Auditing I (Acct 411)

Table of Contents

Contents
Unit 1: Overview of Auditing

Unit 2: Internal Control

Unit 3: Internal Control Over Cash

Unit 4: Internal Control Over Purchase & Inventory

Unit 5: Internal Control Over Receivables & Credit Sales

Unit 6: Internal Control Over Payroll

Unit 7: Internal Control Over Fixed Assets

Unit 8: Internal Auditing

Unit 1: overview of auditing

Contents
1.1 Introduction
1.2 Over view of Auditing
1.2.1 Definition
1.2.2 Demand for Audit

1
 1.2.3 Internal Auditing
1.3 Types of Auditing
1.3.1 Financial Statement Audits
1.3.2 Compliance Audits
1.3.3 Operational Audits

1.1 INTRODUCTION

This unit deals with the definition of Auditing, why there is a demand for Auditing by stock
holders, managers, employees, and debt holders, what is the role of Internal Auditing in an
organization; and deals with description of types of Audits commonly used by the professional
Auditors.

The public accounting profession (CPA), as we knew it today grew mainly out of the demand
for financial statement Audits. Very specific auditing standards, referred to as generally
accepted auditing standards (GAAS), are provided for conducting financial statement audits.
How ever, In recent years, the profession has been asked to provide services beyond the
traditional financial Statement Audit. These include compliance and operational Audits.

1.2. OVERVIEW OF AUDITING

1.2.1 Definition of Auditing

The American Accounting Association, committee on Basic Auditing concepts - Defined
Auditing as:

Auditing is systematic process of objectively obtaining and evaluating evidence regarding

assertions about economic actions and events to ascertain the degree of correspondence
between assertions and established criteria and communicating the results to interested users.

The phrases in this definition require additional explanation. The phrase systematic process
implies there should be a well-planned approach for conducting an audit. This plan involves
objectively obtaining and evaluating evidence. The evidence gathered by the auditor must
relate to assertions about economic actions and events. For example. Financial statements
prepared by management contain numerous assertions. If the Balance sheet contains amount of
Br. 10million for property, plant and equipment, management is asserting (declaring) that the

2
company owns the assts, uses them in the production of goods and services, and that this
amount represents their un depreciated historical costs. The Auditor compares the evidence
gathered to assertions about economic activity in order to assess the degree of correspondence
between those assertions and established criteria. Generally Accepted Accounting Principles
(GAAP) are normally used for measuring the degree of correspondence, for financial Audits.
The last Phrase, communicating the results to interested Users, is concerned with the type of
report the auditor provides to the intended users. (Banker, investors, stockholders, Creditors,
e.t.c ).

1.2.2 Demand for Audit

The essence of demand for audit refers to the question “why do organizations request an
audit?” the answer to this question can be described as follows:

(i) Control mechanism – audits whether important control mechanisms for

accountability. The auditors role is determining whether the reports prepared by
management are in conformity with the responsibility and duties provided in the
organization policies. The overall need for monitoring activities, need demands
(requests) Auditing to provide credible or Audited financial information, Audited
performance reports, Audited implementation of rules, & regulations.

(ii) To resolve conflict of interest between management and the owners. The
Agency relation ship that exists between the owner and manager produces a natural
conflict of interest. Because, the manager has more information about the “True
financial position and results of operations of the entity than the owner who is
absentee. It both parties seek to maximize their own self interest, It is likely that the
manager will not act in the best interest of the owner. Example The manager may
spend organizational funds to provide excessive personal benefits or manipulate the
reported earnings in order to earn a larger bonus. Thus, the need for Independent
(non-partian) opinions or view is necessary to resolve such conflicts.

(iii) To reduce damaging Consequences – Even though, the function of accounting is

to provide information for economic decision making; this information must be
verified by auditors, before they are used for decisions that have serious and
subsequent factual economic consequences.

3
 (iv) To simplify complexity – In our age, financial information & translation has been
come complex in preparation, content, and format. Therefore it demands drippy
specialized body of knowledge to prepare (compilation), verify and interpret them.

(v) Regulatory requirements – many business laws, memo random of association and
government regulation, make requirements’ annual audits. For Example –For
renewal of license, or permit, (commercial code to Ethiopia), financial
Administration regulation proclamation tax, requires audited financial statements.

1.2.3. Internal Auditing

Internal auditing is a managerial control activity performed with an organization as service to
management by an employee of the organization. It reviews operations through the
measurement and evaluation of other control mechanisms. Their primary activities are to
conduct compliance and operational audits within the organization. However, they assist the
external auditor with the annual financial statement audit. Internal auditors are employed by
Individual companies, partnerships, government agencies. The Institute of Internal Auditors
(IIA) has developed set of standards that should be followed by Internal auditors and
Established certification program – which Includes passing of uniform writer examination. Like
external auditors they must be Independent and objective.

1.3 TYPES OF AUDIT

While there are many types of audit based on the definitions previously provided, generally
they are discussed under three types: financial statement audits, compliance audits and
operational audits

1.3.1 Financial Statement Audits

The purpose of a financial statement audit is to determine whether the overall financial
statements present fairly in accordance with specified criteria. This type of audit usually covers
the basic set of financial statements (Balance sheet, Income statement, statement of
stockholders equity, and statement of cash flows); and Generally Accepted Accounting
principles (GAAP) serve as the criteria. However, certain financial statements audits may use
of other criteria, such as cash basis or Income tax basis.

1.3.2 Compliance Audits

4
The purpose of a compliance audit is to determine the extent to which rules, policies, Laws
covenants, or governmental regulation are followed by the entity being audited for example,
accompany may use auditors to determine whether the corporate rules, and policies are being
followed by departments within the organization. The corporate rules and policies serve as the
criteria for measuring the departments Compliance. Another example is examination of tax
returns (payment) of individuals and companies by the Internal Revenue Service for
compliance with Tax Laws.

