AT+Lecture++8++-+Tests+of+Transaction+Cycle

DE LA S ALLE UNIVERSITY UNIVERSITY MANILA RVR – RVR – COB  COB DEPARTMENT OF ACCOUNTANCY INTTHRY 2nd Term AY 17 - 18  Audi  Au di ti ng Theo ry

AT - Lect Le ctur ur e 8 Prof. Francis H. Villamin

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“TESTS OF CONTROLS OF TRANSACTION CYCLES”  A. TESTS OF CONTROLS CONTROLS IN THE REVENUE/REC REVENUE/RECEIPT EIPT CYCLE: CYCLE: SA LES 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: a. Receives resources and information information provided by the financing and conversion cycles, cycles, and b. Provides resources resources and and information information to the expenditure/disbursement cycle. 1.

Business functions associated with this cycle: Resources are sold to to customers customers in exchange exchange for promises promises of future payment Cash is collected from customers.

2.

Common activities: Customer order (the cycle begins at this point when the customer’s order is received by fax, mail, e-mail, telephone, or EDI). Credit approval Inventory control Shipping Recording Cash collection Sales return

3.

Common entries: Sales  – a  – 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. 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 documented as a credit memorandum. memorandum. b. Returned goods are handled handled through the Receiving Receiving department and returned to the warehouse along with a receiving report. Inventory Control personnel match the receiving report with a copy of the credi t 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. -  All ow anc e fo r un co ll ect ib le acc ou nt s  – A/R  – 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. Common forms: Customer order  – request  – request from a customer to purchase goods. Sales order  – order  – identifies  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 Sales invoi ce – ce  – identifies  identifies goods sold and represents formal notice to a customer about the amount and terms of payment. Customer remittance advice – advice  – accompanies  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.

4.

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Internal control objectives and potential errors or frauds 1. Control objectives are summarized summarized in the following following categories. If the control control objectives are are not achieved error or fraud may occur: a.

Transaction Transaction Authorization – Authorization  – before accepting a customer’s sales ord er, 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 prices and sales terms terms that are consistent consistent with with the company’s revenue objectives and cash flow needs. Management should establish written policies for sales-related deductions 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, shipment, customers should be billed promptly promptly avoiding losses arising from unbilled shipments or from delayed cash collections. Management should establish procedures to investigate unbilled shipments shipments promptly. Management should require prenumbered shipping documents, 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 function by establishing written procedures, reconciling control totals and periodically comparing actual results with budgets, if available. Management should also establish establish procedures procedures to assure that recorded receivables balances fairly reflect the u nderlying 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.  Acc ess to Asset As set s  –   –  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 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 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. Documenting the system – system  – auditors typically document an entity’s internal controls with flowcharts, questionnaires, and/or written narratives. a. Questionnaires – Questionnaires  – are  are designed to detect control deficiencies and typically require one of three responses for each q uestion; yes, no or N/A b. Narratives – Narratives  – describe in prose one or more phases of management’s management’s controls. controls. . 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. Performing a transaction walk-through  – an  – an auditor tests his or her understanding of a system by performing a transaction walk-through. Determining whether existing control procedures is potentially reliable in assessing control ris k below the maximum maximum –  – once an auditor au ditor 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: a. Identify the system’s control objectives b. Consider the potential potential errors or frauds frauds that might result if specific specific control objectives are not achieved.

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c.

Determine what control procedures management management uses to prevent or detect potentially material errors or frauds. d. Design tests of controls: Shipping  – weaknesses  – 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 – Recording – the  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 receivable ledgers, and to the general ledger. Cash Collection  – an entity’s cash collection activities are particularity susceptible to frauds. Tests of controls controls over cash collections are designed to detect misappropriation of cash receipts and lapping.  Lapping  –   –  a fraud that conceals cash shortages resulting from delays in recording cash collections. Sales Returns and Allowances – Allowances  – an auditor’s tests of controls for sal es 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.

B. TESTS OF CONTROLS IN THE EXPENDITURE/DISBURSEME EXPENDITURE/DISBURSEMENT NT CYCLE:PURCHASES CYCLE: PURCHASES AND CASH DISBURSEMENTS TRANSACTIONS

THE EXPENDITURE/ EXPENDITURE/DISBURSEMENT DISBURSEMENT CYCLE The expenditure/disburs expenditure/disburs ement ement c ycle encompasses ycle encompasses both the acquisition of goods and services and the payment of cash for the goods and services acquired. 1.

