Auditing Part 3

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Revenue Cycle

B. Preliminary Control Risk, Allowable Detection Risk and Audit Programs

At this point, you are going to work on one particular transaction cycle (only) depending upon
what was assigned to your team (Make sure you are updated with the advisory as to what
transaction cycle will be audited by team in which you are a member)

Activity 4 - Performance of Risk Assessment Procedures to Identify/ Assess Risk of


Material Misstatement Through Understanding the Entity's Internal Control

Area Transaction Cycle Account Name

Revenue & Sales (Cash & Credit), Sales Adjustments


Collection Cycle (discounts, returns, bad debts), Cash Receipt
A

Acquisition of goods & services, cash disbursement,


Purchase returns & discounts, production cycle,
B Expenditure Cycle inventory warehousing & payroll transactions

1. Assess inherent risk qualitatively at assertion level (on the transaction cycle). After
which quantify such assessment.
 Receivables incorrectly classified as current when likelihood of collection during
next year is low
 Collection of a receivable contingent on specific events that cannot currently be
estimated Payment not required until purchaser sells product to its end customers
 Accounts receivable aged incorrectly, and potentially uncollectible amounts not
recognized Orders accepted from customers with poor credit, but allowance for
doubtful accounts not increased accordingly
 Right of customer to return a product, as well as returns history
 Proper treatment of sales transactions made with recourse or that have an abnormal
or unpredictable amount of returns.

In this, the Inherent Risk of the company is more or less 80% when it comes to the
Revenue & Collection Cycle of the company.
2. Preliminarily obtain understanding of the client's internal control by following the steps
below:
a. Base on the information you gathered in Activity 2, prepare a flowchart
supported by explanation on critical areas to document your understanding about
the client's internal control.

The Revenue cycle flow chart consist the process in the important areas of the cycle
to document the client's internal control. The steps and its important detailed process are
the following:
1. Production Department inform the Sales Department of the finished goods/orders.
Wholesale or outlet supervisor coordinate with the customer and approved
dispatching of goods for delivery. Dispatch order is
accomplished in triplicate; 1) original - file copy 2) duplicate to AR clerk & 3) triplicate
to Stockroom.
2. Quadruplicate copy of sales invoice is prepared by the AR clerk upon the receipt of
dispatch order from the Sales Dept. Entries in the invoice is based on the dispatch
order. Except for the quadruplicate copy, all copies of the invoice are forwarded to
stockroom to be included in delivery of goods. Remaining copy is used as basis in
recording in the sales journal.
3. Duplicate & Triplicate copies were returned with customer acknowledgement
receipt. Duplicate copy is
forwarded to AR clerk while the triplicate copy is retained by the stockroom.
4. AR clerk send collection letter five days after the date of delivery. Part of the job of
AR clerk is to go to customers and collect amount due 15 days after delivery or until
the account is fully paid.
The critical areas of the process are the recording of the sales and collection of
accounts receivable that needs more inspection and monitoring of the staff.

b. After which you are ask to prepare a tabulation of error or fraud that may
occurred with the present system of internal control.

Internal Control Internal Control Deficiencies Possible Fraud or Error


Procedures

Individuals with the ability


Quadruplicate copy of sales The same person performs the to adjust customer
invoice is prepared by the duty of recording and collecting receivable accounts (with no
AR clerk upon the receipt of to the customer. second-person approval or
dispatch order from the review) also collect cash can
Sales Dept and also the AR manipulate the amount
clerk is the one who go to
customers and collect
amount due.

AR clerk visit the outlets Receiving remittances must be Without proper schedule or
once or twice a week done on a scheduled and regular cutoff of remitting it can be
received remittances. basis. done in an improper way and
unrecorded if the situation
permits the AR clerk.

Risk of material misstatement


Large portion of receipts The company must monitor its for accounts receivable and
came from the collection of accounts receivable and find way revenues
AR Clerk. to increase cash sales to control
bad debts.
The cashier prepares deposit The one who prepare the deposit The amount of depositing
slip and go the bank to make slip cannot be the one to deposit money can be can be change
the deposit. in the bank. There must be a as the one who make the
middle person approval of the deposit slip is the one who will
amount to deposited. deposit it to the bank.

c. With your tabulation above evaluate the effectiveness of the internal control covering
the transaction cycle that was assigned to you and give your preliminary assessment
of control risk (maximum, high, moderate or low).  Explain your answer

The effectiveness of the internal control of Forever Manufacturing Company is


moderate because although the company shows a good internal control in many
aspects of the cycle there are still some areas that did not given the right amount of
monitoring. Since in the revenue cycle, money is the most involved in the
transactions and the most susceptible of fraud internal control system must be high.
Revenue cycle controls are perhaps the most important component of an
organization's overall internal control framework. Not only are revenue cycle controls
an organization's strongest defense against fraud and loss, they help ensure that
decisions are made based on valid and reliable information.

d. With these possible errors or fraud, you are asking to prepare a recommendation on
how internal control system can be improved (total revision of the system is not
allowed).

