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200CHAPTER 9Revenue and Collection CycleLEARNING OBJECTIVESReviewCheckpointsExercisesand ProblemsCases1. Describe the revenue and collection cycle, including typical source documents and controls.1, 2, 3, 4, 750, 51 29, 302. Give examples of detail test of controls procedures for auditing control over customer credit approval, delivery, accounts receivable accounting, cash receipts accounting, and bank statement reconciliation.5, 6, 8, 9, 10, 1152 31, 32, 64, 653. Describe some common errors, irregularities, and frauds in the revenue and collection cycle, and design some audit and investigation procedures for detecting them.12, 13, 14, 15, 16, 1753, 54 61, 62, 63, 64, 654. Explain the importance of the existence assertion for the audit of cash and accounts receivable balances, and describe some procedures for obtaining evidence about the existence of assets.18, 19 55, 56, 60 64, 655. Identify and describe considerations for using confirmations in the audit of cashand accounts receivable.20, 21, 22, 23, 24, 2558, 59, 60 33, 656. Design and perform substantive audit procedures for the audit of a bank statement reconciliation, and tell how auditors can search for lapping and kiting.26, 27, 28 57 62POWERPOINT SLIDESPowerPoint slides are included on the website. Please take special note of:* Revenue and Collection Cycle SOLUTIONS FOR REVIEW CHECKPOINTS9.1 The basic sequence of activities and accounting in a revenue and collection 201cycle is:1. Receiving and processing customer orders. Entering data in an order system and obtaining a credit check.2. Delivering goods and services to customers. Authorizing release from storekeeping to shipping to customer. Entering shipping information in the accounting system.3. Billing customers, producing sales invoices. Accounting for customer trade accounts receivable.4. Collecting cash and depositing it in the bank. Accounting for cash receipts.5. Reconciling bank statements.9.2 When documents such as sales orders, shipping documents, and sales invoices are prenumbered, someone can later account for the numerical sequence and determine whether any transactions have failed to be recorded. (Completeness control objective.)9.3 Access to computer terminals should be controlled so only authorized persons can enter or change transaction data. Access to master data files is important because changes in them affect automatic computer controls, such ascredit checking and accurate inventory pricing.9.4 It might be easier just to send the cash to the accounts receivable accountants, but (1) that would delay the bank deposit and the company would lose interest income, and (2) a dishonest accountant could steal cash while still giving the customer credit (to forestall complaints). The accountant could cover the theft by making false debit entries to such accounts as allowance for doubt accounts (account write-offs) or discounts and allowancesexpense.9.5 Auditors could examine these files for evidence of:Unrecorded sales -- pending order master file,Inadequate credit checks -- credit data/check filesIncorrect product unit prices -- price list master file9.6 With a sample of customer accounts receivable(1) Find the support for debit entries in the sales journal file. Expect to find evidence (copy) of a sales invoice, shipping document, and customerorder. The sales invoice showing recording on the shipping date.(2) Find the support for credit entries in the cash receipts journal file. Expect to find a remittance advice (entry on list), which corresponds todetail on a deposit slip, on a deposit actually in a bank statement for the day posted in the customers' accounts.9.7 The account balances in a revenue and collection cycle include:Cash in bankAccounts receivableAllowance for doubtful accountsBad debt expenseSales revenueSales returns, allowances, discounts9.8 These specific control policies and procedures (in addition to separation of duties and responsibilities) should be in place and operating in a control 202structure governing revenue recognition and cash accounting:(1) no sales order should be entered without a customer order(2) a credit-check code or manual signature should be recorded by an authorized means(3) access to inventory and the shipping area should be restricted to authorized persons(4) access to billing terminals and blank invoice forms should be restrictedto authorized personnel(5) accountants should be under orders to record sales and accounts receivable when all the supporting documentation of shipment is in order, and care should be taken to record sales and receivables as of the date goods and services were shipped, and cash receipts on the date the payments are received(6) customer invoices should be compared with bills of lading and customer orders to determine that the customer is sent the goods ordered at the proper location for the proper prices and that the quantity being billedis the same as the quantity shipped(7) pending order files should be reviewed timely to avoid failure to bill and record shipments(8) bank statements should be reconciled in detail monthly.9.9 In a "walk through" of a sales transaction, auditors take a single example ofa sales transaction and trace it from the initial customer order through credit approval, billing, and delivery of goods, to the entry in the sales journal and subsidiary accounts receivable records, then its subsequent collection and cash deposit. Sample documents are collected and employees in each department are questioned about their specific duties. The information gained from documents and employee; can be compared to answers obtained on aninternal control questionnaire. The purpose of the "walk through" is to obtain an understanding of the transaction flow, the control procedures, and the populations of documents that may be utilized in test of controls auditing.9.10 The two important characteristics of a detail test of control procedure are (1) identification of the data population from which a sample of items will be selected for audit, and (2) an expression of the action that will be takento produce relevant evidence. In general, the actions in detail test of control audit procedures involve vouching, tracing, observing, scanning, and recalculating.9.11 Dual direction test of controls sampling refers to procedures that test file contents in two "directions" -- the validity direction and the completeness direction. The validity direction is a sample from the account balance (e.g. sales revenue) vouched to supporting sales and shipping documents for evidence of validity. The completeness direction is a sample from the population that represents all sales (e.g. shipping document files) traced tothe sales journal or sales account for evidence that no transactions (shipments, sales) were omitted.9.12 The goals of dual-direction sampling relate to the first two objectives of internal control: (1) recorded sales (accounts receivable) are valid and documented and (2) valid sales transactions (accounts receivable) are recorded and none omitted. One direction is to ensure that all recorded debits to accounts receivable represent valid credit sales that actually occurred--the relevant population for sampling to achieve this goal is from recorded receivable debits which should be vouched to supporting documents, 203such as sales invoices. Likewise, a sample of recorded credits to accounts receivable should be vouched to cash receipts documents such as remittance advices and deposits.The other direction is to ensure that all credit sales and cash receipts thatoccurred were recorded in the receivable records. The relevant populations for sampling to achieve this goal are: (1) evidence of credit sales such as shipping documents, then trace these to the receivable accounts, and (2) evidence of cash receipts such as remittance advices, then trace these to thereceivable accounts.9.13 In the "Canny Cashier," if someone other that the assistant controller had reconciled the bank statement and compared the details of bank deposit slips to cash remittance reports, the discrepancies could have been noted and followed up. The discrepancies were that customers and amounts on the two didnot match.9.14 To prevent the cash receipts journal and recorded cash sales from reflecting more than the amount shown on the daily deposit slip, the internal control system should provide that receipts be recorded daily and intact. A careful bank reconciliation by an independent person could detect such errors.9.15 Confirmations to taxpayers who had actually paid their taxes would have produced exceptions, complaints, and people with their counter receipts. These results would have revealed the embezzlement.9.16 Auditors might have obtained the following information:Inquiries: Personnel admitting the practices of backdating shipping documentsin a "bill and hold" tactic, or personnel describing the 60-day wait for a special journal entry to record customer discounts taken.Detail test of controls: The sample of customer payment cash receipts would have shown no discount calculations and authorizations, leading to inquiries about the manner and timing of recording the discounts.Observation: When observing the physical inventory-taking, special notice should be taken of any goods on the premises but excluded from the inventory.These are often signs of sales recorded too early.Confirmations of accounts receivable: Customers who had not yet been given credit for their discounts can be expected to take exception to a balance toolarge.9.17 The auditors would have known about the normal Friday closing of the books for weekly management reports, and they could have been