2.

3.

Two major major business functions are associated with with the cycle: Resources (goods and services are acquired acquired from from vendors and employees in exchange exchange for for obligations to pay. Obligations to vendors and employees are paid. Paper or computer image documents documents affecting the expenditure/disbursement expenditure/disbursement cycle include: Purchase requisition  – a  – a request from an employee or department supervisor that goods be purchased. Purchase order  – a  – a request issued by the Purchasing department to a vendor to purchase goods. Receiving Receiving report – report  – identifies  identifies information about goods received from a vendor. Vendor’s invoice  –   –  identifies goods purchased and represents formal notice about the amount and terms of payment (often called the b ill). Voucher package – package – the  the purchase requisition, purchase order, receiving report, and invoice. (Often includes a summarizing document, the voucher.) Common activities: Purchasing – Purchasing – involves  involves the acquisition of goods and services from vendors. o Goods include Goods  include tangible resources, such as i nventory, supplies, and equipment. o Services include Services  include nontangible resources, such as advertising, repairs and maintenance, utilities, and insurance. o An employee employee of the department that requests the purchase prepares a purchase requisition, which is submitted to a supervisor for a pproval. o  Appr  Ap pr ov ed pu rc has e req ui si ti on s  are forwarded to Purchasing, where the request is reviewed, a vendor selected, and a purchase order prepared. A purchase order describes the goods or services requested, specifying the price, o quantity, shipping terms, and catalog numbers. Purchasing sends copies of purchase orders orders to the vendor and to the requisitioning requisitioning o department, to Receiving, and to Accounts Payable. -

Receiving  – goods  – 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 department maintains maintains a receiving log cross-referenced to to related receiving reports. A copy of the receiving report is forwarded to Purchasing Purchasing and to Accounts Payable. o

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Recording  –   –  Accounts Payable compares purchase requisition, purchase order, receiving report, and vendor’s invoice.  Acc ou nt s Pay abl e prepares the voucher upon receipt of a vendor’s invoice. o A voucher package is package is filed in an unpaid vouchers file by due date. o A copy of the daily summary summary of vouchers is forwarded forwarded to General Accounting for o recording in a voucher register. o Column totals in the voucher voucher register register are are posted posted to general ledger accounts.

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Payment – Payment – cash  cash disbursements di sbursements 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  checks   should be prenumbered and voided checks should be retained and accounted for. o Unused Unused c hecks should hecks should be controlled physically; limiting access to authorized personnel only. o Drawn Drawn c hecks and hecks  and approved supporting vouchers should be reviewed by an individual not otherwise involved in either processing o r recording payables. Signed checks  checks   should be mailed directly to the payee without intervention by o employees responsible for approving, recording, or processing the transaction. o Paid voucher packages  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  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 OBJECTIV OBJ ECTIVES ES AND POTENTIAL ERRORS OR FRAUDS Control objectives are summarized in the following categories: - Transaction Transaction authorization – authorization  – effective control over an entity’s purchasing activities requires that purchases be made only i n accordance with general or specific authorization. All purchases should be initiated by user departments and approved by authorized o supervisors. o Goods or services should not be ordered in the the absence of authorized purchase requisitions. Management should approve approve vendors before Purchasing executes an order. o o Management should also establish policies for the the types, quantities, payment terms, and prices of good and services purchased. o Management should maintain current 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 that Receiving personnel inspect and count all all received goods before releasing the carrier. Management should institute policies to assure that cash is disbursed only for bona fide fide o liabilities, protecting against disbursements for goods not received, payment to unauthorized parties, and duplicate payments. o To control control against improper disbursements, disbursements, management could prenumber 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 – Recording  – after  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. To protect against against inaccurate account account balances and against misstated financial financial o statements, management should institute policies to assure that all purchases and cash disbursements are recorded properly and in the proper period. To control control against inaccurate vendor accounts, management management could establish validation o procedures to verify postings, and reconcile input totals to processed and output totals. o Authorized personnel personnel should should investigate correspondence from from vendors, particularly particularly collection notices.

