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Fundamentals of Auditing

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Fundamentals of Auditing ­ACC 311
VU
Lesson 17
DOCUMENTING THE INTERNAL CONTROL SYSTEM
Benefits of Internal Control to the entity
Based on our previous studies we can now identify the following principal benefits that may arise for an
entity from a sound system of internal control:
a)
Assurance that all transactions are completely and accurately processed.
b)
Confidence that only authorized transactions takes place.
c)
Assurance that adequate documentation supporting transactions is created and retained.
d)
Assurance that the company's assets and liabilities are correctly stated, in order for them to
make informed decisions on the operations of the business.
e)
Minimization of the risk of fraud and misappropriation of assets.
Benefits of Internal Control to the auditor
Of course, if the audit client benefits from a sound system of internal control, it is likely that the auditor will
also be benefited. All of the above stated benefits help to promote a situation where the financial statements
present a true and fair view. In simple terms, a good system of internal control will make life easier for the
auditor.
Auditor's work on the Internal Control
International standards on auditing emphasize the importance of internal control to the auditor by stating
that auditor should:
a)
Obtain an understanding of the accounting and internal control system sufficient to plan the
audit and develop an effective audit approach, and
b)
Use professional judgment to assess the components of audit risk and to design audit
procedures to ensure it is reduced to an acceptably low level.
At an early stage in their work auditors will have to decide the extent to which they wish to place reliance on
the internal controls of the enterprise. As the audit proceeds, that decision will be kept under review and,
depending on the results of their examination, they may decide to place more or less reliance on these
controls.
Categories of Internal Control
These are often summarized by using the mnemonic SOAP MAPS as follows:
a) Supervision
b) Organization
c) Arithmetic and Accounting
d) Physical
e) Management and Monitoring
f)  Authorization
g) Personnel
h) Segregation of duties
a) Supervision
There should be adequate supervision of work to ensure that controls are being complied with.
Possible application: a supervisor or manager reviews and checks the work of a subordinate.
b) Organization
Enterprises should have a formal, documented organization structure with clear lines of
responsibility.
Possible application: lines of authority within an organization make it clear which individuals are responsible
for decisions and transactions
c) Arithmetic and Accounting
The company should ensure that there are adequate controls to ensure the completeness and
accuracy of its financial records.
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Fundamentals of Auditing ­ACC 311
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Possible application: standard accounting procedures such as the use of control accounts, reconciliation
procedures and the performance of arithmetic checks on accounting records.
d) Physical
There should be adequate physical control to ensure the security and safekeeping of its assets such
as plant and machinery, valuable inventory items and cash.
Possible application: banking cash immediately, controlling access to inventory areas; electronic tagging of
inventory and portable non-current assets.
e) Management and Monitoring
There should be sufficient controls in existence to ensure management can effectively control the
business operations.
Possible application: the use of budgeting and standard costing systems; the establishment of an internal
audit department
f) Authorization
All transactions should be authorized.
Possible application: authorization of purchases, cash and bank payments, sale of non-current assets, sales
to customers on credit, bad debt write offs.
g) Personnel
Employees should be appropriately qualified and of suitable caliber to perform the required tasks.
Possible application: recruiting the right people for the job; training them effectively, motivating and
rewarding employees in an appropriate way.
h) Segregation of duties
There should be an appropriate division of responsibilities to reduce the opportunity for fraud and
manipulation.
This is a fundamental control procedure designed to ensure that one person does not have sole
charge of a transaction from beginning till end. Perfect segregation of duties exists where each of
the main stages in a transaction are under the control of a different person.
Possible application:
Consider an inventory purchasing system in a manufacturing company:
Stage
Documentation
Responsibility
Initiation
Stores requisition
Stores keeper
Authorization
Purchase order
Purchasing officer
Custody
Goods received note
Receiving officer
Recording
Invoice
Account department
Documenting the system
Documenting the system is an extremely important stage in the audit;
Auditing standards state that in planning the audit, auditors should obtain and document an understanding
of the accounting system and control environment sufficient to determine their audit approach.
The various methods of ascertaining and recording the system may be summarized as follows:
1. Organization chart
2. Narrative notes
3  Flowcharts
4  Internal control questionnaires (ICQs)
5  Internal control evaluation checklists (ICEC)
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Fundamentals of Auditing ­ACC 311
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Organization Chart
Managing Director
Production
Sales
Finance
Director
Director
Director
Distribution
Advertising
Manager
Manger
Chief
Manager
Production Factory
Purchases
Accountant
Accounts
Planning
Manager
Controller
Narrative Notes
This is a simple and apparently convenient way of describing systems. Having ascertained the system, the
auditor draws up a narrative description of it for the audit files. An example might be:
Sales invoices are prepared by Mr._____ They are checked by Mr. _____ and then passed to Mr. _____ for
recording in the customer's account in the sales ledger etc.
Shortcomings of the method:
1. Notes can take up a disproportionate amount of space
2. Notes may be difficult to interpret
3. What happens it personnel change?
Flowcharts
This is becoming an increasingly widely used technique for recording accounting systems in audit files.
