Test Of Control And Main Transaction

Question 1

Main transaction

Answer 1

When planning tests of controls, auditors aim to adopt a systems-based approach whenever possible. This approach focuses on testing the systems and internal controls that generate financial reporting figures, rather than the figures themselves. If the systems and controls are effective, the figures produced should be reliable.

Two key conditions must be met before an auditor can adopt a systems-based approach:

1. Design Effectiveness:
   
   • The systems and controls should be designed to minimize the risks of misstatements. The auditor evaluates this through procedures for documenting and assessing the controls¹.
2. Operational Effectiveness:
   
   • The systems and controls should operate effectively in practice. The auditor gains evidence of this by performing tests of control¹.

1. Define the Scope and Objectives:
   
   • Determine which controls to test based on their relevance to the audit objectives and the risk of material misstatement².
2. Assess Risk and Prioritize Controls:
   
   • Identify and prioritize controls based on their impact on financial reporting and the likelihood of failure².
3. Select Testing Methods:
   
   • Choose appropriate methods for testing controls, such as inspection, observation, inquiry, and re-performance².
4. Develop a Testing Schedule:
   
   • Plan the timing of control tests, considering interim and year-end periods².
5. Assign Responsibilities:
   
   • Allocate tasks to audit team members based on their expertise and experience².
6. Establish Criteria for Evaluating Control Effectiveness:
   
   • Define criteria for determining whether controls are operating effectively².
7. Plan for Documentation and Evidence Collection:
   
   • Ensure that all testing procedures and results are thoroughly documented².
8. Communicate the Plan:
   
   • Share the testing plan with the audit team and client management to ensure alignment and understanding².

1. Define the Scope and Objectives:
   
   • Focus on controls related to cash handling to ensure accuracy and prevent fraud.
2. Assess Risk and Prioritize Controls:
   
   • Identify high-risk areas such as cash receipts and disbursements.
3. Select Testing Methods:
   
   • Use observation to watch cash handling procedures, inquiry to ask staff about their processes, and re-performance to verify cash reconciliations.
4. Develop a Testing Schedule:
   
   • Plan to test controls both at interim periods and at year-end.
5. Assign Responsibilities:
   
   • Allocate tasks to team members with experience in cash handling audits.
6. Establish Criteria for Evaluating Control Effectiveness:
   
   • Define criteria such as timely and accurate cash reconciliations and proper segregation of duties.
7. Plan for Documentation and Evidence Collection:
   
   • Ensure all observations, inquiries, and re-performance results are documented.
8. Communicate the Plan:
   
   • Discuss the testing plan with the audit team and client management to ensure everyone is on the same page.

By following these steps, auditors can effectively plan and execute tests of controls, ensuring a thorough and reliable audit process¹²³.

Computer-Assisted Audit Techniques (CAATs) are specialized methods used by auditors to obtain audit evidence from IT systems. These techniques are essential when auditing IT-based systems, as they help auditors verify the completeness and accuracy of electronic processing, which may not provide an adequate audit trail.

1. Audit Software:
   
   • Used for substantive testing, such as analyzing large volumes of data to identify anomalies or trends.
2. Test Data:
   
   • Relevant for tests of control, this technique involves processing a sample of data through the IT system and comparing the results with pre-determined outcomes.

Test Data involves the auditor inputting a sample of data into the client’s IT system to verify the operation of specific application controls. This method provides evidence of how controls function in practice.

Let’s consider a retail company, Dolally, and how test data can be used to test its system:

1. Out-of-Stock Order:
   
   • Input: A dummy order for goods known to be out of stock.
   • Expected Result: The system should not produce a dispatch note.
   • Purpose: Verify that the system correctly handles out-of-stock situations.
2. In-Stock Order:
   
   • Input: A dummy order for goods known to be in stock.
   • Expected Result: The system should produce a dispatch note.
   • Purpose: Ensure that the system processes in-stock orders correctly.
3. Unflagged Dispatch Notes:
   
   • Input: Dummy dispatch notes without flagging them for invoicing.
   • Expected Result: These should appear on the exception report.
   • Purpose: Check that the system identifies unflagged dispatch notes.
4. Flagged Dispatch Notes:
   
   • Input: Flag dummy dispatch notes.
   • Expected Result: Invoices should be raised for these notes.
   • Purpose: Confirm that the system raises invoices for flagged dispatch notes.

While CAATs are powerful tools, they come with certain disadvantages:
- Cost: Developing or purchasing audit software can be expensive.
- Maintenance: Keeping programs up-to-date with changes in hardware and software requires ongoing investment.
- Training: Auditors need proper training to use CAATs effectively, which can be time-consuming and costly.

1. Scenario: Auditing the sales order process in Dolally.
2. Step 1: Input a dummy order for out-of-stock goods and verify no dispatch note is produced.
3. Step 2: Input a dummy order for in-stock goods and ensure a dispatch note is generated.
4. Step 3: Input dummy dispatch notes without flagging for invoicing and check the exception report.
5. Step 4: Flag dummy dispatch notes and verify that invoices are raised.

By using test data, auditors can effectively evaluate the operation of specific controls within an IT system, ensuring that the system processes transactions account.