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 Acces  Ac ces s t o as set s  – management  – management should establish procedures to safeguard assets by restricting access to purchasing and cash di sbursement records and forms.

For each of the categories, the types of errors or frauds that could occur if the control objective i s not met, and the control procedure designed to prevent or detect the error or fraud is described.

Considering internal control in a financial statement 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 prelim inary 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 iden tifies, 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 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 con tinuing to consider internal control.

b.

Document the system  –   –  this can be accomplished with the use of flowcharts, questionnaires, and/or narratives.

c.

Perform 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 i n Purchasing, Receiving, and Accounts Payable. System documentation would be revised if the transaction walk-through revealed that the auditor’s auditor’s understanding of internal control is inaccurate.

d.

Determining Determining whether existing contro l procedures are potentially reliable in assessing control risk below the maximum  – following system documentation, and assuming that controls are potentially reliable i n assessing control risk below the maximum, an audi tor: - Identifies the system’s control objectives. - Considers potential errors errors or frauds that that might might result if specific specific control objectives are not met. - Determine what control procedures management uses to prevent or detect potentially material errors or frauds. - Design tests of controls. 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: PURCHASING AN D CASH DISBURSEMENTS In respect to high-volume high- volume transactions like purchases and cash disbursements, an auditor’s strategy is to expend significant audit effort performing tests of controls, since evidence supporting the assessment of control risk below the maximum would justify restricting substantive tests of account balances at year end.

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TESTS OF CONTROLS CONTROLS OF PERSONNEL PERSONNEL A ND PAYROLL

THE PERSONNEL AND PAYROLL EXPENDITURE/DIS EXPENDITURE/DISBURSEMENTS BURSEMENTS CYCLE)

FUNCTION

(AN

EXTENSION

OF

THE

Business Business functions functions - the services of employees are acquired in exchange for obligations to pa y and those obligations are paid. - Personnel and payroll are critical critical to most entries for at least three reasons: I. Salaries and wages wages are a major major expenditure for most most service, manufacturing, manufacturing, and nonprofits nonprofits entities. II. In manufacturing companies, companies, labor is an important component in valuing valuing inventory and, if misclassified, both inventory and cost of goods sol d could be misstated materially. III. Payroll typically includes several categories of employee employee compensation and bonuses, overtime, vacation pay, and employee benefits such as pensions, health care, and profit sharing. Personnel Personnel and payroll activiti es include: 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. Documents include: Personnel record s : includes information for each employee, including date of employment, job  Personnel classification, salary or hourly pay rate, promotions, payroll deductions, terminations, etc.  Time Recor Recor d : hours worked by an employee during a pay period.  Payroll Register : a record of gross pay, withholdings, deductions, and net pay for each employee for a pay period; the basis for preparing pay checks, recording payroll, and updating employee earnings records.  Employee earnings earnings record: record : a cumulative, year-to-date summary of total earnings, withholdings, and deductions for each employee.  All action taken by management on behalf of an employee should be approved by both department supervisors and by the Personnel department, and should be documented in an employee’s personnel records. Personnel Personnel records include:  Salary or wage rates,  Payroll deductions,  Employee signatures,  Job classifications, and  Performance evaluations. To minimize chance of fraud, personnel records should not be accessible to employees who are responsible for preparing, approving, or distributing payroll. When employees are terminated, the Personnel department should determine the nature and terms of any related termination settlement and notify the Payroll department of the settlement and termination. INTERNAL CONTROL OBJECTIVES AND POTENTIAL ERRORS OR FRAUDS Control objectives are summarized in the foll owing categories: -Transaction authorization  –   –  management should establish criteria for hiring line and staff employees. Otherwise, unqualified employees may be hired, potentially resulting in excessive training costs, unnecessary relocation costs, or penalties for violating equal opportunity laws, among other things. unauthorized hiring, management should establish written hiring policies.  To control against unauthorized  Verify all information included in employment employment applications.  Maintain updated personnel records for all employees.  Authorize compensation and payroll deductions. the  Establish written policies for pay rate adjustments and communicating the policies to the Personnel department and to operating department supervisors.

