounts
Payable. These are used to keep the General Ledger Control accounts current and to verify the
overall accounting accuracy of the process.

9. IT Controls
Using the flowchart for Problem 9, describe the IT application controls that would apply to the
system. Be specific as to the role each control plays.

a. Automated Purchase Approval. Computer logic, not a human being, decides when to purchase,
what to purchase, and from which vendor. The key attributes needed to execute this logic come
from the purchase requisition file and the valid vendor file. The objective is to prevent
unauthorized purchases from unapproved vendors.
b. Automated Three-Way Match and Payment Approval. When the AP clerk receives the
supplier’s invoice, the clerk accesses the system and adds a record to the vendor invoice file. This
act prompts the system to automatically create a virtual AP packet by linking the vendor invoice
to the associated purchase order and receiving report records, using the PO number as a common
attribute. The application then reconciles the supporting documents, using programmed criteria
for assessing discrepancies. Discrepancies in excess of the threshold are submitted to
management for review and manual approval.
c. Automated Posting to Subsidiary and GL Accounts. All of the record keeping functions are
automated in the advanced technology system. In the advanced technology system, a computer
application, which is not subject to human failings such as yielding to situational pressures and/or
lacking ethical standards, decides which accounts to update and by how much. By eliminating the
human element from accounting activities, the potential for errors and opportunities for fraud are
significantly reduced. Also, since these are labor intensive activities, automating them greatly
improves efficiency of operations.

10. Payroll Controls

Sherman Company employs 400 production, maintenance, and janitorial workers in eight
separate departments. In addition to supervising operations, the supervisors of the departments are
responsible for recruiting, hiring, and firing workers within their areas of responsibility. The
organization attracts casual labor and experiences a 20 to 30 per-cent turnover rate in employees
per year.
Employees clock on and off the job each day to record their attendance on time cards. Each
department has its own clock machine located in an unattended room away from the main
production area. Each week, the supervisors gather the time cards, review them for accuracy, and
sign and submit them to the payroll department for processing. In addition, the supervisors submit
personnel action forms to reflect newly hired and terminated employees. From these documents,
the payroll clerk prepares payroll checks and updates the employee records. The supervisor of the
payroll department signs the paychecks, which are drawn on the general cash account, and sends
them to the department supervisors for distribution to the employees. A payroll register is sent to
the cash disbursements department where it is filed.
Required
1) Prepare a flowchart of the Sherman’s payroll system.
2) Discuss the risks for payroll fraud in the Sherman Company payroll system.
3) What controls would you implement to reduce the risks?

Response:
1. (Flowchart on the following page)
2. Risks
• Department supervisors have too much control over human resources. They are
responsible for recruiting, hiring, and firing.
• The high degree of casual labor creates an environment that lends itself to abuse.
• High employee turnover rate makes identifying absent or nonexistent employees difficult.
• Clock machines are unsupervised and located in non-prominent areas.
• Department supervisors submit personnel action forms.
• Department supervisors distribute the paychecks to the employees; checks written for
nonexistent employees could be kept and cashed by the supervisors.

3. Controls
• Authorization: A separated personnel function should be established to account for
employees and to authorize their payment
• Segregation of Duties: The department supervisors should not distribute the paychecks to
employees. This should be the task of a paymaster.
• Supervision: The clocking in and out process should be supervised.
11. Flowchart Analysis
Discuss any control weaknesses found in the flowchart for Problem 11. Recommend any
necessary changes.

Control problem:
Payroll checks appear to be drawn on the general cash account.
This can result in undetected payroll errors and payroll fraud.

Recommendations:
The payroll register should be reviewed by AP who then authorizes the cash disbursements
department to issue a check for the entire payroll, which is deposited into a payroll Impress
(clearing) account.

