TEST OF INTERNAL CONTROLS
- The sales system
- The purchases system
- The inventory system
- The payroll system
- Cash and banking system
- Non-current assets
- Controls in small entities
- Reporting control weaknesses
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
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 •
Confirm segregation of duties
| • customers are •
encouraged to pay promptly
|authorisation of •
|Review new customers for authorisation of credit limits|
| • orders are •
|Orders accepted •
from credit worth customers
|Match debtor balances with credit limits|
numbering of blank
|Check sequential numbering of book copies of documents|
|all goods and services are correctly invoiced all invoices raised relate to goods and services supplied||•
|authorisation of delivery notes
Examination of goods outwards
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.
• 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|
|To ensure that:
• orders and expenditure for goods are
• goods ordered are for the benefit of the
• orders are only made to
• orders are made at competitive
• Control policy for the choice of suppliers
• Production of evidence for the requirement of purchases ie. purchase
• 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
|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
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
|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
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
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
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.
- The inventory system
|Area||Control objective||Control||Test of control|
To ensure that:
movements, authorisation & recorded
- Segregation of Confirm
duties segregation of
- inventory records
- 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,
|||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,
|||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
inventory limits Re-order levels
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
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
|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
| 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