alerted to the possibility that the accounting employees overlooked the once-a-year occurrence of the year end date during the week.9.18 It is important to place emphasis on the existence and rights assertions because auditors have often got into malpractice trouble by giving unqualified reports on financial statements that overstated assets and revenues and understated expenses. For example, credit sales recorded too early (fictitious sales?) result in overstated accounts receivable and overstated sales revenue; failure to amortize prepaid expense results in understated expenses and overstated prepaid expenses (current assets).9.19 These procedures are usually the most useful for auditing the existence and rights assertions:204Recalculation. Expired prepaid expenses are recalculated, using auditors' vouching of basic documents, such as loan agreements (prepaid interest), rentcontracts (prepaid rent), and insurance policies (prepaid insurance). Goodwill and deferred expenses are recalculated using original acquisition and payment document information and term (useful life) estimates. A bank reconciliation is a special kind of calculation, and the company's reconciliation can be audited. Physical Observation. Inventories and fixed assets can be inspected and counted. Titles to autos, land, and buildings canbe vouched, sometimes using public records in the county clerk's office. Petty cash and undeposited receipts can be observed and counted. Securities held as investments can be inspected if held on the company's premises.Confirmation. Letters of confirmation can be sent to banks and customers, asking for a report of the balances owed the company. Likewise, if securitiesheld as investments are in the custody of banks or brokerage houses, the custodians can be asked to report the names, numbers, and quantity of the securities held for the company. In some cases, inventories held in public warehouses or out on consignment can be confirmed with the other party. Verbal Inquiry. Inquiries to management usually do not provide very convincing evidence about existence and ownership. However, inquiries should always be made about the company's agreements to maintain compensating cash balances (may not be classifiable as "cash" among the current assets), about pledge or sale with recourse of accounts receivable in connection with financings, and about pledge of other assets as collateral for loans.Examination of Documents (Vouching). Evidence of ownership can be obtained bystudying the title documents for assets. Examination of loan documents may yield evidence of the need to disclose assets pledged as loan collateral.Scanning. Assets are supposed to have debit balances. A computer can be used to scan large files of accounts receivable, inventory, and fixed assets for uncharacteristic credit balances. The names of debtors can be scanned for officers, directors, and related parties, amounts for which need to be reported separately or disclosed in the financial statements.Analytical Procedures. Comparisons of asset and revenue balances with recent history might help detect overstatements. Relationships such as receivables turnover, gross margin ratio and sales/asset ratios can be compared to historical data and industry statistics for evidence of overall reasonableness. Account interrelationships also can be used in analytical review. For example, sales returns and allowances and sales commissions generally vary directly with dollar sales volume, bad debt expense usually varies directly with credit sales volume, and freight expense varies with thephysical sales volume. Accounts receivable write-offs should be compared withearlier estimate of doubtful accounts.9.20 The following information is requested in a bank confirmation:For Deposit Accounts:Account nameAccount numberInterest rateBalance as of the confirmation dateFor Direct Liabilities:Account number or description205Balance dueDate dueInterest rateDate through which interest is paidDescription of collateral9.21 A "positive" confirmation is a request for a response from an independent party who the auditor has reason to expect is able to reply. A "negative" confirmation is a request for a response from the independent party only if the information is disputed. Negative confirmations should also be sent only if the recipient can be expected to detect error and reply accordingly.9.22 The response rate for positive confirmations is the proportion of the number of confirmations returned (to the auditor) to the number mailed. The detection rate is the proportion of exceptions reported to the auditors to the number of account errors intentionally made in the statements mailed to customers (in research studies regarding confirmations).9.23 Response rate can be increased by:1. Sending a postcard in advance, notifying the customer a confirmation is coming.2. Sending confirmations by special delivery mail.3. Using a first class postage stamp rather than metered mail postage.4. Marking the envelope "Confirmation Enclosed: Please Examine Carefully."9.24 Justifications for the decision not to use confirmations for trade accounts receivable in a particular audit include: (1) receivables are not material, (2) confirmations would be ineffective, based on prior years' experience or knowledge that responses could be unreliable, and (3) analytical procedures and other substantive test of details procedures provide sufficient, competent evidence.9.25 Special care in examining sources of accounts receivable confirmation responses:Auditors need to control the confirmations, including the addresses to which they are sent. Experience is full of cases where confirmations were mailed tocompany accomplices, who provided false responses. The auditors should carefully consider features of the reply such as postmarks, FAX and telegraphresponses, letterhead, electronic mail, telephone, or other characteristics that may give clues to indicate false responses. Auditors should follow up electronic and telephone responses to determine their origin (for example, returning the telephone call to a known number, looking up telephone numbers to determine addresses, or using a criss-cross directory to determine the location of a respondent).9.26 The cutoff bank statement is a bank statement sent by the bank directly to the auditor, and it is usually for a fifteen or twenty day period following the reconciliation date. The basic use of the statement by the auditor is to determine whether outstanding checks were actually mailed before the reconciliation date and outstanding deposits in transit were actually received in a timely manner by the bank.9.27 The term "lapping" refers to an employee's stealing the cash receipts of a company and then covering the amount with a following day's payment received for another customer's account. A "lapping" operation is possible when a single employee has access to both cash and accounts receivable records.206The auditor is alerted to the possibility of a "lapping" operation when thereis not a proper separation of duties. Surprise confirmation is the primary means which an auditor can use to uncover such activity. Also, details of deposit slips and cash remittance reports can be compared to detect discrepancies.9.28 Cheque kiting is the practice of building up apparent balances in one or morebank accounts based on uncollected (float) cheques drawn against similar accounts in other banks. Kiting involves depositing money from one bank account to another, using a hot cheque. Kiting is the deliberate floating of funds between two or more bank accounts. By this method, a bank customer utilizes the time required for checks to clear to obtain an unauthorized loanwithout any interest charge.Auditors can detect signs of kiting by observing in the bank statements:# Frequent deposits and cheques in same amounts# Frequent deposits and cheques in round amounts# Frequent deposits with chequess written on the same (other) banks# Short time lag between deposits and withdrawals# Frequent ATM account balance inquiries# Many large deposits made on Thursday or Friday to take advantage of the weekend# Large periodic balances in individual accounts with no apparent businessexplanation# Low average balance compared to high level of deposits# Many cheques made payable to other banks# Bank willingness to pay against uncollected funds# "Cash" withdrawals with deposit cheques drawn on another bank# Cheques drawn on foreign banks with lax banking laws and regulationsIf these cash transfers are recorded in the books, a company will show the negative balances that result from cheques drawn on insufficient funds. However, perpetrators may try to hide the kiting by not recording the deposits and cheques. Such maneuvers may be detectable in a bank reconciliation audit.A schedule of interbank transfers can be constructed from the canceled checksand cleared deposits in the bank statements. This schedule shows each check amount, the name of the paying bank (with the book recording date and the cheque clearing date), the name of the receiving bank (with the book deposit date and the bank clearing date). The purpose of this schedule is to see thatboth sides of the transfer transaction are recorded in the same period (and in the proper period).SOLUTIONS FOR KINGSTON CASE PROBLEMS9.29 ICQ Items: Objectives and Errors from Control WeaknessesQuestion Possible Error or Irregularity1 Cash could be withheld and revenue and expense both understated2 Cash can be removed from the deposit, and the cashier and accounts receivable bookkeeper could hide the theft by manipulating the accounts.2073 The cashier can steal money in custody and could manipulate records to hide the theft.4 