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-Transaction execution  –   –  to control against disbursements for work not performed, all disbursements for payroll should be based on a recognized liability.  Management can control unauthorized unauthorized payroll disbursements disbursements by requiring a second, manual signature for all unusual or excessive paycheck amounts. payroll procedures manuals and and advertise available  Companies should establish personnel and payroll  job openings widely throughout the company. company. - Recordin Recordin g  – all  – all amounts owed to employees should be recorded at the properly amounts and in the proper period, and should be classified properly. against improper recording, recording, management management could establish establish account distribution, distribution, and  To control against labor cost allocation procedures and reconcile appro priate ledgers, journals, and su mmaries. - Access to assets  – to  – to control against misapplied cash and unauthorized labor costs, management should institute policies that restrict access to personnel and payroll records to authorized personnel only. - Segregation of duties  –   –  to assure adequate segregation of duties, Personnel department responsibilities should be separated from cash disbursements and operating departments. CONSIDERING CONSIDERING INTERNAL CONTROL 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 invol ves: 1.

Obtaining an understanding of the controls  – when  – when an auditor attempts to determine how the system is supposed to work and whether control procedures have been prescribed by management to assure that the system is functioning as planned. This involves:  Performing Performing a preliminary review – review  – when  when an auditor develops a general understanding of a client’s control environment, the flow of transactions and records re cords through the accounting system, and the control procedures management has implemented to prevent and detect errors or frauds.  Documenting the system  –   –  the process when auditors use narratives, flowcharts, and questionnaires to describe the payroll sy stem.  –  to confirm his or her understanding of the  Performing a transaction walk-through  –  system documented, the auditor could select a line item from a processed payroll register and trace the information: 1. To time records summarized in the the Payroll department and filed in the Inventory  Accounting department and 2.

To records records maintained maintained in the Personnel department.  Determining whether existing controls are potentially reliable in assessing control ri sk below the maximum. maximum.  Identify the systems control objectives  Consider the potential errors errors or frauds that that right result if specific control control objectives are not met.  Determine what what control procedures are used by the entity entity to prevent or or detect potentially material errors or frauds.  Design the tests of controls.

C. TESTS OF CONTROLS CONTROLS IN THE CONVERSI CONVERSION ON CYCLE: INVENTORY and FIXED ASSETS

THE CONVERSION CYCLE 1.

2. 3.

The conversion cycle –encompasses  –encompasses the production of finished products for sale, and relates directly to two other cycles:  It uses resources and information information provided by the expenditure/disbursement expenditure/disbursement cycle  Provides resources and information to the revenue/receipt cycle Business functions –the  –the production of finished products for sale. Common activities: a. Inventory - Maintaining perpetual records  –   –  Throughout the conversion cycle, journal entries are made to process inventory costs through production, to record the cost of goods sold, and to write down obsolete or damaged inventory. Paper or computer images documents include:  Labor charge report: report : A summary of labor costs to be applied to work in-process inventory.

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Materials Materials requisitio n : An operating department’s formal request for materials. Perpetual Perpetual inventory record: record : A cumulative record of quantities on hand for an item or a class of inventory.

Fixed assets – assets  – are  are related both to the conversion cycle and to inventory: conversion cycle because fixed assets transform transform inventory from raw materials  To the conversion to finished goods, and  To inventory because some some depreciation is applied to products as overhead. overhead. Throughout the conversion cycle, journal entries entries are made made to record depreciation and to to apply overhead to inventory. Paper or computer image documents include:  Depreciate Depreciate s chedule: chedule: A spreadsheet computing and summarizing depreciation.  Overhead application report: report : A summary of overhead applied to work-in-process inventory.

