NAME: 

YEAR & SECTION: 

DATE:
PART 3 REQUIREMENT OF THE SIMULATED AUDIT OF FOREVER MFG. COMPANY

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

Are
a Transaction Cycle Account Name

Revenue & Sales (Cash & Credit), Sales Adjustments (discounts, returns, bad
A Collection Cycle debts), Cash Receipt

Expenditure Cycle Acquisition of goods & services, cash disbursement, Purchase returns
& discounts, production cycle, inventory warehousing & payroll
B transactions

1. Assess inherent risk qualitatively at assertion level (on the transaction cycle). After which quantify
such assessment.

  Pressures from management to misstate revenues and the cut off dates are the inherent
risk for this cycle. The auditor can provide some assurance that the revenues of the company are
correctly recorded by conducting substantive tests and tests of controls. The company makes sure
that the internal controls are organized. Collection of cashier happens from 8am to 5pm, Monday to
Friday and cut-off at 2pm in which total collection is computed afterwards. After the cashier prepares
a deposit slip, then she will deposit it to the bank. All collections after cut-off time are recorded as
transactions of the following day in the cash collection book. These are being validated to ensure
accuracy. Then, a valid deposit slip is attached to the corresponding page of the cash collection
book bearing the same date and amount.

2. Preliminarily obtain understanding of the client's internal control by following the steps below:
 
a.   Based 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.
 Significant areas in the process of documenting internal control are shown in the flowchart of
Revenue Cycle.  It starts from the Production Department who informs the Sales Department of the
finished goods/orders. The outlet sales supervisors coordinate to request outlets and approve
dispatching of goods for delivery. Dispatch order is executed in triplicate; 1) original - file copy 2)
duplicate to AR clerk & 3) triplicate to Stockroom. The AR clerk will prepare a quadruplicate copy of
the outlet cash sales invoice. Upon the receipt of dispatch order from the Sales Dept. Entries in the
invoice are based on the dispatch order. All copies, except for the quadruplicate copy of the invoice
are forwarded to the stockroom to be included in delivery of goods. Remaining copy is used as the
basis for recording in the sales journal. Duplicate & Triplicate copies were returned with customer
acknowledgement receipt. Meanwhile, a duplicate copy is forwarded to the AR clerk while the
triplicate copy is retained by the stockroom. Weekly summary of deliveries is submitted to the
accountant for cash sales & on account. AR clerks visit the outlets once or twice a week and receive
remittances. Collections are done by the cashiers. Large portion of the receipts are collected by the
AR Clerk.  Only a few customers pay directly to the cashier. Checks collection is about 4 times of
cash collection. Cashier designates the sales/outlet invoice to the official receipt for reference, then
summarizes it in the cash collection book. During cut-off time, total collection is computed. The
cashier prepares a deposit slip then goes to the bank to make a deposit. Validated deposit slip is
attached to the corresponding page of the cash collection book with the same date and amount. All
collections after cut-off time are recorded as transactions of the following day in the cash collection
book. Official receipts are forwarded to the Accounting Head for Cash Receipt Journal recording.
Afterwards, the same is forwarded the AR Clerk for subsidiary ledger updating.
 b. After which you are asked to prepare a tabulation of error or fraud that may occur with the
present system of internal control.
Internal Control Procedures Internal Control Possible Fraud or Error
Deficiencies  

The AR clerk prepares a The same individual is in Individuals who have the power to
quadruplicate duplicate of the sales charge of both recording and alter customer receivable accounts
invoice upon receipt of the dispatch collecting from the (without the need for a second
order from the Sales Dept, and the consumer. person's consent or review) and
AR clerk is also the one who visits collect cash can manipulate the
consumers and collects the owed amount collected. 
sum.

AR staffers go to the outlets once or Remittances must be If there is no suitable timeline or cutoff
twice a week to collect remittances.  received on a regular and for remitting, it might be done
planned basis.  incorrectly and unrecorded if the
scenario allows the AR clerk. 

The collection of the AR generated a The corporation must keep Accounts receivable and revenue are at
large share of the revenues.    track of its receivables and risk of substantial misrepresentation. 
find a means to enhance
cash flow to Control bad
debts through sales.

The cashier creates a deposit slip and The person who prepares
travels to the bank to deposit the the deposit slip cannot
funds. deposit it in the bank. The
amount to be deposited
must be approved by a third
party.
The amount of money deposited can be
adjusted because the person who
creates the deposit slip will be the one
who deposits 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.

Forever Manufacturing Company's internal control effectiveness is moderate because, while

the company exhibits good internal control in many components of the cycle, there are still certain
areas that did not receive the appropriate degree of monitoring. Because money is the most
involved in transactions and the most vulnerable to fraud during the revenue cycle, the internal
control system must be strong. Revenue cycle controls are possibly the most significant aspect of a
company's total internal control system. Revenue cycle controls are not only an organization's finest
defense against fraud and loss; they also help ensure that choices are formed and supported by
valid and trustworthy data. 