1.3.3 Operational Audits

Operational Audit involves a systemic review of organizational activities, or apart of them, in
relation to the efficient and effective use of resources. The purpose of operational audit is to
assess performance, Identity areas of Improvement, and develop recommendations. Sometimes
this type of audit is referred to as a performance audit or management audit. Operational audits
are generally more difficult to conduct than financial and compliance audits. Since the purpose
of an operational audit is to assess effectiveness and efficiency, it can be very difficult to
Identify objective, measurable criteria that can be used for that purpose.

Examples of such audit include – audit of government programs, Efficiency of the food and
Drug administrations procedures for Introduction of new Drugs, to market. Assessment of the
efficiency and effectiveness of organizations use of computer resources.etc.

Unit 2: Internal Control

Contents
2.1 Introduction
2.2 Definition
2.3 Purpose and objective of Internal
2.4 Essential Elements of Sound (Effective) Internal Control
2.4.1 Competent, Trustworthy Personnel With Clear Lines of Authority and
Responsibility
2.4.2 Segregation of Duties
2.4.3 Documentation Procedures
2.4.4 Authorization Procedures
2.4.5 Physical Control Over Assets and Records

5
 2.4.6 Internal verification (Independent Internal Verification or Checking)
2.5 Limitations of Internal Control

2.1 INTRODUCTION

The Important consideration of internal control in this unit has three major objectives first, to
explain the meaning of internal control, second, the significance of purpose and objective of
internal control third, the characteristics of good internal control. In this Unit, students should
able to know the broad classification of internal control as accounting and administrative
control; and the major weakness of internal control. This unit tries to show the internal control
over cash, Accounts Receivable (credit sales), payroll, and fixed assets.

2.2 DEFINITION

Internal Control is a process effected by an entity’s board of directors, management, and other
personnel that is designed to provide reasonable assurance regarding the achievement of
objectives in the following categories.

(1) effectiveness and efficiency of operations

(2) Reliability of financial reporting, and
(3) Compliance with applicable laws and regulations. alternative definition defined by
AICPA (American Institutes for certifications of public accountants) as: Internal control
referees to all coordinate methods and measures within an organization or within a
system adopted to safeguard assets, cheek accuracy and reliability of accounting data,
promote operational efficiency and encourage adherence to prescribed managerial
policy.

Overall internal controls are also defined as operational checks and balances that prevent loss
due to fraud, waste, abuse, and management of resources. The resources include: personnel,
information, and capital.

2.3 PURPOSES AND OBJECTIVES OF INTERNAL CONTROL

The purpose of internal control can be explained in to two aspects:

6
 a) The management (client) concern and
b) The Auditors concern

(a) The client concern – the reason an organization establishes a system of internal control
is to attain objectives (goals). Generally management has six purposes in setting good
system of internal control. These are to:
(i) achieve reliability of accounting records.
(ii) safeguard assets
(iii) increase profitability
(iv) prevent and defeat frauds and errors
(v) prepare financial statements timely
(vi) discharge laws, rules & regulations
(b) Auditors concern: The generally accepted auditing standard field work standard,
number, (3) three states that a sufficient understanding of internal control is to be
obtained to plan the audit and determine the nature, timing and extent of testes to be
performed. Thus, the primary purpose of studying and evaluating of internal control
system by external auditors is to determine the amount of audit work. It is assumed that
good internal control provides more reliable financial data and statements.

The objectives internal control includes to:

(i) control operations – to ensure efficiency and effectiveness
(ii) control financial reports – To ensure the preparation of reliable financial
statements
(iii) control compliance – To ensure compliance of laws, regulations.

2.4 ESSENTIAL ELEMENTS OF SOUND (EFFECTIVE) INTERNAL CONTROL

Essential elements are components of strong internal control. They are used to evaluate the
strengths and weakness of internal control system.

2.4.1. Competent, trustworthy personnel with clear lines of authority and

responsibility
The most important element of any internal control is personnel. If the employees are
component (well trained) and trustworthy (TRUST), some of other elements can be absent and
reliable financial information’s will still result. Specific responsibility for performance of a

7
given duties must be assigned to specific Individuals. Organizational structure defines how
authority and responsibility are delegated and monitored. It provides a frame work for
planning executing, and monitoring operations.

2.4.2. Segregation of Duties

It is Important for an organization to segregate (separate) the authorization of transactions,
recording of transactions, and custody of the related assets. Independent performance of each of
these functions reduces the opportunity for any one person to be in apposition both to
perpetrate and to conceal errors or Irregular in the normal course of his or her duties. Example:
first, if an employee can authorize the sale of marketable securities and has access to the stock
certificates, the assets can be misappropriated. Second, If an employee receive payment from
customers on account and has access to the accounts receivable subsidiary ledger, It is possible
for that employee to misappropriate the cash and cover the shortage in the accounting records.

There are four guidelines for segregations of duties to prevent both intentional and
unintentional errors and frauds.

(a) Separation of the custody of assets from accounting. For example, If one
person is responsible for store keeping (custody of inventory) and maintains
inventory records, it is possible to ship (dispatch) some Items for his /herself and
adjust the Inventory balance by recording a factious transaction.
(b) Separation of the authorization of transaction from the custody of related
assets – for example, If one person is assigned For authorization of payment
transaction, and handling of cash it in creases the possibility of frauds.
(c) Separation of duties within the accounting section function: Examples
include: The recording in journals and related subsidiary ledgers and then keeping
of control ledgers in principle should be separated. Recording in sales journals and
recording in cash receipts journal and Accounts Receivable control Ledger keeping
should be separated. Accounts payable control clerk should not record cash
payments journal.
(d) Separations of operational responsibilities from record – keeping. For
example, accounting functions should be separated from management department
activities.