The cashier can steal money and, with access to the records, could manipulate them to hide the theft.5 If the reconciliation is done by someone with access to cash or other records, the reconciliation could be manipulated to hide thefts or errors in the accounts.6 Erroneous entries could be made if the amounts are not compared and differences corrected.7 Failure to make a list early gives up the chance to capture a control total for later comparison to accounting entries, and math mistakes and thefts could go undetected.8 Failure to use machine totals (cash registers and point-of-sale computers) gives up the chance to use a control total as in # 7.9 Failure to use and check prenumbered documents lets documents getlost, not recorded, and the incompleteness go undetected.10 Failure to approve discounts may permit dishonest employees to account for discounts and steal the money.11 The duplicate deposit retained by a control person (internal auditor) can be used to compare to account entries. Without it, erroneous entries cannot be detected.12 Failure to compare the remittance list to the deposit gives up the chance to detect thefts from the money received (the remittance list being a control total as in # 7).13 No accounting manual instructions for classifying cash entries contributes to employee's classification mistakes and inconsistencies.14 If the accounts receivable subsidiary and control do not balance,some entries are not the same in both, and failure to make the comparison gives up the chance to detect failure to post all entries.15 Failure to date cash entries the same date as the receipt gives up control over proper cutoff of cash entries.9.30 Internal Control Questionnaire - Sales Transaction ProcessingObjectives and Questions Yes, No, N/ACommentsEnvironment:1. Is the credit department independent of the sales department?Yes. Credit manager in Treasurer's office2. Are sales of the following types controlled by the same procedures described below? Sales to employees, COD sales, disposals of property, cashsales, and scrap sales.No available informationValidity Objective:3. Is access to sales invoice blanks restricted?Yes. Kept in locked closet4. Are prenumbered bills of lading or othershipping documents prepared or completed in the shipping department?Yes. Shipping departmentCompleteness Objective:5. Are sales invoice blanks prenumbered? Yes2086. Is the sequence checked for missing invoices?Yes. Accounts receivable clerk7. Is the shipping document numerical sequence checked for missing bills of lading numbers?No available informationAuthorization Objective:8. Are all credit sales approved by the credit department prior to shipment?Yes. Credit manager file9. Are sales prices and terms based on approved standards?Yes. Approved price file10. Are returned sales credits and other credits supported by documentation as to receipt, condition, and quantity and approved by a responsible officer?No available informationAccuracy Objective:11. Are shipped quantities compared to invoice quantities?Yes. Shipping department clerk12. Are sales invoices checked for error in quantities, prices, extensions and footing, and freight allowances, and checked with customers' orders?Yes. Accounts receivable clerk13. Is there an overall check for errors in arithmetic accuracy of period sales data by a statistical or product-lineanalysis?Yes. Marketing vice president14. Are periodic sales data reported directly to general ledger accounting independent of accounts receivable accounting?NoClassification Objective:15. Does the accounting manual contain instruction for classifying sales?Yes. Lumber and hardware analysisAccounting Objective:16. Are summary journal entries approved before posting?Yes. General ledger supervisor (procedure manual)Proper Period Objective:17. Does the accounting manual contain instructions to date sales invoices onthe shipment date?Yes. General ledger supervisor (procedure manual)9.31 Bridge Working Paper for Cash ReceiptsPrepared by__________Date_________________KINGSTON COMPANYBridge: Cash Receipts ControlDecember 31, 2002209Strength/Weakness Audit Implication Audit ProgramS: Monthly bank reconciliationErrors detected by clientReview the bank reconciliations (This compliance procedure will indirectly audit the client comparison of cash entries and deposit slips)W: No remit list or machine controlCash records may be incompleteConfirm larger sample of A/R for evidence of balances paid by customers but not so reflected by accounts.S: Cash discountsapprovedAccurate calc of amountsSelect sample of A/R, vouch discount approval to signatureS: Acct manual directs cash credit classifProper credit classificationScan journals to see whether all cash entries include credit to A/RS: Reconciles subto control A/RPosting errors detectedReview file of reconciliation work, followup correctionsS: Acct manual directs cash entry datingProper dates on cash entriesSelect sample of cash receipts andtrace entry dates to A/R, and deposit dates to bank deposit slip9.32 Matching ICQ Questions to Test of Controls Audit ProgramICQ (Appendix 9A-3) Procedures (Ex 9-6)1 separation of duties A4, B3 observe peoples' duties2 cashier separation B3 observe cashier work3 collection separation (nothing to test because of weakness)4 written off A/R review the memo ledger5 separation of duties B4 observe people at work6 NA7 NA8 monthly A/R mailing C5 observe monthly A/R mailing9 internal confirms (nothing to test because of weakness)10 customer complaints A4 observe who handles complaints11 returned goods C3 vouch returns to receiving reports12 CMs prenumbered (nothing to test because of weakness)13 credit approval A3d vouch credit approval14 writeoffs,etc approval C3a review for proper approval15 NA16 NA17 NA18 A/R reconciliation (not in program) Review subsidiary-control account reconciliation working papers prepared by client9.33 Accounts Receivable Confirmationa. There are two forms of accounts receivable confirmation requests: the "positive" form and the "negative" form.210A positive form asks the debtor to respond whether or not the debtor is in agreement with the information on the confirmation request. A negative form asks the debtor to respond only if the debtor disagrees with the information on the confirmation request. The positive form generally requires follow-up by the auditor in the form of practicable alternative procedures that are used to obtain necessary evidence if a reply is not received.The use of the positive form is preferable when individual account balances are relatively large, when there is reason to believe that there may be a substantial number of accounts in dispute, or with inaccuracies or irregularities.The negative form is useful when internal control surrounding accounts receivable is considered to be effective, and a large number of small balances is involved, and the auditor has no reason to believe that persons receiving the requests are unlikely to give them consideration.b. The items that comprise the balance (recent sales debits and cash receipts credits) can be vouched to supporting internal documentary evidence--sales invoices and bills of lading and cash entries and deposit slips. This work is "extended procedures" to determine internally the information the customers did not provide externally. An auditor can also vouch payments received in the subsequent period as evidence to validate the existence of the receivable balance.SOLUTIONS FOR MULTIPLE CHOICE QUESTIONS9.34 c. Nobody in the company has access to cash, therefore it cannot be stolen.9.35 a. Impropriety of write-offs can be controlled by the review and approval by someone outside the credit department.9.36 b. Less sales revenue and correct amount of cost of goods sold results in less gross profit, therefore the ratio of gross profit to sales will decrease. (Actually, the gross profit numerator will decrease at a greater rate than the sales denominator in the ratio, causing the ratio to decrease.)9.37 d. The direction of the test establishes support for recorded amounts.9.38 d. A bookkeeper could steal money and "write off" to unsuspecting customer's balance with a fictitious "sales return."9.39 c. The cashier would have both custody of cash and recordkeeping responsibility, hence could steal money and fix the records without interference by anyone else.9.40 c. The age of accounts is an indication of credit losses.9.41 b. False sales journal entries made near the end of the year may have shipping or other documents that reveal later dates or show lack of sufficient documentation.9.42 c. Accounts receivable confirmation enables recipients to respond that theyowe the company or that they dispute or disagree with the amount the 211company says they owe. A response without exception, however, does not necessarily mean that the debtor will actually pay the amount.9.43 c. Kiting involves a mismatching of dates of recording around year-end, andthe schedule of bank transfers is designed to show all the relevant dates so the auditor can see that the entries are in the proper periods.9.44 c. Correct. Checking the sequence for missing numbers identifies documents not yet fully processed in the revenue cycle.9.45 a. Correct. The accounts receivable debits are supposed to represent sales that have been ordered by customers and actually shipped to them.9.46 b. Correct. The existence assertion is very important because the company asserts the cash and accounts receivable to exist.d. Presentation and disclosure assertion is second best choice among the ones offered in the question.9.47 c. Correct mainly because the other three choices are listed as appropriatework to do. Also, automatic sending of 100% negative