SYSTEM OF INTERNAL CONTROL

Learning objectives:
 Understand how to evaluate system of internal control
 Use system of internal control by auditors
 Perform test of controls
 Communication on weaknesses noted in internal controls
Impact of tests of controls on the audit strategy and plan
The extent of substantive testing to be carried out will depend on the
results of the tests of controls which will affect the auditor's
assessment of the effectiveness of the internal control system and the
auditor's assessment of control risk.
If control risk is deemed low:
If tests of controls provide evidence that an effective control system is
in place, this may allow the auditor to place more reliance on internal
controls and evidence generated internally within the entity.
Typically this increases the appropriateness of interim audit testing and
allows the auditor to reduce the quantity of detailed substantive
procedures performed at the final audit stage.
The audit strategy and plan will be updated to reflect that fewer
substantive procedures may be required or smaller sample sizes can be
tested at the final audit stage.
If control risk is deemed high, the auditor should respond by:
 Increasing procedures conducted at and after the yearend.
 Increasing substantive procedures, in particular, tests of detail.
 Increasing the locations included in the audit scope.
  Placing less reliance on analytical procedures as the information
produced by the client's systems is not reliable.
 Placing less reliance on written representations from
management if the control environment generally is considered to
be weak.
 Obtaining more evidence from external sources e.g. external
confirmations from customers and suppliers.
 Updating the audit strategy and plan to reflect the additional
testing required at the final audit stage.
Limitations of internal controls
The auditor can never eliminate the need for substantive procedures
entirely because there are inherent limitations to the reliance that can
be placed on internal control due to:
 Human error in the use of judgement.
 Simple processing errors and mistakes.
 Collusion of staff in circumventing controls.
 Systems designed for routine transactions, processing oneoff or
unusual transactions.
 The abuse of power by those with ultimate controlling
responsibility (i.e. management override).
As a result, the auditor must always perform substantive testing on
material balances in the financial statements.
Testing System of Control
A test of control involves the auditor obtaining evidence that the client
has implemented the controls they say they have and that they have
worked effectively during the period.
Typical methods of controls testing include:
  Observation of control activities, e.g. observing the inventory
count to ensure it is conducted effectively and in accordance with
the instructions.
 Inspection of documents recording performance of the control,
e.g inspecting an order for evidence of authorisation.
 Computer assisted audit techniques (such as test data to ensure
the programmed controls are working effectively).
Sales Cycle:
1. Order Received
2. Goods Dispatched
3. Invoice Issued
4. Transaction recorded in books
5. Cash Received
Ordering • Goods are only supplied to customers who
pay promptly and in full.
• All orders are processed.
Despatch • Orders are despatched promptly and in full to
the correct customer.
• All orders are despatched.
Invoicing • All goods despatched are invoiced.
• Invoices are raised accurately.
Recording • Only valid sales are recorded.
• All sales and related receivables are recorded
and in the correct accounts.
• Revenue is recorded in the period to which it
relates.
• Sales are recorded accurately and related
receivables are recorded at an appropriate value.
Cash Received • Cash received is allocated against the correct
customer and invoices to minimise disputes.
• Overdue debts are followed up on a timely
basis.
• Irrecoverable debts identified and written off
appropriately.
PROCEDURES:
The key assertions for bank and cash are existence and valuation.
Bank and cash is a good example of where the reliability of the evidence available means that only a
small quantity of evidence is needed. The auditor relies mainly on just two key pieces of evidence:
the bank confirmation letter and the bank reconciliation.