2.4.3. Documentation Procedures

8
Documents provide evidence that transactions and events have occurred. Several procedures
should be established for documents. first, whenever, possible, document should be pre –
numbered and all documents should be accounted for pre numbering accounting documents
should be promptly forwarded to accounting to help timely recording documents should be
produced in copies, they should be simple to understand, sufficient, and designed for multiple
uses.

2.4.4. Authorization Procedures

Every transaction must be properly authorized. Properly authorization implies that concerned
personnel should authorize (approve) each transactions at each step where transactions occurs.
For example, the authorized person for paying cash is the cashier, for receiving, it is the store
clerk, for permitting the transaction it is the manager etc.

2.4.5. Physical Control Over Assets and Records

Physical control relates primarily to safeguard asset from theft, deterioration, spoilage, etc.
Accounting records and securities, (bonds, Debentures, Treasury stocks, cheeks, notes,) should
be in well locked custody. Inventories should be protected by constructing from fire proof
materials, well – ventilated room and locked doors, generally,
 Safes and vaults are necessary to store cash before the cash is deposited in a bank.
 Locked ware houses for inventories.
 Fencing of the organization.
 Locked storage cabinets for accounting records. etc; are necessary elements, of physical
control.

2.4.6. Internal verification (Independent Internal Verification or Checking)

This element of internal control refers to the need of Independent checking process. Which
involves, Reviewing, comparison, reconciliation of data, which are prepared by the other
personnel, and the findings (discrepancies) should be corrected.

2.5 LIMITATIONS OF INTERNAL CONTROL

9
An internal control system should be designed and operated to provide reasonable assurance.
That is an entity’s cost of internal control system should not exceed the benefits that are
expected to be derived. The necessity of balancing the lost of Internal controls with the related
benefits requires considerable estimation and judgment on the part of management.

Therefore the idea of reasonable assurance arises from two concepts: cost – benefit, and the
inherent weakness: The cost – includes paying employees for implementing the system,
constructing and acquiring facilities (safes, stoves) printing of vouchers, forms, etc. the
benefits includes prevention of potential losses.

The inherent limitations include management override of internal control, personnel errors, or
mistakes, and collusion.

(i) Management override of internal control: an entity’s controls may be overridden

by management. For example, a senior – Level manager can require a low – level
employee to record entries into the accounting records (because) that are not
consistent with the substance of the transactions and are in violation of the
organization’s control. The lower – level employee may record the transaction,
even though he or she knows that it is a violation of control, because of fear of
losing he’s or her job.
(ii) Personnel errors or mistakes – The internal control system is only as effective as
the personnel who implement and perform the controls. For example, employees
may misunderstand instructions or make errors of judgment. They may make
mistakes because of personnel careless ness, distraction, or fatigued.
(iii) Collusion – the effectiveness of segregation of duties lies in the Individuals per
forming only their assigned tasks or in the performance of one person being checked
by another. Collusion may occur, for example, an individual who receives cash
receipts from customerscolide (agree) with the one who records those receipts in the
customers’ records order to steal cash from the entity.

UNIT 3: INTERNAL CONTROL OVER CASH

Contents
3.1 Introduction
3.2 Nature of Cash

10
 3.3 Internal Control Objectives for Cash Receipts
3.4 Internal Control Over Cash Disbursements
3.5 Segregation of Duties
3.6 Limitation of Internal Control Over Cash

3.1 INTRODUCTION

This unit tries to describe the nature of cash, in general; the nature of cash receipts and
disbursements separately; and tries to Identify and explain the fundamental internal controls
over cash receipts and disbursements. Moreover, it tries to describe the auditor’s objectives for
the audit of cash –finally, some of the weakness of internal control over cash is presented. This
unit helps the students to understand and describe the internal control over cash receipts and
disbursements in relation to the important documents and records used to control cash
transactions.

3.2 NATURE OF CASH

The item cash reported in the financial statements represents currency on hand and cash on
deposit in Bank accounts, including certificate of deposit, time deposits, and saving accounts.
Certain “cash equivalents” are combined with cash for presentation in the financial statements.
FASB statement of financial accounting standards No 95, statement of cash flow”, defines cash
equivalents as short – term, highly liquid investments that are readily convertible to cash or so
near to their maturity that there is little risk of change in their value. examples of such type
include, Treasury bills, commercial paper and money market funds.

Cash is affected in one or another, by all of the entity’s transaction cycles. Although the main
source of cash is revenue, other sources of cash include (1) the sale of property, plant, and
equipment and (2) the proceeds from issuing large – term debt or capital stock - the main
source of disbursements are the purchasing and payroll.

(i) Types of Bank accounts – the entity’s management must be concerned with the
control and safekeeping of cash. The use of different types of bank accounts keeps
in controlling the entity’s cash. The following types of Bank accounts all usually
used.

11
 (ii) General cash account – It is the principle cash account for most entity’s the major
source of cash receipts for this account is the Revenue cycle, and the major sources
of cash disbursements are the purchasing and payroll cycles.
- Impress cash account contains a stipulated amount of money, and the account is
used for limited purposes. This account is usually used for disbursing of payroll checks
and the account contains a minimum balance.
- Branch accounts-companies that operate with multiple branches located in
multiply Locations may maintain separate accounts at local banks. This provides each
branch with ability to pay local expenses. The Branch submits periodic cash reports to
head quarters, and the branch account receives check or transfer from general cash
account.

3.3 Internal control objectives for cash Receipts Transactions

There are seven detailed internal control over cash objectives that internal control over cash
receipts transactions must meet to prevent errors in journals and ledgers, as well as to prevent
International misstatements (frauds) the internal control over cash receipts must be sufficient to
provide reasonable assurance that.
i) Recorded transactions are valid (validity)
ii) Transactions are properly authorized (authority)
iii) Existing transactions are recorded (completeness)
iv) Transactions are properly valued (valuation)
v) Transactions are properly classified (classifications)
vi) Transactions are recorded at proper time (timeliness)
vii) Transactions are properly included in subsidiary ledger and correctly
summarized (posting and summarizations).

