Far Eastern University

Institute of Accounts Business and Finance

Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 4 – Internal Control Considerations and Substantive Tests

Learning Objectives

After completing and discussing this case you should be able to

• Develop audit programs to gather evidence to test various assertions of the client on their financial
statements

Background1

Y
ou are a senior auditor assigned to
the Superconductor Manufacturing
Company (SMC) audit. This is the
first year your firm has conducted the audit
for this client. The company is planning an
initial public offering (IPO) of its securities
in the next three to five years and has hired
your firm to conduct its first financial
statement audit in preparation for the
upcoming IPO.

SMC is a medium-sized company that buys

raw materials and use them in
manufacturing microchips and microchip
components. SMC operates in a factory
complex that includes a small
administrative office, production area,
shipping and receiving, and a warehouse. SMC sells its product to both local and international customers. The
company has a good reputation for quality products. You have been assigned responsibility in preparing the audit
program for auditing SMC’s accounts. You have already performed preliminary analytical procedures to identify
areas that may represent heightened risk and thus may require further attention.

Your staff assistant assembled information relating to your identified significant accounts including a brief
description of each.

Cash

The cash account of the company is mainly comprised of various checking accounts for different purposes, one for
payment of purchases to suppliers, a payroll account, and another for payment of interest and loans. The company
also maintain a revolving fund in the factory for items that cannot be paid by checks. The treasury handles all these
accounts and approves all disbursements. The treasury also oversees the cashiers that process receipts from
customers. The controller is in charge for posting the transactions to the company’s general ledger. A personnel who
does not have any cash handling and recording function performs bank reconciliation at least once a week. Internal
audit conducts cash count for the revolving fund on a surprise basis.

1 The case was prepared by the Auditing Cluster of Accountancy Department of Institute of Accounts Business and Finance
(IABF) of Far Eastern University (FEU), as a basis for classroom discussion. Superconductor Manufacturing Company is a
fictitious company and all characters and names represented are fictitious; any similarity to existing companies or persons is
purely coincidental.
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 Far Eastern University
Institute of Accounts Business and Finance
Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 4 – Internal Control Considerations and Substantive Tests

Receivables and Sales

SMC mainly caters to industrial clients which are most of the times maintain factories or production plants as well.
SMC grants a standard of 30 to 60 days credit term to its customers. It takes the company around 40 to 50 days on
the average its receivables. The company estimates its bad debt losses by aging its accounts receivables. Once an
invoice went past a threshold (in company’s policy, more than 90 days past due), it is sent to a collection agency.

Inventories and Cost of Sales

SMC makes several different microchips and microchip components for use in computer manufacture. The
production area is divided into five areas, with each area specializing in a particular product group. Production is
done in batches according to orders placed with the company. The different types of products that the company
manufactures all use similar raw materials which are stored in a single location. Finished goods are stored on a
specially designed warehouse with a controlled environment to prevent it from being damaged. Each product is
contained in a barcoded container that also stores the product information of the inventory.

The company’s production process includes a lot of automation using specialized machineries but still requires a
relatively large amount of labor for machine operations and quality inspection. Thus, the company’s conversion costs
are fairly evenly divided between direct labor and factory overhead. Overhead consists primarily of the costs of the
production facilities and depreciation and maintenance on the machinery. The company uses a hybrid product
costing system to accommodate both the continuous and homogenous nature of the manufacturing process and the
fact that production runs are performed in separately identifiable batches.

Investments

The company has various investments in financial instruments some of which are held by independent custodians
and some are held in the premises of the company. These financial instruments include marketable securities both
debt and equity issued by other corporations. The company has also several investments in real estates which are
maintained by the company for capital appreciation or source of additional funds if needed.

Plant, Property, and Equipment

The company has a land where its plant is situated. As mentioned in the introduction, the factory complex includes
a small administrative office, production area, shipping and receiving, and a warehouse. Inside the factory, the
machineries, specialized equipment, and assembly lines are installed. The company also maintains several units of
vans and trucks that are being used to deliver its products to its customers.

Accounts Payable and Accrued Expenses

The Company has both local and international suppliers for its various raw materials. On average, SMC’s suppliers’
terms range from 30 to 60 days before the company pays its due. The Company generally pays via check while
international accounts are settled via fund transfer arrangements. The treasurer approves expenditures below
P100,000, while expenditures amounting to P100,000 and above should be approved by both the president and the
treasurer. Other usual accruals of the company include accrual for salaries and wages, government dues, interests,
and

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 Far Eastern University
Institute of Accounts Business and Finance
Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 4 – Internal Control Considerations and Substantive Tests

Loans

The company has both short-term and long-term loans from local banking institutions. The funds are used to finance
the company’s working capital requirements. The company has never defaulted in any of its loan payments including
interests. The banks closely monitor the Company’s financials by regularly asking for its interim financial reports
and audited annual financial statements as condition for the loans. The company has also existing credit lines with
these banks wherein the Company can avail funds up to a certain amount without undergoing formal loan approval
process.

Equity

The shares of the company are held by eight directors, one of which is an outside director. The equity-related records
are kept by the company in their premises. One of the directors who is a lawyer by profession serves as the
Company’s Corporate Secretary, although they also maintain a law firm on a retainer basis which serves as their legal
counsel.

Requirements:

1. Identify 3 – 5 internal considerations on each of the significant accounts identified above that will be helpful
in preparation of the audit program for tests of controls of the company.
2. Identify 3 – 5 substantive audit procedures that an auditor can perform on each of the significant accounts
above in order to gather sufficient appropriate evidence to support the auditor’s opinion on the fairness of
the financial statements in accordance with identified financial reporting framework.

Submission guide:

Write your name, student number, and section.

Letter size (8.5” x 11”)

Font style: Calibri, Font size: 11
Single Spaced

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