TRANSACTION CYCLES – TEST OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS TRANSACTION CYCLES – the means through which an accounting system processes transactions of related activities A. REVENUE & COLLECTION CYCLE Activities involved: (1) Exchange of goods and services with customers; (2) collection of revenue in cash Accounts affected: (1) Sales and related sales adjustments; (2) Cash in bank; (3) Accounts receivable and related allowances; (4) Uncollectible accounts expense; and (5) Inventories Documents used and Audit Significance Documents Significance Customer’s purchase order - Provides evidence that a customer actually ordered the goods. - PO numbers are recorded on sales invoices to determine to which PO an invoice relates. Sales order - Contains the seller’s understanding of the terms. - Numerical sequence helps ensure that shipments are made for sale orders and all sales are billed. Bill of Lading (Shipping Documents) - Signature of carrier provides evidence that goods have been shipped. - Numerical sequence helps ensure that all shipments are recorded as sales. Credit memo - Provides evidence that the seller has reduced the amount billed to a customer. - Numerical sequence helps ensure that CMs are recorded. Remittance Advice - Indicates date and amount of payment and the invoices paid. Uncollectible account authorization form - Numerical sequence helps ensure that all write – offs are recorded. Monthly statements - Reports the beginning balance and transactions that occurred during the period. Accounting records employed: (1) Sales journal; (2) Sales returns and allowances journal; (3) Cash receipts journal; (4) General journal; (4) accounts receivable ledgers; and (5) Accounts receivable TB I.
TEST OF CONTROL OVER SALES TRANSACTION (1) Inquiry, (2) Observation, and (3) Review CONTROLS TEST OF CONTROLS Assertion: EXISTENCE/OCCURRENCE, recorded sales are for shipments actually made to customers Recording of sales is supported by customer’s PO, sales - Examines approved customer PO, sales order, shipping orders are approved by the credit departments and documents and sales invoice. approved and executed shipping documents Contains required approval Terms and descriptions should be consistent Independent personnel prepares and mails monthly - Observe whether these duties are segregated. statement (follows up on complaints) and records accounts - Examine files on complaints received receivable Assertion: COMPLETENESS, all sales transactions that occurred are recorded Prenumbered shipping documents are accounted to - Observe the procedure determine that all sales invoice is prepared for all - Examine the invoice that bills the sale (sample) shipments A copy of sales invoice indicates that the shipment was billed. Prenumbered sales invoices are accounted to determine - Observe the recording process if the personnel accounts that all sales are recorded for the numerical sequence - Trace sales invoice to sales journal (sample) Procedures are put in place to ensure timely recording of - Inquire how the procedures are followed. sales and proper cut – off are established - Observe if the procedures are followed. - Inspect the report in the last shipment sent by the shipping clerk to the billing clerk. Proper cut – off provides evidence of existence. Assertion: RIGHTS AND OBLIGATIONS, sales recorded represent only sales transactions Clerk checks sales orders and sales invoices for terms - Observe whether such procedure is being performed Assertion: VALUATION AND ALLOCATION, sales are correctly billed and recorded (For goods shipped) Counted and descriptions on sales - Observe whether such procedure is being performed. order are compared with the shipping document - Examine shipping orders for signature on the shipping documents (sample) Customer credit is approved by a responsible official prior - Examine sales order for credit approval prior to shipment to shipment. (sample) Sales invoices are checked to pricing, mathematical - Inquiry on the updating of price list. accuracy and terms - Examine copies to determine that they contain signature that they have been checked (sample) AR subsidiary ledger is balanced to the general ledger - Observe whether such procedure is being performed. control account regularly. - Foot the subsidiary ledger and compare to the balance of the control account. Page 1 of 8
Assertion: PRESENTATION AND DISCLOSURE, sales and accounts receivable are recorded in accordance with PFRS Sales must be properly classified - Determine whether the invoice copy contains approval signature for account classification used. II.
SUBSTANTIVE TEST OF SALE TRANSACTIONS ASSERTIONS AUDIT OBJECTIVES a. Occurrence and Validity To determine that recorded sales are b. Rights and Obligations authorized and are for shipments actually made to real customers.
c.