confirmations ignores the judgment in deciding the nature, timing, and extent of the work needed.9.48 Assessed level Properof control risk Number of considerationrelating to small by thereceivables is balances is recipient isa. Low Many Likely Correctb. Low Few Unlikely Incorrectc. High Few Likely Incorrectd. High Many Likely Incorrect9.49 a. Correct. Shipments are traced to customers were invoiced. (This does not imply that the invoices were recorded in the sales journal.)b. Incorrect. See (a) above. The invoice copies need to be traced to the sales journal and general ledger to determine whether the shipments were recorded, and the procedure does not go this far. Shipments to customers were recorded as sales.c. Incorrect. Recorded sales were shipped is not established because the sample selection is from shipments, not from recorded sales.d. Incorrect. Invoiced sales were shipped (see (c) above).SOLUTIONS FOR EXERCISES AND PROBLEMS9.50 Cash Receipts Control Objectives and ExamplesGeneral SpecificValidity 1. If the remittance advice is not returned, the person opening the mail should prepare one so that each check received is represented by a remittance advice.Complete 2. All cash receipts should be listed from remittance advices.Deposits prepared by a person separate from the one who opens the mail.212Subsidiary customer accounts posted from remittance advices.General ledger control account posted from cash receipts journal.Bank statement reconciled independent of other functions.Control account reconciled to subsidiary ledger monthly.Author 3. (Authorization is usually not a problem for cash receiptson accounts receivable.) Cash receipts from other than merchandise sales authorized on unique remittance advice forms.Accuracy 4. Daily remittance list compared to duplicate deposit slip received from bank by person independent of either function.Classif 5. Cash receipts entered properly in cash receipts journal as to the origin of the receipts. Separate deposits made for nonmerchandise sales cash receipts.Acctg 6. Monthly reconciliation of control account to customers' individual accounts and bank statement reconciled promptly.Proper period 7. Daily deposit of all cash receipts. Cash receipts recorded as period of date of receipt. Accounts posted asof date cash received.9.51 University Books, IncorporatedREVOLVING CASH FUNDINTERNAL CONTROL QUESTIONNAIREQuestion Yes NoIs responsibility for the fund vested in one person?Is physical access to the fund denied to all others?Is the custodian independent of other employees who handle cash?Is the custodian bonded?Is the custodian denied access to other cash funds?Are receipts unalterable?Are receipts prenumbered?Is the integrity of the prenumbered sequence periodically accounted for?Does the seller sign receipts?Are receipts attached to reimbursement vouchers?Are vouchers that are submitted for reimbursement approved by someone other than the custodian?Are reimbursement vouchers and attachments (receipts) cancelled after reimbursement?Is the fund used exclusively for the acquisition of books?Is the fund periodically counted and reconciled by someone other than the custodian?Is the fund maintained on an imprest basis?Question Yes NoIs the size of the fund appropriate for the purpose intended?9.52 Other Audit Procedures Reason for Other Audit Procedures1. Source of debit entries in general ledger cash account, other than from cash receipts journal, should be investigated and supporting documents examined.1. Since the auditor, using standardprocedures, only examined the cash receipts journal, he must investigate the validity of all other sources of cash receipts which are not recorded in these journals.2. A surprise examination of cash receipts should be performed. Prior to the accounts receivableclerk obtaining the cash receipts, the auditor should make a list of them without the clerk's knowledge. The undeposited mail receipts shouldthen be controlled after completion of their preparation for deposit and postings have been made to the subsidiary accounts receivable ledger. The deposit slip should be compared to the remittances for accuracy and totaled. Individual items onthe deposit slip should be compared to postings to the subsidiary accounts receivable ledger. The auditor should then supervise the mailing of the deposit to the bank. The auditorshould ask Gutzler to ask the bank to send the statement containing this deposit directlyto the auditor.2. Since there are no initial controls over cash receipts established prior to the time theaccounts receivable clerk obtainsthe cash, a surprise examination is the only method of determiningif cash receipts are being recorded and deposited properly.3. Postings from the deposit slips should be traced to the subsidiary accounts receivable ledger. Also, entries in the subsidiary accounts ledger should be traced to deposit slip.3. Since there is no separation of duties between cash receipts and accounts receivable, the accountsreceivable clerk may have been careless in performing her posting duties. This procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts.4. Review the subsidiary accounts receivable ledger and confirm accounts that have abnormal transaction activity such as consistently late payments.4. See No. 3 above.5. If Gutzler allows customers to take discounts, the amount of such discounts and the discount period should be checked.5. Since there is no separation of duties between cash receipts and accounts receivable, the account receivable clerk may have appropriated discounts which could have been but were not taken or may have been careless in checking the appropriateness of discounts taken.6. Dates and amounts of daily deposits per bank statement should be compared with entries in the cash receipts journal.6. Since there are no initial controls over cash receipts established prior to the time theaccounts receivable clerk obtainsthe cash, she may have become careless about prompt deposit of the daily receipts.7. A proof-of-cash working paper should be prepared which reconciles total cash receipts with credits per bank statement.7. Since internal control over cash receipts is weak, the auditor should perform this overall checkto help substantiate that he has investigated all material items during his detail tests.8. For those periods for which the above audit procedures were not performed and for a period afterthe balance sheet date, scan thecash receipts journal and bank statements for unusual items.8. Since internal control over cash receipts is weak, the auditor should perform this review to help substantiate that he has investigated all material items not covered during his other tests.9.53 MemorandumTO: Board of Directors, The Pottstown Art LeagueFROM: (Student's name)DATE:SUBJECT: Control weaknesses related to Cash Admission FeesYou requested a report which identifies the weaknesses in the existing systemof cash admission fees and my recommendations. Below are the weaknesses that exist and my recommendations for procedures that overcome these weaknesses. Iwill be pleased to discuss these at the next board meeting and offer further explanations that may be necessary.Weakness: There is no segregation of duties between persons responsible for collecting admission fees and persons responsible for authorizing admission.Recommendation: One clerk (hereafter referred to as the collection clerk) should collect admission fees and issue prenumbered tickets. The other clerk (hereafter referred to as the admission clerk) should authorize admission upon receipt of the ticket or proof of membership.Weakness: An independent count of paying patrons is not made.Recommendation: The admission clerk should retain a portion of the prenumbered admission ticket (admission ticket stub).Weakness: There is no proof of accuracy of amounts collected by the clerks.Recommendation: Admission ticket stubs should be reconciled with cash collected by the treasurer daily.Weakness: Cash receipts records are not promptly prepared.Recommendation: The cash collections should be recorded by the collection clerk daily on a permanent record that will serve as the first record of accountability.Weakness: Cash receipts are not promptly deposited. Cash should not be left undeposited for a week.Recommendation: Cash should be deposited at least once each day.Weakness: There is no proof of accuracy of amounts deposited.Recommendation: Authenticated deposit slips should be compared with daily cash collection records. Discrepancies should be promptly investigated and resolved. In addition, the treasurer should establish a policy that includes an analytical review of cash collections.Weakness: There is no record of the internal accountability of cash.Recommendation: The treasurer should issue a signed receipt of all proceeds received from the collection clerk. These receipts should be maintained and should be periodically checked against cash collection and deposit records.9.54 Control Weakness: ComputerWeaknesses RecommendationsLack of segregation of duties Computer operations, program changes, andmaintenance of logs should be performed by different people.No librarian function Custody and control over databases and system documentation should be under a librarian function and not rotated.Deficient restricted access Programmers should not have free access to the computer room (equipment).Deficient documentation Need documentation of flowcharts, programchanges, systems software, testing.Lack of control totals Error-checking validations need control totals for effective operation.No computer price list For manual entry process, clerk should not need to enter the sales price. It should be in a database.Numerical sequence The computer should be used to check numerical sequence.Control total The billing clerk's control total of sales should be used to compare to total sales processed by the computer.Customer accounts The computer system should be programmed to maintain customer accounts instead of using a manual open invoice file.b. Shipping clerks could enter the date, customer identification, shipment quantities, and product identification numbers in a terminal. Then the computer system could automatically produce a sales invoice. Controls include:Autoclock date checkingSelf-checking customer identification numbersSelf-checking product identification numbersTerminal batch hash total of customer ID numbersAutomatic numbering of sales invoicesAuthorized price list in databaseControl total comparison of hash ID numbers in run-to-run totals9.55 Bank ReconciliationCASHBasic audit procedures that should be performed in gathering evidence in support of each of the items (a) through (f) of the CYNTHIA COMPANY bank reconciliation are as follows:(a) Balance per bank*Confirmation by direct written communication with bank (see Standard Bank Confirmation).