Inventory and Internal Control The acquisition of inventory is part of the expenditure/disbursement cycle, and the distribution of finished goods is a part of the revenue/receipt cycle. The conversion cycle encompasses movement of goods through the production process. Inventory control  A materials requisition form is prepared by production personnel to request materials and supplies for use in production. o Requisitions should be approved by a supervisor and forwarded to Inventory Control. o Inventory Control Control personnel personnel should not release materials materials and supplies supplies in the absence of an approved requisition. personnel not involved in purchasing, purchasing, receiving, shipping, production, production, or  Inventory Control personnel recording should control raw materials and finished goods. o Access to storage areas should be limited to to authorized authorized personnel. Control personnel should should be responsible responsible for controlling transfers transfers in and out of storage storage  Inventory Control areas, and for monitoring inventory levels and for reporting slow-moving or damaged items. o Inventory levels should should be monitored monitored to assure that they are neither too high, resulting in needlessly high carrying costs, or too low, which coul d risk insufficient quantities on hand. Inventory accounting  – involves two major sets of records: perpetual inventory records and cost records.  – inventory quantities, physical locations, and selected unit cost  Perpetual Inventory Records  – inventory information usually are accumulated on perpetual inventory records maintained for a variety of major inventory classifications, including supplies, raw materials, and finished goods. Work-in-process inventory Work-in-process inventory should also be controlled on perpetual records. o o As inventory flows through the production process, process, perpetual perpetual records should be updated continually, thereby providing a cumulative up-to-date record of quantities, physical location, and selected unit cost information. o Off-premises inventory  inventory   should be accounted for and controlled by the outside parties holding the goods. Periodically, a company should confirm off-premises inventory, physically count quantities at off-premises locations, and reconcile confirmed or counted quantities with internal perpetual records. 

Cost records – records  – An  An inventory accounting system must must account for inventory costs, which may be allocated on a FIFO, LIFO, average cost, or other a cceptable basis. o Like perpetual inventory records, cost accounting accounting records and reports should be updated continually, thereby providing an up-to-date record of accumulated costs. The updated information should should be communicated communicated to General Accounting Accounting personnel for for o summarizing and for recording journal entries in general ledger control accounts. o If updated information is not communicated to the the Accounting department, accounts such as Raw Materials, Work in Process, and Finished Goods coul d be misstated. To maintain segregation of duties, cost accounting records should be maintained by o personnel independent of perpetual records, general accounting, purchasing, production, and inventory control.

FIXED ASSETS AND INTERNAL CONTROL 1.

Land, building, machinery, and and equipment should be documented in detailed detailed records that account separately for each individual asset.  Detailed records might might include the purchase purchase date, historical historical cost, depreciatio depreciation n method, method, estimated useful life, salvage value, and accumulated depreciation. controlling fixed assets should should maintain the records. records.  Personnel not responsible for physically controlling with fixed asset  Periodically, but no less than annually, detailed records should be reconciled with general ledger control accounts.

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Responsible personnel independent of fixed asset recording and physical physical control should periodically determine that recorded assets actually exist by observing machinery and equipment and by comparing identification numbers and general descriptions with detailed records. Fixed assets should be insured against fire or other potential potential casualties. Assets should be appraised periodically to determine that insurance coverage reasonably approximates replacement cost.

2.  Addi  Ad di ti on s : Individual fixed asset addi tions are often material, necessitating specific authorization by the board of directors or by senior management.  Formal authorization is required for major repairs or improvements; improvements; since the expenditures expenditures may be large, management should assess the desirability of replacing, rather than repairing and improving, existing assets.  Authorizations should be documented in writing.  Procedures should require that actual costs be compared compared with amounts amounts authorized, and cost overruns reported to senior management for authorization.  Constructed additions should also be authorized, authorized, and additional controls should be implemented that allow the entity to inspect and approve both actual production and detailed cost records as construction progresses. 3.

Disposals:  Disposals:   Senior management should authorize fixed asset disposals, such as sales or retirements. Authorizations should be documented, and copies forwarded to accounting personnel to assure that assets disposed of are subsequently removed from fixed asset accounts.  Asset disposals should should be reported to insurance companies and premiums adjusted adjusted accordingly. assure that proceeds are deposited and and gains or losses  Controls should be established to assure are recorded.

4.

Depreciation:   Due to the significant impact depreciation expense can have on reported net income, an entity should maintain formal policies for determining depreciation methods, estimated useful lives and salvage values.  Periodically, the policies should be reviewed reviewed to determine determine whether they reasonably approximate actual experience.

5.

