Tests OF Controls OF Transaction Cycles PDF

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“TESTS OF CONTROLS OF TRANSACTION CYCLES”A. TESTS OF CONTROLS IN THE REVENUE/RECEIPT CYCLE: SALES AND CASHRECEIPTS TRANSACTIONSThe revenue/receipt cycle encompasses both the sale of goods or services to customers and the collection of cash. The cycle is related to each of the other three transaction...

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“TESTS OF CONTROLS OF TRANSACTION CYCLES” A. TESTS OF CONTROLS IN THE REVENUE/RECEIPT CYCLE: SALES AND CASH RECEIPTS TRANSACTIONS The revenue/receipt cycle encompasses both the sale of goods or services to customers and the collection of cash. The cycle is related to each of the other three transaction cycles since it: 1. Receives resources and information provided by the financing and conversion cycles, and 2. Provides resources and information to the expenditure/disbursement cycle. 1. Business functions associated with this cycle: o - Resources are sold to customers in exchange for promises of future payment o - Cash is collected from customers. 2. Common activities: o - Customer order (the cycle begins at this point when the customer’s order is received by fax, mail, e-mail, telephone, or EDI). o - Credit approval o - Inventory control o - Shipping o - Recording o - Cash collection o - Sales return 3. Common entries: o - Sales – a sales order is prepared by an employee of the Customer Order department. All documents connected to sales should be prenumbered consecutively and, if paper, missing forms should be accounted for. o - Sales returns and allowances – personnel independent of cash collection and recording should review Customer requests for adjustments on returned goods. a. An approved request is documented as a credit memorandum. b. Returned goods are handled through the Receiving department and returned to the warehouse along with a receiving report. Inventory Control personnel match the receiving report with a copy of the credit memorandum. • - Cash receipts – the revenue/receipt cycle is completed for a transaction when cash is collected. Personnel involved in cash collection are segregated from Accounts Receivable, General Accounting, and Billing, since combining cash collection with any of these other three functions provides opportunities to misappropriate cash. • - Allowance for uncollectible accounts – A/R personnel should review individual customer accounts periodically as a check against unauthorized credit limits and prepare monthly A/R trial balances for reconciliation with general ledger control accounts. Delinquent accounts should be reviewed periodically by personnel who report to the treasurer and are independent of recording functions. • - Write off of specific accounts – when an individual customer account is judged to be uncollectible, written authorization to write off the account is sent to A/R and to General Accounting.

4. Common forms: • - Customer order – request from a customer to purchase goods. • - Sales order – identifies goods ordered by a customer, including relevant information about price, quantity, payment terms, etc. • - Shipping document – identifies goods shipped and represents a contract between the seller and carrier. • - Sales invoice – identifies goods sold and represents formal notice to a customer about the amount and terms of payment. • - Customer remittance advice – accompanies a sales invoice but is intended to be returned with a customer’s payment; a returned remittance advice indicates the purpose of a cash payment, facilitating handling and recording. 5. Internal control objectives and potential errors or frauds 1. Control objectives are summarized in the following categories. If the control objectives are not achieved error or fraud may occur: a. Transaction Authorization – before accepting a customer’s sales order, the customer’s credit should be approved, guarding against shipments made to poor credit risk customers, potentially resulting in uncollectible receivables. • - Management should establish unit prices and sales terms that are consistent with the company’s revenue objectives and cash flow needs. • - Management should establish written policies for sales-related deductions and adjustments. Forms should be numbered and controlled. b. Transaction Execution – goods should be shipped on a timely basis. Management should establish policies for scheduling prompt shipment and for verifying that ordered products are in stock. • - Following shipment, customers should be billed promptly avoiding losses arising from unbilled shipments or from delayed cash collections. • - Management should establish procedures to investigate unbilled shipments promptly. • - Management should require prenumbered shipping documents, periodically assuring that all sequentially numbered documents result in timely billing. c. Recording – all sales, cash receipts, and related transactions should be recorded at correct amounts, in the proper period, and be classified properly within the accounts. • - Management can control the recording function by establishing written procedures, reconciling control totals and periodically comparing actual results with budgets, if available. • - Management should also establish procedures to assure that recorded receivables balances fairly reflect the underlying transactions and events they represent. • - To control the recording of receivables, management could periodically substantiate and evaluate individual customer balances and reconcile supporting detailed ledgers to the general ledger.