*Obtain and inspect a January cutoff bank statement obtained directly from the bank (examine opening balance).(b) Deposit in transit*Verify that the deposit was listed in the January cutoff bank statement on a timely basis.*Trace to the cash receipts journal.*Inspect the client's copy of the deposit slip for the date of the deposit.(c) Outstanding checks*Examine checks accompanying the January cutoff bank statement and trace all 1999, or prior, checks to the outstanding check list.*Trace outstanding checks to the cash disbursements journal.*Examine all supporting documents for those outstanding checks that were not returned with the cutoff bank statement.*Ascertain why check number 837 has been outstanding for so long.(d) NSF check return*Follow up on the ultimate disposition of the NSF check.*Examine all supporting documents.(e) Note collected*Examine the bank credit memo.*Trace to accounting records.(f) Balance per books*Foot the bank reconciliation to this total and compare with the general ledger balance.9.56 a. The PA's test of the sales cutoff at June 30 should include the following steps:1. Determine what Houston's cutoff policy is, review the policy for reasonableness, and compare it to the prior year for consistency.2. Select a sample of sales invoices (including the last serial invoice number) from those recorded in the last few days of June and the first few days of July.3. Trace these sales invoices to shipping documents and determine thatsales have been recorded in the proper period in accordance with company cutoff policy.4. Determine that the cost of goods sold has been recorded in the period of sale.5. Select a sample of shipping documents for the same period and tracethese to the sales invoice. Determine that the sale and the cost ofgoods sold have been recorded in the proper period.6. Review the cutoff for sales returns and allowances, determine that it has been based upon a consistent policy and that there have not been abnormal sales returns and allowances in July; this might indicate either an overstatement of sales during the audit period or the need for a valuation account at June 30 to provide for future returns and allowances.b. 1. The PA will use the July 10 cutoff bank statement in his review of the June 30 bank reconciliation to determine whether:(a) The opening balance on the cutoff bank statement agrees with the "balance per bank" on the June 30 reconciliation.(b) The June 30 bank reconciliation includes those cancelled checksthat were returned with the cutoff bank statement and are datedor bear bank endorsements prior to July 1.(c) Deposits in transit cleared within a reasonable time.(d) Interbank transfers have been considered properly in determining the June 30 adjusted bank balance.(e) Other reconciling items which had not cleared the bank at June 30 (such as bank errors) clear during the cutoff period.2. The PA may obtain other audit information by:(a) Investigating unusual entries on the cutoff bank statement.(b) Examining cancelled checks, particularly noting unusual payees or endorsements.(c) Reviewing other documentation supporting the cutoff bank statement.9.57 a. Cash balance, per books November 30 $18,901.62Add: Credit by bank 100.00Adjusted cash balance (on hand andin bank) $19,001.62Less adjusted bank balance:Bank balance, November 30 $15,550.00Less outstanding checks,6500 $116.257126 150.007815 253.258621 190.718623 206.808632145.28 1,062.2914,487.71Cash which should be on hand for deposit $ 4,513.91Cash deposit reported 3,794.41Amount of theft $ 719.50The minimum amount of the theft is $719.50 if the cash reported as "undeposited receipts" ($3,794.41) was actually on hand, represented November receipts, and was deposited intact in December. If the $3,794.41 was not available to deposit or represented December receipts,the maximum loss could be $4,513.91 (719.50 + 3,794.41) for November. Such a shortage (minimum or maximum) for November and the attempt to conceal the shortage would alert the auditors to examine the bank reconciliations throughout the year for other concealed shortages.b. He attempted to conceal his theft by:1. Not listing all outstanding checks.2. Miscalculating the outstanding checks shown on the reconciliation.3. Subtracting an item from the bank balance that should be added to book balance.c. 1. No one other than the cashier is responsible for tracing cash receipts to the deposits in the bank.2. The cashier is also responsible for preparing the bank reconciliation.d. The following auditing procedures on December 5 would uncover the theft if the October 31 reconciliation is known to be correct:1. Compare checks returned since October 31 with checks outstanding atthat time and with check register for November in order to ascertain outstanding checks.2. Trace cash on hand at October 31 as well as receipts during November to deposits in bank, ascertaining undeposited cash at November 30.3. Count cash on hand on December 5, and by adding deposits since November 30 and subtracting receipts since November 30 to develop cash on hand at November 30.4. Compare adjusted cash on hand developed in count (Step 3) with undeposited cash ascertained in tracing (Step 2).9.58 Auditing procedures other than confirmation which may be used to verify an account receivable include:1. Examination of evidence of subsequent payment of the account including:a. The customer's remittance advice accompanied by the payment.b. The check sent in by the customer.c. An authenticated bank deposit ticket listing a deposited check for the outstanding account.d. An entry in the cash receipts book.e. A credit posted to the customer's account.2. Examination of other evidence including:a. Shipping department's notice of shipment, accompanied possibly by areceipted copy of the bill of lading, the customer's purchase order, sales invoices, and any correspondence referring to the shipment of the goods.b. Entries removing the goods from inventory.c. Time records and work orders, if appropriate.3. External inquiries as to the existence and credit rating of the debtor.4. Discussion of the account with the client's credit manager, examination of credit department records, and records of merchandise returned, and such other investigation as may lead to better understanding of the nature of the account and its collectibility.The auditor might also consider further discussion or correspondence with thedebtor to determine whether alternative methods might be used to confirm the account (e.g., by furnishing the debtor more detail concerning the invoices in the balance.9.59 The procedure followed appears to be appropriate except that the examination of detail transactions for three months might be considered to be excessive in view of the exceptionally good internal control. A lighter test of such transactions, designed to test the effectiveness of the control procedures, might be devised.The procedures followed should be supplemented by the following:1. Review the company's method of sales cutoff at year-end and test billings and shipments (including returns) for an adequate period beforeand after year-end to establish that cut-off procedures have been adhered to.2. Examine collections in early part of subsequent period to determine if asubstantial portion of the receivables has been collected.3. Examine agreements entered into with the distributors. If price protection clauses are included, review the current price position and distributor inventory positions to determine whether a reserve for such protection is needed.4. When a company deals with a limited number of customers, it is dependentupon the continued solvency of all such customers.5. Obtain a representation letter from appropriate company officials covering the receivables.9.60 To audit the schedule of Rent Reconciliation prepared by the controller of CLAYTON REALTY CORPORATION, you would perform the following procedures for those items marked by an asterisk:To substantiate the validity of gross apartment rents, you would--*Physically examine the rental property or review architectural blueprints to ascertain the total number of rental units.*Compare the total number of validated rental units with the total numberof rent charges on the schedule of gross apartment rents (Schedule A).*For occupied units, vouch the individual apartment rental charges per lease agreements to the individual rental charges on Schedule A.*For unoccupied (vacant) units, ascertain the reasonableness of the scheduled rent (by reference to the last rent paid, by reference to comparable rent charges for similar units, etc.).