Auditors focus much of their work on major transaction cycles, which encompass the majority of a business’s day-to-day transactions. These cycles directly impact both the statement of financial position and the income statement (or statement of comprehensive income). The major transaction cycles are:

1. Sales (Revenue) Cycle:
   
   • Risks: Overstatement of revenue, unrecorded sales, incorrect pricing.
   • Control Objectives: Ensure all sales are recorded accurately and completely.
   • Suitable Controls: Segregation of duties, authorization of sales, regular reconciliation of sales records.
   • Tests of Controls: Verify authorization of sales, review reconciliation processes, inspect sales invoices.
2. Purchases Cycle:
   
   • Risks: Unrecorded liabilities, unauthorized purchases, incorrect recording of purchases.
   • Control Objectives: Ensure all purchases are authorized, recorded accurately, and liabilities are recognized.
   • Suitable Controls: Purchase order approvals, three-way matching (purchase order, receiving report, invoice), periodic reconciliation.
   • Tests of Controls: Inspect purchase orders for authorization, verify three-way matching, review reconciliation of accounts payable.
3. Payroll Cycle:
   
   • Risks: Ghost employees, incorrect payroll calculations, unauthorized changes to payroll data.
   • Control Objectives: Ensure all payroll transactions are authorized, accurate, and complete.
   • Suitable Controls: Segregation of duties, payroll reconciliations, authorization of payroll changes.
   • Tests of Controls: Review payroll reconciliations, inspect authorization of payroll changes, verify payroll calculations.

Tests of control are also applied to key statement of financial position headings that link into the main transaction cycles:

1. Bank and Cash:
   
   • Risks: Misappropriation of cash, unrecorded transactions.
   • Control Objectives: Ensure all cash transactions are recorded and reconciled.
   • Suitable Controls: Bank reconciliations, segregation of duties, cash counts.
   • Tests of Controls: Review bank reconciliations, inspect cash count records, verify segregation of duties.
2. Inventory:
   
   • Risks: Misstatement of inventory quantities, theft, obsolescence.
   • Control Objectives: Ensure accurate recording and safeguarding of inventory.
   • Suitable Controls: Physical inventory counts, inventory reconciliations, authorization of inventory adjustments.
   • Tests of Controls: Observe physical inventory counts, review inventory reconciliations, inspect authorization of adjustments.
3. Revenue and Capital Expenditure (Non-Current Assets):
   
   • Risks: Misclassification of expenses, unrecorded assets, overstatement of asset values.
   • Control Objectives: Ensure accurate recording and classification of capital expenditures.
   • Suitable Controls: Authorization of capital expenditures, asset tagging, periodic asset verification.
   • Tests of Controls: Inspect authorization of capital expenditures, verify asset tagging, review asset verification records.

These lists provide detailed guidance on how tests of control may be designed and applied to different aspects of the main transaction cycles. By focusing on these cycles, auditors can ensure a comprehensive evaluation of the business.

When preparing for an exam that includes scenario-based questions on transaction cycles, it’s essential to understand how to identify suitable internal controls and tests of controls. Here’s a structured approach to help you think through these concepts:

1. Risks:
   
   • Identify the risks that weaknesses in the transaction processing system could cause the financial statements to be inaccurate or misleading.
2. Control Objectives:
   
   • Determine the purpose of having controls. What should the control be intended to achieve or prevent? The objective is to eliminate or reduce the identified risks.
3. Controls:
   
   • Devise controls that will help achieve the control objectives. These controls should be designed to mitigate the identified risks.
4. Tests of Controls:
   
   • Develop tests to establish whether the controls are working effectively in practice. These tests should provide evidence that the controls are operating as intended.

• Overstatement of revenue
• Unrecorded sales
• Incorrect pricing

• Ensure all sales are recorded accurately and completely.
• Prevent unauthorized sales transactions.
• Verify that sales are recorded at the correct prices.

• Segregation of Duties: Separate responsibilities for sales authorization, recording, and cash handling.
• Authorization of Sales: Require managerial approval for all sales transactions.
• Regular Reconciliation: Perform regular reconciliations of sales records with inventory and cash receipts.

• Unrecorded liabilities
• Unauthorized purchases
• Incorrect recording of purchases

• Ensure all purchases are authorized and recorded accurately.
• Recognize all liabilities.
• Prevent unauthorized purchases.

• Purchase Order Approvals: Require approval for all purchase orders.
• Three-Way Matching: Match purchase orders, receiving reports, and invoices before payment.
• Periodic Reconciliation: Reconcile accounts payable records with supplier statements.

| Test of Control | Reason for the Control |
|—————–|————————|
| Inspect purchase orders for proper approval. | To ensure that all purchases are authorized. |
| Verify three-way matching of purchase orders, receiving reports, and invoices. | To confirm that purchases are recorded accurately and completely. |
| Review reconciliation records of accounts payable with supplier statements. | To ensure that all liabilities are recognized and recorded. |

• Ghost employees
• Incorrect payroll calculations
• Unauthorized changes to payroll data

• Ensure all payroll transactions are authorized, accurate, and complete.
• Prevent unauthorized payroll changes.
• Verify payroll calculations.

• Segregation of Duties: Separate responsibilities for payroll preparation, authorization, and distribution.
• Payroll Reconciliations: Perform regular reconciliations of payroll records.
• Authorization of Payroll Changes: Require managerial approval for all payroll changes.

| Test of Control | Reason for the Control |
|—————–|————————|
| Review payroll records for segregation of duties. | To prevent unauthorized payroll transactions. |
| Inspect payroll reconciliation records. | To verify the accuracy and completeness of payroll transactions. |
| Check authorization records for payroll changes. | To ensure that all payroll changes are authorized and legitimate. |

By understanding these concepts and applying them to specific scenarios, you can effectively identify and test internal controls in an exam setting. Presenting your answers in a tabular form can help organize your thoughts and clearly communicate your understand.

Test of Control | Reason for the Control |
|—————–|————————|
| Review sales invoices for managerial approval. | To ensure that all sales are authorized and legitimate. |
| Inspect reconciliation records between sales, inventory, and cash receipts. | To verify that all sales are recorded accurately and completely. |
| Observe the segregation of duties in the sales process. | To prevent unauthorized sales transactions and reduce the risk of fraud. |