Internal control objective, (validity) prevents the possible misstatements of cash receipts. That
is cash receipts may be recorded but may not be received or deposited. The completeness
control objective helps to prevent misstatement of receipts such as cash receipts may be stolen
or lost before recording. The timeliness internal control objective prevents cash receipts
misstatements such as cash receipts may be recorded in the wrong period. Authorization
objective prevent, cash miss statements such as cash discounts may not be properly taken. The
valuation objective prevents cash receipts misstatements, like, cash Receipts may be recorded

12
 as incorrect amount. The classification control objective of cash receipts may prevent
misstatements like cash receipts may be recorded in wrong financial statement account. The
posting and summarization objective prevent misstatement such as cash receipts may be posted
to wrong customer account, cash receipts may not be properly posted to general ledger
accounts.
3.4 INTERNAL CONTROL OVER CASH DISBURSEMENTS.

The Internal objectives for cash disbursementscan be summarized as follows.

(i) Validity - It refers that segregation of duties must be made to check

possible misstatements such as cash disbursement recorded may not be made (occurred).
(ii) Completeness – It refers that all transactions of the given period which
are made or occurred must be included or recorded in records. How ever there night be
cash disbursements made or occurred but mot recorded or included. Auditors have to
check numerical sequence of cheeks, daily cash disbursements reconciled to postings to
accounts payable subsidiary records.
(iii) Timeliness – It refers that all disbursement transactions must be
recorded in proper time then, the internal control objective helps to prevent cash
disbursements not to be recorded in a wrong period. In control procedure, there would be
daily reconciliation of checks issued with postings to cash disbursements journal and
accounts payable subsidiary records.
(iv) Authorization – It refers that there must be appropriate authorization of
disbursement transactions by concerned personnel. Control procedure to insure this
objective is segregation of duties; checks must be prepared only after all source
documents have been independently approved.
(v) Valuation – It refers that cash disbursements must be properly
determined. The balances of cash disbursements must be determined accurately. There
might be incorrect amount of cash disbursed and recorded in journal, there fore, there
must be a control procedure to check this misstatement. Daily cash disbursements report
must be reconciled to checks issued; vendor statements must be reconciled to accounts
payable records, and independently reviewed, monthly bank statements must be
reconciled and independently reviewed.
(vi) Classification - The cash disbursements must be properly classified to in
accord dance with chart of accounts. There fore, there might be cash disbursements

13
 charged to wrong account. The control procedure includes that there must be well –
prepared chart of accounts, independent approval and review of general ledger account on
voucher packet.
(vii) Posting and summarization – It refers that all cash disbursement
transactions must be posted and summarized. There might be cash disbursement posted
to the wrong vendor accounts, or cash disbursements journal may not be summarized
properly or not properly posted to general ledger accounts. Then, there must be
reconciled and independently reviewed, monthly cash disbursements journal agreed must
agree to general ledger postings, Accounts payable subsidiary records must be reconciled
to general ledger control account.

3.5. SEGREGATION OF DUTIES

Segregation of duties with regard to control over cash includes the following types. The
custody (possessing), recording, and Authorization of cash should be separated. That is, the
same person should not be entrusted to perform the two or three activities. The reason is that if
the custody and record keeping are done by the same person, that person can steal money and
they change the ledger to conceal the theft. If cashier has custody, the bookkeeper makes
entries, and the finance head authorizes payments, this is good segregation of duty regarding to
petty cash. If the Bank account is reconciled by one who does not have access to cash, then it
is good segregation of duties regarding to cash in Bank the store keeper should not fill our
receiving reports to control Inventory. The person who authorizes salary for new employee
should not be the one paying the salary. The receiving of cash, depositing of the cash in the
Bank, recording of cash and general ledger should be segregated. Cash payment preparation,
authorizing of cash payment, cash payment, (disbursing), and recording of cash payments in
cash disbursement journal and general ledger such as Account payable ledger and cash control
ledger should be segregated; that is each activity should be performed by different persons.

3.6. LIMITATIONS (WEAKNESS) OF INTERNAL CONTROL OVER CASH

Weak internal control procedures would create opportunity for fraud or defalcation /theft/ of
cash. The most common defalcation techniques of cash are:
a. Withholding of cash receipts – proceeds form cash sales are withheld at point of sales
recording and receiving of cash. For example, a cash register clerk can fail to register
sales or under register amounts, and pocketing full or partial amounts, If the customer

14
 does not wait for his receipts and changes, or check amounts charged, registered, and
paid.
b. Lapping- refers to cash collection on account from credit customer may be postponed
(delayed). This is usually practiced as temporary borrowing, but in the long run they
lead to cover up by more elaborate means. This is possible if a single person is
responsible to receive cash from charge customers and keep records for accounts
receivable at the same time.
c. Sales discount – cash can be abstracted from sales discount not taken by customers. i.e
when customers pay the full amount, only amount net of discount are recorded to
customers and the difference would be pocketed by recording it to discount account.
d. Writing off bad debts – Accounts Receivable could be written off as bad debts when
actually customers remittance is pocketed.
e. Fictions Accounts Receivable – Goods could be taken for private use or stolen by
charging fictions customers and writing off as bad debts later on.
f. Check – kiting – It refers to transferring of check from one back to another when
business has two bank accounts say in bank X and Y check is written to withdraw an
account from bank X account balance, and deposited into Bank Y account. Because of
lag (delay) of time for clearance, the amount deposited in bank Y is immediately
reflected, but is not reflected as deduction (withdrawal) from Bank X account soon,
Consequently such technique is practiced by casher to cover up cash shortage which an
auditor might uncover.
g. Window – Dressing – Cash Shortage or cash position could be improved by holding
the cash book open /unclosed) beyond the closing date to include subsequent cash
receipts.
h. Others includes as, cashier payable to self, check payable to others, petty cash
vouchers.