 Obtain the company’s bank reconciliation and cast to ensure

arithmetical accuracy. Agree the cash book figure to the financial
statements: valuation.
 Obtain a bank confirmation letter from the company’s bankers:
existence, rights & obligations.
 Agree the reconciliation’s balance per the cash book to the year
end cash book: valuation.
 Agree the balance per the bank statement to an original year end
bank statement and also to the bank confirmation letter:
valuation.
 Trace all of the outstanding lodgements to the pre yearend cash
book, post year end bank statement and also to paying in book
pre yearend: valuation, existence.
 Trace all unpresented cheques through to a pre year end cash
book and post yearend statement. For any unusual amounts or
significant delays obtain explanations from management:
valuation, completeness.
 Examine any old unpresented cheques to assess if they need to be
written back into the purchase ledger as they are no longer valid
to be presented: valuation, completeness.
 Examine the bank confirmation letter for details of any security
provided by the company or any legal right of setoff as this may
require disclosure: presentation.
 Review the cash book and bank statements for any unusual items
or large transfers around the year end, as this could be evidence
of window dressing: completeness, existence.
  Count the petty cash in the cash tin at the year end and agree the
total to the balance included in the financial statements:
valuation, existence.
CASH COUNTS
Where cash in hand is material, or when fraud is suspected, a cash
count should be arranged to verify existence.
The auditor should make sure that all cash balances are counted at the
same time to avoid manipulation of the balances between different
sites.
The auditor should always be accompanied by a member of the client
staff to avoid any allegations of theft by the auditor.
The details of the cash counts should be recorded such as the locations
counted, the amount counted at each location, the client staff present
as well as the auditor performing the tests and the date performed.
Noncurrent liabilities
The key assertion for liabilities is completeness. With noncurrent
Liabilities allocation must also be assessed as there is a need to split the
liability into its current and noncurrent elements.
The bank confirmation letter will provide details of loans held, the
amounts outstanding, accrued interest and any security provided in
relation to those loans. Additional procedures that the auditor will need
to perform in relation to loan payables include:
 Obtain a breakdown of all loans outstanding at the year end, cast
to verify arithmetical accuracy and agree the total to the financial
statements: completeness.
 Agree the balance outstanding to the bank confirmation letter:
valuation, rights & obligations.
  Inspect bank confirmation letters for any loans listed that have
not been included in the financial statements: completeness.
 Inspect financial statements for disclosures of interest rates, and
the split of the loan between current and noncurrent: allocation,
presentation.
 Inspect the loan agreement for restrictive covenants (terms) and
determine the effect of any loan covenant breaches: allocation,
presentation. [If loan covenants have been breached the loan may
become repayable immediately and should therefore be included
as a current liability].
 Inspect the cash book for loan repayments made: existence,
valuation.
 Recalculate the interest charge and any interest accrual in
accordance with terms within the loan agreement, to ensure
mathematical accuracy: accuracy of finance costs in the
statement of profit or loss, completeness of accruals.

Noncurrent assets
The key assertions for non current assets are existence, valuation,
completeness and rights and obligations.
Auditing tangible noncurrent assets requires the auditor to obtain
sufficient appropriate evidence over many areas:
– existing assets
 additions
 disposals and the related profit/loss in the statement of profit or
loss
 depreciation (which of course affects both the statement of
financial position and the statement of profit or loss)
  revaluations
 related disclosures (the property, plant and equipment note,
depreciation policies, useful economic lives, revaluations and
assets held under finance leases).
REFER FIXED ASSET SCHEDULE
Procedures
Obtain the noncurrent asset register, cast and agree the total to the
financial statements: verifies completeness.
Select a sample of assets from the noncurrent asset register and
physically inspect them: verifies existence.
Select a sample of assets visible at the client's premises and inspect the
asset register to ensure they are included: verifies completeness.
Cast the noncurrent asset register totals and subtotals to ensure
arithmetical accuracy: verifies valuation.
• Inspect assets for condition and usage to identify signs of impairment:
verifies valuation.
For revalued assets, inspect the valuer's report and agree the amount
stated to the amount included in the general ledger and the financial
statements: verifies valuation; and ensure that all assets in the same
class have been revalued.
Obtain a breakdown of additions, cast the list and agree to the
noncurrent asset register: verifies completeness.
Select a sample of additions and agree cost to supplier invoice: verifies
valuation.
Inspect the list of additions and confirm that they relate to capital
expenditure items rather than repairs and maintenance: verifies
existence.
Inspect the repairs and maintenance account in the general ledger for
items of a capital nature: verifies completeness.
Inspect supplier invoices (for equipment), title deeds (for property), and
registration documents (for motor vehicles) to ensure they are in the
name of the client: verifies: rights and obligations.
If assets have been constructed by the client, obtain an analysis of the
costs incurred, cast for arithmetical accuracy and agree a sample of
costs to supporting documentation (e.g. payroll, material invoices):
verifies valuation.
DISPOSAL
 Obtain a breakdown of disposals, cast the list and agree all assets
removed from the noncurrent asset register: verifies existence.
 Select a sample of disposals and agree sale proceeds to
supporting documentation such as sundry sales invoices: verifies
accuracy of profit on disposal.
 Recalculate the profit/loss on disposal and agree to the statement
of profit or loss: verifies accuracy of profit on disposal.
DEPRECIATION
(audit procedures verify valuation, allocation, and accuracy of the
depreciation charge in the statement of profit or loss)
 Inspect the capital expenditure budgets for the next few years to
assess the appropriateness of the useful economic lives in light of
plans to replace assets.
  Recalculate the depreciation charge for a sample of assets to
verify arithmetical accuracy.
 Inspect the financial statement disclosure of the depreciation
charges and policies in the draft financial statements and compare
to the prior year to ensure consistency.
 Recalculate the depreciation charge for revalued assets to ensure
the charge is based on the new carrying value.
 Review profits and losses on disposal of assets disposed of in the
year, to assess the reasonableness of the depreciation policies (if
depreciation policies are reasonable, there should not be a
significant profit or loss).
 Compare depreciation rates to companies with the same type of
assets to assess reasonableness.
 Perform a proof in total calculation for the depreciation charged
for each category of assets, discuss with management if
significant fluctuations arise. (Analytical procedure)
INVENTORY
The key assertions for inventory are existence, valuation, completeness
and rights & obligations.
The main source of evidence for inventory, is normally the yearend
inventory count (although some clients may use perpetual or
continuous inventory counting, throughout the year). (Detailed
procedure will be shared for reading)