Completeness
To determine that existing sales transactions are recorded on a timely basis.
d.
Valuation or Allocation
To determine that recorded sakes are for the amount of goods shipped and are correctly billed and recorded.
e.
Presentation
To determine that sales transactions are properly classified.
AUDIT PROCEDURES Review sale journal, GL and accounts receivable masters file or TB. 2. Trace sales journal entries to supporting documents. 3. Trace shipping documents to entry of shipments in perpetual inventory records. 4. Compare prices on sales invoice with authorized price list or contracts. 5. Trace shipping documents to sales invoices and entry to sales journal and AR master file. 6. Compare date sales are recorded and date on shipping records (perform sales cutoff test) 7. Recompute information on sales invoices. 8. Trace entries in sales journal to sale invoices. 9. Trace details on sales invoices to related documents. 10. Examine document supporting sales transactions for proper classification. 1.
III.
TEST OF CONTROLS OVER SALE ADJUSTMENTS TRANSACTIONS Cash Discounts – substantive test of account balances Sales returns, allowances, corrections – emphasis is on testing the existence of recorded transactions as a means of uncovering any diversion of cash from the collection that have been covered up by fictitious sales returns and allowances (existence); understatement of these may lead to management reporting overstated net income (completeness) Uncollectible Accounts – most important audit objective is existence because of the possibility that the management may use this account to cover up misappropriations of company assets. The control to prevent this is to employ proper authorization when writing off uncollectible accounts
IV.
SUBSTANTIVE TEST FOR SALES RETURNS AND ALLWOANCES The same audit objectives with sales except for the following: (1) Materiality – if amount reflected in the CMs are immaterial, they can be ignored (2) Emphasis on the objective – emphasis is on testing the validity of recorded transactions as a means of uncovering any diversion of collections that has been covered by a fictitious sales returns and allowances Audit procedures normally include: - Review of the use and authorization of CM; CMs must be serially numbered signed by an employee separate from the handling of cash or maintenance of the customer’s ledger - Review of credits for returned merchandise supported by receiving report on the return shipment - Verify prices, extensions and footings. - Trace postings from sales returns journal and other accounting records to the customer’s accounts in the SL
V.
TEST OF CONTROLS OVER CASH RECEIPTS TRANSACTIONS CONTROLS TEST OF CONTROLS Assertion: EXISTENCE/OCCURRENCE, recorded receipts represent actual cash collections from customers An employee prepares a prelisting of cash receipts - Observe whether a prelisting is prepared - Inquire about the procedures followed by the employee A validated receipt is obtained for deposits and compared - Compare the validated slips to the cash receipts summary to cash receipts summary Segregation of duties: handling cash and posting to AR - Observe the separation of duties - Inquire from personnel about their responsibilities. Preparation of a bank reconciliation by a person - Observe whether a bank reconciliation had been prepared independent if cash, AR, or GL records by an independent employee Assertion: COMPLETENESS, all receipts are processed and recorded Prelisting and monitoring of cash register procedures - Observe the monitoring of this procedure Checks are restrictively endorsed immediately after - Observe whether the procedure is followed. receipts. Preparation of daily cash summary and reconciliation of - Inquire from responsible employees about the regularity OTC receipts and prelisting. and consistency of the performance of this procedure. Page 2 of 8
Reconciliation of cash receipts journal to the total posted to AR
-
Observe the procedures. Inquire from employees who perform the procedures.
Assertion: RIGHTS AND OBLIGATIONS, all cash receipts are deposited in the bank account of the client Cash receipts are deposited intact daily in the company’s - Observe whether the procedure is followed bank account - Compare cash in the prelisting and validated deposit slip. Assertion: VALUATION AND ALLOCATION, the DR to cash and CR to AR are valued at amount actually received Cash receipts should be recorded at the amount indicated - Compare entries made in the cash receipts journal to in the remittance advice remittance advices. Assertion: PRESENTATION AND DISCLOSURE, cash receipts transactions are recorded in accordance with PFRS An accounting supervisor approves classifications made in - Determine whether the accounting supervisor approval is journalizing recorded. VI.