d. Access to Assets – within the revenue/receipt cycle, management attempts to safeguard assets by restricting access to cash and cash-related records, controlling against loss or diversion and against misstated cash balances. • - Management could establish procedures to prenumber and control remittance advices, prepare separate lists of incoming mail receipts, and periodically reconcile cash receipts records to deposit slips and bank statements. • - Management should also limit physical access within Shipping, Billing, and Inventory Control, primarily to avoid the misappropriation of assets between or among related departments. 6. Considering internal control in a financial statement audit The focus of the internal control section of the chapter is on the application of audit procedures to the tests of controls in the revenue/receipt cycle. This involves: 1. Obtaining an understanding of the controls – an auditor’s objective when considering internal control is to obtain an understanding of a client’s prescribed policies and procedures sufficient to plan the audit. •

- Performing a preliminary review – an auditor begins considering a client’s internal control by developing a general understanding of the control environment; the control procedures; and how the entity identifies, captures, communicates, and monitors external and internal conformation in a form and time frame that enables employees to discharge their assigned responsibilities.

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- Documenting the system – auditors typically document an entity’s internal controls with flowcharts, questionnaires, and/or written narratives. 1. Questionnaires – are designed to detect control deficiencies and typically require one of three responses for each question; yes, no or N/A 2. Narratives – describe in prose one or more phases of management’s controls. 3. Flowcharts – provide concise, informative, and unambiguous descriptions of internal controls and are used when an entity’s system is complex and processes large volumes of transactions.

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- Performing a transaction walk-through – an auditor tests his or her understanding of a system by performing a transaction walk-through.

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- Determining whether existing control procedures is potentially reliable in assessing control risk below the maximum – once an auditor understands an entity’s internal controls and determines that the controls are potentially reliable in assessing control risk below the maximum, he or she continues to: 1. Identify the system’s control objectives 2. Consider the potential errors or frauds that might result if specific control objectives are not achieved.

Determine what control procedures management uses to prevent or detect potentially material errors or frauds. Design tests of controls: • - Shipping – weaknesses in the Shipping department controls present two major risks for errors or frauds: Goods may be shipped without authorization, or shipped goods may not be billed and recorded at all. Tests of controls for Shipping are intended to determine whether shipments are made only in accordance with approved sales orders and whether shipments have been billed and recorded properly. • - Billing – tests of controls for billing focus on whether billed goods have been shipped and whether bills are accurate and have been prepared properly and recorded. • - Recording – the objective of all three tests for recording is to determine whether details are summarized, periodically reconciled, and accurately posted to sales journals, to the accounts receivable ledgers, and to the general ledger. • - Cash Collection – an entity’s cash collection activities are particularity susceptible to frauds. Tests of controls over cash collections are designed to detect misappropriation of cash receipts and lapping. à Lapping – a fraud that conceals cash shortages resulting from delays in recording cash collections. • - Sales Returns and Allowances – an auditor’s tests of controls for sales returns and allowances focus on whether credit memoranda are approved and recorded properly. • - Uncollectible Accounts – an auditor’s tests of controls over uncollectible accounts focus on whether write-offs are properly authorized and recorded.