15
UNIT 4: INTERNAL CONTROL OVER PURCHASE AND INVENTORY

Contents

4.1. Introduction
4.2. Nature of Internal Control Over Purchase
4.3. Control Procedures and Tests of Controls of Purchases
4.4. Segregation of Duties
4.5. Inventory
4.6. Control Procedures and Tests of Controls of Inventory
4.1. INTRODUCTION

The relationship of inventories and purchase makes it logical for the two topics to be
considered together. The Internal control that assures the fair valuation of inventories are
found in the purchase (or acquisition) cycle. These procedures in clued procedures for the
selection of vendors, ordering merchandise or materials, inspecting goods, receive, recording
the liabilities to the vendor, and authorizing and making cash disbursements.

This unit explains the essential control procedures and tests of controls used by the auditors for
purchase and inventory. Thus student should be able to understand these procedures and Tests
with relation to necessary do comments and records used for control purposes.

4.2 Nature of internal control over purchase

Purchase transaction usually begins with a purchase reacquisition being generated by

department or support function. The purchasing department prepares a purchase order for the
purchase of goods or services from a vender when the goods are received or the services hare
been rendered, the entity records a liability to the vender. Finally, the entity makes payment to
the vender.

The three major types of transactions are processed through the purchasing cycle.
 Purchase of goods and services for cash or credit
 Payment of the liabilities arising from such purchases.
 Return of goods to suppliers for cash or credit.

The types of documents and records involved in the purchasing cycle Include.

16
 1. Purchase requisitions – this document is a request for goods or services by authorized
individual department within the entity. Example of such requests include an order for
raw materials for production from the production management department, an order for
newspaper advertising space from a marketing manager.
2. Purchase order – this document Includes the description, quality and quantity of and
other information as date of delivery, credit terms means of transportation, the purchase
order also indicates the person who approved the acquisition and represents the
authorization to purchase the goods or services.
3. Receiving report - this document is used to record the receipts of goods. Normally,
the receiving report is a copy of the purchase order with the quantities omitted. This
procedure encourages receiving department personnel to make adequate, independent
count of the goods received. Receiving department personnel records the date,
description, quantity and other Information or this document.
4. Vender invoice – this document is the bill from the vender. The Vender invoice or
purchase invoice includes the description and quantity of goods shipped or services
rendered the prices including freight costs, insurance the terms of trade including cash
discounts and date billed.
5. Voucher – this is a document that is frequently used by entities to control payment for
acquired goods and services. This document serves as basis for recording a venders
invoices into voucher register or purchase journal the voucher is attached to the
purchase reacquisition, purchase order, receiving report, and vender invoices to create a
voucher packet – this vouch example Include check payment voucher,
6. Accounts payable – is an account used to record all vender invoices, cash
disbursements and adjustment in individual vender accounts.
7. General ledger – proper accumulation, classification and summarization of purchases,
cash disbursement and payable in the general ledger.

4.3 CONTROL PROCEDURES AND TESTS OF CONTROLS

There are seven control procedures applied for control of purchase Transactions.
a. Validity - the Auditors concern in testing of the validity of purchase transaction
is that factious or non-existent purchase may have been recorded in the clients records.
If fraudulent transactions are recorded, assets or expenses will be overstated. A liability
will also be recorded and a resulting payment made, usually to the individuals who

17
 initiated the factious purchase transactions proper segregation is the control test for
preventing factious purchases. The critical segregation of duties is the separation of the
reacquisition, and purchasing functions from the accounts payable and disbursement
functions.
b. Completeness of purchase transaction- If the client fails to record a purchase
that has been made assets or expenses will be understated and the corresponding
accounts payable will also understated. Control Test that provides assurance
that the completeness objective is being met includes accounting or checking the
numerical sequence of purchase orders, receiving Reports, and Vouchers;
matching receiving vouchers with vender invoices, etc.
c. Timeliness of recording of purchase transaction - the client should have
controls to ensure that purchase transactions are recorded or timely basis (in a proper
time). For example, the client’s procedure should require that all receiving reports
should be forwarded to the accounts payable department or section on daily basis.
d. Authorization of purchase transaction - possible misstatements due to
improper authorization includes the purchase of unauthorized goods and the purchase of
goods or services at unauthorized price or terms. The major control procedure to
prevent these misstatements is the use of authorization schedule or table which shows
the amount that different levels of employees (personnel) are authorized to purchase.
e. Valuation of purchase transactions - The possible misstatements for valuation
of Internal control objective is that purchase transactions may be recorded at in correct
amounts due to improper pricing or erroneous calculation.
f. Classification of purchases - Proper classification of purchase transactions is
an important internal control objective for the purchasing cycle. If purchase
transactions are not properly classified, asset and expense accounts will be misstated. A
control test for this objective is proper documentation and records for example having
chart of accounts.
g. Segregation of duties – the major segregation of duties to control purchasing
transactions including the following
- The purchasing function should be separated from the requisitioning
and Receiving functions (that is separate Individuals should involve in each
functions.

18
 - The invoice (vender invoice) processing function should be segregated
from the accounts payable function.
- The account payable function should be segregated from the general
ledger function.

4.5. INVENTORY

The inventory cycle is affected by the control procedures previously discussed for cash receipts
review purchasing, and payroll cycles. The acquisition of and payment for raw materials and
overhead costs is controlled via the purchasing cycle. The cost of both direct and indirect labor
assigned to inventory is contro9lled through payroll cycle. Family, finished goods are sold and
accounted for as part of revenue cycle. Thus, the cycle for Inventory in manufacturing
company begins when goods are purchased and stored as raw materials, proceeds to the
processing of the goods through manufacturing departments, and ends when the finished goods
are shipped to customers.

4.6. CONTROL PROCEDURES AND TESTS OF CONTROLS OF INVENTORY

1. Validity of inventory Transactions- the auditors main concern is that all recorded
inventory exists and actually belongs to the client. The major control procedure for
preventing factious inventory transactions form being recorded is proper segregation of
duties, in which the production management and inventory stores functions are separated
form the departments responsible for inventory and cost – accounting records
2. Completeness – The Control procedure for completeness objective relate to recording
inventory which has been received. Typically, the control procedures for this objective are
contained within the purchasing cycle.
3. Authorization – unauthorized production activity that may lead to excess levels of
certain types of finished goods.
4. Valuation – Inventory transactions that are not properly valued result in misstatement
that directly affect the amounts reported in the financial statements for cost of goods sold
and inventory. Proper valuation of inventory involves a accurately determining the quantity
of goods on hand and assigning the appropriate costs to these goods.
5. Classification of inventory transactions – control procedures must insure that
inventory is properly classified as raw materials, work in process or finished goods.

19
UNIT 5: INTERNAL CONTROL OVER RECEIVABLES AND CREDIT SALES

Contents
5.1 Introduction
5.2 The Nature of Control Over Receivables and Sales
5.3 Steps and Procedures in Sales and Collection Cycle
5.4 Segregation of Duties

5.1 INTRODUCTION

This unit is concerned with the audit of the accounts balances affected by the revenue cycle.
The numerous documents and records used by large companies in processing credit sales
transactions often include the following:
 Customer order
 Sales order
 Shipping documents
 Sales invoice
 Authorized price list
 Accounts Receivable subsidiary ledger or accounts receivable master file
 Sales transactions file
 Customer monthly statement

The processing of credit sales or credit sales functions involves a sequence of steps or credit
sales functions as follows:
 Accepting customer orders
 Approving credit
 Filing sales orders
 Shipping sales order
 Dealing with customers
 Recording the sales

Details of the controlling of Account Receivables and sales will be discussed in the following
titles of this unit.

20
5.2 THE NATURE OF CONTROL OVER RECEIVABLES AND SALES

The following control objectives and Test of controls are applicable in the accounts
Receivable and sales (Revenue) Transaction.
(i) Validity – the validity internal control objectives relates to management’s assertion
about existence or occurrence. Auditors are concerned about the validity objective
for revenue from actions because clients are more likely to overstate sales than to
understate them. The possible misstatement including sells to fictions customer, and
recording of revenue when goods have not been shipped or services have not been
performed. The major control for preventing such misstatement is segregation of
duties between the shipping function and the order entry and billing function.
Requiring an approved customer sales order and shipping document before revenue
is recognized also minimizes the recording of fictions sales in client’s records.
(ii) Completeness – the completeness objective relates to the completeness assertion.
The major misstatement that concerns both management and Auditor is that goods
are shipped or services are performed and no revenue is recognized control
procedures that provide assurance that accounting for numerical sequences of
shipping documents and sales invoices, matching shipping documents with sales
invoices, reconciling the sales invoices to daily sales report, and minting and
reviewing the open –order file.
(iii) Timeliness – timeliness internal control objective relates to the completeness
assertion. After client does not have adequate controls to ensure that revenue
transaction recorded on timely basis, sales may be recorded in the wrong accounting
period. The client should require that all shipping documents be for warded to the
billing function daily for processing on a timely basis. The Auditor should test this
control by comparing the date on a bill of lading with the date on the respective
sales invoice and the date the sales invoice was recorded in the sales journal. All
billing must occur with the minimum delay.
(iv) Authorization of revenue Transaction - this internal control objective relates to
the valuation assertion’ possible misstatements due to improper authorization
include shipping goods to or performing services for customers who are bad credit
risks and making sales at unauthorized prices or terms. Authorized price lists and
specified terms of trade, for shipping and credit must be established.

21
 (v) Valuation – This control relates to valuation assertion – Incorrectly valued
(determined) amount of Revenue results in misstatements that directly affect
amounts reported in financial statements there must be authorized price, terms of
trade, type of goods shipped, a sales invoices should be verified for. Mathematical
accuracy before being sent. To recording.
(vi) Classification of Revenue Transaction - This control objective relates to the
presentation and disclosure assertion – the use of chart of accounts and proper codes
for recording transactions should provide adequate assurance about the objective.
The auditor can review the sales journal and general ledger for proper classification.
(vii) Posting and summarization of revenue - This Internal control objective relates to
the presentation and disclosure assertion. There is possibility that transactions are
not properly summarized from source documents or posted properly from journal to
subsidiary and general ledgers. There fore, the control test should include as,
reconciling sales invoices to the daily sales report (summary report) and the daily
recordings in sales journal should be reconciled with the posting to the accounts
receivable subsidiary ledger, this ledger should periodically be reconciled to the
general ledger control account.

5.3 STEPS AND PROCEDURES IN SALES AND COLLECTION CYCLE

Selling the Goods and Billing the Customers

(a) Processing customer orders - the cycle begins when the customer
makes an order. The company may have preprinted order forms, or the customer
may make a verbal or informal written request.
(b) Credit approval – If the order is on account (on credit), credit should be
approved by producing credit approval form for approving credit, limit, terms of
credit and (credit worthiness of the customer).
(c) Shipping goods – this is a key part of the process, because this is when
the companies assets are actually given up. A shipping document (such as bill of
lading) is prepared giving the description, the quantity, the receivers, freight costs,
and other information the sales invoice is prepared of this stage. It should show the
description, quantity and prices including shipping charges – Transport cash,
Insurance, etc.

22
 (d) Bill customers and recording sales – the sales invoice is the most
important document in this activity – The sales invoice is the basis for recording sales
and for billing the customer. The monthly statement should be prepared and sent to
each customer who has an account. This monthly statement should list the invoices
and payments for the period, with the necessary information about each transaction
will used for confirmation by the auditor.
(e) Processing and recording cash receipts – A remittance advice should
be sent to the customer with the sales invoice. The customer should return that
advice which contains customers name invoice number, and amount paid. When cash
arrives, prelisting of cash receipts should be prepared. It should be by some onewith
out access to cash, and with no knowledge of A/R. All cash receipts should be
prepared. And recorded in cash receive Journal.
(f) Charging off un collectible accounts – uncollectible authorization form
should be needed for charging –off uncollectible expenses.
5.4 SEGREGATION OF DUTIES

Authorization of sales, recording of sales, and custody of goods in the warehouse should be
separated. The people who are recording sales and cash receipt of have no access to cash.
Separate credit granting from sales. Separate posting to the cash receipts ledger from posting to
individual accounts receivable. Further, monthly statement should be sent out by person with
no responsibility for handling cash. Inquires or complaints about the statements should be
maintained for handling cash, recording sales or recording accounts receivable.

UNIT 6: INTERNAL CONTROL OVER PAYROLL

Contents
5.1 Introduction
5.2 Nature of Control Over Payroll
5.2.1 The Types of Documents and Records Involved for Control of Payroll
5.3 Control Procedures and Tests of Controls of Payroll Transactions
5.4 Segregation of Duties

6.1 INTRODUCTION

23
Payroll transaction usually begins with an employee performing some job and recording the
time spent on a time card. The time card is approved by a supervisor before being forwarded to
the payroll department. Finally, payment is made directly to the employee or deposited in the
employee’s bank account. The reader should focus on the basic concepts so that they can be
applied to the specific payroll cycles encountered. The following topics are related to the
payroll cycle.

6.2 NATURE OF CONTROL OVER PAYROLL

There are two major types of transactions that are processed through the payroll cycle.
(i) Payments to employees for services rendered
(ii) Accrual and payment of payroll – related liabilities arising from employees services,
including liability for social security and unemployment Taxes. The discussion of
Internal control focuses on payments to employees, including a description of how
such transactions are processed and the key control procedures that should be
present to ensure that no material misstatements occur.

6.2.1 The Types of Documents and Records Involved for Control of Payroll
The following documents and records are Important for the control of payroll transactions.
(a) Personnel Records, including wage – Rate or salary authorizations – The personnel
records contain information on each employees work history, including hiring date,
wage rate, or salary, payroll deduction, authorization forms, wage –rate and salary
adjustment authorizations performance evaluations, and termination notice, are
applicable.
(b) Time card – This document is used to record the hours worked by the employee
including the time the employee has started and stopped work.
(c) Payroll Register – this document whishing also referred to as the payroll journal, is a
summary of all payroll checks is used to employees. Of indicated, employee’s gross
pay, deductions, and net pay.
(d) Periodic payroll reports – at the end of each week or month, a number of summary
payroll reports may be prepared one such report would be a summary of payroll for
various job classifications or departments.

6.3 Control procedures and Tests of controls of payroll transactions

24
The following control procedures &Tests of control are used to prevent possible misstatements.
(i) Validity of payroll Transactions – the auditor wants assurance that payments for
payroll related services are being made to valid employees for time actually worked.
Thus, the client needs to have control procedures that prevent payments to fictitious
employees and to valid employees who have not worked. It also needs to assure
that payroll payment stop once. An employee is terminated. Proper segregation of
duties provides the main control against payments to fictious employees.
(ii) Authorization of payroll transactions – The client should have authorization
procedures for hiring and Terminating employees, setting pay rates, making with
holdings, awarding benefits, and Issuing payroll checks. Supervisor should approve
the amount of time reported by an employee on his or her time card.

Similarly, hiring and termination of employees and changes in pay rates should be authorized
by the office of human resources consistent with union contract or corporate policies. A
payroll check should not be issued unless an employees time card has been approved and that
employee has a valid employee number on the payroll master tile.
(iii) Valuation of payroll Transactions - The mainconcern related to thevaluation
objective is that an employee with gross Pay and payroll deductions maybe
incorrectly computed. For example, employee may be paid at higher rate than
authorized or payroll deductions may be incorrectly computed. The client should
maintain verification procedures to ensure that payroll expense is charged to wrong
accounts; the financial statements may be misstated. It has to be classified into
direct, and indirect labor, inventory and cost of goods sold. The use of adequate
chart of accounts is one control mechanism.

6.4 SEGREGATION OF DUTIES

Proper segregation of duties provides the main control against payments to fictious employees.
Proper segregation of duties among operating departments, the office of Human Resources, and
the payroll department minimizes the possibility of fictious employees existing with in the
system. Further, imitation of wage or salary changes should be performed by operating
department, initiation of employee living and firing by operating department, approval of wage
or salary changes by personnel department, up dating of personnel records by personnel
department; approval of time cards and job classification by operating department; review of

25
time data and payroll distribution by time keeping department; preparation of payroll
department; preparation and signing of payroll checks by financial department, distribution of
payroll checks, by payroll taxes by payroll department and the other activities related to payroll
transactions must be properly segregated.

UNIT 7: INTERNAL CONTROL OVER FIXED ASSETS

Contents:
5.5 Introduction
5.6 Nature of Internal Control Over Fixed Assets
5.6.1 Validity and Authorization
5.6.2 Completeness
5.7 Segregation of Duties
5.8
7.1 INTRODUCTION

The term property, plant, and equipment include all tangible assets with a service life of more
than one year that is used in the operation of the business and are not acquired for the purpose
of resale. Three major subgroups of such assets are generally recognized and the concepts are
given in the glossary part of this unit.

For most entities, property, plant and equipment represent a material amount in the
financial statements. When the audit is on going engagement, the auditor is able to focus
his or her efforts on the current year’s activity since the assets acquired in earlier years
were subjected to audit tests at the time of acquisitions.

