CHAPTER 19

TESTS OF CONTROLS

Questions and Answes

A test of controls is an audit procedure to test the effectiveness of a control
used by a client entity to prevent or detect material misstatements. Depending
on the results of this test, auditors may choose to rely upon a client's system
of controls as part of their auditing activities.

Substantive test is an audit procedure that examines the financial statements

and supporting documentation to see if they contain errors. This test is
needed as evidence to support the assertion that the financial records of an
entity are complete, valid, and accurate.
Lapping occurs when a cashier or clerk steals cash from one customer's
payment and covers it up by stealing cash from the next customer's
payment ... and so on.
Blind” Purchase Order is one that does not show the quantity ordered. It is
given to the receiving department so personnel there will know what has been
ordered, but they will have to do an independent count. If a blind purchase
order is not used, receiving personnel may not count the goods received and
just record ...
Consignment Sale: Trading arrangement in which a seller sends goods to a
buyer or reseller who pays the seller only as and when the goods are sold. The
seller remains the owner (title holder) of the goods until they are paid for in full
and, after a certain period, takes back the unsold goods. Also called sale or
return, or goods on consignment. See also guaranteed sale.

A bill of materials or product structure (sometimes bill of material, BOM or

associated list) is a list of the raw materials, sub-assemblies, intermediate
assemblies, sub-components, parts and the quantities of each needed to
manufacture an end product..
Labor Ticket or Work Ticket' is a form that shows the time spent by an
employee working on a particular job. It is used as a basis for billing the costs
of direct labor to customers, and may also be used for calculating wages of
employees who are paid by the hour. Also known as time card.
19-2 Solutions Manual – Public Accountancy Profession
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?
Answer:

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. Explain how a walk-through is done? What is the purpose of a walk-through?

Answer:

A “walk through” is the process of following a transaction from its initiation

(customer order in the Revenue Cycle) through all the various processing
steps until it is recorded in the formal accounting records (accounts
receivable and sales). Usually samples of all documents are collected
(sales order, sales invoices, sales return slip, credit memo, shipping
document, remittance advice and daily remittance report) and notes are
made of procedures each person performs.

The purpose of the “walk through” is to obtain an understanding of the

transaction flow, the control procedures and populations of documents that
may be utilized in test of controls auditing.

3.What is the primary purpose of “reviewing” the internal controls in the

revenue and collection cycle?

Answer:

The review (obtaining an understanding) of the control structure is primarily

a process of identifying control procedures (strengths) and lack of controls
(weaknesses) which will affect subsequent substantive procedures.

4. What Test of Controls audit procedures might internal auditors use to

ensure that the controls in the accounts receivable system are functioning?
 Tests of Controls 19-3
Answer:

The internal auditors should, through periodic checks, ensure that the
control account is periodically reconciled to the customer subsidiary
accounts, bank statements are reconciled and that all prenumbered
documents, especially invoices, have all numbers accounted for. Some
internal auditors also confirm accounts receivable. Internal auditors also
might review and evaluate customer complaints for signs of weaknesses in
the procedures leading to errors in accounts receivable.

5. 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 an audit engagements with cash from the employee
pension fund, an (b) the cash receipts journal and recorded cash sales from
reflecting more than the amount shown on the daily deposit slip?

Answer:

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 noncompany
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.

6. 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?

Answer:

The evaluation after the review phase was to determine which controls
appeared adequate as a basis for justifying a low control risk assessment.
19-4 Solutions Manual – Public Accountancy Profession
The final assessment after test of controls auditing is to determine if the
controls are actually operating as well as they appeared to be.

7. What are the objectives of internal control? Express each objective in

specific terms to apply to cash receipts.