TESTS OF CONTROLS IN THE EXPENDITURE/DISBURSEMENT CYCLE:PURCHASES AND CASH DISBURSEMENTS TRANSACTIONS THE EXPENDITURE/DISBURSEMENT CYCLE The expenditure/disbursement cycle encompasses both the acquisition of goods and services and the payment of cash for the goods and services acquired. 1. Two major business functions are associated with the cycle: o - Resources (goods and services are acquired from vendors and employees in exchange for obligations to pay. o - Obligations to vendors and employees are paid. 2. Paper or computer image documents affecting the expenditure/disbursement cycle include: o - Purchase requisition – a request from an employee or department supervisor that goods be purchased. o - Purchase order – a request issued by the Purchasing department to a vendor to purchase goods. o - Receiving report – identifies information about goods received from a vendor. o - Vendor’s invoice – identifies goods purchased and represents formal notice about the amount and terms of payment (often called the bill). o - Voucher package – the purchase requisition, purchase order, receiving report, and invoice. Often includes a summarizing document, the voucher.) 3. Common activities: - Purchasing – involves the acquisition of goods and services from vendors. o Goods include tangible resources, such as inventory, supplies, and equipment. o Services include nontangible resources, such as advertising, repairs and maintenance, utilities, and insurance. o An employee of the department that requests the purchase prepares a purchase requisition, which is submitted to a supervisor for approval. o Approved purchase requisitions are forwarded to Purchasing, where the request is reviewed, a vendor selected, and a purchase order prepared. o A purchase order describes the goods or services requested, specifying the price, quantity, shipping terms, and catalog numbers. o Purchasing sends copies of purchase orders to the vendor and to the requisitioning department, to Receiving, and to Accounts Payable. - Receiving – goods ordered from vendors are delivered to the Receiving department, where the goods are compared with the purchase order and a receiving report is prepared. o The Receiving department maintains a receiving log cross-referenced to related receiving reports. o A copy of the receiving report is forwarded to Purchasing and to Accounts Payable. - Recording – Accounts Payable compares purchase requisition, purchase order, receiving report, and vendor’s invoice. o Accounts Payable prepares the voucher upon receipt of a vendor’s invoice. o A voucher package is filed in an unpaid vouchers file by due date.

o A copy of the daily summary of vouchers is forwarded to General Accounting for recording in a voucher register. o Column totals in the voucher register are posted to general ledger accounts. - Payment – cash disbursements should be authorized and executed by personnel who report to the treasurer and are independent of purchasing and recording. o Voucher packages in the unpaid voucher file are forwarded to the Treasury department, prior to the date payment is due. o The Treasury department reviews voucher packages for accuracy and authenticity before approving vouchers for payment and submitting vouchers for check printing. o Blank checks should be prenumbered and voided checks should be retained and accounted for. o Unused checks should be controlled physically; limiting access to authorized personnel only. o Drawn checks and approved supporting vouchers should be reviewed by an individual not otherwise involved in either processing or recording payables. o Signed checks should be mailed directly to the payee without intervention by employees responsible for approving, recording, or processing the transaction. o Paid voucher packages should be cancelled immediately. Cancellation prevents duplicate payments and is often accomplished by perforating the voucher package or by notation son a computer screen. Cancelled voucher packages, with check numbers on the vouchers should be filed. o A daily summary of all remittances should be prepared and forwarded to Accounts Payable for posting to subsidiary payables ledger and to General Accounting for recording in the voucher register. INTERNAL CONTROL OBJECTIVES AND POTENTIAL ERRORS OR FRAUDS Control objectives are summarized in the following categories: - Transaction authorization – effective control over an entity’s purchasing activities requires that purchases be made only in accordance with general or specific authorization. o All purchases should be initiated by user departments and approved by authorized supervisors. o Goods or services should not be ordered in the absence of authorized purchase requisitions. o Management should approve vendors before Purchasing executes an order. o Management should also establish policies for the types, quantities, payment terms, and prices of good and services purchased. o Management should maintain current price lists and actively seek suppliers whose goods or services optimize price and quantity. Where applicable, competitive bids or formal price quotations should be obtained from suppliers.