Control objectives, potential potential errors or frauds, frauds, and control procedures procedures are summarized summarized in the following categories: - Transaction Authorization  –   –  Fixed asset additions, disposals, and retirements should be authorized in accordance with management’s criteria. To control control unauthorized transactions, management could develop written procedures for  all additions, disposals, and retirements, and periodically compare scrap sale prices with published price lists. - Transaction Execution  –   –  Management should establish procedures for operating, using, physically moving, and restricting access to movable fixed assets. -

Recording  –   –  To avoid unreported transactions, fixed asset additions, disposals, and retirements should be recorded at the correct amount, be recognized in the proper period, and be classified properly. Unrecorded or improperly recorded transactions could result in misstated fixed asset accounts and misstated financial statements.  Management can control the recording recording function by establishing procedures for processing and recording fixed asset transactions and for identifying fixed asset eligible for sale or retirement. maintained and periodically periodically reconciled with  Detailed fixed asset records should be maintained existing accounts.  The expiration of future service potential  –   –  depreciation and amortization  –   –  should be calculated in accordance with management’s authorization and be recorded in the proper period.  Managements should establish polices for determining depreciation methods methods and for calculating depreciation on all fixed assets.

- Access to Assets – Assets – To  To control against stolen or lost fixed assets, access should be restricted to personnel authorized by management.  Management should establish establish physical controls over unused assets, maintain maintain adequate insurance coverage, and segregate the physical custody of fixed assets from recording and general accounting.  To control fixed assets records, management management should establish controls controls over unused forms and records or could coul d perform periodic compliance audits, reconciling recorded assets with existing assets.

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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 t o prevent or detect the error or fraud is described. CONSIDERING CONSIDERING INTERNAL CONTROL: INVENTORY INVENTORY & FIXED ASSETS 1. The focus of the the internal control control section of the chapter is on the application of audit procedures to the tests of controls in the conversion cycle as applied to inventory and fixed assets. This involves:  Preliminary review  –   –  An auditor performs the preliminary review for inventory by reading the client’s procedures manuals and by interviewing client personnel who are re sponsible for perpetual inventory records, cost records, and inventory accounting. o Assuming that that existing controls appear potentially reliable reliable in assessing control risk below the maximum, an auditor proceeds by documenting the system.  Documenting the system  –  An entity’s inventory control and inventory accounting procedures can be documented with flowcharts, questionnaires, and/or narratives, although detailed flowcharts are less common in practice.  –  To confirm his or her understanding of the  Performing a transaction walk-through  –  system, the auditor could trace one or several materials transfers from raw materials to work in process, to finished goods perpetual records, and to entries and postings in cost records, inventory accounting, and general accounting. Determining whether existing control procedures are potentially reliable in assessing assessing  Determining contro l risk below the maximum maximum Identify the system’s control objectives. o o Consider the potential errors errors or frauds that that might might result in specific control control objectives are not met. Determine which which control procedures are are used by the the entity to prevent to detect o potentially material errors or frauds. o Design tests of control. 2. Tests of controls over over inventory focus on whether transfers transfers of inventory through the production production process are authorized and recorded.  Perpetual Records  – tests of controls over an entity’s perpetual records focus on physical transfers of inventory to and from raw materials, work in process, and finished goods. could suggest that control procedures are neither compiled  Inaccurate recording of transfers could with, nor operating as planned, casting doubt on the reliability of the records.  Inaccurate recording could could suggest the possibilities possibilities of double-counted inventory quantities.  Cost Records: Records : tests of controls must be performed for the flow of inventory costs from raw materials to work in process, finished goods, and cost of goods sold. 3.  Asses  As ses s Contr Con tr ol Ris k  – an  – an auditor reviews system documentation and the results of tests of controls to determine whether existing control procedures can be relied on to assess control risk below the maximum, assess detection risk above the minimum, and to restrict substantive tests of inventory. The evaluation is based o n four issues:  The types of errors errors or frauds frauds that could occur,  Necessary control control procedures that should should prevent or detect the errors errors or frauds,  Whether the the necessary procedures exist and and are followed, and  Any deficiencies in internal control. CONSIDERING CONSIDERING INTERNAL CONTROL: FIXED ASSETS 1.