12. Separation of Duties

Human resource management systems necessitate that employees from both the payroll and
personnel departments have access to confidential employee data.
1) List the tasks that personnel and payroll department employees respectively should and should
not be able to perform.
2) Describe the data types in such a system that are sensitive and confidential.
3) What IT controls will provide the necessary separation of duties to limit access to functions
and data.
Response:

Part 1) and 2). The tasks to be performed by Personnel and Payroll employees and the data they
may or may not access include:
Personnel Employees:
Should be able to activate new employees and change the status of existing employees including
rank, pay rates (salary), full time, part-time, active, and terminated.
Should not be able to submit time and attendance data for employees.

Payroll Employees:
Should be able to verify that an employee is an active valid employee.
Should initiate the payroll process from time and attendance data
Should not be able to change employee status.
Should not be able to view or edit performance evaluation data, health records, pension plan
balances or contributions, injury claims, etc.

Part 3) The central storage of sensitive data requires multilevel security that ensure privacy and
accuracy of data by limiting access to certain processes and data to authorized personnel.

13. Unrecorded Liabilities

You are auditing the financial statements of a New York City company that buys a product from
a manufacturer in Los Angeles. The buyer closes its books on June 30. Assume the following
details:
Terms of trade: FOB shipping point
June 10, buyer sends purchase order to seller
June 15, seller ships goods
July 5, buyer receives goods
 July 10, buyer receives seller’s invoice

Required:
a. Could this transaction have resulted in an unrecorded liability in the buyer’s financial
statements?
b. If yes, what documents provide audit trail evidence of the liability?
c. On what date did the buyer realize the liability?
d. On what date did the buyer recognize the liability?
New assumption:
Terms of trade: free on board destination
e. Could this transaction have resulted in an unrecorded liability in the buyer’s financial
statements?
f. If yes, what documents provide audit trail evidence of the liability?
g. On what date did the buyer realize the liability?
h. On what date did the buyer recognize the liability?

Response:
Term FOB shipping point:
a. Yes
b. The best evidence is provided by the Purchase Order and Bill of Lading
Purchase Order—is evidence that the item was ordered, but does not indicate when it was
shipped.
Bill of Lading—reviewed post-period; will indicate when the goods were shipped
Receiving Report—prepared post-period; establishes possession but may not indicate when goods
were shipped
c. June 15
d. July 10
Term FOB destination:
e. No
f. N/A
g. July 5
h. July 15

14. Payroll Flowchart Analysis

Discuss the risks depicted by the payroll system flowchart for Problem 14. Describe the internal
control improvements to the system that are needed to reduce these risks.
Response:
Risks:
Supervisor submits the personnel action form and time cards. This allows him/her to create
nonexistent employees.

Supervisor distributes the paychecks to the employees. Checks written for nonexistent employees
can be kept and cashed by the supervisor.
Cash disbursements is authorizing funds transfer into the bank account and is also writing the
funds transfer check. This is a segregation of duties problem.

Controls:
Authorization: A separated personnel function should be established to prepare personnel action
forms and manage the human resource.
Segregation of Duties. The supervisor should not distribute the paychecks to employees. This
should task should be performed by an independent paymaster.
Accounts Payable should approve the register and authorized payment by Cash Disbursements.

15. Comprehensive Flowchart Analysis

Discuss the internal control weaknesses in the expenditure cycle flowchart for Problem 14.
Structure your answer in terms of the control activities within the COSO control model.

Transaction authorization
Payroll clerk prepares paychecks without authorization from a personnel action form.
Cash disbursements department prepares vendor payments based solely on the Invoice. No
supporting documents are used.

Segregation of duties
Cash disbursements department prepares the paychecks; this should be done by payroll.
Cash disbursements department maintains the AP ledger and approves and writes checks.
Payroll checks and vendor check are paid through the general cash account. An imprest account
should be used to clear the payroll checks.
The supervisor should not distribute the paychecks to employees. This should task should be
performed by an independent paymaster.

Accounting records
No journal vouchers are prepared. The general ledger is being updated from source documents.