SUBSTANTIVE TESTS OF CASH RECEIPTS TRANSACTIONS ASSERTIONS AUDIT OBJECTIVES a. Existence or occurrence To determine that recorded cash receipts represent actual collection from customers.
1.
b.
Completeness
To determine that all cash and checks are recorded.
3.
c.
Valuation or Allocation
To determine that debits to cash and credits to AR are values at amounts received.
4.
To determine that cash receipts transactions are presented and disclosures are prepared in accordance with PFRS.
6.
d.
Presentation
2.
5.
AUDIT PROCEDURES Trace cash receipts journal to prelisting of cash receipts and to remittance advice. (sample) Reconcile daily deposits to validated deposit ticket. (from a sample of entries) Reconcile daily listings and validated deposit ticket to cash receipts journal to verify that all cash receipts are recoded Examine remittance advice and verify that discount taken was appropriate (sample) Foot AR subsidiary ledger and reconcile with GL account. Review account coding in the cash receipts journal (sample).
B. EXPENDITURE AND DISBURSEMENT CYCLE Activities involved: (1) Acquisition of goods and services; (2) payment for these acquisitions Accounts affected: (1) Purchases and related adjustments, (2) Accounts payable and trade notes payable, (3) cash in bank, (4) inventories, and (5) manufacturing and operating expenses Documents used and Audit Significance Documents Significance Purchase requisition - C Provides evidence that the purchasing department was authorized to initiate purchase. Purchase order - Contains signature of an employee who authorized purchase from a vendor. Receiving report - F Provides evidence that goods were received. Vendor’s invoice - B Provides evidence about a purchase of goods or services Debit Memo - G Provides evidence that the amount owed to vendor has been reduced. Voucher - D Provides documentation for recording of a transaction. Check - A A canceled check provides evidence about payments that the entity has made. Vendor’s statement - E Used to determine that all transactions recorded on the statements have been recorded in the books. ACTIVITY 1: Match the following audit significance to the documents presented above. a. A canceled check provides evidence about payments that the entity has made. b. Provides evidence about a purchase of goods or services c. Provides evidence that the purchasing department was authorized to initiate purchase. d. Provides documentation for recording of a transaction. e. Used to determine that all transactions recorded on the statements have been recorded in the books. f. Provides evidence that goods were received. g. Provides evidence that the amount owed to vendor has been reduced. Accounting records employed: (1) Purchase journal; (2) Cash disbursement file/journal; and (3) Accounts payable master file/subsidiary ledger I.
TEST OF CONTROLS FOR ACQUISITION CONTROLS TEST OF CONTROLS Assertion: EXISTENCE/OCCURRENCE, recorded acquisitions are for items that were acquired Acquisitions approved by authorized personnel as - Examine the approval signature. evidenced by signature on PO. Page 3 of 8
Preparation of voucher for the purchase of goods.
Check signer examine supporting documents and cancel the documents when paid.
- Observe the procedure. - Examine file documents. When vouchers are not prepared: - Review entries in the purchase journal. - Examine documents underlying them for authenticity and reasonableness. - Examine cancellations on the documents.
Assertion: COMPLETENESS, all acquisitions that occurred recorded 1. Prenumbered receiving reports are used and accounted - D. Observe the procedure and account for the numerical to determine that a liability is recorded. sequence of receiving report. 4. Vouchers are prenumbered and accounted ad they are - B. Observe the procedure and account for the numerical entered in the voucher register. sequence of the voucher. Assertion: RIGHTS AND OBLIGATIONS, recorded acquisitions are the entity’s purchases and liabilities 5. Receiving reports are prepared by persons who have - C. Observe that the procedure is performed. access to a blind copy of PO details. Assertion: VALUATION AND ALLOCATION, acquisitions are recorded in the proper amounts. 3. Invoice amounts are verified by reference to the PO and - E. Examine the voucher for signature indicating receiving report. Mathematical accuracy is also checked. performance. Assertion: PRESENTATION AND DISCLOSURE, acquisitions are recorded in accordance with PFRS 2. Employees are required to use a chart of accounts. - A. Examine the chart of accounts and signature of employee performing the verification. Account coding is assigned to one person and checked by another. ACTIVITY 2: Identify the following controls as to what assertion they pertain and match the test of control to appropriate control. CONTROLS TEST OF CONTROLS 1. Prenumbered receiving reports are used and accounted to a. Examine the chart of accounts and signature of determine that a liability is recorded. employee performing the verification. 2. Employees are required to use a chart of accounts. Account b. Observe the procedure and account for the coding is assigned to one person and checked by another. numerical sequence of the voucher. 3. Invoice amounts are verified by reference to the PO and c. Observe that the procedure is performed. receiving report. Mathematical accuracy is also checked. d. Observe the procedure and account for the 4. Vouchers are prenumbered and accounted ad they are numerical sequence of receiving report. entered in the voucher register. e. Examine the voucher for signature indicating 5. Receiving reports are prepared by persons who have access performance. to a blind copy of PO details. II.
