12-1

Chapter 12 Audit of the Sales and Collection Cycle: Tests of Controls

Review Questions

12-1 a. The bill of lading is a document prepared at the time of shipment of goodsto a customer indicating the description of the merchandise, the quantity shipped, andother relevant data. Formally, it is a written contract of the shipment and receipt ofgoods between the seller and carrier. It is also used as a signal to bill the client. Theoriginal is sent to the customer and one or more copies are retained.

b. A sales invoice is a document indicating the description and quantity of goodsshipped, the price including freight, insurance, terms, and other relevant data.It is the method of indicating to the customer the amount owed for the sale anddue date of the payments. The original is sent to the customer and one ormore copies are retained. The invoice is the basic document for recordingsales in the accounting records.

c. The credit memo is a document indicating a reduction in the amount due froma customer because of retained goods or an allowance granted. It takes thesame general form as a sales invoice, but it reduces the customer's accountsreceivable balance rather than increasing it.

d. The remittance advice is a document accompanying the sales invoice mailedto the customer for return to the seller with the cash payment. It is used toindicate the customer name, sales invoice number, and the amount of theinvoice when the payment is received. A remittance advice is used to permitthe immediate deposit of cash as a means of improving control over thecustody of assets.

e. The monthly statement to customers is the document prepared monthly andsent to each customer indicating the beginning balance of that customer'saccounts receivable, the amount and date of each sale, cash paymentreceived, credit memo for sales returns and allowances, and the endingbalance due. It is in essence a copy of the customer's portion of the accountsreceivable master file.

12-2 Proper credit approval for sales helps minimize the amount of bad debts andthe collection effort for accounts receivable by requiring that each sale be evaluated forcollection potential.

Adequate controls in the credit function enable the auditor to place more reliance on theclient's estimate of uncollectible debts. Without these controls, the auditor would have tomake his or her own credit checks on the customers in order to assure him- or herselfthat the allowance for bad debts is reasonable.

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12-3 The charge-off of uncollectible accounts receivable is a process whereby thecompany writes off receivables already in existence that it decides will not be collected.This usually occurs after a customer files for bankruptcy or the account is turned over toa collection agency. The bad debt expense is a provision for sales that the company willbe unable to collect in the future. It is an estimate used because of the matchingconcept of accounting.

The uncollectible accounts write-off must be carefully audited to assure that accountsthat have been paid are not written off to cover up a defalcation. This is done byexamining the authorization for the write-off and the correspondence in the filesconcerning that account, and possibly by circularizing accounts receivableconfirmations.

Bad debt expense is audited by examining past trends in uncollectibility, as it is aprojection of future uncollectibles.

12-4Transaction-Related AuditObjective

Key Internal Controls

1. Recorded sales are forshipments actually made tononfictitious customers(existence).

Recording of sales is supported by authorizedshipping documents and approved customer orders.Monthly statements are sent to customers;complaints receive independent follow ups.Authorization of credit before shipment takes place.Only customer numbers existing in the computer datafiles are accepted when they are entered.Shipping documents (that is, bills of lading) areprenumbered and accounted for.

2. Existing sales transactionsare recorded(completeness).

Sales invoices are prenumbered and accounted for.Shipping documents are prenumbered and accountedfor.

3. Recorded sales are for theamount of goods shippedand are correctly billed andrecorded (accuracy).

Determination of prices, terms, freight, and discountsis properly authorized.Internal verification of invoice preparation.Approved unit selling prices are entered into thecomputer and used for sales.Batch totals are compared with computer summaryreports.

4. Sales transactions areproperly classified(classification).

Use of adequate chart of accounts.Internal review and verification.

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5. Sales are recorded on thecorrect dates. (timing).

Procedures require billing and recording of sales on adaily basis.Internal verification.

6. Sales transactions areproperly included in thesubsidiary records and arecorrectly summarized(posting andsummarization).

Regular monthly statements to customers.Internal verification of accounts receivable master fileor trial balance with general ledger balance.

12-5 The most important duties that should be segregated in the sales and collectioncycles are:

1. Receiving orders for sales2. Shipping goods3. Billing customers and recording sales4. Maintaining inventory records5. Maintaining general accounting records6. Maintaining detailed accounts receivable records7. Processing cash receipts8. Granting credit and pursuing unpaid accounts

Segregation of duties should be used extensively in the sales and collection cycle fortwo reasons. First, cash receipts are subject to easy manipulation. Second, the largenumber and nature of transactions within the cycle makes the procedure of cross-checking, where one employee's duties automatically serve to verify the accuracy ofanother's, highly desirable.