INTERNAL CONTROL CASES

1. Smith’s Market (Small Business Cash Sales Accounting System)

Required:
a. Create a data flow diagram of the current system.
b. Create a system flowchart of the current system.
c. Analyze the internal control weaknesses in the system. Model your response according to the
six categories of physical control activities specified in the COSO internal control model.
d. What financial statement misrepresentations may result from the control weaknesses?
e. Describe the substantive tests that an auditor would perform to identify material
misrepresentations.

Solution
a), b) See diagrams on the following pages.

c) Internal Control Weaknesses

1) Warehouse clerk has transaction authorization and purchasing responsibility.

2) Warehouse clerk has asset custody and recordkeeping responsibility. Blind PO is not
used to verify received inventory.
 3) Accounting clerk approves invoice for payment without the benefit of a receiving report
or a purchase order. No three way match control.

4) Accounting clerk has account payable and cash disbursement responsibility.

d) Financial statement misrepresentations

Inventory value is misstated

Liabilities are misstated

Cash account is incorrect

e) Substantive tests:
Purchases

Search for Unrecorded Liabilities

Review for Accurate Invoice Prices

Review Disbursement Vouchers for Unusual Trends and Exceptions

Search for Unauthorized Disbursement Vouchers

Review for Multiple Checks to Vendors

 2. Tight Lines Fishing and Camping Supplies (Networked Computer System and Manual
Procedures)

Required
a. Create a data flow diagram of the current system.
b. Create a system flowchart of the existing system.
c. Describe internal control weaknesses in the system and discuss the risks associated with these
weaknesses.
d. What financial statement misrepresentations may result from the control weaknesses?
e. Describe the substantive tests that an auditor would perform to identify material
misrepresentations.

Solution:

a), b), See diagrams on the following pages.

c) Internal Control Weaknesses and Risks
1) Purchasing clerk should not authorize purchases; this is an inventory control
function.
Risk. Purchasing clerk could purchase items not needed. This could result in
inefficient inventory management. It could also allow fraud such as a kick-back
from vendors who are unloading items.
2) The receiving department clerk should receive a ‘blind copy’ of the purchase
order and should not have access to the packing slip.
Risk: This situation would allow the receiving clerk to complete a receiving
report without actually counting and inspecting the items.
3) Inventory clerk updates the inventory subsidiary ledger.
Risk: This is a segregation of duties issue – asset custody and recordkeeping.
Clerk could steal inventory and adjust inventory records to conceal the theft.
4) The AP Clerk should not update the general ledger AP Control account.
Risk: With access to both the sub ledger and control account, discrepancies
caused by errors and fraud can be concealed.
5) Cash Disbursement clerk should not update the AP subsidiary ledger or the AP
Control account in the GL.
Risk: Clerk prepares check and updates the AP subsidiary and GL accounts. The
clerk could set up a fraudulent AP and pay it (vendor fraud).

d) Financial statement misrepresentations

 Inventory value is misstated

 Liabilities are misstated

 Cash account is incorrect

e) Substantive tests:

 Search for Unrecorded Liabilities

 Review for Accurate Invoice Prices

 Review Disbursement Vouchers for Unusual Trends and Exceptions

 Search for Unauthorized Disbursement Vouchers

 Review for Multiple Checks to Vendors

3. TVR Classics (Manual and Stand-Alone Computer Processing)

Required
a. Create a data flow diagram of the current system.
b. Create a system flowchart of the existing system.
c. Analyze the physical internal control weaknesses in the system.
d. What financial statement misrepresentations may result from the control weaknesses?

e. Describe the substantive tests that an auditor would perform to identify material
misrepresentations.

Solution:

a), b), See diagrams on the following pages.

c) Internal Control Weaknesses

1) The inventory clerk in the warehouse department has asset custody and transaction
authorization to order inventory.
2) The receiving clerk prepares the receiving report from the packing slip information. The
receiving department clerk should receive a ‘blind copy’ of the purchase order to force the
receiving clerk to count and inspect the items before preparing the receiving report.
3) The inventory clerk in the warehouse department has asset custody and record keeping
responsibility.
4) Accounts Payable does not verify that the good have been received via a formal receiving
report. Payment approval is based on a PO and invoice only.