Answer:

The objectives of internal control relate to transactions, and by category

are: validity, completeness, authorization, accuracy, classification,
accounting and proper period. The objectives expensed in general terms and specific terms
applied to cash receipts are as follows:
Example of Cash
General Objective Receipts
Specific Objective
1. Recorded 1. Recorded cash
transactions are receipts are
valid and supported by
documented. remittance advices.
2. All valid transactions 2. All cash receipts are
are recorded and entered in the daily
none omitted. remittance list,
deposited intact and
recorded in the
accounts receivable
control account.
3. Transactions are 3. Cash receipts for
authorized by transactions other
company policy. than merchandise
sales (scrap sales,
sales of fixed assets)
are properly
authorized.
4. Transaction peso 4. Cash receipts are
amounts are properly compared to invoice
calculated. terms to determine
proper cash
 Tests of Controls 19-5
discounts.
5. Transactions are 5. Cash receipts for
properly classified in nonmerchandise
the accounts. sales are posted to
proper accounts.
6. Transaction 6. All cash receipts for
accounting is credit sales are
complete. posted to customer
individual accounts.
7. Transactions are 7. Cash receipts are
accounted in the deposited daily
proper period. intact and recorded
as of date received.

8. In a computerized revenue and collection accounting system, certain

functions such as credit status are performed by the computer. Why should
the auditor be concerned with controls over how the credit limit is set and
entered into the accounts receivable data base?

Answer:

If the credit limits are set and entered incorrectly, the credit approval
process will be systematically deficient.

9. What are the primary functions that should be segregated in the acquisition
and expenditure cycle?

Answer:

The functions which should be separated to maintain internal control in a

purchasing system include (1) custody of the goods (receiving and stores
departments), (2) authority to initiate a transaction (purchasing department)
and (3) bookkeeping (accounts payable department, inventory record-
keeping department).
10. Describe a “walk-through” of a purchase transaction. What sample
documents would be collected? Why?

Answer:
19-6 Solutions Manual – Public Accountancy Profession
The “walk through” of a purchase transaction would begin with the
preparation of the requisition by the Stores department, through the bidding
process and preparation of the purchase order by the purchasing agent, to
receipt of vendor’s invoices and receiving report by the purchasing agent
and finally to accounts payable voucher preparation. Procedures would be
observed and notations made on document samples of procedures followed.

Documents are collected to note where documentary evidence exists or

control procedures being followed. The following documents would be
collected: requisition, purchase order, receiving report and voucher. The
“walk through” and sample documents would assist the auditor in
understanding the flow of transactions.

11.What feature of the acquisition and expenditure control would be expected

to prevent an employee’s abstracting cash through creation of fictitious
vouchers?

Answer:

a. Blank vouchers kept in secure location available only to authorized

personnel.
b. Blank supporting documents (invoices, receiving reports, requisitions,
purchase orders) kept in secure locations available only to authorized
personnel.
c. Supporting documents canceled by Cash Disbursement function when
checks are prepared.
d. Separation of duties of preparers of supporting documents, preparation
of vouchers, check preparation, and check signing.
e. Vouchers and other supporting documents reviewed by check signers.
f. Checks mailed directly by signer and not returned to accounts payable.

12.The essential characteristic of the liabilities control system is to separate

the authorization and approval to initiate a transaction from the
responsibility for recordkeeping. What would constitute the authorization
for vouchers (account) payable?

Answer:
 Tests of Controls 19-7
Authorization for vouchers payable recording mainly consist of an approved
purchase order, a receiving report, and an accurate vendor invoice.
Auditors should look for purchase approval signatures, receiving approval
signatures, and approval of the vendor invoice – checks by client for proper
quantity, price, and discount.

13.Evaluate the following statement made by a client purchasing manager:

“We have computerized the purchasing/inventory/payables system. The
most important of our system is people; However, they are also our greatest
problem.”