- Transaction execution – goods should be inspected for quality when received, and quantities should be verified by physical count and compared with purchase orders. o Management should require that Receiving personnel inspect and count all received goods before releasing the carrier. o Management should institute policies to assure that cash is disbursed only for bona fide liabilities, protecting against disbursements for goods not received, payment to unauthorized parties, and duplicate payments. o To control against improper disbursements, management could prenumber and control vouchers and checks, require a second manual signature for checks exceeding pre specified amounts, and cancel paid voucher packages immediately upon payment. - Recording – after purchase transactions are executed, all goods and services received should be reported promptly to Accounts Payable, indicating title has passed, and to Purchasing, indicating ordered goods have been received. o To protect against inaccurate account balances and against misstated financial statements, management should institute policies to assure that all purchases and cash disbursements are recorded properly and in the proper period. o To control against inaccurate vendor accounts, management could establish validation procedures to verify postings, and reconcile input totals to processed and output totals. o Authorized personnel should investigate correspondence from vendors, particularly collection notices. - Access to assets – management should establish procedures to safeguard assets by restricting access to purchasing and cash disbursement records and forms. For each of the categories, the types of errors or frauds that could occur if the control objective is not met, and the control procedure designed to prevent or detect the error or fraud is described. Considering internal control in a financial statement audit The focus of the internal control section of the chapter is on the application of audit procedures to the tests of controls in the expenditure/disbursement cycle. This involves: 1. Obtaining an understanding of the controls – an auditor obtains an understanding of internal control in four steps. a. Perform a preliminary review – auditors will interview client personnel and review accounting procedures manuals to develop a general understanding of the client’s control environment, accounting system, and how the entity identifies, captures, communicates, and monitors external and internal information in a form and time frame that enables employees to discharge their assigned responsibilities. - The preliminary review determines whether investing additional audit effort is likely to support a decision to assess control risk below the maximum allowing the auditor to assess detection risk above the minimum and restrict the extent of substantive tests for the very account balances that are processed through the expenditure/disbursement cycle.

If existing controls are inadequate to justify assessing control risk below the maximum, then the auditor’s documentation of the system is limited simply to a memorandum in the working papers that describes the reasons for not continuing to consider internal control. 2. Document the system – this can be accomplished with the use of flowcharts, questionnaires, and/or narratives. 3. Perform a transaction walk-through – to confirm an auditor’s understanding of the system of internal control, the auditor can select a cancelled voucher package and compare the purchase requisitions, purchase order, receiving report, and invoice for compliance with company policies and with documents filed in Purchasing, Receiving, and Accounts Payable. System documentation would be revised if the transaction walk-through revealed that the auditor’s understanding of internal control is inaccurate. 4. Determining whether existing control procedures are potentially reliable in assessing control risk below the maximum – following system documentation, and assuming that controls are potentially reliable in assessing control risk below the maximum, an auditor: - Identifies the system’s control objectives. - Considers potential errors or frauds that might result if specific control objectives are not met. o - Determine what control procedures management uses to prevent or detect potentially material errors or frauds. o - Design tests of controls.

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Those control procedures relevant to management’s financial statement assertions about accounts payable, prepaid expenses, and accrued liabilities are subjected to tests of controls.

TESTS OF CONTROLS OF PERSONNEL AND PAYROLL THE PERSONNEL AND PAYROLL FUNCTION (AN EXTENSION OF THE EXPENDITURE/DISBURSEMENTS CYCLE) Business functions - the services of employees are acquired in exchange for obligations to pay and those obligations are paid. Personnel and payroll are critical to most entries for at least three reasons: I. Salaries and wages are a major expenditure for most service, manufacturing, and nonprofits entities. II. In manufacturing companies, labor is an important component in valuing inventory and, if misclassified, both inventory and cost of goods sold could be misstated materially. III. Payroll typically includes several categories of employee compensation and bonuses, overtime, vacation pay, and employee benefits such as pensions, health care, and profit sharing. Personnel and payroll activities include: • ¬ Hiring and terminations, • ¬ Payroll preparation and recording, and • ¬ Distribution of payroll checks to employees. Journal entries are made for: ¬ Wage and salary payments, ¬ Account distributions, and ¬ End of period accruals.

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