If the asset-handling activities (shipping goods and processing cash receipts) arecombined with their respective accountability activities (maintaining inventory, accountsreceivable, and general accounting records), a serious weakness with respect tosafeguarding those assets exists. It would be very easy for an employee, by eitheromitting or adding an entry, to use the company's assets for his or her own purpose. Ifthe credit granting function is combined with the sales function, a weakness as toadherence to management's policies exists, as the credit function checks the naturaltendency of sales to optimize volume even at the expense of high bad debt write-offs.12-6 The use of prenumbered documents is meant to prevent the failure to bill orrecord sales as well as to prevent duplicate billings and recordings. An example of auseful control to provide reasonable assurance that all shipments are billed, is for thebilling clerk to file a copy of all shipping documents in sequential order after a shipmenthas been billed. Periodically, someone can account for all numbers in the sequence andinvestigate the reason for missing documents. The same type of control is also usefulfor duplicate sales invoices. An example of a useful test in this area is to account for thesequence of duplicate sales invoices in the sales journal, watching for omitted numbers,

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duplicate numbers, or invoices outside the normal sequence. This test simultaneouslyprovides evidence of both the "existence" and "completeness" objectives.

12-7 1. Credit must be properly authorized before a sale takes place.

Test: Analyze the allowance for doubtful accounts and writeoffs ofaccounts receivable during the period to determine the effectiveness of thecredit approval system.

2. Goods should be shipped only after proper authorization.

Test: Review physical inventory shortages to determine the effectiveness ofinventory control.

3. Prices, including payment terms, freight, and discounts, must beauthorized.

Test: Compare actual price charged for different products, including freightand terms, to the price list authorized by management.

12-8 The purpose of footing and crossfooting the sales journal and tracing theposting to the general ledger is to determine that all transactions are included in thesales journal from which the auditor will make his or her sample selection for testing thetransactions and to determine that the general ledger balance results from the sales andcollection cycle.

12-9 The verification of sales returns and allowances is quite different from theverification of sales for two primary reasons:

1. Sales returns and allowances are normally an insignificant portion ofoperations and therefore receive little attention from the auditor.

2. The primary emphasis the auditor places on sales returns andallowances is to determine that returns and allowances are properlyauthorized and that sales are not overstated at year-end andsubsequently reversed by the issuance of returns.

12-10 Cash is the most liquid asset that the company owns and thus is the mostlikely target of a fraud. The emphasis the auditor places on the possibility of fraud incash is not inconsistent with this responsibility, which is to confirm the fairness of thepresentation of the financial statements. If material fraud has occurred, and it is not fullydisclosed in the financial statements, those statements are not fairly presented.

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12-11

Transaction -Related AuditObjective

Key Internal Controls

1. Recorded cash receiptsare for funds actually receivedby the company. (existence)

• Separation of duties between handlingcash and record keeping.• Independent reconciliation of bankaccount.

2. Cash received isrecorded in the cash receiptsjournal. (completeness)

• Separation of duties between handlingcash and recordkeeping.• Use of remittance advices, or a prelistingof cash.• Immediate endorsement of incomingcheques.• Internal verification of the recording ofcash receipts.• Regular monthly statements tocustomers.

3. Recorded cash receiptsare deposited and recorded atthe amount received.(accuracy)

• Same as 2 above.• Regular reconciliation of bank accounts.• Batch totals are compared with computersummary reports.

4. Cash receipts areproperly classified.(classification)

• Use of adequate chart of accounts.• Internal review and verification.

5. Cash receipts arerecorded on the correct dates.(timing)

• Procedure requiring recording of cashreceipts on a daily basis.• Internal verification.

6. Cash receipts areproperly included in thesubsidiary records and arecorrectly summarized. (postingand summarization)

• Regular monthly statements tocustomers.• Internal verification of accounts receivablemaster file contents.• Comparison of accounts receivablemaster file or trial balance totals with generalledger balance.

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12-12 Audit procedures the auditor can use to determine whether all cash receiptswere recorded are:

1. Confirmation of accounts receivable.2. Gain an understanding of and test internal controls over cash.3. Reconciliation of bank account.4. Tracing receipts listed by person opening mail to the deposit slip

validated by the bank.5. Trace credits in accounts receivable to their source (i.e., cash receipts,

sales return, uncollectible account).