RECEIVABLES
The focus of testing for receivables is valuation and existence. Note the
effect of directional testing, e.g. directly testing receivables for
overstatement also indirectly tests revenue for overstatement (Dr:
Receivables, Cr: Revenue).
• Obtain an aged receivables listing, cast it to verify arithmetical
accuracy and agree the total to the financial statements.
• Agree the sales ledger control account with the sales ledger list of
balances: verifies completeness and existence.
• Select a sample of yearend receivable balances and agree back to
valid supporting documentation of GDN and sales order: verifies
existence.
Inspect after date cash receipts and follow through to preyearend
receivable balances: verifies valuation, rights and obligations and
existence.
Select a sample of goods despatched notes (GDN) before and just after
the year end and follow through to the sales invoice to ensure they are
recorded in the correct accounting period: verifies completeness and
existence (cutoff of revenue).
Perform a positive receivables circularisation of a representative
sample of Co's yearend balances, for any nonreplies, with Murray Co's
permission, send a reminder letter to followup: verifies existence and
rights and obligations.
Inspect the aged receivables report to identify any slow moving
balances, discuss these with the credit control manager to assess
whether an allowance or write down is necessary: verifies valuation
and allocation.
Inspect customer correspondence in respect of any slow moving/aged
balances to assess whether there are any invoices in dispute: verifies
existence and rights and obligations.
Inspect board minutes of Co to assess whether there are any material
disputed receivables that may require write off: verifies existence and
rights and obligations.
Inspect the sales ledger for any credit balances and discuss with
management whether these should be reclassified as payables: verifies
existence of receivables and completeness of payables.
Inspect a sample of post year end credit notes to identify any that
relate to pre year end transactions to ensure that they have not been
included in receivables: verifies existence (occurrence of revenue).
Calculate average receivable days and compare this to prior year,
investigate any significant differences: verifies completeness and
valuation. (Analytical procedure)

PREPAYMENTS
Prepayments are services or goods for which a company has paid in
advance.
Inspect bank statements to ensure payment has been made: verifies
existence.
Inspect invoices to ensure payment relates to goods or services not yet
received: verifies existence.
Recalculate the amount prepaid to confirm mathematical accuracy:
verifies valuation.
Compare prepayments with the prior year to identify any missing items
or any new prepayments which require further testing: verifies
existence, valuation, and completeness. (Analytical procedure)
PAYABLES & ACCRUALS
The focus of testing for liabilities is completeness. Note the effect of
directional testing, e.g. directly testing payables for understatement
also indirectly tests cost of sales for understatement (Dr: Payables, Cr:
Purchases).
Obtain a listing of trade payables from the purchase ledger, cast to
verify arithmetical accuracy and agree to the general ledger and the
financial statements: verifies completeness.
Reconcile the total of purchase ledger accounts with the purchase
ledger control account: verifies completeness.
Obtain supplier statements and reconcile these to the purchase ledger
balances. Investigate any reconciling items: verifies existence,
completeness, obligations and valuation.
Inspect after date payments, if they relate to the current year then
follow through to the purchase ledger or accrual listing: verifies
completeness.
Inspect invoices received after the year end to ensure no further items
need to be accrued: verifies completeness.
Enquire of management their process for identifying goods received
but not invoiced or logged in the purchase ledger and ensure that it is
reasonable: verifies completeness.
Select a sample of goods received notes before the yearend
And follow through to inclusion in the yearend payables balance:
verifies completeness of payables and cutoff of purchases.
• Select a sample of payable balances and perform a trade payables’
circularisation, follow up any nonreplies and any reconciling items
between balance confirmed and trade payables’ balance: verifies
completeness and existence.
• Insect the purchase ledger for any debit balances, for any significant
amounts discuss with management and consider reclassification as
current assets: verifies valuation of payables and completeness of
receivables.
• Compare the list of trade payables and accruals against the prior year
list to identify any significant omissions: verifies completeness.
(Analytical procedure)
• Calculate the trade payable days and compare to prior years,
investigate any significant differences: verifies completeness and
valuation. (Analytical procedure)
• Obtain the list of accruals from the client, cast it to confirm
mathematical accuracy and agree to the general ledger and the
financial statements: verifies completeness and classification and
understandability.
• Recalculate a sample of accrued costs by reference to contracts and
payment schedules (e.g. loan interest): verifies valuation (accuracy of
purchases and other expenses).
• Inspect invoices received post year end to confirm the actual amount
and assess whether the accrual is reasonable: verifies valuation.
• Compare the accruals this year to last year to identify any missing
items or unusual fluctuation in amount and discuss this with
management: verifies completeness and valuation. (Analytical
procedure)