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Marlene S. Datuin Applied AuditingMODULE 3POSTTEST1. How do different levels of control risk in the revenue and collection cycle affect the nature, timing, and extent of accounts receivable confirmation procedures? Directly. Higher levels of control risk induce auditors to audit larger samples of re...

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Marlene S. Datuin

Applied Auditing

MODULE 3 POSTTEST 1. How do different levels of control risk in the revenue and collection cycle affect the nature, timing, and extent of accounts receivable confirmation procedures? Directly. Higher levels of control risk induce auditors to audit larger samples of receivables, with confirmation date closer to the fiscal year end date. As for nature of the procedures: higher levels of control risk induce auditors to use positive confirmations instead of negative confirmations, and to consider vouching subsequent payments by the customers. 2. What feature(s) of cash receipts internal control system would be expected to prevent (a) an employee's absconding with company funds and replacing the funds during audit engagements with cash from the employee pension fund, and (b) the cash receipts journal and recorded cash sales from reflecting more than the amount shown on the daily deposit slip? The features of a cash receipts internal control system which would be expected to prevent an employee from absconding with company funds and covering with funds from the employee pension fund is the prohibition against one employee having custody of company funds and non company funds. The auditor can detect such transfers by controlling and counting both funds simultaneously. To prevent the cash receipts journal and recorded cash sales from reflecting more than the amount shown on the daily deposit slip, the internal control system should provide that receipts be recorded daily and intact. A careful bank reconciliation by an independent person could detect such errors. 3. What is the meaning of strength in the transaction processing controls of the revenue and collection cycle? A weakness? Why are the weaknesses not subject to test of controls auditing? A strength is defined as a control procedure that can detect, prevent or correct errors in a timely matter from entering into the accounting records that form the basis of financial statements. A weakness is the lack of a control procedure where the auditor thinks one should exist. Weaknesses are not subject to test of controls auditing because no reliance is placed on a weakness. Strengths must be audited because the review phase only describes apparent strengths that may not actually exist.

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Marlene S. Datuin

Applied Auditing

4. Why is it necessary to evaluate the controls after the test of controls audit of the revenue and collection cycle when an evaluation was already made after the understanding phase? The evaluation after the review phase was to determine which controls appeared adequate as a basis for justifying a low control risk assessment. The final assessment after test of controls auditing is to determine if the controls are actually operating as well as they appeared to be. 5. Describe the processing of transactions in the sales and collections cycle in the following functions: a. Order entry An order entry department generally receives customers’ requests to purchase merchandise either by telephone or in the form of a written purchase order from the customer. A purchase order is a legal offer to purchase goods under the terms specified. In some entities, on receipt of an order, the order entry department generally prepares a sales order. The sales order is the first document prepared by the merchandiser in the sales and collections cycle, and it should be prenumbered to facilitate control over processing transactions. A copy of the sales order, acknowledging that the order has been received and is being processed, may be mailed to the customer. Four copies of the sales order are sent to the credit department, which either approves or denies credit and returns a copy of the sales order to the order entry department. The credit department then sends a copy bearing credit approval (assuming it is granted) to the warehouse, the shipping department, and the billing department. The sales order bearing credit approval serves as authorization to warehouse personnel to release goods to shipping. Shipping personnel verify that the quantity and description of goods received from the warehouse match the copy of the sales order received directly from order entry. Billing matches the customer order, the sales order, and the shipping document before recording the sale. In some entities, when an order is received, the purchase order is sent to the credit department for approval. The credit department’s decision is returned to the order entry department. When the credit department has approved the sale, a multipart sales invoice is prepared. One copy serves as a shipping order, another as the bill of lading, and another is sent to billing. The sale, however, is not recorded (entered in the sales journal) until the bill of lading is received by billing. b. Credit approval Before goods are shipped, the customer’s credit must be approved. The credit department maintains a list of unauthorized customers and their credit limits, which an employee must review to determine whether to accept an order. A credit department Page 2 of 23

Marlene S. Datuin

Applied Auditing

employee signs a copy of the sales order authorizing the credit sale. When an order is received from a prospective customer not on the list or when a customer has exceeded the authorized credit limit, the credit department generally conducts a credit investigation and makes a decision to accept or reject the order. When the order is accepted, a copy of the sales order is sent to the warehouse and a copy is retained in the credit department. c. Warehousing On the basis of the sales order approved by the credit department, warehouse personnel issue goods to the shipping department. The accounting department, rather than warehouse personnel, maintains perpetual records for the inventory. d. Shipping The shipping department verifies that the goods received from the warehouse to be shipped agree with the quantity and description of goods on the sales order. The shipping department then packs the merchandise, arranges transportation with a common carrier, and prepares a shipping document. The shipping document is a multi copy document that lists the items, gives instructions to the common carrier as to whom and to what the address to ship the merchandise, and may serve as a packing slip for the merchandise. Copies of the shipping document are given to the carrier, and copies are sent to the billing department. Sometimes entities use a bill of lading as a shipping document; it may include a general description of the goods and a quantity or number of pounds. e. Customer billing Billing involves notifying the customer (by means of an invoice) of the amount due for the goods or services delivered. The billing function is typically performed by a section of the accounting department and should be independent of sales executives. Billing personnel should (1) account for the sequence of shipping documents to determine that all shipments are billed, (2) compare the details included on the sales order with the shipping documents to serve as an independent check on shipping, (3) prepare the sales invoice from data on the shipping document and sales order, (4) price the invoice by reference to an authorized price list obtained from the sales department, (5) extend and foot the invoices, and (6) account for the sequence of sales orders and shipping documents to ensure that all sales are recorded. Some entities prepare a turnaround document simultaneously with the sales invoice. A turnaround document is a form the customer mails back to the merchandiser, along with payment of the invoice that facilitates handling and processing of cash receipts. It contains information, such as the customer’s name and account number, and a place to indicate the amount of the payment. Page 3 of 23