*Foot the gross apartment rent schedule (Schedule A) and compare the total with the figure indicated on the rent reconciliation.To substantiate the validity of the vacancies, you would--*Physically examine the apartments that were vacant during the month.*Compare the rental charge (validated in the gross apartment rents procedures above) for each vacant apartment with the schedule of vacancies (Schedule B)*Foot the schedule of vacancies (Schedule B) and compare the total with the total indicated on the rent reconciliation.To substantiate the validity of unpaid January rents, you would--*Trace unpaid rents from individual tenant apartment ledger cards to Schedule C.*Foot the unpaid rents schedule (Schedule C) and compare the total with the amount shown on the rent reconciliation.*Examine the collection file for evidence of collection attempts.*Request written confirmations from tenants with accounts in January arrears.To substantiate the validity of the prepaid rent collected, you would --*Trace the receipt to the individual tenant apartment ledger card.*Compare the amount collected with the lease terms.To substantiate the validity of the cash collected, you would --*Foot the client-prepared rent reconciliation.*Reconcile the cash receipts per the rent reconciliation with the books and records.*Confirm and reconcile the special bank account balance.SOLUTIONS FOR DISCUSSION CASE9.61a) This question involves matching the type of audit procedure and type of evidence it creates to a described audit activity, vouching subsequent receiptsb) Knowledge of accounting system components, such as the names of boos and recordsuse to record cash receipts can be applied9.6!a) The importance and reliability of the audit evidence obtained from confirming "ero balances needs to be considered against the cost of the procedureb) Key ris is omitting to record sales, specific controls procedures to address this ris can be described9.6#The case presents a situation where the company management has incentives to meet certain financial statement targets and this may motivate them to tae actions or mae accounting choices that have an impact on their financial statements. The auditor is looing for ob$ective evidence to support the financial statement numbersthat management has prepared. %oints that can be discussed include the following.a) &osella is applying a nowledge of the business operation to perform analysis procedures. 'n particular, the nowledge of the business indicates certain operatingfactors that determine what results are reasonable and attainable (ma)imums). *he isalso trying to support the sales figure by analy"ing monthly data trends, and maingcomparisons to prior periods and to related amounts such as gross profit and engineers+ travel e)penses. These procedures can provide evidence about validity andcompleteness of sales.b) The findings suggest that the company has e)perienced a large increase in orders and is attempting to meet these orders with its current production capacity. ,lternately, given the debt covenants and bonuses, management may be trying to push sales out the door before they are finished so they can recogni"e revenue in the current year to avoid missing ey targets. This can distort gross profit since not all costs have been incurred at the time of shipment, and since the costs are not a usual part of production there may be no procedures in place to identify and accrue for them. -arious conclusions are possible depending on the interpretation of the case facts, any assumptions made and how this is all analy"ed.c) .ith this recognition policy it is possible that the facts support revenue recognition. 't appears machines were loaded and titled transferred to customer before year end. 'n any case, this can be verified with e)amination of relevant documents and confirmation of customer receivables. The possibility of current income being overstated still e)ists, but this may be due to a problem of completeness of liabilities (i.e., /warranty+ costs of getting the machines woring at the customers+ premises) rather than validity of sales. 0ther valid points can bediscussed.9.61This could occur if the company+s record eeping is inadequate or it lacs internal controls over cash.9.62The case requires one to consider riss in a stoc broerage business and evaluate the appropriateness of negative confirmations as audit evidence. , possible approachto the analysis is as follows.a) The main inherent ris is failing to record a customer stoc transaction correctly, or omitting recording it. This would result in invalid or incomplete information in the customer+s account. 3iven that maretable securities are involved, there is also a fairly high ris of fraud by misappropriation of customer funds or investments. &egulatory non4compliance is another consideration. 3iven the types of inherent riss to be controlled,strong controls are required over authori"ation5ownership, completeness and validity of customer trades and account balances. There is also the ris that customers will provide incorrect information and the need to eep records of customer telephone orders and instructions, issue confirmations, and verify customer account details regularly. The e)ternal audit in this situation can complement internal controls by providing a further chec on validity, completeness and authori"ation5ownership.b) 6egative confirmations are relatively ine)pensive and a large percentage of the customer population can be queried. .hile a weaness is the low response rate, and the inability to now if non4responses would have indicated errors, they do get at the ey concern that customer assets have been misappropriated by the stoc broerage firm since customers are more liely to respond when their accounts are incomplete. 9.66 1. Situations encountered in the audit of Trinity Company's financial statements that may indicate an attempted concealment of defalcation:1. Underfooted Sales Journal--The July sales journal was underfooted by $4,500. Because the understated monthly total was posted as a debit to Accounts Receivable, accountability for future receivable collections was also understated by $4,500. This could permit someone to intercept customer remittances without an apparent shortage resulting.2. False Debit Posting--The first situation dealt with the theft of cash for which accountability had not been established. The establishment of recorded accountability, however, will not necessarily prevent the perpetration and concealment of a defalcation.For example, a person with access to a company's supply of blank checks may steal by issuing a check to himself or herself. Concealing such a theft would also require access to certain accounting records. A person who posts the general ledger could conceal the theft by:*reducing the recorded accountability for cash in the checking account. This could be accomplished by posting a credit to Cashthat did not come from any preceding record;*transferring the resulting shortfall to an expense account. Situation 2 indicates one way this might be done--entering an unsupported debit posting in an expense account. Later, to complete the concealment, it might be necessary to remove the returned check from the next bank statement before the checkingaccount is reconciled.3. Uncancelled Supporting Documents--Uncancelled supporting documents can be removed from a voucher and used again as support for a fraudulent voucher. This fraudulent voucher could be entered into acompany's purchase/disbursement system, resulting in an improper disbursement.4. Omitted Outstanding Check--A misappropriation of cash similar to that described in Situation 2 might have occurred. The resulting cash shortage could be concealed by manipulating the bank reconciliation at month-end. An unrecorded, improperly issued checkwould reduce the bank balance, but would not reduce the book balance. so a properly prepared bank reconciliation would not reconcile, and the cash shortage would be revealed.However, the person who reconciles the bank statement could concealthe shortage by understating the amount subtracted for outstanding checks. for example, a check that should have been listed as outstanding might be omitted from the list as described in Situation 4 or the list might be underfooted. Alternatively, concealment could be attempted by overstating deposits in transit.2. a. There is an important distinction between the type of concealment discussed in Situation 4 and those discussed previously. The concealment in Situation 4 is temporary because the perpetrator must repeat the concealment at each subsequent reconciliation date.Defalcation can be permanently concealed by reducing (crediting) cash so that it agrees with the shortage as a debit to some income statement account. The offsetting debit to an income statement account will result in either an understated revenue (Situation 1) or an overstated expense (Situation 2 and 3). Such concealments are"permanent" because no further action by the perpetrator is required.b. A careful consideration of the ways concealments might be attemptedis an important factor in determining appropriate directions for substantive tests of details. For example, when auditing a bank reconciliation, auditors should audit deposits in transit for overstatement and outstanding checks for understatement. (See also SAS 39, AU 350.)To detect permanent concealments of material defalcations, auditorsmight plan their substantive audit procedures to audit revenues forunderstatement and expenses for overstatement. These directions areopposite to those often associated with auditing for management-inspired distortions of financial data; such distortions