The auditor can recommend to the organization that there should always be a
separation of duties in all aspects of transactions and make sure that there are double
checking personnel who will confirm the computed collections and any other areas
related. Make sure that the recorded accounts and amounts are up to date or on its real
time transaction to mitigate the errors that may happen. Being careful and hands-on
on the flow of transaction will greatly help the organization to its success and fair
view presentation of financial statements.

IMPORTANT ASSUMPTION (only for those who assessed Control Risk at Maximum):
If your assessment of control risk is at maximum, your activity ends here. Thus, an
important assumption is added to you   - Assuming that the In-charge Audit Partner lowered
the assessment to below maximum since the effect of internal control weaknesses can be
addressed by the team's audit strategy making it appropriate to conduct test of controls. 
Therefore, irrespective of your actual findings you will assume that control risk is below
maximum in the succeeding activities.  For this purpose, you have to quantify Control Risk
assessment to a percentage of what could have been made by your In-charge Audit Partner
and use it in the following requirements.

3. Mathematically show the relationship between audit risk and its components by
a. Using the risk model and considering the assessment of audit, inherent and
control risks determine allowable detection risk

AUDIT RISK = INHERENT RISK x CONTROL RISK x DETECTION RISK

4% = 80% x 70% x Allowable Detection Risk


Allowable Detection Risk = 4% / (80% x 70%)
Allowable Detection Risk= 7.15%

b. Explain how the result of computation above will affect the nature, time & extend
of audit procedures required by the engagement in general.

An audit risk model is a conceptual tool applied by auditors to evaluate


and manage the various risks arising from performing an audit engagement. The
tool helps the auditor decide on the types of evidence and how much is needed for
each relevant assertion.

The audit risk model has become increasingly important. Regulations for
business accountability became more strict and other legislation designed to beef
up auditing practices and provide more information to investors. The audit risk
model, with its flexibility and broad-based approach, allows auditors to
incorporate such standards and make strong audits that both businesses and
investors can count on.

The audit risk model is a vital step for complex audits because it allows
for a great amount of adaptation. If auditors were limited to a set audit procedure
composed of steps they had to follow, they would not be able to change their
approach based on the company and audits would not be complete or useful. The
risk model allows for assessment of the current situation and makes the resulting
audit a flexible tool that can be used to inspect for particular errors
PHASE 2 - RISK RESPONSE (TEST OF CONTROLS)

C. General Response and Audit Programs

Activity 5 - Determine overall response of the auditor related to the risk assessed at
Financial Statement level & Assertion Level, explain how it will affect the following:

1. Professional skepticism
Financial Statement Level- the auditor should evaluate the integrity of the management,
assess the management experiences and knowledge and the changes of management during
the period to know if the management is inexperience that could possibly affect the
preparation of the financial statements of the company and to determine if there are unusual
pressure on the management to misstate the F/S possibly due to the industry experiencing
large number of business failures or if the going concern assumption is in question. For the
auditor to detect on who will possibly commit fraud or error.

Assertion Level- the auditor to determine the financial accounts that are susceptible to
misstatements and to determine the complexity of transactions and other events that may
require the work of an expert. For the auditor to ascertain on which accounts are prone to
misstatements so that the auditor would focus to those critical transactions that could affect
the financial statements.

2. Level of staff assigned


Financial Statement Level- the auditor should determine who works in which transactions
to trace who will he or she ask questions regarding a particular account and system of
control. To determine if the level of staff assigned is really applicable to handle the particular
work delegated to that person.

Assertion Level- Every staffed assigned should be knowledgeable about the process, scope
and handling of the case assigned. The knowledge, skill, and ability of personnel assigned is
significant.

3. Ongoing staff supervision


Financial Statement Level- the auditor should assess if the supervision system of the
company is effective and to determine if there is a pressure coming from the higher ups to
misstate the financial statement of the company so that the auditor would know who will he
or she suspect.
Assertion Level- the auditor should assess if the accounts in the financial statements are
properly accounted for with the supervision of the appropriate personnel. The auditor could
make inquiries to the staff responsible in the recording of the particular transactions.

4. Evaluate accounting policies


Financial Statement Level- the auditor should evaluate if the management really knows the
accounting policies set by the PFRS or PAS as to the correct recognition of transactions in its
proper accounts. The auditor should know the experience level of the responsible staffs in the
recognition procedures of accounts.