12-13 Proof of cash receipts is a procedure to test whether all recorded cashreceipts have been deposited in the bank account. In this test, the total cash receiptsrecorded in the cash receipts journal for a period of time, such as a month, arereconciled to the actual deposits made to the bank during the same time period. Theprocedure is not useful to discover cash receipts that have not been recorded in thejournals or time lags in making deposits, but it is useful to discover recorded cashreceipts that have not been deposited, unrecorded deposits, unrecorded loans, bankloans deposited directly into the bank account, and similar errors or fraud.

12-14 Lapping is the postponement of entries for the collection of receivables toconceal an existing cash shortage. The fraud is perpetrated by someone who recordscash payments in the cash receipts journal and then enters them into the computersystem. He or she defers recording the cash receipts from one customer and covers theshortage with receipts from another customer. The shortage is in turn covered by thereceipts from a third customer a few days later. The employee must either continue tocover the shortage through lapping, replace the stolen money, or find another way toconceal the shortage.

This fraud can be detected by comparing the name, amount and dates shown onremittance advices to cash receipts journal entries and related duplicate deposit slips.Since the procedure is relatively time-consuming, auditors ordinarily perform theprocedure only where there is a specific concern with fraud because of a weaknessdiscovered in internal control.

12-15 The audit procedures most likely to be used to verify accounts receivablecharged off as uncollectible and the purpose of each procedure are as follows:

1. Examine approvals by the appropriate persons of individual accountscharged off. The purpose is to determine that charge-offs are approved.

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2. Examine correspondence in client's files that indicates theuncollectibility of the accounts for a selected number of charge-offs.The purpose is to determine that the account appears to beuncollectible.

3. Consider the reason for the charge-off as compared to the companypolicy for writing off uncollectible accounts. Purpose is to determinewhether or not company policy is being complied with.

12-16 It is always acceptable to perform tests of controls at an interim date. Theauditor may decide it is necessary to test the untested period at year end especially ifthe period is longer than a month or two. It is acceptable to perform tests of controls forsales and cash receipts at an interim date and not perform additional tests of the systemat year end under the following circumstances:

The auditor feels internal control over the accounting system is effective.1. The auditor does not anticipate significant changes in internal control

during the remaining period.2. The transactions normally occurring between the completion of the

tests of controls and the end of the year are similar to the transactionsprior to the test date.

3. The remaining period is not too long in the circumstances; conventionalwisdom suggests three months or less.

4. Other matters of concern to the auditor indicate that the limitation oftransactions testing is appropriate.

Note that if the auditor decides not to test the controls for the interim period and thereare problems (for example, a material error or fraud) arising from transactions that tookplace during that period, the onus would be on the auditor to prove that he or she wasnot negligent by not testing for the interim period. The auditor must consider thepotential impact of such decisions in making the decisions.

12-17 Generally, a successful test of controls allows for a reduction of tests of detailsof balances at year end. However, Deidre Brandt chose the month of March, which onlyrepresents one-twelfth of the year, as her test period. With such a short test period,Deidre cannot conclude that she has selected a representative sample from the totalpopulation; therefore, without testing additional months (consensus of coverage), Deidrecannot change the scope of her tests of details of financial balances at year end. By anystandard, she is being negligent in adopting such an audit approach.

12-18a. In considering the appropriate TER the auditor uses judgement to determine

what exception rate would be material. It is deciding how important each

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attribute is. A tolerable exception rate of 3% leads to a larger sample size than a6% TER.

b. In deciding the ARACR the auditor is considering if there are other controls inplace for this attribute that he/she may rely upon. A sample size based on a 10%ARACR will be smaller than a sample size based on a 5% ARACR.

c. A sample of 100 invoices, an ARACR at 5% and three exceptions found wouldindicate a CUER of 7.6. This is the computed upper exception rate based on theactual number of deviations found in the sample. If this number exceeds theTER then more deviations were found than the auditor decided was appropriate.