Cash Disbursements Procedures

5) The company may be paying for items not received. The cash disbursement voucher is based
on a flawed process to set up the AP. A proper 3-way match needs to be performed prior to
establishing the liability.
6) No valid vendor file is used to approve payment.
7) No formal Journal vouchers are used to update the General Ledger.

d) Financial statement misrepresentations

Inventory value is misstated

Liabilities are misstated
Cash account is incorrect
e) Substantive tests:
Search for Unrecorded Liabilities
Review for Accurate Invoice Prices
Review Disbursement Vouchers for Unusual Trends and Exceptions
Search for Unauthorized Disbursement Vouchers
Review for Multiple Checks to Vendors
4. Discount Tools Inc. (Networked Computer System with Manual Procedures

Required
a. Create a data flow diagram of the current system.
b. Create a system flowchart of the existing system.
c. Analyze the physical internal control weaknesses in the system.
d. Describe the IT controls that should be in place in this system.
e. What financial statement misrepresentations may result from the control weaknesses?
f. Describe the substantive tests that an auditor would perform to identify material
misrepresentations.

Solution:
a), b) see the following pages
c) Internal Control Weaknesses
1) Purchasing clerk should not authorize inventory purchases.
2) Receiving clerk should receive a blind copy of the PO and not have access to the
packing slip
3) Warehouse clerk should not update inventory sub ledger.
4) AP Clerk does not perform a three way match. The clerk sets up a liability based only
on a PO and the vendor’s invoice, but no receiving report.
d) Relevant IT Controls are below:

e) Financial statement misrepresentations

Inventory value is misstated
Liabilities are misstated
Cash account is incorrect

f) Substantive tests:
Purchases
Search for Unrecorded Liabilities
Review for Accurate Invoice Prices
Review Disbursement Vouchers for Unusual Trends and Exceptions
Search for Unauthorized Disbursement Vouchers
Review for Multiple Checks to Vendors
5. ABE Plumbing, Inc. (Centralized Small Business Accounting System)

Required
a. Create a data flow diagram of the current system.
b. Create a system flowchart of the existing system.
c. Analyze the physical internal control weaknesses in the system.
d. What financial statement misrepresentations may result from the control weaknesses?
e. Describe the substantive tests that an auditor would perform to identify material
misrepresentations.

Solution:
a), b) see the following pages
c) Internal Control Weaknesses
1) Purchasing agent authorizes and executes the purchase transaction.
2) Receiving clerk prepares receiving report from the packing slip. He should receive a
“blind” copy of the PO.
3) Warehouse clerk should not be updating the inventory subsidiary ledger. The clerk
has asset custody and record keeping responsibility.
4) Accounts Payable clerk should not be writing checks. The clerk has asset custody and
record keeping responsibility.
d) Financial statement misrepresentations

Inventory value is misstated

Liabilities are misstated

Cash account is incorrect

e) Substantive tests:

Search for Unrecorded Liabilities

Review for Accurate Invoice Prices

Review Disbursement Vouchers for Unusual Trends and Exceptions

Search for Unauthorized Disbursement Vouchers

Review for Multiple Checks to Vendors

 ABE Plumbing, Inc. DFD Expenditure
Cycle
Purchase Order
Inventory
Vendor
Requirements
Review Inventory
Inventory
Records
Packing Slip
Order Data PO

PO File Payment Data

Update AP
Receive Check
Inventory Receiving Number
Data RR CD Voucher

Quantity and
Hard Due Date
Condition Receiving
Copy Post
Report
RR
Update AP
Post Check
General Amount
Update ledger
Inventory

Post Check
Inventory Register
Quantity
Check
Vendor Purchasing Department Data Processing Receiving Department Warehouse