III.
SUBSTANTIVE TESTS OVER ACQUISITION TRANSATION ASSERTIONS AUDIT OBJECTIVES a. Existence or occurrence To determine that recorded purchases are for items that were acquired.
b.
Completeness
To determine that purchases that occurred are recorded.
c.
Rights and obligations
To determine that purchases are the entity’s acquisitions and liabilities.
d.
Valuation or Allocation
e.
Presentation
To determine that purchases are recorded for proper amounts. To determine purchases are presented and disclosures are prepared in accordance with PFRS.
AUDIT PROCEDURES Examine underlying documents for authenticity. Scan voucher register for large or unusual items. 3. Inspect asset acquired. 4. Trace inventory purchased to perpetual records. 5. Scan voucher register for duplicate payments. 6. Trace a sequence of receiving reports to entries in the voucher register. 7. Test cutoff. 8. Account for sequence of entries in voucher register. 9. Trace from invoices to perpetual inventory records. 10. Examine vendor’s invoices. 11. Recompute the invoices and compare invoice price to purchase order. 12. Check accuracy of accounts on invoices by reference to chart of accounts 1. 2.
TEST OF CONTROLS OVER CASH DISBURSEMENT TRANSACTIONS CONTROLS
TEST OF CONTROLS Page 4 of 8
Assertion: EXISTENCE/OCCURRENCE, recorded cash disbursement occurred. Authorized individual signs and mails promptly the checks. - Inquire/observe whether the procedure is followed. A person independent to handling of disbursement reviews - Inquire whether the procedure is followed. whether checks are processed on a timely basis. - Examine outstanding checks list. Assertion: COMPLETENESS, all cash disbursements made are recorded Checks are prenumbered and accounted for. - Observe whether employee who prepares the check register accounts for the sequence of the checks. Preparation of bank reconciliation by a person independent - Observe the procedure with emphasis on the segregation of cash disbursements and cash receipts. of duties. - Inspect reconciliation. Assertion: RIGHTS AND OBLIGATIONS, all cash disbursements made are for obligations of the entity. Examination of supporting documents before check signer, - Inquire about the segregation of duties. - Observe whether separation really exists. who is independent of voucher preparation, signs check. - Inquire about the check signer’s procedures for reviewing documents. Assertion: VALUATION AND ALLOCATION, amounts recorded are valued at proper amounts. Verify amounts and calculations on vendor’s invoices. - Observe the procedure. Employee signs voucher after this procedure. - Examine signature on paid invoices. Assertion: PRESENTATION AND DISCLOSURE, cash disbursements are recorded in accordance with PFRS Chart of accounts adequately describe the account to be - Observe the procedure. used and account coding and checking is assigned to different persons. IV.
SUBSTANTIVE TESTS OVER CASH DISBURSEMENTS ASSERTIONS AUDIT OBJECTIVES a. Existence or occurrence To determine that recorded cash disbursements occurred. b.
Completeness
c.
Rights and obligations
To determine that all cash disbursements made are recorded.