Multiple Choice Questions

12-19 a. (2) b. (3) c. (1) d. (1)12-20 a. (1) b. (3) c. (1)12-21 a. (1) b. (1) c. (3)

Discussion Questions and Problems

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1. a. Recorded sales are for the amount of goods ordered and are correctlybilled and recorded. (Accuracy)

b. Examine indication of internal verification on sales documents.

c. Incorrect prices may be charged, the customer may be billed for the wrongquantity, or the total amount may be computed incorrectly.

d. Recompute information on the sales invoices. Trace details on salesinvoices to shipping records, price lists, and customers' orders.

2. a. Recorded sales and credit transactions are for shipments actually madeand existing sales transactions are recorded. (Existence andCompleteness)

b. Account for the numerical sequences of sales orders, invoices, and creditmemoranda.

c. Shipments or returns are not recorded. Orders from customers aremisplaced and not filled.

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d. Examine correspondence concerning credit memoranda to assure thatthey were properly issued. Trace shipping documents to resultant salesinvoice and entry into sales journal and accounts receivable master file.Send accounts receivable confirmations.

3. a. Existing transactions are recorded; recorded transactions are valid.(Completeness and Existence)

b. The auditor should observe the employees and discuss the procedureswith personnel.

c. Sales could be made and not recorded, with the employee keeping theproceeds of the sale.

d. Trace selected shipping documents to related duplicate sales invoices, thesales journal, and accounts receivable master file.

4. a. Existing transactions are recorded. (Completeness)

b. The auditor should observe the activities of those employees and discussthe procedures with personnel.

c. These unusual sales could be made but not recorded and the proceedskept from the company.

d. Examine sales documents for these sales and trace the entries into thecash receipts books.

5. a. Existing transactions are recorded and recorded sales are for the amountof goods ordered and are correctly billed. (Completeness and Accuracy)

b. The auditor should observe the activities of employees and discuss theprocedures with personnel.

c. A receivable might intentionally not be recorded, allowing the cash to bekept from the company.

d. Trace from the shipping records to the sales invoice, to the accountsreceivable master file, and to cash receipts.

6. a. Sales and collection transactions are properly included in the subsidiaryrecords and are correctly summarized. (Posting and Summarization)

b. Observation of procedures and examination of indication of internalverification.

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c. Unintentional misstatements could be posted in the control accounts andleft undetected for long periods of time.

d. Perform tests of clerical accuracy—foot journals and trace postings fromjournal to general ledger and accounts receivable master file.

7. a. Existing cash receipts transactions are recorded. (Completeness)

b. Observation and discussion of procedures with employees.

c. Cash could be received, not recorded, and kept from the company by anemployee or lost prior to deposit.

d. Trace receipts recorded on a list—such as from a prelist of cash—to thebooks of original entry; send accounts receivable confirmations.

8. a. Transactions are recorded at the proper time. (Timing)

b. Compare date per books to the date the deposit appears on the bankstatement.

c. Cash receipts might be recorded in the wrong accounting period, lost, orstolen.

d. Trace cash recorded on a list, such as a prelist of cash, to the cashreceipts journal and to the bank statement.

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1-a Error1-b Print a list of all master file changes for independent verification.1-c Compare approved master file change form to listing of master file.

2-a Error2-b Sales invoices are prenumbered, properly account for in the sales journal, and a

notation on the invoice is made of entry into the sales journal.2-c Account for numerical sequence of invoices recorded in the salesjournal, watching for duplicates. Confirm accounts receivable at year-end.

3-a Fraud3-b All payments from customers should be in the form of a cheque payable to the

company. Monthly statements should be sent to all customers.

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3-c Trace from recorded sales transactions to cash receipts for thosesales; confirm accounts receivable balances at year end.

4-a Fraud4-b The listing of cash received should be compared to the postings in theaccounts receivable master file and to the validated bank deposit slip.4-c Trace cash received from prelisting to cash receipts journal. Confirm accounts receivable.

5-a Error5-b Use of prenumbered bills of lading that are periodically accounted for.5-c Trace a sequence of prenumbered bills of lading to recorded sales transactions.Confirm accounts receivable at year end.

6.-a Error6-b No merchandise may leave the plant without the preparation of a prenumbered

bill of lading.6-c Trace credit entries in the perpetual inventory records to bills oflading and the sales journal. Confirm accounts receivable at year end.

7-a Error7-b Internal review and verification by an independent person.7-c Test accuracy of invoice classification.