Assertion Level- the auditor should evaluate if the accounts are properly recognized in the
books of the company using the accounting policies set by the PFRS or PAS and determine
which accounts are recorded erroneously or due to fraud committed by the management.

5. Nature/extend/timing and unpredictability of planned procedures


Financial Statement Level- the auditor should implement an unpredictability of planned
procedures so that the staffs do not know in which areas and departments he or she will audit
next and to decrease the possibility of concealment of fraud by the responsible person.

Assertion Level-since unpredictable tests are required in the audit, concealment of fraud will
be mitigated. Those accounts that are susceptible for fraud or error should undergo in the
unpredictable tests by the auditor.

6. Other further procedures

Upon the development information that gives rise to additional perceived areas prone to
material misstatements, audit procedures will be further applied for the aim of attaining
dealing with those assessed risks. Number of procedures to be done is carefully taken into
consideration, wherein evidence that will further reduce risk of misstatement to that assertion
is also considered. Generally, the selection of particular procedures which is aimed at
objective attainment is influenced by several considerations such as the nature and
materiality of the particular component of the financial statements, nature of the audit
objective to be achieved, reliance that can be placed on internal control structure, relative risk
of material errors or irregularities, kinds and competence of available evidence and the
expected efficiency and effectiveness of possible audit procedures

Activity 6 - Preparation of Initial Audit Program for Substantive Testing:

Activity 6 A - Preparation of Audit Program for Substantive Testing:

1. Based on the computation of Allowed Detection Risk in Activity 4.3.a & the Audit Plan in
Activity 2, prepare Initial Substantive Audit Program by accomplishing the table below:
Assertion Audit Objective Substantive Audit Procedure

The auditor should trace the


source documents to the books
of entry if there was omission
of transactions and account
To test if the transactions are
understatement or
Accuracy accurate and account balances
overstatement and tracing
are correctly stated.
recorded transactions to source
documents if there was
unsupported transactions and
under/overstatements.

 To test the details of account Auditor’s professional


balances if it really in existence judgement should be used to
Existence
in the record and if it really determine which accounts to
occurred. scrutinize.

This involves the comparison


of current period financial
information with:
To compare the relationships  Prior period
between data to data and to have information
Comparability a basis of reporting and  Expected results
recording of transactions that fit
 Predictable pattern
between industries.
 Intra-industry
information
 Non-financial
information

The auditor should check all


the records to check if the
To know if the transactions are
Classification transactions are classified and
recorded in the proper accounts.
presented fairly in the financial
statements.

Understandability Proper presentation and The auditor should review the


disclosures of the quantitative financial statements to verify
and qualitative information to proper classifications of
help users of the financial accounts. The auditor should
also review the disclosures to
statements to understand the verify disclosures such as
information stated those relating to compensation
balances

2. Explain how these audit procedures provide assurance that the Allowable Detection Risk will
be achieved.

The Allowable Detection Risk will be achieved if the auditor will carefully follow the
audit procedures mentioned above. The auditor set the allowable detection risk to assess how
many percent of not detecting an error or fraud will likely to occur in the audit work being
performed. It is important that auditor should pay attention as to the technical aspects of the
audit to ascertain that the auditor will detect possible errors and fraud at financial statements
level and at assertion level.

Keep in mind that you can never completely eliminate detection risk because you’ll most
likely never look at each and every transaction. You’ll always have some risk of a
misstatement being missed, but your goal is to keep it to an acceptable minimum. The only
way to eliminate detection risk completely is to examine every transaction. Because
reviewing every item isn’t practical, auditors use sampling methods to assess transactions
and balances. Therefore, the auditor aims to keep the detection risk within an acceptable
level.

Activity 6 B -   Preparation of Audit Program for Test of Controls:

1. Based on the preliminary assessment of control risk in Activity 4.2.d. and in consideration of
the Initial Substantive Audit Program you accomplish above, prepare Audit Program for Test
of Control by:

Assertion Related Control Activities Audit procedures for test


of controls

Occurrence Ensuring that the recorded Checking of sales receipt


transactions in be books and records of attendance
occurred. of the employees.

Completeness Giving the employees the right Reviewing all payroll


amount, they deserve and they transaction are properly
work for. recorded 

Accuracy Verifying the amount of all Payroll transaction and


transactions with the company. receipts are recorded at
the proper amount.

Cut-off Only those transactions that Checking that all


occurred in the accounting transactions are recorded
period should be recorded. in the correct accounting
period.

Classification Classifying those accounts and Payroll transaction are


transactions that belong in a recorded in proper
group of accounts. account.

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