ACCA Paper F 8

AUDIT AND ASSURANCE SERVICES (INTERNATIONAL STREAM)

Lecture 4

DATE: Autumn 2008

TUTOR:

Test of Controls

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Control Environment:
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2 The control environment is design by the senior management
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Factors that are included in the control environment are:
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1. Management's philosophy and operating style

1 Characteristics that form part of a management's philosophy and operating style

and which have an impact on the control environment include the
management's:

1 • approach to the taking and monitoring of business risks;

1 • reliance on informal face to face contacts with key managers versus a

formal system of written policies, performance indicators and exception
reports;

1 • attitudes and actions toward financial reporting;

1 • conservative or aggressive selection of accounting principles from

available alternatives;

1 • conscientiousness and conservatism in developing accounting

estimates;

1 • attitudes towards information processing and accounting functions and

personnel.

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3 2. Integrity and ethical values.

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1 In order to emphasise the importance of integrity and ethical values among all
personnel of an organisation the management should:

1 • Demonstrating integrity and practising ethical behaviour among all

employees of the organisation.

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3
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3. Commitment to competence. Personnel at every level in the organisation
must possess the knowledge and skills needed to perform their jobs
effectively.

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 4. Organisational structure and assignment of authority and responsibility.

An organisational structure contributes to an entity's ability to meet its objectives

by providing an overall framework for planning, executing, controlling and
monitoring the entity's activities.

Methods of imposing control

The board of directors and the audit committee and the manner in which they
exercise their governance and oversight responsibilities have a major impact on the
control environment.

Factors include the:

1 • Proportion of outside directors and the establishment of an audit

committee.

1 • Experience of members in audit committee.

1 • Extent of their involvement with and scrutiny of management's activities.

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3 * Degree to which they raise and pursue difficult questions with
management.

4 * Nature and extent of their interaction with internal and external auditors.

Internal audit

Internal audit function strengthens the control environment. To be effective,

internal audit auditor need to:

1 • skilled
2 • integrity;
3 • Have appropriate access to the board of directors and the audit committee,
and to the external auditors.

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Personnel policies and practices

A fundamental concept of internal control is that it is affected or implemented by

people. For the accounting and internal control systems to be effective, human
resource policies and practices must ensure that entity personnel possess the
expected integrity, ethical values and competence.

Such practices include:

1 • Developing appropriate recruiting policies.

1 • Screening prospective employees.

1 • Developing training policies that communicate prospective roles and

responsibilities.

1 • Exercising disciplinary action for violations of expected behaviour.

1 • Evaluating, counselling and promoting people based on periodic

performance appraisals.

1 • Implementing compensation programmes that motivate and reward

superior performance while avoiding disincentives to ethical behaviour.

Control procedures:

Control procedures are those policies and procedures which established to

achieve the entity’s specific objective.

1 They include in particular procedures designed to prevent or detect errors

and fraud.

1 Control procedures are details check and control which are built into the
system

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Types of internal control

1. Segregation of duties:
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2 No one person should be responsible for the recording and processing of the
complete work. This reduces the risk of fraud or error.

2. Physical: To ensure that assets are safeguard and there is restriction the
access to the authorised personnel. E.g. using password locks.

3. Authorisation and approval. All transaction should require authorisation or

approval by an appropriate person.

4. Arithmetic and accounting. To ensure completeness and accuracy of recoding

e.g. Trial Balances, reconciliation’s and control accounts.

5. Personnel. Delegation of duties to people with appropriate skills.

6. Supervision: All actions by all levels of staff should be supervised. The

responsibility for supervision should be clearly set out.

7. Management: These are control exercised by management, which are outside

and over and above the day to day routine of the system.

Limitation of internal control

1. Cost of implementation internal control systems.

2. Potential human error due to stress of workload, or carelessness.
3. The possibility of circumvention of controls either alone or through collusion
with parties outside or inside the entity.
4. Abuse of responsibility.

5. Management override internal control

Methods of recording the internal control systems

 1. Narrative Notes

Advantages

• Useful when systems are elementary.

• Capable of logical appraisal if properly compiled

- Documents listed in order of processing

1 - Cross-referenced to procedures performed on documents
2 - Division of duties indicated
3 - Authority levels and limit indicated
• Useful supplement to flowcharts and record exception routines (e.g.
processing of credit notes in a sales system.

Disadvantages:

• Difficult to appraise complex systems.

• Difficult to highlight controls
• Changes in systems might require a complete rewrite

2. Internal Control Questionnaires

Questions determine accounting procedures, documents raised and controls
imposed.