AUDIT PROCEDURES b. Examine paid checks for appropriate endorsements. e. Examine documents underlying payments. a. Reconcile cash disbursements per books with cash disbursements per bank. d. Test bank reconciliation. e. Examine documents underlying payments
To determine that all cash disbursements made were the entity’s obligations. d. Valuation or Allocation To determine that purchases are recorded f. Recalculate invoices paid. for proper amounts. e. Presentation To determine purchases are presented c. Check accuracy of accounts on invoices. and disclosures are prepared in accordance with PFRS. ACTIVITY 3: Match the following audit procedures with the assertions and audit objectives presented above. a. Reconcile cash disbursements per books with cash disbursements per bank. b. Examine paid checks for appropriate endorsements. c. Check accuracy of accounts on invoices. d. Test bank reconciliation. e. Examine documents underlying payments. f. Recalculate invoices paid.
C. PAYROLL TRANSACTION Activities involved: (1) acquisition of employee services; (2) compensation Accounts affected: (1) Salaries Payable; (2) Cash in bank; and (3) Payroll expenses Documents used and Audit Significance Documents Significance Time Card - Provides evidence about the validity of the hours employee is paid for working. Deduction authorization - Indicates that the employee authorized an amount to be withheld from a paycheck. Certification of Taxes withheld - Indicates that taxes withheld were reported to the various taxing authorities. Labor ticket and labor ticket summary - Records specific activity of a laborer and the labor used in production on any given day. Payroll tax returns - Provides evidence that amount withheld are paid to the appropriate authorities. Other personnel records - Numerical sequence helps ensure that all write – offs are recorded. Accounting records employed: (1) Payroll register; (2) Employee Earnings Record; (3) Labor Distribution journal; (4) and General journal I.
TEST OF CONTROL OVER PAYROLL TRANSACTION Page 5 of 8
(2) Inquiry, (2) Observation, and (3) Review CONTROLS TEST OF CONTROLS Assertion: EXISTENCE/OCCURRENCE, recorded payroll transactions occurred Personnel department authorizes the addition of an - Observe the procedures followed employee to the payroll or any changes in employees’ - Examine written approvals for selected payrolls status Segregation of duties between the employee who reviews - Observe this procedure. details of payroll and signs checks, and another for distribution of checks Requiring supervisor approval for hours entered in the time - Observe whether the procedure is followed. cards Assertion: COMPLETENESS, all payroll earned by employees is recorded Prenumbered checks and accounted for in the bank - Observe whether the reconciliation is routinely prepared reconciliation done by a personnel separate from the by a person independent of the payroll function. payroll preparation Assertion: RIGHTS AND OBLIGATIONS, recorded payroll transactions are for services received. Employees are required to record the time work using a - Observe whether such procedure is being followed. time clock - Examine signature on card. Assertion: VALUATION AND ALLOCATION, payroll transactions recorded for proper amount. Verification of accuracy of payroll calculations. - Examine payroll register for signature indicating verification. Control total of hours worked and verified independently of - Examine worksheet that documents the comparison. payroll accounting and compared to hours for which payment is recorded Assertion: PRESENTATION AND DISCLOSURE, payroll transactions are recorded in accordance with PFRS Employees use chart of accounts in assigning codes for - Examine payroll summary for the signature indicating that labor charges. Another employee would check work of the this procedure is being followed. employees who assigned the codes. II.
SUBSTANTIVE TEST OF PAYROLL TRANSACTIONS ASSERTIONS AUDIT OBJECTIVES a. Existence or Occurrence To determine that recorded payroll transactions occurred.
b.
Completeness
To determine that all payroll earned by employees is recorded.
c.
Rights and obligations
d.
Valuation or Allocation
To determine that recorded payroll transactions are for services received. To determine that payroll transactions are recorded for the proper amounts.
e.
Presentation
AUDIT PROCEDURES Check the personnel records to determine whether the employees are actually employed. 2. Observe actual payroll distribution. 3. Investigate the method of the company in handling unclaimed pay. 4. Trace payroll tested to summaries. 5. Trace postings to summary totals to the GL and subsidiary ledgers. 6. Check propriety of the accounting distribution. 7. Examine the canceled employee payroll checks for propriety. 8. Examine receipts signed by employees. 9. Check the recorded pay against the original record for hours worked or units produced. 10. Compare the rates paid with authorization forms/contracts. 11. Check computations and deductions 12. Compare the total amount of payroll tested with appropriate recorded disbursements from general bank account. 1.