Answwr:

The point of this quotation is to generate discussion on the source of errors

and therefore the controls necessary when an accounting process is
computerized. Discussion items might include the following:
1. People have bad days and make mistakes; computers do not have bad
days.
2. Murphy’s Law – If it is possible to make an error, someone will find a way
to do it.
3. People initiate the transactions and will make errors.
4. All controls should be considered together (manual and computer).
Excellent computer controls cannot be relied upon if the related manual
controls are weak.
5. In computer systems, it is extremely important to establish extensive
input validation controls to prevent people errors from getting into the
processing (GIGO – garbage in, garbage out).
6. People can prevent a good computer system from working well if they are
not convinced it is in their best interests.
7. People will rarely question computer printed output, even though it may
not be correct.
8. Most computer controls are to prevent, detect, or correct errors made by
people.

14.Describe the purpose and give examples of audit procedures in the “search
for unrecorded liabilities.”

Answer:
19-8 Solutions Manual – Public Accountancy Profession

The purpose of the auditor’s search for unrecorded liabilities is to gather

evidence as to whether the liability assertion is true. The same concern
exists in the internal control objective “all valid transactions are recorded
and none are omitted.” From an evidence gathering perspective, it is much
more difficult to gather evidence on unrecorded transactions than to gather
evidence that recorded transactions (and account balances) are proper.

The search for unrecorded liabilities includes procedures in other audit

areas such as questions on bank and insurance confirmations and vouching
the source of funds for asset additions. Specific audit procedures in the
search for unrecorded liabilities include:
1. Obtain vendor’s invoices (or accounts payable vouchers) recorded for
several days after the balance sheet date to determine if the liability
relates to the balance sheet period under audit.
2. Scan cash disbursements for several days subsequent to year-end and
vouch to support to determine if cutoff was proper. Scan all cash
disbursements until the end of field work for unusual amounts and
payees to determine if amounts paid represent liabilities of the balance
sheet period.
3. Examine BIR tax reports and correspondence and the audit reports of tax
authorities and trace additional tax assessments to the accounts.
4. Confirmation of accounts payable.
5. Use analytical procedures such as trend comparisons of accounts
payable to sales, sales taxes to sales, payroll taxes to gross payroll and
interest expense to average notes payable.

15.Descrive a” walk-through” of the production and conversion transaction

from productions order to entry in the finished foods perpetual inventory
records. What document copies would be collected? What controls noted?
What duties separated?

Answer:

A “walk through” involves following a transaction from initiation through the

various steps until the transaction is recorded in the formal accounting
records. In the conversion cycle, the following would constitute a complete “walk through:”
Step Documents Controls Noted
 Tests of Controls 19-9
Collected
Prepare Production Support for P.O.
production Order (P.O.)
orders
Prepare bill of Bill of Separation
materials and materials planning from
manpower (B.M.) production.
needs Manpower
needs (M.N.)
Assign job Note
order and separation
foreman production
supervisor
from foreman
duties.
Job tickets Job tickets Production
and material (JT) foreman duties
requisitions Material separated from
prepared requisition (MR) authorization.
Raw material Issue slip (IS) Materials not
records issued without
updated, issue MR. IS
slips prepared prepared for all
materials
released.
Observe time Approval by
entered and foreman of
foreman hours.
approval on JT
Direct labor Labor report Job tickets
report (LR) support L.R.
prepared
Observe Reconciliation
timekeeping, hours per clock
compare job cards to hours
19-10 Solutions Manual – Public Accountancy Profession
tickets to per J.T.
clock cards
Material used Material used Issue slips and
report report (MUR) requisitions
prepared support MUR.
Observe Records from
matching issue sources
slips and reconciled.
material used
report
Observe Records from
matching job separate
time tickets (or sources
labor reconciled.
distribution) to
labor report
Enter costs in Job cost Support for all
job cost sheets sheets (JCS) entries in JCS.
Summary entry Summary Job cost
prepared. entry form sheets support
summary
entries.
Trace Separation of
summary entry duties; cost
to General accounting and
Ledger posting general ledger.
Preparation of Report of units Independent
completion completed report of
report (RUC) production
completed.
Observe units Independent
compared to check of RUC.
RUC, post
finished
 Tests of Controls 19-11
records
Products Products Independent
received received records of
report report (PRR) units put into
prepared finished goods
inventory.
Observe Records from
comparison separate
RUC and PRR sources
reconciled.
Job sheets Summary Closed job
closed out, entry form sheets, RUC
summary entry and PRR
prepared support
summary
entries.
Trace Separation of
summary entry duties; cost
to General accounting and
Ledger posting general ledger.