have usually exaggerated reported profits by overstating revenues or understating expenses.c. Through the four situations presented, one can see that the perpetration and concealment of a defalcation usually requires bothaccess to an asset (for perpetration) and access to related accounting records (for concealment). Therefore, a good internal control system should be designed so that one employee does not have both types of access.However, all control systems have inherent limitations that preventauditors from placing complete reliance on them. Therefore, auditors should not rely exclusively on good control procedures to fulfill their responsibility to search for material defalcations. Some substantive procedures should be performed, although the extent of such substantive procedures may be appropriately reduced when effective control procedures are present (SAS 39, AU 350).d. Substantive audit procedures include analytical review procedures and tests of details, which can be applied in any combination the auditors deem appropriate. For the purpose of detecting material defalcations, analytical review procedures may be especially effective in situations where defalcations have been cleverly concealed through elaborate and collusive falsification of supporting documents.However, it is possible that material and recurring defalcations involving similar amounts may have occurred over an extended period. Because the continuation of such defalcations may not causeunusual fluctuations, analytical review procedures may not detect the defalcations. Accordingly, auditors should carefully weigh the risk that recurring and material defalcations may have occurred when they make decisions about the appropriate mix of analytical review and detailed procedures to be performed.9.67 Interbank TransfersNote to Instructors: Check #1799 ($10,000 payable to Citizen National Bank) drawn on the 1st National Bank account was not recorded in EverReady's cash disbursements journal. This is the reason it is not in the schedule of interbank transfers in Exhibit 9.62-1. The auditors obtained the initial information from the cash receipts and cash disbursements journals, and #1799was not in them.a. Complete the Schedule of Interbank Transfers (working paper C-5) by entering the new information.EXHIBIT 9.62-1Schedule of Interbank TransfersC-5 EVERREADY CORPORATIONSCHEDULE OF INTERBANK TRANSFERS Prepared__________December 31, 2002 Date__________Reviewed__________Date__________Disbursing Account Receiving AccountCheck Date per Date per Date per Date perNo. Bank Amount Books Bank Bank Books Bank2220 Chase 11,000 28-Dec Commerce 22-Dec4050 Commerce 10,000 29-Dec North Country 23-Dec1417 1st N.C. 10,463 24-Dec 24-Dec North C. payroll 24-Dec 24-Dec4051 Commerce 12,000 31-Dec Chase 28-Dec2221 Chase 15,000 05-Jan Commerce 30-Dec4052 Commerce 12,000 05-Jan North County 30-Dec1601 1st N.C. 11,593 31-Dec 31-Dec N.C. payroll 31-Dec 31-Dec4053 Commerce 14,000 07-Jan Chase 04-Jan1799 N.C. 10,000 08-Jan Commerce 05-Jan2222 Chase 12,000 12-Jan Commerce 07-Jan4054 Commerce 20,000 13-Jan North Country 08-Jan1982 N.C. 9,971 08-Jan 08-Jan N.C. payroll 08-Jan 08-JanTraced from cash disbursements journal.Check properly listed as outstanding on bank reconciliation.Vouched to check cleared in bank statement.Traced from cash receipts journal.Vouched deposit cleared in bank statement.Note: We scanned the cash disbursements and cash receipts journals for checksto and deposits from other bank accounts. Found none other than those noted in this workpaper.b. What is the actual cash balance for the four bank accounts combined, considering only the amounts given in this case information, as of December 31, 2002 (before any of the December 31 payroll checks are cashed by employees)? As of January 8, 2003 (before any of the January 8payroll checks are cashed by employees)? (Hint: Prepare a schedule of "apparent balances" and "actual balances" illustrated in Chapter 18 to explain check kiting.)SCHEDULE OF APPARENT BALANCES AND ACTUAL BALANCESCumulative Record of Bank BalancesChase Bank Commerce North Country Payroll CombinedDec 22 (Tu)Apparent balance -0- 11,000Actual balance (11,000) -0-Dec 23 (W)Apparent balance -0- 11,000 10,000Actual balance (11,000) 1,000 10,000Dec 24 (Th)Apparent balance -0- 11,000 537 9,463Actual balance (11,000) 1,000 537 9,463Dec 28 (M)Apparent balance 1,000 11,000 537 -0-*Actual balance 1,000 (11,000) 537 -0-** Payroll checks assumed cashed by employees.Dec 29 (Tu)Apparent balance 1,000 1,000 537Actual balance 1,000 (11,000) 537Dec 30 (W)Apparent balance 1,000 16,000 12,537Actual balance (14,000) ( 8,000) 12,537Dec 31 (Th)Apparent balance 1,000 4,000 944 11,593Actual balance (14,000) ( 8,000) 944 11,593 (9,463)Jan 4 (M)Apparent balance 15,000 4,000 944 -0-*Actual balance -0- (22,000) 944 -0-*Jan 5 (Tu)Apparent balance -0- 2,000 944Actual balance -0- (12,000) (9,056)Jan 7 (Th)Apparent balance -0- -0- 944Actual balance (12,000) -0- (9,056)Jan 8 (F)Apparent balance -0- -0- 973 9,971Actual balance (12,000) (20,000) 973 9,971 (21,056)9.68 Manipulated Bank ReconciliationYes, something is wrong, and it takes a careful eye to detect it. The bank statement in Exhibit 19-3 has been altered. Cleared check # 2233 for $5,000 has been erased, and the bank balance has been changed from $2,374.93 to $7,374.93. The bank balance is actually $5,000 lower than the reconciliation shows. Since the problem says: "all checks entered in Caulco's cash disbursements journal through February 29 have either cleared the bank or arelisted as outstanding checks in the February bank reconciliation," the conclusion is that this $5,000 check was not recorded.Students can find the alteration several ways. (1) They can notice the check in Exhibit 19-2 (!) and find that it is not on the bank statement, even though it is dated and cleared in February, (2) they can add the checks listed in the February bank statement and find that the total is $5,838.29, not the $10,838.29 shown on the bank statement, (3) they can add the previousbalance to the deposit and subtract the withdrawals to find a balance of $2,374.93 instead of the altered $7,374.93, and (4) they can notice the skip in the numerical sequence not noted by the bank's double asterisk (**) used toindicate a skip (this is the place the paid check was erased).CAULCO, INC.Bank Reconciliation (Corrected)February 29, 1998Balance per bank $ 2,374.93Deposit in transit 1,097.69Outstanding Checks:Number Date Payee Amount2239 Feb 26 Alpha Supply 500.002240 Feb 29 L.C. Stateman254.37Total Outstanding ( 754.37)Reconciled balance $ 2,718.25General ledger balance Feb 29, 1998 $ 7,718.25Cash overstatement, Check #2233 not recorded $ 5,000.009.69 Employee Embezzlement via Cash Receipts and Payment of Personal ExpensesObjective: Obtain evidence to determine whether expenses paid from the extra bank account were for legitimate school business. Auditors cannot ignore informants' tales.Control: Cash disbursements should be authorized by responsible officers of the organization to be for valid business purposes. It is not unusual for a business manager to have the authorization responsibility. Tight control would call for disbursement review (at time of check signature) by another responsible person (superintendent), and this control was not always observed. Cash receipts should be listed by the person initially in control (cafeteria manager), deposited by another person (business manager), and a responsible person (superintendent, internal auditor, external auditor) should compare the initial control record to the deposit to note any differences.Test of Controls: Forewarned by the informant, the auditors could make inquiry: "Does the school district have a fund for which individual disbursements are not approved by the school board?" and "Does the business manager have responsibility for this fund?" Answers to both questions directed to the superintendent would be "yes," and the auditors can then concentrate initial attention on the particular account records.The next question is: "Does the cafeteria manager make a record of the daily receipts?" Answer by the superintendent: "I don't know, ask her." Luckily, itturned out that the cafeteria manager, without direct instructions, made notes on a calendar of the amount of money sent forward to the business manager for deposit. Procedure: Compare the amounts from the cafeteria manager's calendar to the deposits in the account.Audit of Balance: The "balances" being audited are the expense accounts that received the debits from the extra bank account. However, it is efficient to go to the bank account records as a starting point for the investigation. Obtain the bank statements and supporting documents for cash disbursements. Study them for evidence of (1) improperly authorized payments, (2) payments of personal expenses on the school district's VISA account, and (3) payments to unauthorized persons (including "cash" with no supporting documents).Discovery Summary: After finding payments to American Express and VISA, auditors asked the superintendent about the credit card used by the school and learned that the school used only VISA. Inquiry at American Express revealed the business manager as the owner of the account number found on receipts in the supporting documents. (Actually, by this time the business manager had confessed, but identification of the account might have been harder.) Study of the items and dates on the VISA charge slips showed items (e.g. hosiery) not used at the school and dates that did not match business periods. Review of the checks identified some unsupported checks to "cash."During this review, the auditors found checks dated out of