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Chapter 13: Audit of the

Sales and Collection Cycle:


Copyright © 2007 Pearson Education Canada
Tests of Controls
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Chapter 13 objectives
 Identify typical records and transactions in the
sales cycle
 Explain how general controls affect the audit of
the sales and collection cycle
 Describe the methodology for designing tests of
controls for sales
 Discuss the effect of the results of tests of
controls on the audit
 Explain how the tests of control audit program
organized

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Classes of transactions in the sales
and collection cycle
 Sales (cash and on account)
 Cash receipts
 Sales returns and allowances
 Charge-off (or write-off) of uncollectible
accounts
 Bad-debt expense

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Typical records and transactions in
the sales cycle
 Sale is initiated with a customer order;
shipping documents and invoice
accompany the sale, which is recorded
both in a transaction file (sales) and
summarized in a customer master file (or
in a database)
 Routine reports include a sales journal and
an aged accounts receivable trial balance
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Method of recording the transaction

 Can be recorded manually (rare now)


 Alternatively, could be entered in batches
in the computer system (groups of
transactions)
 If recorded one transaction at a time, is
online transaction processing

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Control differences between batch
and online systems: audit trails
 Batch systems:  Online systems:
 Transactions readily  Transactions may be
traced from source initiated and recorded
transaction to general without source
ledger posting documents (e.g.
 Totals from groups of phone orders)
transactions are  Document sequencing
totaled, and these is important to track
totals traced documents.
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Control differences between batch and online
systems: error detection and correction
 Batch systems:  Online systems:
 If one transaction is in  Focus is on
error, the whole batch preventing errors
is rejected  Input edit processes
 Error followup is check for valid
required to ensure customer data and
timely processing and reasonableness
avoid cutoff errors

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Control differences between batch and
online systems: segregation of duties

 Batch systems:  Online systems:


 Can be achieved by  Decentralization may
separating totaling result in inadequate
and counting from segregation of duties
data entry  Use passwords to
 Reconciliation and separate transaction
error followup should entry from master file
be independent of entry (e.g. update of
data entry credit limits)
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Effect of general controls
 Prior to assessing the individual transaction
cycles, the auditor documents general controls
that are pervasive and that affect multiple
transaction cycles
 If general controls are good, the auditor may be
able to rely upon and test interdependent or fully
automated controls
 If general controls are poor, the auditor may be
able to rely upon only manual controls, or may
need to conduct a substantive-oriented audit
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Methodology for designing tests of
controls for sales

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Documentation of internal controls

 Internal controls need to be documented


for every audit assertion for every class of
transactions
 The auditor focuses on key controls, or
those controls that have the greatest effect
for that audit assertion
 These controls could be manual,
automated, or interdependent

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Tests of internal controls
 Once the key controls have been identified,
the auditor can decide whether the
control(s) will be tested or whether tests of
details will be conducted instead
 Tests of internal controls will be devised
for each key control that will be tested

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Example of internal control:
occurrence assertion (manual)
 Key control: credit is approved before
shipment takes place: The sales manager
initials all sales orders over $25 to indicate
approval.
 Possible test of control: Examine a sample
of sales orders to ensure that the sales
manager’s initial is present.

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Example of internal control:
occurrence assertion (automated
batch)
 Key control: Orders causing balances to exceed
credit limits are printed on an exception report
and are not processed for shipment.
 Possible test of control: Examine a selection of
exception reports and ensure that: these orders
exceed the credit limit and that the orders were
not processed for shipment.

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Example of internal control:
occurrence assertion (automated
online)
 Key control: Orders causing balances to exceed
credit limits are held in a separate transaction file
and are not processed for shipment.
 Possible test of control: Request the client to
print off the day’s on-hold transaction file. View
the file to ensure that all orders in the file exceed
the customer’s credit limits.

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Example of internal control:
occurrence assertion
(interdependent)
 Key control: Orders causing balances to exceed
the credit limit are printed on an exception report
and must be approved by a credit manager prior
to shipment by means of entering a password.
 Possible test of control: Review an exception
report and ensure that all sales orders there
caused the customers’ credit limit to be exceeded.
Discuss with the sales manager processes
followed to release such held orders.
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Practice problem 13-22 (p. 412)
 Practice identifying
the audit assertion that
goes with a particular
control
 How would you test
the control?

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Manual, automated and
interdependent controls
 From the previous examples, you can see
that:
– Manual controls are controls performed
entirely by people
– Automated controls (batch or online) are
performed only by computerized systems
– Interdependent controls rely upon computer
processes (automation) but a person must also
be involved to fully perform the control
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Frequency of testing of internal
controls
 Which type of controls must be tested
annually?
 Which type of controls could potentially be
tested every three years? Under what
circumstances?

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Full testing of interdependent
controls
 The interdependent control has two parts:
– A function performed by an automated systems
– A function performed by an individual
 It is only possible to rely upon the automated
function if: general controls have been assessed
as good
 Then, both parts of the control must be tested to
enable reliance upon the control

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What if control testing yielded
many errors?
 The first step is to determine whether the
errors (exceptions) were due to a particular
circumstance or restricted to a particular
time period
 For example, the credit manager was on
holidays, and so no one approved credit, or
the person who approved credit in his/her
absence made many errors
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Practice problem 13-21 (p. 412)
 Practice
differentiating
between what is likely
an error or fraud
 How would you
prevent the error or
fraud?

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What if control testing yielded
many errors? (cont’d)
 If it turns out that the errors are systemic (i.e.
throughout the period and cannot be isolated to a
particular cause), then
 The auditor first looks for a compensating
(alternative control)
 If this alternative control achieves the same
purpose and is functioning correctly, then the
auditor can still rely upon internal controls

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How do we decide whether there
could be a material error?
 If there is no compensating control, then
the auditor needs to investigate to
determine whether there is potential for
this weakness to result in a material error
 Conduct dual-purpose or weakness
investigation (detail) tests
 These tests help to quantify the extent of
the error

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Results of quantifying the error
 If it turns out that the results of the weakness
could result in immaterial error, the weakness
will be reported in a management letter, and
extended tests of detail may not be required
 If a material error could result, the matter needs
to be reported both to management and the audit
committee and the tests need to be sufficient to
provide a reasonable range for the extent of the
error
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Design versus performance format
of audit program
 The initial audit program is organized by audit
assertion, to ensure that controls are assessed
(and possibly tested) for each assertion
 It is then organized into a performance format to
maximum efficiency (e.g. all tests for the
shipping document would be grouped)
 The use of automated working paper software
facilitates this process

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Computer-assisted audit tests
 Where there are a large number of transactions, it
is effective for auditors to use computer-assisted
audit tests
 For example, in internal controls testing, the
auditor could use automated sampling routines to
access the client sales transaction file and select
an attribute sample of sales transactions, printing
details of the transactions

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Practice problem 13-24 (p. 413)
 Look at the sampling
process for sales
 How are results
evaluated?

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Suitability of test data
 Batch systems: Test data may be inappropriate,
as the transactions would be processed by the
accounting system. Only transactions that will be
rejected could be used.
 Online systems: Test data is useful to verify the
accurate functioning of online input edit controls
(e.g. rejection of invalid customer numbers)

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Suitability of generalized audit
software
 Best suited for analytical review, tests of
detail, or dual-purpose tests, for example:
– Adding up the sales transactions to sum to the
sales for the day, month or year
– Reperformance of tax calculations
– Examination of customer master file to
determine if any balances exceed their credit
limit

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