A
1 2
PO
B
Monitor / Packing
PO
Prepare PO Slip
Rec
Report
Purchases /
Prepare
AP System
Packing Rec Report 3
Slip
Accounts Pay
Update
Inventory
A Rec
Invoice PO File Report
Rec
Report
Invoice Inventory
Reconcile Sub Ledger
and Post
Rec Report
B File
4

Review and GL
Check
Write
Checks Open/Closed
Cash Disb

Check Reg ABE Plumbing Purchases / Cash

Disbursements System
7. Custom Fabrications, Inc. (Stand-Alone PC-based Accounting System)

Required
a. Create a data flow diagram of the current system.
b. Create a system flowchart of the existing system.
c. Analyze the physical internal control weaknesses in the system.
d. What financial statement misrepresentations may result from the control weaknesses?
e. Describe the substantive tests that an auditor would perform to identify material
misrepresentations.

Solution:
a), b), see the diagrams on the following pages.
C and d) Internal Control Weaknesses and Risks:
1) Purchasing clerk should not authorize purchases; this is an inventory control function.
Risk. Purchasing clerk could purchase items not needed. This could result in
inefficient inventory management. It could also allow fraud such as a kick-back from
vendors who are unloading items.
2) The accounts payable department creates a liability in their records with only the
receiving report and vendor’s invoice. No three way match.
Risk: Company may be paying for items that were never officially ordered.
3) The warehouse receives the goods and prepares the receiving report. No formal and
separate receiving function.
Risk: This is a poor organization structure. By separating warehousing from
receiving, errors in the receiving function may be detected by the warehousing
function. This independent review is lost when the functions are combined.
4) The receiving report is prepared based on packing slip. No blind Copy of the PO.
Risk: This situation allows the receiving clerk to complete a receiving report without
actually counting and inspecting the items.
5) The general ledger updates the inventory control account from the receiving report.
No journal voucher.
Risk: Erroneous data may be entered into GL accounts. To reduce this risk, journal
vouchers are used to formally post to the GL.

d) Financial statement misrepresentations

Inventory value is misstated
Liabilities are misstated
Cash account is incorrect

e) Substantive tests:
Search for Unrecorded Liabilities
Review for Accurate Invoice Prices
Review Disbursement Vouchers for Unusual Trends and Exceptions
Search for Unauthorized Disbursement Vouchers
Review for Multiple Checks to Vendors
8. Patriot Generators, Inc.—Payroll System (Manual and Stand-Alone PC Procedures)

Required
a. Prepare a data flow diagram of the current payroll system.
b. Prepare system flowcharts for the payroll system.
c. Describe the uncontrolled risks associated with the system currently designed.
d. Describe the physical and IT controls needed to reduce the risks identified in “C” above.
Explain your solution.

Solution:
Part A and B see following Pages.

C. Uncontrolled Risks
1) Payroll fraud by submitting false timesheets
2) Cash asset misappropriation by AP clerk
3) Accounting errors in the General Ledger
Physical Controls
1) Transaction Authorization – Employ personnel action report to validate employees
2) Segregation of duties – Paymaster to distribute paychecks. Supervisors should not
submit and review time cards and also distribute paychecks.
3) Segregation of duties – Cash disbursement function. The AP department should not be
writing checks. They should authorize cash disbursements to do so.
4) Independent Verification/Accounting records – The general ledger department should
receive a journal voucher from cash disbursements and an account summary from the AP
department.
IT Controls

Limit tests,
Validation controls,
Password control over access to computers
Error Messages
File backup
Automated posting to accounts
9. Turner Patio Furniture (Manual and Stand-Alone PC System)

Required
a. Prepare a data flow diagram of the current payroll system.
b. Prepare system flowcharts for the payroll system.
c. Describe the uncontrolled risks associated with the systems as currently designed.
d. Describe the physical and IT controls needed to reduce the risks identified in “C” above.

Solution:
a), b) see diagrams on the following pages.

c) Uncontrolled Risks.