Marlene S. Datuin

Applied Auditing

Prior to mailing, each invoice should be reviewed by a person not involved in its preparation. The review should cover the propriety and accuracy of prices, extensions, footings, credit terms, and freight charges. The billing department should develop a total of sales invoices and submit it directly to the clerk responsible for maintaining the accounts receivable control account. The accounts receivable subsidiary ledger clerk or data processing department prepares the sales journal and posts debits to individual accounts in the accounts receivable subsidiary ledger. Subsequent reconciliation of the accounts receivable subsidiary ledger to the accounts receivable control account is an important aspect of internal control. Shipping documents are used by accounting to update perpetual inventory records when they are maintained. f. Collecting accounts receivable One of the best controls over cash receipts is a lockbox system in which customers mail their remittances to a post office box controlled by a bank. The bank’s bonded employees obtain the mail from the post office box, make a listing of the amount by customer, mail the remittance advices and a copy of the list to the business, and deposit the cash. When mail containing remittances comes directly to the entity, the first step in the control process is to obtain a listing of the cash and checks. This listing is generally prepared by a receptionist or a mailroom employee designated to open mail. However, the person should have a high level of integrity and not be otherwise involved in handling cash or maintaining accounts receivable records. The listing of cash receipts, referred to as a prelisting, serves to establish control over cash receipts. Remittance advices are prepared if necessary, and when the listing has been prepared, the cash and remittance advices are separated. The cash is given to the cashier to prepare the bank deposit, and the remittance advices are given to the accounts receivable clerk for preparing the cash receipts journal and updating the accounts receivable subsidiary records. The employee preparing the prelisting also develops a total of cash receipts to send directly to the accounting department supervisor, who maintains control over the general ledger accounts. g. Granting credit for returns and allowances A business issues a credit memo when a customer returns merchandise or when a price adjustment is allowed. Credit memo authorizations should bear the signature of an employee with authority to issue a credit memo and should be based on a receiving report when merchandise has been returned, or on correspondence between the sales department and the customer when a price adjustment has been authorized.

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Marlene S. Datuin

Applied Auditing

h. Recording uncollectible accounts expense The allowance for uncollectible accounts expense is the result of an adjusting entry, which should be approved by the controller or chief accountant. Any entries recording uncollectible accounts expense should bear the written authorization of the controller. i. Writing off uncollectible accounts After exhausting all reasonable efforts to collect accounts, businesses should write off accounts judged to be uncollectible. Frequently, accounts are written off after the customer declares bankruptcy. Accounts written off should be transferred to a separate control account, and statements should continue to be sent to those debtors in an effort to collect the account. 6. Identify features of the following documents that facilitate control and explain how they do so: a. Shipping document A merchandiser prepares a shipping document that includes the name and address of the customer and a description of the goods. The document is a contract between the seller and the carrier and is signed by the carrier when it accepts the goods. Businesses often use a bill of lading as a shipping document. The document may be a copy of the invoice or a delivery ticket. The signature of the carrier on the shipping document provides externally created evidence that a sale has occurred. Accounting for the numerical sequence determines that all shipments are recorded as sales. b. Remittance advice A customer attaches a remittance advice to a check in payment of an invoice. The document may be a turnaround document, a part of a check, or a statement identifying the invoices being paid. Remittance advices facilitate recording cash receipts. If a customer does not return a remittance advice, the employee opening the mail usually prepares one. A remittance advice indicates the date and amount of payment and the invoices paid. Remittance advices are separated from cash and given to the accounts receivable clerk for posting to accounts receivable. c. Uncollectible account form Uncollectible account forms authorize an accounting clerk to write off an account receivable as an uncollectible account. The form provides permanent written evidence that authorization was made for writing off an account.