Advantages:

• Comprehensive list of questions on all sub systems and all possible aspects of
control automatically highlights strengths, weakness and omissions.
• All aspects of accounting and control are considered.
• Facilitates review and evaluation are facilitated
• Provides an easy way to cross-referencing to audit programmes

Disadvantages:

• The questions concentrate on the controls themselves rather than the error,
fraud or irregularity the control is designed to prevent or detect.
• The questions do not assess materiality or relative importance of controls.
• It is difficult to determine the existence of compensating or mitigating
controls when no answers indicate a weakness.
• Experience and judgement are required in evaluation.
• Standard questions may not apply to the specific situations of different
clients.
EXAMPLE: Internal control questionnaire for bank transactions

1. How often is bank reconciliation prepared?

2. (a) Is the person responsible for function independent of the receipts and
payment function?
(b) Alternatively is the reconciliation independently checked?
3. Does the person preparing the bank reconciliation obtain statements direct from
the bank and retain them until the reconciliation is effected?
4. Does the independent reconciliation include?
(a) A comparison of the debits and credits shown on the bank statements with the
cashbook?
(b) A comparison of paid cheques with the cashbook as to names, dates and
amounts?
(c) A test of the detailed paying-in-slip with the cashbook?
(d) An enquiry into contra items?
(e) Are items more than one month old investigated to?

3. Flowcharts

Advantages:

• Diagrammatic and shorthand symbols give perspective to the system’s

description.
• They aid understanding and communications
• The discipline of construction ensures complete recording of processes,
documents files, books and controls.
• Controls and weaknesses are easily highlighted
• Continuity of the audit is facilitated where audit staff changes take place.
• Review is facilitated by those not familiar with the client or system.
Disadvantages:

• Complex systems are difficult to evaluate by inexperienced staff.

• Changes in systems may require a complete redraft.

4. Internal Control Evaluation Questionnaires (ICEQ’s)

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2 An ICQ tries to establish how good the system of controls is. The ICEQ tries to
establish if specific errors and fraud are possible.
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4 Method of evaluating an already ascertained system (e.g. by flowchart)

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2 ICEQ is a list of supplementary questions to assess whether desirable controls
are present which individually or collectively prevent or detect the error or
fraud in the key questions.

Advantages

1 ICEQ’s facilitate the determination of whether desirable are present to detect,

eliminate or prevent the risk of serious error, fraud or irregularity.

1 They aid the evaluation process of complex flowchart.

1 They provide a logical basis for subsequent design and selection of detailed
audit tests-they are easily cross-referenced to audit programme.

1 They encourage better comprehension of systems by more junior staff.

Disadvantages:
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2 Too many supplementary questions can turn the ICEQ and ICQ and hence
cause confusion.
Purpose of Test of Controls at Interim audit:

• To obtain information about the operational system on a theoretical basis for

example:

1 • Organisational chart
2 • Procedures manual
3 • Systems notes

• Gather information about the system and perform walk through test.
• Ascertain strengths and weaknesses of major operational areas for example:
• Complete internal Control Questionnaires
• Perform tests of control

At Final audit:

• Final audit of the company at year-end is to produce statutory financial

statement.
• Audit concentrates on verifying the items and management assertions in the
balance sheet and profit and loss contained in the financial statement.
• Complete substantive procedures, perform subsequent events review and
obtain management representation and form an opinion.
• Report opinion
Internal Control Tests in specific areas of a business:

Cash and Cheques received by post:

Objective:

• To ensure that all cash and cheques received by post are accounted for and
accurately recorded in the books. To ensure all such receipts are promptly
deposited in the bank.

Measures:

• Measures to prevent interception of mail between receipts and opening

1 - Appointment of a staff to be responsible for opening of the post and two

other person present at the opening of the post.
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- All cheques and other negotiable instrument to be immediately given a
restrictive crossing “accounts payee only”.
- Immediate entry of the details of the receipts in a cash book and
independent person should be responsible for banking and recording the
transaction (Date, payer details amount either cash or cheques).

1 - Regular independent comparison of the post list with banking records. The
tests should be of total, detail and dating to detect teeming and lading at a
later stage in the processing
Cash sales and collections:

Objective:

To ensure that all cash, to which the enterprise is entitled is received, and
ensure that all such cash is properly accounted for and entered in the
records.

Measures:
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2 Authorised person should be responsible to receive cash for example sales
assistants, cashiers.

1 Evidence of cash receipts for example pre-numbered duplicate receipts cash

or cash registers with sealed till rolls. The duplicate receipts form books
should be securely held and issue should be controlled.

1 A staff should be responsible for emptying cash registers at prescribed

intervals and agreeing the amount present with till roll totals or internal
registers.
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3 Immediately banked the cash and payments for petty cash should be on
imprest system.