16.Why are weaknesses (lack of desired control procedures) not tested for
compliance? Describe how weaknesses may not be detected during the
review phase but discoed during the test of controls audit.

Answer:

Weaknesses (lack of control where auditors believe one is necessary) are

not audited because auditors do not rely upon weaknesses to prevent,
detect or correct material errors. Auditors must consider the financial
impact of weaknesses on financial statements and plan substantive tests
accordingly.

A control strength may be identified in interviews during the review phase

(or in preparing the flowcharts or questionnaires), but during test of controls
auditing, found to be nonexistent or operating ineffectively. For example, in
19-12 Solutions Manual – Public Accountancy Profession
the conversion cycle the production management may state that foremen
approve workers’ job time tickets. However, when a sample of job time
tickets are examined by auditors for evidence of approval, none is found.
Thus, a weakness is not found until the control is tested. Therefore, control
risk should not be assessed low until evidence is gathered that the control
is operating effectively.

17.Evaluate the following statement by an auditing student. I do not

understand cost accounting, therefore, I want to get a job with an auditing
firm where I will only have to know financial accounting.”

Answer:

The purpose of this review question is to foster discussion toward what

information an independent auditor needs to know. Items relevant to the
quotation might include:
1. Reference to the standard regarding “adequate technical training and
proficiency as an auditor.”
2. Reference to the standard regarding “due professional care.”
3. Obviously, the auditor must be knowledgeable about cost accounting to
audit a manufacturing company.
4. In a manufacturing company, the inventories most likely will be a major
asset which will require substantial audit work.
5. A proficient auditor must be knowledgeable in all phases of the business,
including production, marketing, finance as well as accounting data
processing.

18.Why might an auditor conduct a surprise observation of a payroll

distribution? What should be observed?

Answer:

The surprise observation enables the auditor to see how the distribution
system really works and increases his chances of detecting fraud. Such an
observation involves taking control of paychecks, then accompanying a
client representative as the distribution takes place. The auditor checks to
see that each employee is identified and that only one check is given to
 Tests of Controls 19-13
each individual. Unclaimed checks are controlled and examined to detect
any fictitious persons on the payroll.

19.Describe a walk-through of the personnel and payroll transaction flow from

hiring, authorization to payroll check disbursement. What document copies
would be collected? What controls noted? How would the walk-through be
modified if payroll is processed by a computer?

Answer:

A “walk through” of a personnel and payroll transaction would include

discussions with each person handling personnel and payroll records. The
following illustrates the steps and documents collected.

Steps Document(s) Collected

Hiring – Authorization to hire and
personnel rate assignment
dept.
Deductions – Personnel forms, employee
personnel authorization for
dept. deductions
Timekeeping Clock card
Shops Job time ticket
Cost distribution Labor distribution sheet
Accounts Payroll voucher
payable
Cash Payroll checks
disbursement

If the payroll is processed by computer, the clock cards and job time tickets
would be traced to batch control in the timekeeping and production
departments, to data preparation (keying to machine sensible form), to edit
and validation error reports and other computer output indicating control
and finally to computer prepared checks, labor distribution reports and
summary general ledger entries.

Multiple Choice Questions and Answers

19-14 Solutions Manual – Public Accountancy Profession

1. c 5. a 9. d 13. b 17. d
2. c 6. c 10. b 14. a 18. d
3. b 7. c 11. a 15. c 19. c
4. c 8. b 12. a 16. d 20. b

Cases

1. 1. Controlled access to blank sales invoices.

a. Observation. Visit the storage location yourself and see if
unauthorized persons could obtain blank sales invoices. Pick some up
yourself to see what happens.
b. Someone could pick up a blank and make out a fictitious sale.
However, getting it recorded would be difficult because of the other
controls such as matching with a copy from the shipping department.
(Thus a control access deficiency may be compensated by other
control procedures.)

