9-1 copyright 2006 mcgraw-hill australia pty ltd revised ppts t/a auditing and assurance services...

9-1Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Chapter 9

Tests of Controls


Tests of Controls

• Provides auditor with evidence to support their assessment of control risk. When control risk assessed at less than high, necessary to gather evidence that controls are working. This evidence is gathered via test of controls.

• If control risk is assessed at high, auditor will not undertake test of controls.

• Auditor selects most efficient and effective combination of tests of controls, and substantive tests of transactions and balances.

Learning Objective 1:


Assessing control risk

• To assess control risk as high, auditor must expect that substantive procedures alone will provide sufficient appropriate evidence.

• Areas where substantive procedures alone may not provide sufficient appropriate evidence include routine recording of significant classes of transactions, such as revenue or purchases. These areas often highly automated with little or no manual intervention.


Planning the scope of tests of controls

• Nature – if controls exist that the auditor expects to rely upon, undertake tests of these controls, otherwise undertake substantive testing.

• Timing – to aid ability to meet deadlines and scheduling of staff, tests of controls sometimes scheduled before year-end. Testing then extended (rolled forward) until year-end.

• Extent – the more the auditor relies on controls, the greater the extent of tests of controls. For tests of controls related to documents, extent determined by reference to sampling theory.

• Controls related to accounting routines (e.g. bank reconciliations) usually tested by re-performing a small number.


Existence, Effectiveness and Continuity of Controls

• For internal controls to provide audit evidence about risk of material misstatements at the assertion level, the auditor must collect audit evidence about the existence, effectiveness and continuity of controls.

• Evidence of existence of controls is usually gained when auditor is evaluating control risk.

• Tests of controls are aimed at establishing their effectiveness and continuity.



Aspects of internal control


Sufficiency and Appropriateness

• Dependent on the level of control risk the tests must support.

• The lower the planned assessed level of control risk, the greater the amount of testing that is required.



Others factors affecting sufficiency and appropriateness

• Auditor should also consider:– type and source of evidence– timeliness– interrelationship of evidence.


Effect of documentation of controls: audit trail

• Methods used by auditor is dependent on whether a documentary audit trail exists.

• Where no audit trail exists, greater emphasis is placed on:

– observation– inquiry of the control.

• If audit trail does exist:– Inspect documentation for evidence of the control.


Relationship between tests of controls and assertions

• When auditor’s assessment of material misstatement at assertion level includes an expectation that controls are operating effectively, the auditor should perform tests of controls to obtain evidence that the controls were operating effectively at relevant times during the audit.

• Controls that relate to the control environment of a company’s internal control system relate less directly to specific financial report assertions.


Assertions and testing control activities

• The information system, control activities and monitoring of controls are built around major flows of transactions and events. Possible to relate most tests of controls for these elements to assertions about classes of transactions and events:(i) Occurrence – transactions and events that have been recorded,

have occurred and pertain to the entity;(ii) Completeness – all transactions and events that should have

been recorded have been recorded;(iii) Accuracy – amounts and other data relating to recorded

transactions and events have been recorded appropriately(iv) Cutoff – transactions and events have been recorded in the

correct accounting period; and(v) Classification – transactions and events have been recorded in

the proper accounts.


Revenues, Receivables and Receipts (Sales Cycle)

• Sales cycle involves all those transactions and events that are initiated when an entity makes a sale. It is commonly characterised by a high volume of routine transactions.

• Audit problems commonly related to clerical processing rather than complex accounting problems.



Key functions in typical sales cycle

• Order entry and order approval by credit department• Shipping• Invoicing• General ledger entry• Accounts receivable• Mail opening• Cashier functions.


Typical credit sales flowchart


Typical cash collection flowchart


Sales cycle — routine and non-routine transactions

• Routine transactions: – credit sales to customers, cash collections from

customers (flowcharts), usually strong control system, auditor considers (and usually undertakes) tests of controls.