Obtain an Understanding  – compared  – compared to inventory, fixed asset transactions are considerably less numerous and individual transactions usually involve considerably larger dollar amounts. An auditor’s focus is different, since any one transaction alone could exceed the auditor’s tolerable error for fixed assets.  Preliminary Review – Review  – an  an auditor performs the preliminary review for fixed assets by reading the client’s procedures manuals and by interviewing client personnel who are re sponsible for fixed assets additions, disposals and retirements, and recording. potentially reliable in assessing control risk below the  Assuming that existing controls appear potentially maximum, an auditor proceeds by documenting the system. System  – flowcharts  flowcharts are seldom used to document fixed assets systems  Documenting the System – because the number of transactions is not likely to justify extensive flowcharting. Auditors use internal control questionnaires to identify apparent deficiencies and narratives to document procedures for fixed asset additions, disposals and retirements, and recording.  –  to confirm his or her understanding of the  Performing a Transaction Walk-Through  –  system, the auditor could trace an addition transaction, a disposal transaction, and a retirement transaction through the system and examine depreciation schedules for conformity with prescribed procedures.

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Determining Determining whether existing contro l procedures are potentially reliable in assessing contro l risk below the maximum maximum Identify the system’s control objectives. Consider the potential errors or frauds that might might result in specific control objectives objectives are not not met. Determine which which control procedures are used by the entity to prevent to to detect potentially potentially materials errors or frauds. Design tests of control.

Tests of Controls: Fixed Assets  – w hen the number of fixed asset transactions is limited, an auditor may forego or limit tests of controls, electing instead to assess control risk at the maximum, assess allowable detection risk at the minimum, and rely on substantive tests of  details. If the number of transactions is large, an auditor may elect to perform tests of controls over an entity’s recording, addition, disposal, and depreciation activities.  Fixed Asset Records  –   –  tests of fixed asset records focus on the relationship between detailed records and the general ledger and on the existence of, and insurance coverage for, recorded assets.   Addi  Ad di ti on s  – an auditor’s predominant concern in tests of fixed asset additions is that the related transactions are authorized and properly recorded.  Disposals – Disposals  – like  like additions, an auditor is concerned that fixed asset disposals are authorized and properly recorded.  –  tests of depreciation involve calculations and the review of recorded  Depreciation  –  amounts, useful lives, and salvage values. Similar tests are performed for the amortization of intangible assets and the depletion of wasting assets.  Asses  As ses s Con tr ol Ris k : an auditor reviews system documentation and the results of tests of controls to determine whether existing control procedures can be relied on to assess control risk below the maximum, assess detection risk above the minimum, and to restrict substantive tests of inventory. The evaluation is base on four issues:  The types of errors or frauds frauds that that could could occur, control procedures that should prevent or detect the errors errors or frauds, frauds,  Necessary control the necessary necessary procedures procedures exist exist and are followed, followed, and  Whether the  Any deficiencies in internal control.

D. TESTS OF CONTROLS CONTROLS IN THE THE FINANCING FINANCING CYCLE: INVESTMENTS, INVESTMENTS, DEBT DEBT & EQUITY

THE FINANCIAL CYCLE The financing cycle processes transactions and events that generate capital funds, and is directly related to two other cycles:  It uses resources and information provided by the expenditure/disbursement cycle, and  Provides resources and information to the revenue/receipt cycle. Two major business functions are functions  are associated with the cycle: Capital funds are received from investors and creditors.   Capital funds are used for operations or temporarily invested until needed for operations. Throughout the financing cycle, journal entries are made for the issuance and retirement of debt and capital stock and the acquisition and sale of investments. Common forms and documents include:  Bond certificate – certificate – a  a debt security document representing a stated a mount of corporate debt. Commercial paper  – a   – a general category of commercial loan instruments, due and payable in accordance with terms described on the instrument.  Stock certificate – certificate  – an  an equity security document representing o wnership of a stated number of shares of capital stock. Treasury Treasury bill  – a  – a debt instrument issued by the Philippine Government   Investments – Investments  – the  the financing cycle processes current and non current investments, directing resources into other private- and public-sector equity and debt instruments, with the objective of optimizing financial return on idle cash. Custody, Recording, and Valuation Valuation:: an entity’s investment securities are held in the custody  of either internal officials or independent external custodians, such as stock brokerage firms.    

If securities are maintained internally, at least two officials should be held jointly responsible, responsible, thereby minimizing the likelihood of unauthorized sales. Employees who do not otherwise have custody or access should count securities maintained by internal parties periodically on a surprise basis. An employee independent of the custodial function should maintain detailed records for securities held. Compiling information such as certificate numbers and quantities. If maintained externally, securities listings should be prepared by the custodian at least monthly, mailed to the company, and reconciled with internal records.