numerical sequenceand a missing block in the most current month. This was a sign of having blank checks signed, so the superintendent was asked, and he admitted doing so. The missing block was in a desk drawer, already signed.Comparing the cafeteria manager's notes of cash receipts showed shortages in numerous deposits. The business manager admitted taking the cash.9.70 RING AROUND THE REVENUE: Overstated Sales and Accounts ReceivableThis case is a take-off on the Mattel, Inc. financial statements misstatementcase.AUDIT APPROACHObjective: Obtain evidence to determine whether sales were recorded in the proper period and whether gross accounts receivable represented the amounts due from customers at year end.Control: Sales terms should be properly documented. Accounting treatment, including billing at agreed-upon prices, should follow the terms of the sale.If the risks and rewards of ownership have not been transferred to the customer, or the price has not been reliably determined, or the collectibility of the amount is seriously in doubt or not estimable, an accrual sale should not be recognized. Recorded sales should be supported by customer orders and agreements. Shipping documents should be sufficient to show actual shipment or a legitimate field warehousing arrangement.Test of Controls: Questionnaires and inquiries should be used to determine the company's accounting policies. If the auditors do not know about "bill and hold" practices, they should learn the details. For detail procedures: Select a sample of recorded sales, and examine them for any signs of unusual sales terms. Vouch them to customer orders and other sales agreements, if any. Vouch them to shipping documents, and examine the documents for externalvalidity--recognizing blank spaces (carrier name, date) and company representative's signature (two places, both company and carrier). Compare prices asked in customers' orders to prices charged on invoices. These tests follow the vouching direction--starting with data that represent the final recorded transactions (sales) and going back to find originating supporting source documents. These procedures might reveal some transactions of the problem types--bill and hold, and overbilling. The last month of the fiscal year (although a typical seasonal low month) could be targeted for greater attention because the sales are much higher than the previous January and because the auditors want to pay attention to sales cut-off in the last month.Select a sample of shipping documents, trace them to customer orders, and trace them to invoices and to recording in the accounts receivable with proper amounts on the proper date. These tests follow the tracing direction--starting with data that represent the beginning of transactions (orders, shipping) and tracing them through the company's accounting process. If extraattention is given in January for cut-off reasons, this sample might reveal some of the problem transactions.Audit of Balance: Confirm a sample of customer accounts. Follow up exceptionsnoted by customers relating to bill and hold terms, excessive prices, and double billing. Even a few exceptions raise red flags for the population of receivables.Use analytical comparison on comparative month's sales. Investigate any unusual fluctuations (e.g. January this year much larger than January last year, the reversal month next year with negative sales). The January comparative increase in sales should cause auditors to extend detail procedures on some of the month's transactions.Discovery Summary: The auditors performed a detail sales cut-off test on January sales, selecting a sample of recorded sales. However, they did not notice the significance of "bill and hold" marked on the invoices, and they did not figure out the meaning of the blank spaces and duplicate company employee signatures on the shipping documents.In the following year's audit, they tested sales transactions in a month whenthe prior year's bill and hold sales were reversed. They noticed the discrepancy but were told that it involved various billing errors. They did not connect it with reversal of the prior year's sales.The auditors confirmed a judgment sample of large accounts receivable balances. Twelve replies were received on 103 confirmations. Six of the replies were from "bill and hold" customers who listed discrepancies. The auditors followed up the six by examining sales invoices and shipping documents. They did not grasp the significance of the "bill and hold" stamps or the features of the shipping documents described earlier. Three confirmation responses indicated the customers did not owe the amounts. The auditors relied on Mattox internal documents to decide that the customers were wrong. They did not examine the sales orders that indicated that these customers had a right of cancellation.The auditors did not perform month-by-month analytical sales comparisons withthe prior year. Thus they did not recognize the significant fluctuations in the comparative January sales. In the next year's audit, they did not recognize the significant comparative decrease in month's sales for the months when the prior year bill and hold sales were reversed.9.71 a. The purpose of a cut-off test is to verify that transactions (particularly those occurring on and around the balance sheet date) are recorded in the proper accounting period. Such tests relate to managements assertions about valuation and allocation (that is, amountsare appropriately valued and allocated to the correct period).b. In order for those financial statements which measure flows (that is, the statement of income and retained earnings, and the statement of changes in financial position) to be correct, the transaction cut-offs at both the beginning and end of the fiscal year must be correct. Thus, in an initial engagement, an auditor must test both transaction cut-offs.c. i) Review the clients procedures for ensuring that a proper cut-off of sales transactions and any sales returns and allowances is made.ii) If a prenumbered shipping document is used, obtain the number of the last shipment in the fiscal year. Compare this number to sales transactions recorded in the current and the subsequent period. iii) If there is no prenumbered shipping document, select a sample of sales recorded during the last few days of the current year and thefirst few days of the next year. Examine shipping dates to verifyrecording in the proper period.iv) Select a sample of credit memoranda issued near the end of the current fiscal year and at the beginning of the next fiscal year and examine supporting documents, including receiving reports for any returned goods. Verify that credit memos are recorded in the same period as the related sales transactions. d. The cut-off of cash receipts is tested by tracing cash receipt transactions recorded near the end of the fiscal year to a deposit recorded by the bank. Any deposits in transit at the end of the periodshould be traced to a cut-off bank statement (covering the first few days of the next fiscal year) sent directly by the bank to the auditor. An unreasonable delay in the recording of a deposit by the bank could indicate a cut-off error.9.72 a. i) There is no apparent accounting control over the linens carried by drivers for sale to customers.Specifically, no one seems to reconcile the nature and quantity of linens sold, to customers charges as recorded by the driver. ii) There is a lack of segregation of functions in that drivers have control over assets--both linens and cash-- as well as records of those assets (the route book).iii) There is a lack of adequate cash receipt records.Specifically, noreceipt for cash received is given by the driver to the customer.iv) No one seems to account for completeness of the numerical sequence of sales invoices prepared at the plant. Thus sales invoices might be prepared but not entered in the route books.v) Regular monthly statements are not sent to customers.vi) There are apparently no procedures for follow-up on overdue accounts.vii) There are no independent internal verification procedures, for example, by an internal auditor.b. No, the procedure of opening each route book twice, at random, would not produce a statistically valid random sample. Since there are different numbers of accounts on the various routes (from 25 to 40), customers on a small route (25) have a greater probability of selection than customers on a large route (40). This violates the equal probability of selection requirement for a random sample. In addition, opening the route book at random is a haphazard procedure which can easily be biased (for example, the book tends to open most readily to certain pages).c. Since the internal controls in this situation are quite poor, the use ofpositive accounts receivable confirmations is most appropriate.That is, the auditor should request that customers respond whether of not they agree with the recorded balance.Moreover, positive confirmations should be used since there is a considerable risk of fraud by the drivers, who control both the records and cash collections.d. Dollar-unit sampling is most effective and efficient when the auditor isconcerned primarily with the risk that an account balance may be overstated, and the expected error rate in the population is low. Neither condition is likely to be present in this case. Since there is arisk of fraud by the drivers which could result in unrecorded receivables and sales, the accounts receivable balances may be understated. In addition, since internal controls are not good, there islikely to be a fairly high error rate in the accounts. Thus, dollar-unitsampling should probably not be used in this situation.