• Non-routine transactions: – adjustments to sales, and provisions for doubtful debts.

Less well controlled. Where material, auditor undertakes substantive testing.


Control objectives for sales system

• Controls are in place to ensure that:– Occurrence – all sales recorded are bona fide

transactions for merchandise actually shipped to customers;

– Completeness – all sales shipped are invoiced and recorded in accounting records;

– Accuracy – invoices have been recorded correctly as to amount and summarised correctly;

– Cutoff – invoices have been recorded in correct period;– Classification – sales classified in accordance with written

policies.


Example of linking objectives to control policies and tests of controls for sales (Ref. Table 9.4 p. 411)

top of table 9.4

Special control objectives

Common control policies and procedures

Tests of controls

• Occurrence – All sales recorded are bona fide transactions for merchandise actually shipped to customers.

• Policy of authorisation of credit and terms

• Evidence of quantities shipped reconciled to quantities invoiced

• Select sample of sales transactions from sales journal (daily activity report), check for authorisation and trace to shipping document file

• Inspect reconciliation of shipments to invoices


Control objectives for cash receipt system

• Controls are in place to ensure:– Occurrence – recorded cash receipts are for collection of

receivables resulting from sales to customers of the entity;

– Completeness – all cash receipts are recorded and deposited;

– Accuracy – cash receipts have been recorded correctly as to amount;

– Cutoff – cash receipts have been recorded in correct period;

– Classification – cash receipts are classified in accordance with company policy.


Example of linking control objectives to control policies to tests of controls: cash receipts (Ref.: Table

9.5 p. 413)



Test of controls

• Occurrence – Recorded cash receipts are for collection of receivables resulting from sales to customers of the entity.

• Cash receipts matched to specific sales invoices in posting to accounts receivable master file.

• Select a sample of entries in cash receipts journal and review evidence that matched to specific sales invoices.


Types of misstatement in sales cycle

• Generally result of:– clerical mistakes;– employee fraud;– misapplied accounting principles, especially around some

revenue recognition issues;– management fraud.


Expenditures, Payables and Disbursements

• Expenditure cycle — all transactions and events initiated when an entity acquires assets or services used for cash or credit.

• Auditors (and many entities) often separate this cycle into a number of sub-cycles, which reflect various types of services and assets that can be acquired.



Sub-cycles in expenditures,payables and disbursements

• These sub-cycles are:– payroll– property, plant and equipment– inventory– income taxes– selling and administrative expenses– miscellaneous expenses paid from petty cash.


Key functions within the inventory sub-cycle

• Purchasing• Receiving • Accounts payable• Cash disbursements function.


Typical purchases and cash payments flowchart


Control objectives for purchases of inventory

• Controls are in place to ensure:– Occurrence – all recorded purchases are bona fide

transactions in that they relate to goods or services authorised or received;

– Completeness – all purchases for the period of inventory received are recorded;

– Accuracy – purchases of goods or services for inventory are recorded correctly as to amount and summarised correctly;

– Cutoff – purchase invoices have been recorded in correct period;

– Classification – purchase are classified in accordance with classification policies.


Example of Linking Control Objectives, Controls and Test of Controls: Purchases


Common controls Tests of controls

• Occurrence – All recorded purchases are bona fide transactions in that they relate to goods or services authorised or received.

• Approval of purchase order

• Goods received are counted, inspected and compared to purchase order before acceptance

• Comparison of purchase order, receiving report and supplier’s invoice and recomputation of supplier’s invoice before recording liability

• Examine evidence of approved purchase and service orders

• Select a sample of order entries in purchases journal, trace back to vouchers and inspect for existence of supporting document including receiving report, ensuring agreement of details and indication of approval

From Table 9.6 (p. 422-3)


Control objectives in a cash disbursements system

• Controls are in place to ensure:– Occurrence – recorded cash disbursements are for goods

or services authorised and received;– Completeness – all cash disbursements are recorded;– Accuracy – cash disbursements are recorded correctly as

to amount;– Cutoff – cash disbursements recorded in correct period;– Classification – cash disbursements are recorded

correctly as to account.


Example of linking control objectives, controls and test of controls: purchases : cash disbursements (Ref.: Table 9.7 p. 423)



Tests of controls

• Occurrence – Recorded cash disbursements are for goods or services authorised and received.

• Cheques printed or prepared only when receipt of goods or services and approval are documented (e.g. supporting documents compared, recomputed and voucher approved)

• Cheques signed only after viewing supporting documentation and prior approval

• Supporting documentation cancelled and reference to cheque number

• Select a sample of cash disbursement transactions from cash payments journal and inspect supporting documentation for indication of checking, review and approval

• Observe and inquire about cheque preparation and signing and protection of unissued cheques

• For the sample of cash disbursement transactions inspect supporting documents for cancellation, cheque number and endorsement


Potential misstatements in expenditure cycle

• As expenditure cycle involves disbursements of cash there is a greater risk of fraud or irregularity, including:

– classic disbursements fraud– kickbacks– illegal acts– unauthorised executive perks– kiting.


Selling and Administrative Expenses

• Processing and related control policies and procedures for selling and administrative expenses are similar to those for purchases of inventory.

• Auditor will normally obtain comfort from cash disbursement testing for inventory purchases and perform minimal testing in this area.

• Analytical procedures (e.g. comparing balance with prior periods) widely used as a key type of testing.



Petty cash disbursements

• Petty cash disbursements are usually immaterial in amount and therefore few, if any, audit procedures are applied to this area.

• Where the area is significant, emphasis is on ensuring appropriate procedures are in place to safeguard cash.


Payroll

• The payroll function is usually audited in either of two ways (or best combination):

– focusing on analytical procedures (there are disaggregated and strong relationships in this area, e.g. comparing fortnightly payrolls);

– an emphasis is placed on tests of transactions over the payroll area with the key control being appropriate segregation of duties in the hiring function, approval of time worked, payroll preparation and payroll distribution.


Tests of controls in payroll

• If tests of controls are necessary the following audit procedures may be undertaken:

– authorisation by supervisors of time worked;– check signed time cards/sheets;– check use of approved pay rates (personnel department);– check for reasonableness, compared with awards.


Interest, rent, lease and insurance payments

• Auditor usually takes a more substantive approach, which includes checking terms and conditions of contracts;

• Auditor interested in the key control of authorisation of the contract;

• Accounting treatment of leases is complex, and auditor might check controls that ensure leases are properly accounted for.


Testing Controls in Client Computer Programs

• Separate techniques have to be developed for testing programmed controls. These are:

– test data– integrated test facility– controlled processing, reprocessing or parallel processing– review program code and results of job processing.



Test data


Integrated test facility


Auditing through computer – processing client data

• Controlled processing – auditor establishes control over processing of client’s data;

• Controlled reprocessing – auditor reprocesses client data;

• Parallel processing – simultaneously processes client data through client and auditor programs.


Auditing through computer –other approaches

• Program code review — involves reviewing relevant code line by line, considering whether processing steps and control procedures are properly coded and logically correct.

• Review of job accounting data — involves reviewing printed log of jobs, looking for excessive processing time, abnormal halts, and etc.


Advanced CAATs

• Systems control audit review file (SCARF) – audit modules embedded in programs to monitor

transaction activity.

• Snapshot– transactions are tagged and then identified at certain

points during processing to see how program is treating them.

• Audit hooks– points in program that allow auditor to insert commands

for special processing.

9-1 copyright 2006 mcgraw-hill australia pty ltd revised ppts t/a auditing and assurance services...

Documents

test of controls

audit evidence

extent of tests

assessment of control

evidence of existence

control environment

control riskto

scope of tests