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Marlene S. Datuin

Applied Auditing

7. Why do people perpetrate fraud involving sales transactions? Managers may experience pressure to show high profits and may inflate sales because of the pressure to meet target profits established by senior managers, to obtain bonuses, to retain the respect of senior managers, or even to retain their jobs. 8. Why is it difficult to detect the withholding of cash receipts? Until a record of cash received has been made, removing cash is one of the easiest forms of fraud to commit and among the hardest to detect because records do not reflect what has occurred. 9. Identify three ways an employee might misappropriate cash receipts. Answers will vary. Three possible examples are the following: 





A cashier in a retail establishment who does not ring up a transaction on the cash register can generally take the cash without detection. Ringing up the transaction adds the receipt to the total cash receipts, which can be compared to the cash on hand. An employee who has access to cash receipts and maintains accounts receivable records can record a sale at an amount lower than the invoice amount. When the customer pays, the employee takes the difference between the invoice and the amount recorded as a receivable. An employee who makes the cash deposit and also prepares the bank reconciliation can withhold cash and hide the shortage by overstating deposits in transit on the bank statement, under footing the list of outstanding checks, or omitting outstanding checks from the outstanding check list. Routinely testing bank reconciliations should uncover this form of fraud.

10. Explain why auditors perform tests of controls. Auditors are not required to perform tests of controls. However, when a client has effective internal control, performing tests of controls is cost effective because it may provide a basis for the auditor to assess control risk at less than maximum. Assigning a reduced level of risk to control risk reduces the amount of substantive testing the auditor must perform. Substantive tests are more expensive to perform than tests of controls. Hence, auditors perform tests of controls when they believe it will enable them to reduce the amount of substantive testing. Also, auditors may perform much of the testing of controls before year end, thus spreading the audit work. 11. What concern does an auditor have in auditing adjustments to sales? Adjustments to sales include cash discounts, sales allowances or reductions in price, returns of merchandise, volume rebates, corrections of billing errors, and write-offs of uncollectible accounts. The greatest concern from a control point of view is that one of these types of transactions will be recorded to cover a misappropriation of cash receipts. Page 6 of 23

Marlene S. Datuin

Applied Auditing

12. When an entity's controls for collection are ineffective, what potential misstatements could arise in the financial statements? The following potential misstatements could arise:     

Fictitious cash receipts may be recorded, or cash receipts may be misappropriated. Cash may be misappropriated and lapping may occur. Bank reconciliations may cover shortages. Credits posted to customers’ accounts may be overstated or understated. Entries may be made to the wrong accounts.

13. What tests of controls related to uncollectible accounts do auditors perform? Auditors’ primary concern with regard to uncollectible accounts is that accounts written off have actually become uncollectible, rather than being written off to cover a misappropriation. To prevent accounts from being written off to cover misappropriations, any account written off must be authorized by a responsible official not involved in the granting of credit. The auditor usually tests the effectiveness of this control by examining the approvals of accounts written off. For a sample of accounts written off, the auditor generally examines correspondence indicating that efforts were made to collect the account and that the account is uncollectible. Sometimes the auditor examines credit reports on the accounts. The auditor should trace a sample of the entries to the accounts receivable accounts. 14. Perez, CPA, is auditing the financial statements of Mayor Forwarders, Inc. (MFI) for the year ended January 31, 2006. Perez has compiled two lists. The first contains the possible errors and frauds that may result in the misstatement of MFI's financial statements. The second is a corresponding list of controls that, if properly designed and implemented, could assist MFI in preventing or detecting the errors and frauds. Required: For each possible error and fraud in the left column, select from the right column one control that, if properly designed and implemented, could most likely assist MFI in preventing or detecting the error and fraud. The entries in the list of controls may be selected once, more than once, or not at all. 1

Possible Errors and Frauds Invoices for goods sold are posted to incorrect customer accounts.

a

2

Goods ordered by customers are shipped but are not billed to anyone.

b

3

Invoices are sent for shipped goods but are not recorded in the sales journal.

c

Controls Shipping clerks compare goods received from the warehouse with the details on the shipping documents. Approved sales orders are required for goods to be released from the warehouse. Monthly statements are mailed to all customers with outstanding balances. Page 7 of 23

Marlene S. Datuin 4

5

6 7

8

9

10

11

Applied Auditing

Invoices are sent for shipped goods and are recorded in the sales journal but are not posted to any customer account. Credit sales are made to individuals with unsatisfactory credit ratings.

d

Shipping clerks compare goods received from the warehouse with approved sales orders.

e

Goods are removed from inventory for unauthorized orders. Goods shipped to customers do not agree with goods ordered by customers. Invoices are sent to allies in a fraudulent scheme, and sales are recorded for fictitious transactions. Customers' checks are received for less than the customers' full account balances, but the customers' full account balances are credited. Customers' checks are misappropriated

f

Customer orders are compared with the inventory master file to determine whether ordered items are in shares. Daily sales summaries are compared with control totals of invoices. Shipping documents are compared with sales invoices when goods are shipped.

before being forwarded to the cashier for deposit. Customers' checks are credited to incorrect customer accounts.

g

h

Sales invoices are compared with the master price file.

i

Customer orders are compared with an approved customer list.

j

Sales orders are prepared for customer order
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