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1 Independent comparison of agreed till roll totals with subsequent banking
records.

1 Persons handling cash should not have access to other cash funds or
maintain sales ledger records.
 1 Rotation of duties and cover for holidays and sickness.

1 Collections by sales should be banked intact daily. There should be

independent comparison of the amount banked and records of the salesmen.

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Cash Balances:

Objective:
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2 To prevent mis-appropriation of cash balance and to prevent unauthorised
cash payments

Measures:
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3 To establish of cash floats of specified amount and location

1 Appointment of staffs responsible for each cash balance.

1 Arrangement of security measures including use of safes.

1 Use of imprest system on the basis that petty cash is replenished by the
amount of what the company has spent and there are specific rules on
reimbursement only against authorised vouchers.

1 Strict rules on the authorising of cash payments.

1 Independent cash count on a regular and a surprise basis.

1 Insurance arrangements e.g. cash balance and fidelity guarantee.

Bank balances:
Objective:

To prevent misappropriation of bank balance and to prevent teeming and lading.

Measures:

Reconciliation should be prepared on regular basis.

1 The reconciliation should be performed by an independent person.

1 Arrangement should be made for bank statements to be sent direct to the

person responsible for the reconciliation.

1 A comparison of debit and credit in the cash book with corresponding entries
in the bank statements.

1 A comparison of returned cheques with cash book entries noting dates, payee
and amounts.

1 A test of the details paying-in slips with cash book.

1 All outstanding cheques and lodgements should be traced through to the

next period and their validity verified.

1 Any unusual items e.g. contras or dishonoured cheques should be

investigated

1 The balance at the bank should be independently verified with the bank at
intervals.

1 Special arrangement should be instituted on the controls and recording of

trust monies e.g. employee’s sick pay or holiday funds, attachment of
earnings.
Cheque payments:

Objective:
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2 To prevent unauthorised payments being made from bank accounts.

Measures:
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2 Control over custody and issue of unused cheque book. A register should be
kept if necessary.

1 Staff should responsible for preparation of cheques.

1 Rules should be established for the presentation of supporting documents

before cheques can be made out. Such supporting documents may include
GRNs, purchase orders and invoices.

1 All such documents should be stamped “paid by cheque no” with date.

1 Established who should sign cheques. All cheques should be signed by a least
two persons, with no person being permitted to sign if he is a payee.
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3 No cheque should be made out to bearer except for the collection of wages or
reimbursement of cash funds.

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5 All cheque should be restrictively crossed.
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7 The signing of blank cheques must be prohibited.

8 Special safeguards should be implemented where cheques are signed

mechanically or have pre-printed signatures. Such signing is often made for
dividends payments, salary cheques and for others.

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10 Rules to ensure prompt despatch and to prevent interception or
misappropriation.
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12 Special rules for authorising and checking direct debits and standing orders.
Wages and salaries

Objective:
1 To ensure that wages are paid only to actual employees at authorised rates
of pay.

1 To ensure that all wages are computed in accordance with records of work
performed whether in respect of time, output, and sales made or other
criteria.

1 To ensure that payments are made only to the correct employees.

1 To ensure that payroll deduction are correctly accounted for and paid over to
the appropriate government bodies.

1 To ensure that all transactions are correctly recorded in the books of account.

Measures:
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2 There should be separate records kept for each employee. The records
should contain such matters as date of engagement, age, next of kin, agreed
wages, deduction, qualification, skill and experience.
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4 Procedures for and specified officials responsible for engagement, retirement,
dismissals, fixing and changing rates of pay. Procedures should be laid down
for notification of these matters to the personnel and wage roll preparation
departments.

1 Time records should be kept, preferably by means of supervised clock card

recording. These should be approved and approval acknowledge. All overtime
should be authorised.

1 The payroll should be prepared by personnel unconnected with other wage

duties. Special procedures should exist for dealing with advances, holiday
pay, luncheon, new employees, employees leaving, sickness and other
absences and bonuses.
1 The preparer of pay wages should be independent.

1 Special rules should be established for distribution of wages. Surprise

attendance at payout should be made at intervals by internal audit or senior
manager.

1 Unclaimed wages should be subject to special procedures. These should

include a record to be maintained of unclaimed wages, safe custody of such
pay packets, a requirement for investigation, subsequent payout only after
proof of entitlement, breaking down and re-bank the unclaimed wage after
specified time period.

1 Payments by cheque and credit transfer should be subject to special

procedures. These could include maintenance of separate bank account with
regular reconciliation.

1 Deduction such as PAYE, national insurance, pension contribution and other

dues should be subject to prompt payment over to the relevant agencies.

1 Regular reconciliation should be made between personnel records and wage

records.

1 Wage records should conform to the requirements of statutory sick pay.

Purchases and Accounts payables

Objectives:
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2 To ensure that goods and services are ordered in the quantity, of the quality,
and at the best terms available after appropriate requisition and approval.

1 To ensure that goods and services received are inspected and only
acceptable items are accepted.

1 To ensure that all invoices are checked against authorised orders and
receipts of the subject matter good condition.

1 To ensure that all goods and services invoiced are properly recorded in the
books.
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Measures:
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2 There should be procedures for the requisitioning of goods and services only
by specified personnel on specified forms with spare for acknowledgement of
performance.

1 Order forms should be pre-numbered and kept in safe custody.

1 Sequences checks of order forms should be performed on regular basis by

senior person in the purchase department.

1 All goods received should be recorded on goods received notes or in special

book.

1 All goods should be inspected for condition and agreement with order and
counted on receipts. The inspection should be acknowledged.

1 Procedures for dealing with rejected goods or services should be include the
creation debit notes with subsequent sequence check and follow up of
receipts of suppliers’ credit notes.

1 Invoice should be checked for arithmetical accuracy, pricing, correct

treatment of VAT and trade discount, and agreement with purchase order
and good-in records.

1 Invoices should have consecutive numbers put on them and batches should
be pre-list.
1 Total of entries in the invoice register or purchase day book should be
regularly checked.

1 A staff should be responsible for preparation of purchase ledger and

independent of other purchased duties.

1 The purchase ledger should be subject to regular reconciliation in total by or

be checked by an independent senior staff.

1 Purchase ledger account balances should be regularly compared with

suppliers’ statements of account.

Cut-off procedures at the year end are essential.

1 A proper coding system is required for purchase of goods and services so that
the correct nominal accounts are debited.
Sales and Accounts Receivable:

Measures

1 To ensure that all customers orders are promptly executed.

1 To ensure that sales on credit are only to bona fide good credit risks.

1 To ensure that all sales on credit are invoiced, that authorised prices are
charged and that before issue all invoices are completed and checked as
regards price, trade discounts and vat.

1 To ensure that all invoices raised are entered in the books.

1 To ensure that all customers’ claims are fully investigated before credit notes
are issued.

1 To ensure that every effort is made to collect all debts.

1 To ensure that no unauthorised credits are made to accounts receivables

accounts.

1 All sales orders should be recorded and if necessary acknowledged on pre-

numbered forms.

1 Procedures on credit control for verify the credit worthiness of all persons
requesting goods on credit.

1 Selling prices should be prescribed. Policies should be laid down on credit

terms, trade and cash discount.

1 Despatch of goods should be properly authorised by senior staff and recorded

in register or use of pre-numbered despatch notes.
1 Appropriate acknowledgement of receipts of goods should be made by
customers on copy despatch notes.

1 Invoicing should be carried out by separate department or by sales staff.

Invoices should be pre-numbered and the custody and issue of unused
invoice blocks controlled and recorded.

1 The sales invoices sequences should be checked in regular basis by senior

staff and missing and or spoiled invoices investigated.

1 All invoices should be independent checked for agreement with customer’s

orders with goods despatch notes for pricing, discount, Vat and other details.
All actions should be acknowledged by signature or initials.

1 Sales invoices should be pre-numbered before entry into the sales day book.

1 Customer’s claims should be recorded and investigated and similar controls

should be applied to credit notes.

1 A control account should be regularly prepared by independent person.

1 Accounts receivables statements should be prepared by personnel separate

from the sales ledger.

1 Legal action should be taken against accounts receivables refusing pay the
debts on time.

1 List of aged accounts receivables should be prepared and investigated

outstanding balances.

1 Bad debts should only be written off after investigation and acknowledged by
senior management.
1 At the year end an aged analysis of accounts receivables should be prepared
to evaluate the need for a provision of bad debts.

1 At the year end cut off procedures will be required, particularly attention will
be paid to orders despatched but not invoiced.
Inventories and Work in Progress:

Objective:
1 To ensure that stock is adequately protected against loss or misuse of
inventory.

Measures:
1
2
3 Separate storage of different type of inventory.

1 Control over the receipts of goods.

1 Inventory should be protected from deterioration due to physical causes.

1 Inventory should be safeguarded against loss of theft by physical controls.

1 Appropriate inventory records should be maintained.

1 Work in progress and finished goods may be subject to recording by value

including the charging of material, labour and overheads cost.

1 Established maximum and minimum inventory level with re-order level

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