2. Sales invoices check for accuracy.

a. Vouching and Recalculation. Select a sample of recorded sales
invoices and vouch quantities thereon to bills of lading, vouch prices
to price lists, and recalculate the math.
b. Errors on the invoice could cause lost billings and lost revenue or
overcharges to customers which are not collectible (thus overstating
sales and accounts receivable).

3. Duties of accounts receivable bookkeeper.

a. Observation and Inquiry. Look to see who is performing bookkeeping
and cash functions. Determine who is assigned to each function by
reading organization charts. Ask other employees.
b. The bookkeeper might be able to steal cash and manipulate the
accounting records to give the customer credit and hide the theft.
(Debit a customer’s payment to Returns and Allowances instead of to
cash, or just charge the control total improperly).

4. Customer accounts regularly balanced with the control account.

 Tests of Controls 19-15
a. Recalculation. Review the client’s working paper showing the
balancing/reconciliation. Do the balancing yourself.
b. Accounting entries could be made inaccurately or incompletely and
the control account may be overstated or understated.

2. The discussion could take several directions, including some or all of the
following:
1. Material Weakness. The facts seem to suggest “a condition in which
specific control features (few or none are described) or the degree of
compliance with them do not reduce to a relatively low level the risk that
errors or irregularities in amounts that could be material to the financial
statements may occur and not be detected within a timely period by
employees in the normal course of performing their assigned functions.”
Castro has authority and influence over too many interrelated activities.
Nothing he does seems to be subject to review or supervision. He even is
able to exclude the internal auditor.

An identification of the potential irregularities will illustrate the

misdeeds he can perpetrate almost single-handedly.

2. Potential irregularities include:

a. Castro can collude with customers to rig low bids and take kickbacks,
thereby depriving the company of legitimate revenue.
b. Castro can direct purchases to favored suppliers, pay unnecessarily
high prices and take kickbacks. He might even set up a controlled
dummy company to sell overpriced materials to the company. No
competitive bidding control prevents these activities.
c. Castro, through the control of physical inventory, can (i) remove
materials for himself, and (ii) manipulate the inventory accounts to
conceal shortages.
d. Castro can order truck shipping services for his own purposes and
cause the charges to be paid by the company.
e. Castro can manipulate the customer billing (similar to a above) to
deprive the company of legitimate revenue while taking an
unauthorized commission or kickback.
19-16 Solutions Manual – Public Accountancy Profession
3. Almost every desirable characteristic of good internal control has been
circumvented:
a. Segregation of Functional Responsibilities. Castro has authorization
and custodial responsibilities.
b. Authorization, Supervision. Castro is apparently subject to no
supervision or review. The accounting staff is probably powerless to
challenge transactions because of Samuel’s apparent approval of
Castro’s powers.
c. Controlled Access. The whole situation gives Castro access to
necessary papers, records, and assets to carry out his one-man show.
d. Periodic Comparison. No one else apparently has any access to the
materials inventory in order to conduct an actual count for comparison
to the book value (recorded accountability) of the inventory.

3. The purpose of this question is to get the student to consider where the
functions that are considered incompatible in a manual system occur in a
computer system.

The functions should be separated in a manual or computer accounting

system such that different people authorize the sales transactions, record
the transactions, have custody to the assets (inventory) and reconcile the
books to the assets.

Different people should: indicate the sales order source document

(authorize), prepare the computer program (authorize and record), operate
the computer (record), have custody of inventory and correct errors
(reconciliation).

4. If the credit limits are set and entered incorrectly, the credit approval
process will be systematically deficient.

5. Memorandum

TO: Board of Directors, The Potter Art League

FROM: (Student’s name)
DATE:
 Tests of Controls 19-17
SUBJECT: Control weaknesses related to Cash Admission Fees

You requested a report which identifies the weaknesses in the existing

system of cash admission fees and my recommendations. Below are the
weaknesses that exist and my recommendations for procedures that
overcome these weaknesses. I will be pleased to discuss these at the next
board meeting and offer further explanations that may be necessary.