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

Excellent controls must be in place to preserve the efficacy of receivables and credit sales;
failing to do so can harm the firm and be costly to the business. As an auditor, I believe that every
transaction involving the receipt, recording, and depositing of money should be carried out by
various persons, with middlemen involved for verification, correction, and protection in order to avoid
errors or fraud.

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 tests 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 (?)

3% = 90% x 85% x 3.92%

Detection Risk = 3% / (90% x 85%)

= 3.92%

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

In deciding the nature, timing, and extent of auditing measures, as well as reviewing the
results of such procedures, audit risk must be taken into account. The primary purpose of computing
audit risk is to identify the assurance level that the auditor could give to its client. Consequently, the
auditor should perform audit procedures in determining the risk material misstatement at the
financial statement through assessing and addressing the overall responses. The detected risks are
the result of the auditor’s assessment which will be utilized as a basis in designing and performing
the audit approach, which is relevant in conducting audit procedures. By performing the preliminary
engagement, we assess that the audit risk is set by 3%, thus the audit procedure provides 96.08%
assurance leaving 3.92% detection risk. Accurate and reliable results are vital in performing
appropriate audit procedures; therefore, changes must be made in accordance with the detected
error and risks.
 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

Professional skepticism is a necessary mindset that improves the auditor's capacity to

recognize and respond to situations that may suggest probable misstatement. It also includes a
critical evaluation of audit evidence. It also entails being on the lookout for audit evidence that
contradicts other audit evidence or calls into question the veracity of information collected from
management and others responsible with governance. This careful evaluation is required for the
auditor to reach proper findings and conclusions. Therefore, upon assessing the risks at the
Financial and Assertion levels, for the auditor/s to be able to detect any material misstatements that
are either due to fraud or error, they should improve and continue to apply it to manage such risks.

2.  Level of staff assigned

The level of staff assigned depends on the level of risks involved. Those that are deemed as
high-risk areas should be taken into account, and a sufficient number of staff should be assigned to
deal with such risks for it to be reduced to an acceptable low level. Therefore, it is necessary to
evaluate the professional skills and capabilities of the staff to see whether the task given to them is
in line with their skills and competence to perform the work. 

3. Ongoing staff supervision

Since there is a higher possibility of material misstatement, ongoing staff observation should
be increased. Sufficient supervision will guarantee that audit staff performs their duties efficiently
and contributes to the fulfillment of audit goals. Staff concerns will also be identified and handled
right away.

4. Evaluate accounting policies

The financial statement data shows how the company must assess its accounting rules in
order for the auditor to obtain accurate information about its operations.

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

The auditor shall perform the element of unpredictability in terms of the nature, time, and
extent of the audit operation, based on the risk assessed at the Financial Statement and Assertion
Levels. As a result, the client will be uncertain about the audit methods, particularly if the account
amounts are unequally allocated, making it more difficult for them to maintain track and create
unneeded preparations to fulfill or do what shouldn't be done.
6. Other further procedures

With the emergence of assessed risks at the Financial Statement and Assertion Levels, the
occurrence of other further procedures must also be handled professionally. Other procedures that
would likely lower the risks gathered, especially in the case of misstatement, error, or fraud, should
be considered by the auditor. Furthermore, the procedures to be executed are always aligned with
the auditor's goal, the nature of the statements, the evidence provided, and the efficacy of
procedures, among other things.

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

1. Overstatement /
Understatement of Cash To assess details of account balance if it tallies the Test of Balance
ending balance of cash.

2. Underpayment of Income tax

payable To check if the evaluation of the underpayment of Test of
income tax payable really exists. Balance     

3. Overstatement /
Understatement of Expenses To have an overview about the comparative Analytical
balance of expenses in prior and current periods. Procedure

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

- Substantive audit procedures are performed by the auditor to gather evidence to check
whether the account balances are materially complete, valid and accurate. It depends upon the
gathered evidence in providing assurance that the allowable detection risk will be achieved because
the gathered evidence will be the basis whether the account balances contain material
misstatement. But since the allowable audit risk is detected at 3%, it is likely that it will be achieved. 

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

 Assertion Related Control Activities Audit procedures for test of
control

 Document Trail
Increase in Established credit limits for every customer.  Reperformance
uncollectible
accounts  Provide an authorization for new customers or
for extending credit limit

Establishing an aging of accounts of accounts

receivable

 Certificate of completion
Oversupply of Data Entry edit controls  Inspection of tangible
inventory assets
Perpetual inventory control system

Periodic physical counts

 Audit Trail 
Improper collection Make a bank reconciliation  Vouching or inspection of
of cash  records or documents
Update the cash receipt system

Segregation of duties. The person who receives

and deposits payments must not be the same
person.

       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: