TOPIC10: TEST OF INTERNAL CONTROLS 

CHAPTER 10

TEST OF INTERNAL CONTROLS 

Topic list

  1. The sales system
  2. The purchases system
  3. The inventory system
  4. The payroll system
  5. Cash and banking system
  6. Non-current assets
  7. Controls in small entities
  8. Reporting control weaknesses

 

Learning outcomes

By the end of this chapter, students should be able to:

  • Identify internal control objectives
  • Describe internal controls for an organization in a given scenario
  • Explain the testing of controls in various aspects.
  • Explain how internal control weaknesses are reported to those charged with governance

 

Introduction

 

This chapter will look at how tests of controls might be applied in practice. Major components of a typical accounting system, as listed above will also be examined.

 

The auditors must establish what the accounting system and the system of internal control consist of. The auditors will then decide which controls, if any, they wish to rely on and plan tests of controls to obtain the audit evidence as to whether such reliance can be warranted. For each of the transaction systems we will look at the system objectives the auditors will bear in mind while assessing the internal controls and give examples of common controls. The chapter also covers ‘standard’ programme of tests of controls. Controls in small entities as well as reporting of control weaknesses to management will also be considered.

 

1 The sales and receivables system

Sales and receivables system can be illustrated by the diagram below

The table below shows the stages, control objectives, internal controls and test of controls in the sales and receivables systems.

 

 

Area Control objective Control Test of control
 

Ordering and granting of credit

        To ensure that:

•      goods are                           •

supplied to credit worthy customers

 

segregation of                      •

duties

 

Confirm segregation of duties

          •     customers are                     •

encouraged to pay promptly

authorisation of                   •

credit terms

Review new customers for authorisation of credit limits
        •     orders are                           •

recorded correctly

Orders accepted                   •

from credit worth customers

Match debtor balances with credit limits
                                                           • sequential                             •

numbering of blank

pre-printed documents

Check sequential numbering of book copies of documents
Invoicing

 

all goods and services are correctly invoiced all invoices raised relate to goods and services supplied

authorisation of delivery notes

Examination of goods outwards

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Check authorisation

Match delivery notes with invoices

                                                                               • Recording of goods             outwards
•     pre-numbering of dispatch notes Check numerical sequences
•     Signatures of delivery notes Check signatures
 

(a)             Deficiencies in the cash sales system

 

•        The physical location of the dispatch department and the cashier are not mentioned here, but there is a risk of the customer taking the goods without paying. The customer should pay the cashier on the advice note and return for the goods, which should only be released on sight of the paid invoice.

 

•        There is a failure in segregation of duties in allowing the cashier to both complete the sales invoice and receive the cash as he could perpetrate a fraud by replacing the original invoice with one of lower value and keeping the difference.

 

•        No-one checks the invoices to make sure that the cashier has completed them correctly, for example by using the correct prices and performing calculations correctly.

 

•        The completeness of the sequence of sales invoices cannot be checked unless they are pre-numbered sequentially and the presence of all the invoices is checked by another person. The order forms should also be pre-numbered sequentially.

 

•        There is no check that the cashier banks all cash received, and this is a further failure of segregation of duties.

 

If the sales department prepared and posted the invoices and also posted the cash for cash sales to a sundry sales account, this would solve some of the internal control problems mentioned above.

 

In addition, the sales department could run a weekly check on the account to look for invoices for which no cash had been received. These could then be investigated.

All of these deficiencies, and possible remedies, should be reported to management.

 

(b)            Tests

 

•        Select a sample of order forms issued to customers during the year. Trace the related sales invoice and check that the details correlate (date unit amounts etc). The customer should have signed for the goods and this copy should be retained by the dispatch department.

 

•        For the sales invoices discovered in the above test, I would check that the correct order form number is recorded on the invoice, that the prices used are correct (by reference to the prevailing price list) and that the castings and cross-castings are correct.

•        I would then trace the value of the sales invoices to the cash book and from the

cash book that the total receipts for the day have been banked and appear promptly on the bank statement.

•        I would check that the sales invoices have been correctly posted to cash or sundry sales account. For any sales invoices missing from this account (assuming they are sequentially numbered), I would trace the cancelled invoice and check that the cancelled invoice was initialed by the customer and replaced by the next invoice in sequence.

•        Because of the weaknesses in the system I would carry out the following sequence checks on large blocks of order forms/invoices, eg four blocks of 100 order forms/invoices.

 

(1)     Inspect all order forms to ensure all present; investigate those missing

(2)     Match sales invoices to order forms

(3)     Check all sales invoices in a sequence have been used; investigate any missing

(4)     Cash for each sales invoice has been entered into the cash book

 

Using the results of the above tests I would decide whether the system for cash sales has operated without material fraud or error. If I am not satisfied that it has then this may impact on the audit

 

 

2 The purchases and payables system

 

The table below shows the stages, control objectives, internal controls and test of controls in the purchases and payables systems.

 

Control Objectives Control Procedures Audit Tests of Controls
 

Ordering

To ensure that:

•         orders        and expenditure   for goods   are

properly authorized.

 

•         goods ordered are for the benefit of the

entity

 

•         orders are only made         to

authorized

suppliers

 

•         orders are made at   competitive

prices

 

•         Control policy for the choice of suppliers

 

•         Production of evidence for the requirement of purchases ie. purchase

requisition authorization.

 

•         Maintenance of prenumbered order forms and safeguarding blank ones.

 

•         Review of orders not received.

 

•         Constant monitoring of supplier terms

 

•         Check that all purchases have been authorized at appropriate level

 

•         Check     against                purchase requisitions.

 

•         Test-check number sequence of order forms and requisitions and enquire into any missing numbers.

 

•         Check whether client staff responsible for purchases shop around before selecting suppliers.

Receiving goods                and

invoices

To ensure that;

 Goods received are used for the organization’s purpose.

 

 Goods received should be checked for quantity, quality and conditions.

 

 Check if invoices for goods are supported by goods received notes

 

 

•         goods are only accepted if they were ordered and orders were authorized.

 

•         goods received are accurately recorded.

 

•         liability is recognized for goods received.

 

 

 

 

Recording of goods in pre numbered goods received notes.

Comparison of goods received notes       and purchase orders.

Recording of goods returned.

Checking of supplier invoices against orders for quantity, prices and discounts if any.

 

 

Trace entries into stock

records

 

Trace entries of goods returned

Check entries and additions into the purchase day book and the purchases ledger.

 

Test number sequence of goods received notes and enquire into missing numbers

Obtain explanations for unusual and long

outstanding items

Maintaining accounting records To ensure that;

•         all expenditure is authorized and is for goods received.

 

•         all expenditure is recorded correctly.

 

•         all credit notes received are recorded.

 

•         antries are made to correct accounts.

 

•         aut-off is applied correctly

 

 

 

 

 

 

 

 

Segregation of duties between ordering, receiving and

accounting

Prompt recording of purchases and returns

Regular   maintenance of purchases ledger

Comparison           of supplier   statements with purchases ledger balances

Review of allocation of expenditure

Reconciliation        of control accounts with purchases                ledger

balances

 

 

 

 

 

 

Verify         recording        of

invoices and credit notes

Check calculations and cross reference with

authorization for payments

Check postings to the ledger and test check castings and ledger

balances

Note any contra entries to the sales ledger

Check that control accounts are maintained and regularly reconciled with the purchases ledger

Note any unusual items and obtain explanations from management.

 

 

  1. The inventory system

 

Below  

Area  Control objective Control Test of control

 

To ensure that:

Recording            

all inventory

movements, authorisation & recorded

 

  • Segregation of   Confirm

duties                                 segregation of

duties

 

  • inventory records
  • Receipting,
  • Trace goods

 

include items belonging to client checking & recording of goods received notes (GRN) to bin cards
                             records include inventory that exists Inventory counts  Confirm inventory counts take place.
                             cut off procedures are properly applied to inventory Maintenance of  inventory records i.e.  Ledger, bin cards,

Transfer records

Trace delivery notes to bin cards
            check sequence of records
Protection of inventory inventory is safe guarded (against loss, damage etc) Restricted access to stores

Consider environment Observe security arrangements
  Controls over stores environment ie right temperature
  Inventory counts Obtain counts, check evidence of reconciliation of counts with book balances
Valuation of inventory Inventory is properly valued Computation of inventory valuation

Obtain cost sheets,

Check valuation

  Slow moving, damaged and obsolete inventory is provided for Review of inventory  records Review records
Inventory holding Reasonable levels of inventory are held

o o o

Control over inventory levels

.

Maximum

inventory levels

Minimum

inventory limits Re-order levels

Check records

 

5.  The payroll system

 

The table below shows the stages, control objectives, internal controls and test of controls in the payroll systems.

 

Area  Control objective control Tests of control
 

Setting of wages and salaries

To ensure that:

 employees are paid for work

done

 

 

    Segregation of

duties

 

          Check authorisation of changes in rates of pay

      gross pay has been calculated correctly  Maintenance of  personal records  Check starters and leavers  are formalised in writing
             Authorisation     Trace gross pay to personnel records
             Recording of

transactions

 
Recording of wages and  salaries  gross  and net pay deductions

are correctly computed

           Authorisation     Trace monthly payroll to general ledger
             wages and

salaries are correctly recorded in the general ledger

    Review of computation            Check reconciliations

(list to G/L)

 
Payment of wages and salaries     Correct employees            Segregation of

duties

      Authorisation of wage cheque            Check authorisation
             Custody of cash             Check unclaimed wages
      Verification of identity     Arrange to attend salary pay out
           Check if employees sign for cheques,  produce identity
 
Deductions  Deductions have been calculated correctly     Reconciliation of total pay and deduction     Re-perform computation
   Correct taxes, pensions etc are remitted to respective departments     Surprise cash counts            Ensure correct payments

to taxation authorities

             Comparison of

actual pay with

budget

 

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