Weakness: There is no segregation of duties between persons responsible

for collecting admission fees and persons responsible for authorizing
admission.
Recommendation: One clerk (hereafter referred to as the collection clerk)
should collect admission fees and issue prenumbered tickets. The other
clerk (hereafter referred to as the admission clerk) should authorize
admission upon receipt of the ticket or proof of membership.

Weakness: An independent count of paying patrons is not made.

Recommendation: The admission clerk should retain a portion of the
prenumbered admission ticket (admission ticket stub).

Weakness: There is no proof of accuracy of amounts collected by the

clerks.
Recommendation: Admission ticket stubs should be reconciled with cash
collected by the treasurer daily.

Weakness: Cash receipts are not promptly prepared.

Recommendation: The cash collections should be recorded by the
collection clerk daily on a permanent record that will serve as the first
record of accountability.

Weakness: Cash receipts are not promptly deposited. Cash should not be
left undeposited for a week.
Recommendation: Cash should be deposited at least once each day.

Weakness: There is no proof of accuracy of amounts deposited.

19-18 Solutions Manual – Public Accountancy Profession
Recommendation: Authenticated deposit slips should be compared with
daily cash collection records. Discrepancies should be promptly
investigated and resolved. In addition, the treasurer should establish a
policy that includes an analytical review of cash collections.

Weakness: There is no record of the internal accountability of cash.

Recommendation: The treasurer should issue a signed receipt of all
proceeds received from the collection clerk. These receipts should be
maintained and should be periodically checked against cash collection and
deposit records.
6. a. The purposes of these audit procedures are:
1. To substantiate the validity of the asset “cash” in the balance sheet,
as it may substantially consist of “cash in transit” from several sales
divisions.
2. To determine proper cash “cutoff”, i.e., to detect any unintentional
errors overstating or understating cash between the current and the
following accounting period.
3. To disclose “kiting” (if any), e.g., perpetrated by the home office
cashier in collusion with one or more sales divisions employees.

b. Audit Program for Sales Divisions – Audit Steps

1. Prepare a schedule of transfer payments made by the branch for a
period covering two weeks prior and two weeks after the end of the
fiscal period showing:
Check number
Date of entry in cash disbursements book
Amount of check
Date of perforation by paying bank
Transfer checks outstanding at the date of cutoff
Transfer checks outstanding at the date of reconciliation.
2. Compare dates of issue on canceled checks and of entries.
3. Trace and compare dates of perforation and dates of payment on the
bank statement and the “cutoff” statement.
4. Compare dates of issue of checks to date of perforation looking for:
 Tests of Controls 19-19
a. unusual delays in payment
b. discrepancy in accounting periods for the two dates.
5. Scan cancelled checks and cash disbursements records during the
year for:
a. names of payees,
b. consecutive numbers of checks to determine whether any
payments other than regular transfers to main office were made
from this account.
6. Reconcile individually several transfers during the year to
corresponding collections presumed to be transferred as of each
individual date.
7. Reconcile total collections for the year to total transfers.

7. 1. a. Recorded payroll transactions are valid (no fictitious employees).

b. Paychecks might be delayed and terminated workers might continue
to be “paid” (with theft of check by someone else) if payroll is not
promptly notified of new hires and terminations.

2. a. Recorded payroll deductions are valid.

b. Incorrect amounts might be deducted from pay.

3. a. Recorded payroll transactions are valid and authorized.

b. If payroll department personnel were also responsible for time
records, they would have effective control over transaction
authorization (i.e., hours worked approval) and could overpay
themselves or friends.

4. a. Payroll and labor cost transactions are complete.

b. Cost accounting records might contain more or fewer pesos than
actually paid (per payroll data). Simple errors in cost analyses might
occur.