1. Payroll Fraud is possible because supervisor approve time cards and distributes
paychecks
2. Absence of personnel action forms allows invalid time cards to be submitted.
3. GL records may be inaccurately prepared because of current accounting procedures.

d. Controls to Reduce Risks

Physical Controls

1. Use personnel action form to validate employees and pay rates.

2. Employ paymaster to distribute checks to employees.

3. General Ledger should not Update GL from a CD disbursement voucher. It should receive
formal Journal vouchers

IT Controls
1. Limit tests,
2. Validation controls,
3. Password control over access to computers
4. Error Messages
5. File backup
6. Automated posting to accounts
10. Holly Company—Payroll Systems (Small Company Uses Manual Procedures with PC
Support)

Required

a. Prepare a data flow diagram of the current system.

b. Prepare a system flowchart of the existing system.

c. Describe the uncontrolled risks associated with this system as it is currently designed.

d. Describe the physical and IT controls needed to reduce the risks identified in “C” above.

Solution to Holly Company Payroll System

Part a) Payroll DFD

Employee
Information Employee
Records
Reviewed
Record Time Cards Review
Time Cards Prepare
Hours Time
Payroll
Worked Cards

File
Time Cards , Payroll
Register Copy
Hours Worked
Payroll Register

Print
Employees checks Payroll Register
and File
Update
Accounts

Signed Paychecks
Paychecks

Signed Paychecks
Sign
Distribute Checks
Checks

Holly Company Payroll System DFD

Part b) Payroll System Flowchart

Part c. Uncontrolled Risks:

1) Timekeeping process is unsupervised allowing for fraudulent time and attendance

records.
2) Accounting Department approves, prepares, and signs paychecks, which allows
payroll fraud by altering paychecks or issuing fraudulent paychecks.
3) Accounting errors and fraudulent transaction may go undetected when the
accounting department is responsible for maintain both subsidiary and control
accounts.
4) Payroll drawn on general cash account rather than a clearing account. This
enables payroll errors and fraudulent transaction to go undetected.
5) Payroll clerk prepares paychecks without authorization from a personnel action
form. This runs the risk of processing unauthorized paychecks.

6) Foremen authorize time cards and distribute paychecks. This permits the foremen
to submit fraudulent time cards and receive the paychecks.
Part d
Physical Controls
1) Provide supervision over timekeeping Process
2) Paychecks should be prepared by Payroll Department
3) Create separate GL function or provide access control to GL and maintain an
audit trail.
4) Establish separate cash disbursement department
5) Establish an Impress account for payroll
6) Employ a paymaster to distribute paychecks to employees
7) Use payroll action form to verify the status of employees before preparing
paychecks.
IT Controls
1) Limit tests,
2) Validation controls,
3) Direct deposit of checks
4) Password control over access to the system
5) Error Messages
6) File backup
7) Automated posting to accounts

ACL Assignments

The files used for the following assignments are located in the sampleproject. acl that
accompanies the ACL educational site license. Some of the assignments employ the ACL’s
Relation and Join features. For detailed information on the use of these and other commands,
consult ACL’s online Help.
1. Open the AP_Trans (purchases) file and stratify it on the Quantity field. Print the last
results window and comment on the action to be taken by the auditor.
2. Using the Relation feature, create a view from data in both the AP_Trans (purchases)
and Inventory files that shows product details (product description and quantity on-
hand). Print the view and comment on the results.
3. Open the EMPMAST (employee master file) and test for duplicate employee records.
Prepare a last-results report that identifies anomalies or potential errors. Print the report
and comment on the results.
4. Using the Relation feature, create a view of data from both the Empmast and Payroll
files that test for paychecks to non-existent employees.
5. Using the Join feature, create a view of data from both the Empmast and Payroll files
that tests for paychecks to nonexistent employees.
6. Bradmark Comprehensive Case.
Required:
Access the Bradmark ACL Case in the Student Resource section of textbook’s Web site.
Your instructor will tell you which questions to answer.