There are four types of property, plant, and equipment transactions in fixed assets.
 Acquisition of capital assets for cash, or other non monetary considerations (exchange
by other fixed assets)
 Disposition of capital (fixed assets) through sale, exchange, retirement, or
abandonment.
 Depreciation of capital assets over their useful economic life
 Leasing of capital assets

26
The property, plant and equipment subsidiary ledger is are record of all capital assets owned by
the entity. It contains information of the cost of the asset, the date acquired, the method of
depreciation, and accumulated depreciation. The subsidiary ledger also includes the calculation
of depreciation expense for both financial statements and income tax purposes. The subsidiary
ledger should be reconciled to the general ledger control account on a monthly basis.

7.2 NATURE OF INTERNAL CONTROL OVER FIXED ASSETS

Key control procedures, and tests of controls that relate directly to property, plant, and
equipment were discussed as part of the purchasing cycle. More over, the following control
procedures are discoursed as follows:

7.2.1 Validity and Authorization

The control procedures for the validity and Authorization objectives are normally part of the
purchasing cycle. Purchase reacquisition are initiated in relevant departments and authorized at
the appropriate level within the entity. How ever large capital asset transactions may be subject
to control procedures out side the purchasing cycle for example, highly specialized equipment
may require skilled engineers approval for the technical specifications for the equipment, for
such transactions, the auditor may need to examine more than the vendors invoices to test
validity; review of additional documentations, such as capital – budgeting documents and
engineering specifications may be needed.
7.2.2 Completeness
The control procedures used in the purchasing cycle for ensuring completeness provide some
assurance that all capital asset transactions are recorded in the property, plant, and equipment
subsidiary ledger and general ledger. One procedure that helps to ensure that this objective is
met is reconciliation of the property, plant and equipment subsidiary ledger to the general
ledger one procedure that helps to ensure that this objective is met is reconciliation of the
property, plant and equipment subsidiary ledger to the general ledger control accounts on
monthly basis. Another control procedure that on entity may use to ensure that all capital
assets are recorded is periodic comparison of the detailed records in the subsidiary ledger with
the existing capital assets. The client may take a complete physical examination of property,
plant, and equipment on periodic or rotating basis and compare the physical asset to the
subsidiary ledger.

7.3 SEGREGATION OF DUTIES

27
The existence of adequate segregation of duties for property, plant and equipment within an
entity depends on the volume and significance of the transaction processed. For example, If an
entity purchases large quantities of machinery and equipment, or if it has large capital projects
under construction, there is a likely to be a formal internal control system. On the other hand,
if an entity has few capital purchases, the entity will generally not have formal control system.

The following notes show the key segregation of duties for property, plant, and equipment
transactions and examples of possible errors or irregularities that can result form conflicts in
duties.
(a) If one individual is responsible for initiating a capital asset transaction and also
has final approval, it is possible for fictitious or unauthorized purchases of assets to
occur. This can result in purchases of unnecessary assets, assets that do not meet
the company’s quality control standards, or illegal payments to suppliers or
contractors. Thus, there must be final approval functions.
(b) If one individual is responsible for the records and also for the general ledger
functions, It is possible for that individual to conceal (fraud) any defalcation that
world normally be detected by reconciling subsidiary records with the general
ledger control account. Thus, the recording function should be segregated from the
general ledger function.
(c) If one Individual is responsible for the records and also has custodian
responsibility for the related assets, it is possible for tools and equipment to be
stolen and for the theft to be concealed by adjustment of the accounting records.
Thus, the recording functions should be segregated from the custodian function.
(d) If the individual who is responsible for the periodic physical inventory fixed
assets, is also responsible for the custodian and record – keeping functions, it is
possible for theft of the entity’s capital assets to be concealed. Thus, individual
responsible for the inventory should be independent of the custodian and record –
keeping functions.

UNIT 8: INTERNAL AUDITING

Contents
8.1 Introduction
8.2 Function of Internal Auditing

28
 8.3 Responsibility and Authority
8.4 Internal Control and Internal Audit

8.1 INTRODUCTION

Most Auditing courses or Topics on Auditing concentrates only “Independent /External

auditing” Some times to the neglect or point of marginalizing the other types of audit, that is
internal auditing. However, since 1950’s and 1960’s in particular with the development of
management theory and management controls (management accounting), the importance and
scope of internal auditing has been gaining greater emphasis.

The development of internal auditing is tied with the advance of better management decision
making internally.
8.2 FUNCTIONS OF INTERNAL AUDITING

The internal auditing function includes verification, evaluation and compliance of operations.
Among others the following are specifiable. These are :-
(i) Review and appraise internal control procedure;
(ii) Ascertain effectiveness and efficiency of operations
(iii) Verify compliance to policies and procedures;
(iv) Ascertain reliability of data and documents
(v) Evaluate quality of performance;
(vi) Recommend improvements in better management controls.
Thus, the internal auditor can perform his work either through functional approach,
operational, or financial approach.

8.3 RESPONSIBILITY AND AUTHORITY

Internal Auditing is a staff function; there fore, the auditor ideally is not in disposition of line
function. This position and place in the organization is determined by the scope of the function
he performs and extent of responsibility entrusted to him by management. It is desirable that he
should be placed as high as possible in the organization structure of he is truly to be of “service
to management” without intimidation, and be in position of surveillance over all the
organizations activity.

29
The independence of internal auditor again depends on his place in the organization, the extent
of responsibility and authority required for performing his function, and the desire to enhance
his competence and independence in reporting to whom. Here it must be appreciated that the
desire to have Independence in the internal Auditing function may not necessarily be attainable
or be as high as in the external auditing function. The matter of qualification for the Internal
auditor is also dependent on the alone factors. Of course, these factors one definitely much
more clearly demarcated in a large organization than in small.
8.4 INTERNAL CONTROL AND INTERNAL AUDIT

Internal audit as we have studied in some detail in the previous discussion is means of
management control mechanism established internally and arising out of need for verification,
evaluation and compliance of internal operation. It is designed for management internal
purposes. As such internal Audit is part of the internal control system in the organization,
while at the same time internal audit (or auditor), is responsible for the surveillance
(monitoring) of the effectiveness of the internal control system and involve in its weakness and
strength.

30