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 Acq ui si ti on s, Sales , and Inco me: all acquisitions and sales of current and non current securities should be authorized by the board of directors or an authorized investment committee. Recorded acquisition and selling prices should be compared with published price quotations assuring that transactions were recorded at accurate prices. Dividend income should be recognized when declared, interest income accrued when earned, and employees not otherwise responsible for the custody, acquisition, or sale of securities should recalculate gains and losses.

Debt  –   –  debt incurrence and retirement transactions are relatively few in number but are usually accompanied by extensive supporting documents, such as SEC filings and bond issuance authorizations from shareholders and the board of directors.  The board of directors should authorize all long-term debt. Authorizations should be expressly documented in the board’s minutes, clearly indicating maximum indebtedness and the names of officers authorized to negotiate each transaction. Debt instruments such as loan agreements contain restrictive covenants that, if violated, could  result in the debt becoming due immediately. Unissued bonds and notes should be prenumbered consecutively and controlled by an  employee who neither maintains detailed debt records nor has access to general accounting records. Periodically, an independent employee should physically inspect unissued debt instruments and account for the numerical sequence. Retired debt instruments should be either cancelled or destroyed. Records should be kept for  cancelled instruments, and affidavits from witnesses should be kept for destroyed instruments. Periodically, an independent employee should reconcile bond or note register with the general  ledger. An authorized employee should calculate interest expense in accordance with the terms of each instrument, and the resulting payments should be processed through the expenditure/disbursement cycle. Equity  –   –  the financing cycle processes equity issuance and retirement transactions, directing resources through the revenue/receipt and expenditure/disbursem expenditure/disbursement ent cycles, respectively.  All transactions relating to equity securities should be authorized by the board board of directors and documented.  All issuances and retirements should be be approved both in price and in quantity by the board of directors either specifically or generally, as in the case of authorized stock option plans.  Stock certificate should be pre numbered consecutively, signed by authorized officers when issued, and promptly cancelled when surrendered for retirement. Unissued certificates should be physically safeguarded with access limited to authorized  individuals.  Treasury shares that have not been retired and cancelled should be accounted for and controlled.  Periodically an independent employee should reconcile the shareholder’s ledger with the transfer journal.  An independent employee not otherwise responsible for maintaining shareholder records or processing dividend payments should reconcile the dividend bank account periodically. Internal Internal Control Objectives and Potential Errors or Frauds: Frauds: Investments, Investments, Debt, Debt, and and Equity Equity Control objectives are summarized in the foll owing categories:  Transaction Authorization & Execution  –   –  all investment acquisitions and sales should be authorized in accordance with management’s criteria. Lacking authorization, investments could be made in violation of company policies. approving investment transactions  Management could establish polices for selecting and approving and for obtaining capital funds, a nd prepare lists of authorized investments if necessary.  Journal entries that adjust investment carrying values and debt obligations should be authorized in accordance with with management’s criteria.  To control adjustments, adjustments, management could establish processing processing procedures, pre number number and control adjustment forms, and require specific authorization for adjustments exceeding pre-established amounts. Recording  –   –  all investment, debt, and equity transactions should be recorded at the correct  amounts, in the proper period, and classified properly, establishing processing and  Management could control against inaccurate records by establishing recording procedures, regularly reviewing board minutes for financing cycle resolutions, and preparing schedules of interest and loan payment due dates.  Ac ces s to Asset As set s  – access  – access to securities should be restricted to personnel and authorized by   Acces management. responsible for approving approving investments investments should not be responsible responsible for recording recording or  Personnel responsible for maintaining custody of securities.  Access to accounting accounting records and forms forms should be restricted to to personnel authorized by by management.

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Management could control access by establishing physical barriers over pre numbered forms and records and by carrying insurance and fidelity bonds. Officials responsible for for unissued, issued, and retired securities should not be responsible for physically controlling securities or for p erforming erforming accounting or cash activities.

For each of the above 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 Internal Control in the Financing Cycle The focus of the internal control section is on the application of audit procedures to the tests of controls in the the financing cycle. cycle. This involves -

Obtaining an understanding of the controls Documenting the system Performing a transaction walk-through Determining whether existing control control procedures are potentially potentially reliable reliable in assessing control control risk below the maximum

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