To determine that payroll transactions are recorded in accordance with PFRS. D. FINANCING AND INVESTING TRANSACTION CYCLES Activities involved: (1) planning the cash need; (2) raising capital; and (3) investing funds *cover the non – operating activities of the company Financing Transactions: 1. Borrowing from third parties excluding open trade accounts with creditors (short – term and long – term) 2. Share capital and dividend transactions share issuance and reacquisition, shares returned and dividend declarations *Authorizing, executing, and recording transaction Investing Transactions: 1. Acquisitions and disposals of financial assets 2. Lending to third parties, other than open trade accounts with customers
Page 6 of 8
Accounts affected: (1) Notes Payable (non – trade); (2) Bonds Payable; (3) Mortgage Payable (4) Long – term Liability (finance lease) (5) Share capital (6) Investment in securities (7) Accounts Receivable (non – trade) (8) PPE and related adjustment
(9) Intangible assets (10) Cash in Bank (11) Interest Expense (Payable) (12) Share premium (13) Retained earnings (14) Treasury Shares (15) Dividends (16) Capital Account
Page 7 of 8
Documents used and Audit Significance Documents used in the expenditure cycle. Documents Significance Share Certificate - Shows the number of shares owned by a shareholder. Bond Certificate - Shows the number of binds owned by a bondholder Bond Indenture - (contract) States the terms of the bond issue Broker’s Advice - Specifies the details of an investing transaction.
I.
INTERNAL CONTROL OVER FINANCING TRANSACTION *Three operative objectives: proper execution, recording and custody of assets EXISTENCE OR OCCURRENCE & RIGHTS AND OBLIGATIONS: Financing cycle transactions actually occurred. a. The BOD authorizes the issuance of long – term notes, bonds, and share capitals, the legal requirements and proceeds are promptly deposited intact. b. Authorized (BOD or management) payments of interest and dividends to proper payees. c. Authorized execution of redemption and reacquisition of bonds and share capital transactions. d. Notes are cancelled when they are paid to avoid double payment. e. Recorded balances are periodically verified with bondholders and shareholders VALUATION/COMPLETENESS/CLASSIFICATION: Financing cycle transactions are properly valued and recorded. a. Transactions and events are correctly recorded as to amount, classification, and accounting period. b. Transactions are promptly and correctly posted to individual accounts.
II.
TESTS OF CONTROL SUBSTANTIVE TESTS OF FINANCING CYCLE TRANSACTIONS o Conduct test of compliance – since transactions are few in volume but large in value; follow the approach of substantiating the individual transactions III.
INTERNAL CONTROL OVER INVESTING TRANSACTION *Audit risks are kept at a very low level because - infrequent occurrence of the transactions - effective control can be implemented at a little cost *Three operative objectives: proper execution, recording and custody of assets EXISTENCE OR OCCURRENCE & RIGHTS AND OBLIGATIONS: Investing cycle transactions actually occurred. a. The management authorizes the acquisition/sale of PPE, securities and intangible assets. b. Interest and dividends checks are promptly deposited intact. c. Access to PPE, securities and intangible assets are restricted to authorized personnel. d. Recorded balances are compared with existing assets at reasonable intervals. VALUATION/COMPLETENESS/CLASSIFICATION: Investing cycle transactions are properly recorded. c. Transactions and events are correctly recorded as to amount, classification, and accounting period. d. Transactions are promptly and correctly posted to individual accounts investment.
IV.
TESTS OF CONTROL SUBSTANTIVE TESTS OF FINANCING CYCLE TRANSACTIONS o Test of control is limited because the number of transactions are relatively small. o The auditor may decide to proceed directly to substantive tests of balances after a preliminary review of the flow of transactions through the accounting system. (cost – benefit relationship) o When the entity has an extensive investment portfolio and numerous transactions, the auditor may decide to complete his review of internal control and perform compliance tests on the controls. Test of Control 1. Trace transactions for purchases and sales of PPE, securities and intangible assets through the system. 2. Review reports by internal auditor on their periodic inspections to PPE, securities and intangibles. 3. Review monthly reports by officer of client company on securities owned, purchased, and sold, and revenue earned. 4. Review significant changes in the composition of PPE and related liens and mortgages.