A flowchart is a diagrammatical representation of an accounting system.
A good flowchart will be supplemented with narrative.
Flowcharts have the following advantages:
(i)
They portray the flow of documents through the system and enable the auditor to relate those
movements with procedures and checks carried out as part of that system.
(ii)
They show the movement of documents in such a way that, when properly prepared, the
sources and destinations of all documents will be clear.
(iii)
They help to highlight weaknesses in the control of the business.
(iv)
They enable audit tests to be clearly related to weaknesses in the accounting system.
Standard symbols are used to represent documents, operations and checks carried out.
Flow lines are used to join up the symbols and represent the movement of documents.
Dotted lines are used to represent the flow of information between documents.
Essentials of flowchart
Internal control evaluation flowcharts must highlight the following:
(a) the sequence of operations happening to each document (e.g. authorization, checking, matching, filing)
(b) the segregation of staff duties and who is responsible for each operation.
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Fundamentals of Auditing ­ACC 311
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Symbols used in manual systems flowcharts
A document
A multi-part set of documents
Pre-numbered document
N
A book of account
An operation performed on a document
A check performed on a document
Filing a book or document
Document flow
Information flow
Connector with another page/flow-line
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Fundamentals of Auditing ­ACC 311
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Flowchart of purchases
Narratives:
1 Requisition note raised when goods
are at a pre-set re-order level. Order
quantity is pre-determined by use of a
copy of the previous purchase order.
2 Signed by store manager.
3 Buyer checks authorization.
4 Purchase order set prepared.
8 P02 filed temporarily to act as a check
on overdue deliveries.
10 P04 and P05 are filed until goods are
received.
11 Weekly check on overdue deliveries.
12 Goods checked to PO to ensure they
are in agreement.
13 If not damaged, goods are accepted
and a goods received note set is raised.
Where quantity received is below order a
shortage memo set is also raised and a
note made on the purchase order.
14 P05 is sent back to the warehouse to
act as the next requisition note.
Commentary on the above flowchart
(a) All operations and checks are positioned on vertical lines within a particular department.
(b) Horizontal lines show the movement of a document between departments.
(c) In practice the flowchart would continue, dealing with the processing of the purchase invoice/credit
note/day books/payables ledger/cash book etc. The
flow-lines at the bottom of the page would continue to page 2 of the flowchart.
(d) Note that the narrative to the flowchart does not deal with all of the operation numbers since some
should be self-explanatory e.g. operation 9 represents the
numerical filing of P03 in the buying department.
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Table of Contents:
  1. AN INTRODUCTION
  2. AUDITORSí REPORT
  3. Advantages and Disadvantages of Auditing
  4. OBJECTIVE AND GENERAL PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS
  5. What is Reasonable Assurance
  6. LEGAL CONSIDERATION REGARDING AUDITING
  7. Appointment, Duties, Rights and Liabilities of Auditor
  8. LIABILITIES OF AN AUDITOR
  9. BOOKS OF ACCOUNT & FINANCIAL STATEMENTS
  10. Contents of Balance Sheet
  11. ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
  12. Business Operations
  13. Risk Assessment Procedures & Sources of Information
  14. Measurement and Review of the Entityís Financial Performance
  15. Definition & Components of Internal Control
  16. Auditing ASSIGNMENT
  17. Benefits of Internal Control to the entity
  18. Flow Charts and Internal Control Questionnaires
  19. Construction of an ICQ
  20. Audit evidence through Audit Procedures
  21. SUBSTANTIVE PROCEDURES
  22. Concept of Audit Evidence
  23. SUFFICIENT APPROPRIATE AUDIT EVIDENCE AND TESTING THE SALES SYSTEM
  24. Control Procedures over Sales and Debtors
  25. Control Procedures over Purchases and Payables
  26. TESTING THE PURCHASES SYSTEM
  27. TESTING THE PAYROLL SYSTEM
  28. TESTING THE CASH SYSTEM
  29. Controls over Banking of Receipts
  30. Control Procedures over Inventory
  31. TESTING THE NON-CURRENT ASSETS
  32. VERIFICATION APPROACH OF AUDIT
  33. VERIFICATION OF ASSETS
  34. LETTER OF REPRESENTATION VERIFICATION OF LIABILITIES
  35. VERIFICATION OF EQUITY
  36. VERIFICATION OF BANK BALANCES
  37. VERIFICATION OF STOCK-IN-TRADE AND STORE & SPARES
  38. AUDIT SAMPLING
  39. STATISTICAL SAMPLING
  40. CONSIDERING THE WORK OF INTERNAL AUDITING
  41. AUDIT PLANNING
  42. PLANNING AN AUDIT OF FINANCIAL STATEMENTS
  43. Audits of Small Entities
  44. AUDITORíS REPORT ON A COMPLETE SET OF GENERAL PURPOSE FINANCIALSTATEMENTS
  45. MODIFIED AUDITORíS REPORT