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Objective Dual-Purpose Test

1. Accuracy Match a sample of duplicate sales invoices to relatedshipping documents checking quantity anddescription.

2. Posting and summarization Not applicable.3. Accuracy Compare unit selling prices on duplicate sales

invoices to the approved price list.4. Classification Not applicable.5. Completeness Accuracy

TimingSelect a sample of customer orders and verify thatshipping documents, vendor's invoices exist for eachone and that there is an entry in the accountsreceivable master file for each one.

6. Existence CompletenessAccuracy, Timing

Procedure listed is a dual-purpose test.

7. Accuracy Recalculate the cash discounts for a sample ofremittances and determine if each one was consistentwith company policy.

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12-25 a. The lack of segregation of duties was the major deficiency that permittedthe fraud for Appliance Repair and Service Corp. Gyders has responsibility for openingmail, prelisting cash, updating accounts receivable, and authorizing sales allowancesand charge-offs for uncollectible accounts. It is easy for Gyders to take the cash beforeit is prelisted and to charge off an accounts receivable as a sales allowance or as a baddebt.

b. The benefits of prelisting cash are to immediately document cash receipts at thetime that it is received by the company. Assuming all cash is included on theprelisting, it is then easy for someone to trace from the prelisting to the cashreceipts journal and deposits. Furthermore, if a dispute arises with a customer, itis easy to trace to the prelisting and determine when the cash was actuallyreceived. The prelisting should be prepared by a competent person who has nosignificant responsibilities for accounting functions. The person should not be in aposition to withhold the recording of sales, adjust accounts receivable or sales forcredits, or adjust accounts receivable for sales returns and allowances or baddebts.

c. Subsequent to the prelisting of cash, it is desirable for an independent person totrace from the prelisting to the bank statement. That can be done by anyoneindependent of whoever does the prelisting, or prepares or makes the deposit.

d. A general rule that should be followed for depositing cash is that it should bedeposited as quickly as possible after it is received, and handled by as fewpeople as possible. It is, ideally, the person receiving the cash that shouldprepare the prelisting and prepare the deposit immediately afterward. Thatperson should then deposit the cash in the bank. Any unintentional errors in thepreparation of the bank statement should be discovered by the bank. Theauthenticated duplicate deposit slip should be given to the accountingdepartment who would subsequently compare the total to the prelisting. When anindependent person prepares the bank reconciliation, there should also be acomparison of the prelisting to the totals deposited in the bank.

Any money taken before the prelisting should be uncovered by the accountingdepartment when they send out monthly statements to customers. Customers are likelyto complain if they are billed for sales for which they have already paid.

12-26 a. Collections

Weakness Recommended Improvement1. Treasurer exercises too much

control over collections.To extent possible, treasurer's responsibilitiesshould be confined to record keeping.

2. Finance committee is notexercising its assignedresponsibility for collection.

Finance committee should assume a moreactive supervisory role.

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3. The auditing function has beenassigned to the financecommittee, which also hasresponsibility for theadministration of the cashfunction. Moreover, the financecommittee has not performedthe auditing functions.

Individuals should be appointed to performperiodic auditing procedures or engageverification procedures.

4. The treasurer has sole accessto cash during the period of thecount. One person should notbe left alone with the cash untilthe amount has been recordedor control established in someother way.

The number of counters should be increased toat least two, and cash should remain under jointsurveillance until counted and recorded so thatany discrepancies will be brought to attention.

5. The collection is vulnerable torobbery while it is beingcounted and from the churchsafe prior to its deposit in thebank.

The collection should be deposited in the bank'snight depository immediately after the count.Physical safeguards, such as locking and boltingthe door during the period of the count, shouldbe instituted. Vulnerability to robbery will also bereduced by increasing the number of counters

6. The ushers do not countcollection but simply place it inthe church safe. If the churchwere to be robbed (see 5.above), there would be norecord of the amount stolen.

The ushers should count the collection usingspecially developed count sheets. One copy ofthe count and the receipts should be placed in anight depository at the bank; the second copyshould be left at the church.

7. No mention is made ofbonding.

Key employees and members involved inreceiving and disbursing cash should bebonded.

8. Written instructions forhandling cash collectionsapparently have not beenprepared.

Especially because much of the work involved incash collections is performed by unpaid,untrained church members, often on a short-term basis, detailed written instructions shouldbe prepared.

b. Record keeping1. The envelope system has not

been encouraged. Controlfeatures which it could providehave been ignored.

The envelope system should be encouraged.Counters should indicate on the outside of eachenvelope the amount contributed. Envelopecontributions should be reported separately andsupported by the empty collection envelopes.Prenumbered envelopes will permit readyidentification of the donor by authorized personswithout general loss of confidentiality.

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2. The church has no record ofindividual givings and thusreceipts are not based on theamounts actually given. It maybe that some members arereceiving tax receipts that arefar in excess of their actualgivings. This weakness isespecially a problem becausethe tax department may revokethe church's status as acharitable organization.

Members should have to document their givingsby using envelopes or cheques payable to thechurch. The counters should list the givings byenvelope number every Sunday and reconciletotal to the funds (cash and cheques) receivedand deposited. The treasurer should use thesame list to update the individual member'sgiving record which is used to prepare theannual tax receipt for the member.

3. Because no records ofindividual givings aremaintained, the church doesnot know which members aremeeting their pledges. Therewould be no way of knowingwho was causing the shortfall

Each member should receive a statementquarterly from the finance committee indicatingamount pledged and amount given to the end ofthe quarter; this would assist delinquentmembers in meeting their pledges.

12-27 a. To test whether shipments have been billed, a random selection ofwarehouse removal slips should be made and examined to see if they have the propersales invoice attached. The sampling unit will be the warehouse removal slip.

b. Assuming the auditor is willing to accept a tolerable exception rate of 3% at a10% ARACR, expecting no exception in the sample, the appropriate sample sizewould be 76, determined from Table 11-6:

c. A one-to-one correspondence is established between the warehouse removalslip number and the 5 digits in the random number table.

The first ten random numbers selected are 30452, 35793, 21027, 29925, 31546, 17563,34535, 35936, 28288, 24841.

d. Other audit procedures that could be performed are:a. Test extensions on attached sales invoices for clerical accuracy.

(Valuation)b. Test time delay between warehouse removal slip date and billing date

for timeliness of billing. (Timing)c. Trace entries into perpetual inventory records to determine that

inventory is properly relieved for shipments. (Posting andsummarization)

e. The test performed in part c cannot be used to test the existence of salesbecause the auditor already knows that inventory was shipped for these sales.To test the validity of sales, the sales invoice entry in the sales journal is the

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sampling unit. Since the sales invoice numbers are not identical to thewarehouse removal slips it would be improper to use the same sample.

12-28 a. It would be appropriate to use attributes sampling for all audit proceduresexcept audit procedure 1. Procedure 1 is an analytical procedure for which the auditor isdoing a 100% review of the entire cash receipts journal.

b. The appropriate sampling unit for audit procedures 2-5 is a line item, or the datethe prelisting of cash receipts is prepared. The primary emphasis in the test is thecompleteness objective and audit procedure 2 indicates there is a prelisting ofcash receipts. All other procedures can be performed efficiently and effectively byusing the prelisting.

c. The attributes for testing are as follows:

Audit Procedure AttributeProcedure 2 Cash receipts in the prelisting are recorded in the

cash receipts journal.

Procedure 3 Customer name, date, and amount are equal to theprelisting and cash receipts journal.

Procedure 4 Cash discounts were approved on the relatedremittance advice.

Procedure 5 Cash included in the prelisting has been included onthe deposit slip.

d. The sample sizes for each attribute are as follows:AuditProcedure

Sample Size SampleSize

ARACR TER EPER2 5% 8% 2% 773 5% 8% 2% 774 5% 8% 2% 775 5% 8% 2% 77

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12-29 a. Use professional judgement to come up with a reasonable sample.

b. Sample Size BeforePopulation SizeAdjustment

Population SizeAdjustment

Sample Size AfterPopulation SizeAdjustment

1 88 none 882 127 none 1273 181 none 1814 127 n = 127 / 1 + 127

/1,000 = 112.7113

5 25 none 256 18 none 187 149 none 149

c.Change inFactors

Effect on Sample Size Illustration in Part a

1 Increase inARACR.

Decrease Compare columns 2 to 1

2 Increase intolerable exceptionrate.

Decrease Compare columns 3 to 2

3 Increase inestimatedpopulationexception rate.

Increase Compare columns 5 to 6

4 Increase inpopulation size.

Increase Compare columns 4 to 2

d. The difference in the sample size for column 3 and 6 result from the largerARACR and larger tolerable exception rate in column 6. The extremely largetolerable exception rate is the major factor causing the difference.

e. The greatest effect on the sample size is the difference between tolerableexception rate and estimated population exception rate. For columns 3 and7, the differences between the tolerable exception rate and estimated populationrate were 3% and 2% respectively. Those two also had the highest sample size.Where the difference between TER and EPER was great, such as columns 5 and6, the required sample size was extremely small.

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Population size also had a relatively small effect on sample size. The difference inpopulation size in columns 2 and 4 was 99,000 items, but the increase in sample sizefor the larger population was only 14 items.

f. The sample size is referred to as the initial sample size because it is based on anestimate of the sample exception rate. Once the test is performed, the actualsample exception rate is used to calculate the final upper exception rate. Theauditor can then decide whether the sample size is adequate.

12-30 a. and b. The sample sizes of CUERs are shown in the following table:

ActualSample Size

Initial SampleSize From Table12-7

Sample exception Rate(SER)

CUERFromTable12-8

1. 100 127 2.0% 6.2%2. 100 99 0.0 3.03. 60 65 1.7 6.34. 100 93 4.0 8.95. 20 18 5.0 18.16. 60 60 13.3 >20.0

a. The auditor selected a sample size smaller than that determined from the tablesin population 1 and 3. The effect of selecting a smaller sample size than the initialsample size required from the table is the increased likelihood of having thecomputed upper exception rate exceed the tolerable exception rate. If a largersample size is selected, the result may be a sample size larger than needed tosatisfy tolerable exception rate. That results in excess audit cost. Ultimately,however, the comparison of CUER to tolerable exception rate determineswhether the sample size was too large or too small.

b. The sample exception rate and computed upper exception rate are shown incolumns 4 and 5 in the above table.

c. The population results are unacceptable for populations 4 and 6. In each of thosecases, the CUER exceeds tolerable exception rate.

The auditor's options are to change tolerable exception rate or ARACR, increase thesample size, or perform other substantive tests to determine whether there are actuallymaterial errors in the population. Increasing sample size would not likely result inimproved results for either population 4 or 6 because the CUER exceeds tolerableexception rate by a large amount.

d. Analysis of exceptions is necessary even when the population is acceptablebecause the auditor wants to determine the nature and cause of all exceptions.

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If, for example, the auditor determines that an error was intentional, additionalaction would be required even if the CUER was less than tolerable exceptionrate.

e.Term Nature of Term1. Estimated population

exception rateNonstatistical estimate made byauditor.

2. Tolerable exception rate Audit decision.3. Acceptable risk of assessing

control risk too lowAudit decision.

4. Actual sample size Audit decision (determined byother audit decisions).

5. Actual number of exceptionsin the sample

Sample result.

6. Sample exception rate Sample result.7. Computed upper exception

rateStatistical conclusion about thepopulation

Cases12-31(a) CA did not consider anything other than the fact that he had the time to do the audit.

Before accepting an engagement the CA should have obtained more informationabout the client including reviewing a copy of the previous financial statements,communication with the predecessor accountant, and exploring the possibility ofunusual risks. The CA did not mention checking to ensure the firm was independentof the prospective client nor whether the firm had the expertise required to fulfill thisengagement.

(b) CA’s preparation, conduct and evaluation did not comply with generally acceptedauditing standards. There is no mention of CA assessing audit risk or of doing anyverification that policies and procedures are followed. CA would need to investigatethis first before deciding and defining what test of controls or substantive procedureswere necessary and assigning someone to carry them out. CA was aware thatSmith Wholesalers Ltd. had inadequate segregation of duties; accounting duties,data entry and handling cash all carried out by the same person. As well, the SalesManager was also responsible for credit approval and volume discounts, specialsales prices and the writing-off of uncollectible accounts. The receiver was incharge of inventory control. This auditing engagement should have been assigned amaximum risk level and the audit should have been designed accordingly. GAASstates that a sufficient understanding of internal control should be obtained to planthe audit. CA was aware there was a lack of controls from reading the company’sformal sales policy and the list of employees and their duties. CA did noinvestigating and the audit program CA designed does not reflect this knowledge.

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GAAS states that if assistants are employed they are to be properly supervised. CAgave the assistant free reign and no supervision. As well CA did not use all themeans described in the GAAS examination guidelines to gather sufficientinformation: inspection, observation, enquiry, confirmation, computation andanalysis. CA’s evaluation of the results was inadequate. CA should have seen redflags and done further investigating himself. CA knew the company’s formal salespolicies and was now aware they were not always followed. GAAS states that theexamination should be performed and the report prepared by a person havingadequate technical training and proficiency in auditing and is to be performed withdue care.

(c) Investigate and confirm the aged accounts receivables.

• Sales are up but cash is low could indicate that accounts receivables are notbeing collected in a timely manner or at all.

Check how the company accounts for uncollectible accounts receivables. Whathappens to bad debts? How many write-offs have there been?

• Are bad debts, write-offs and uncollectible accounts being deducted from thegross sales?

Check the extent of volume discounts and special discounts granted by Zee.

• Overgranting discounts would decrease the profit margin, decreasing cash.

Investigate how the company calculates gross sales. Is it reasonable?

• Zee’s bonus is based on gross sales if it is not adjusted based on GAAP thenZee would be receiving a larger bonus that he should. Perhaps CA shouldrecommend Zee’s bonus be paid on net sales.

Investigate the controls in place with regard to cash and do substantive testing toverify controls are working. Is all cash being deposited in the bank?

• With the same person performing the accounting duties, the data entry andhandling cash, theft of cash would be relatively easy to do.

d) The principle difference between test of controls and substantive procedures istheir objective. Test of controls are used to assess and evaluate the effectivenessof policies and procedures to prevent or detect material misstatements and toassess the control risk range, from maximum to low for the audit. Substantiveprocedures are used to acquire evidence as to the accuracy of the informationproduced by the entity. Both tests of controls and substantive procedures use thesame methods to gather evidence: inspection, observation, enquiry, confirmation,computation and analysis.

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12-32a. Programmed controls1. Check digit on the following fields:

• clerk code• stock number

2. Limit check on maximum and minimums on the following fields:• quantity sold• unit price• total sale• sales tax• amount tendered

3. Field check on the following fields:• clerk code• transaction code• stock number• quantity sold• unit price• amount tendered

4. Logical relationship• total sale cannot exceed amount tendered• return transaction should not have amount tendered

5. Programmed routine to identify error or potential error condition for the following:• Unusual transaction or large value transaction should require a correction

procedure with a restricted use clerk code. The code would be issued only to thestore manager.

• A casual input error would simply be reentered by the clerk.• A limited number of reentries for the same error would require correction by the

restricted clerk.• A program routine should flag transactions left open after a certain period of time

(e.g., “END” key not activated).

6. Numeric test on stock number to ensure that only numeric items are processed.

7. Validity checks (program subroutine) against a table of valid codes (or against themaster inventory file for CD codes) on the following:• transaction code• clerk code• inventory master details

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8. Set up control totals so that cashier can count cash at the end of the shift, enter, andreceive an error message if control does not equal cash count.

9. Anticipatory control to ensure that sequence of data entered is correct, e.g., data,correct operation, data, etc.

10. Control to report on a sale against or generating a negative inventory quantity.

11. Other valid programmed controls.

b. Test transactions1. Put through transactions

• to test that the system correctly handles valid transactions

2. Use an invalid check digit• verify the existence of the check digit

3. Use field overflow• field check

4. Omit data in critical fields to create an incomplete transaction• field check

5. Use unreasonable data• to verify limit checks

6. Use an invalid transaction code• to verify the existence of the table of valid codes• to assess the system response to invalid codes

7. Enter several valid transactions and enter an incorrect cash count• to assess the system response to control totals being out of balance

8. Use of amount tendered less than total sale• To verify the logical relationship test and to review the system response

9. Use an alpha numeric code for the stock number• to assess the numeric test and to assess the system reaction

10. Withhold “END” key• to ensure that open transaction is flagged by the system

11. Enter data out of proper sequence• anticipatory control over sequence of input data

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12. Enter a sale which creates a negative balance in inventory• error flag for credit balance in inventory

Note: Each transaction should contain only one error to facilitate follow-up by theauditor.

c. Integrity of inventory master file1. Use of copy of the client’s inventory master file for processing the test transactions

• Ideally, the copy should be made under conditions controlled by the auditor.

2. Create dummy stock numbers and quantities in a dummy master file and have alltest transactions processed against this dummy file.

OR

3. Use reversing transactions to remove the effects of any tests that affect the masterfile (more risky and less desirable).