Auditing

Corporate Governance

There is no single definition of corporate governance that can be applied to all situations and
jurisdictions. The various definitions that exist today largely depend on the institution or author,
country and legal tradition.

IFC defines corporate governance as “the structures and processes for the direction and control
of companies.”

The Organization for Economic Cooperation and Development (OECD), which in 1999
published its Principles of Corporate Governance, offers a more detailed definition of corporate
governance as:

“The internal means by which corporations are operated and controlled [...], which involve a
set of relationships between a company’s management, its board, its shareholders and other
stakeholders. Corporate governance also provides the structure through which the objectives
of the company are set, and the means of attaining those objectives and monitoring performance
are determined. Good corporate governance should provide proper incentives for the board and
management to pursue objectives that are in the interests of the company and shareholders, and
should facilitate effective monitoring, thereby encouraging firms to use resources more
efficiently.”

There are certain elements in common despite the variations of company definitions of what
corporate governance is.

(1) Corporate governance is a system of relationships, defined by structures and processes.

(2) These relationships may involve parties with different and sometimes contrasting interests.
(3) All parties are involved in the direction and control of the company.
(4) All this is done to properly distribute rights and responsibilities and thus increase long-term
shareholder value.

The figure below illustrates the basic corporate governance system and the relationships
between the governing bodies.

The external aspect of corporate governance, on the other hand, concentrates on relationships
between the company and its stakeholders. Stakeholders are those individuals or institutions
that have an interest in the company. Such an interest may arise through legislation or contract,
or by way of social or geographic relationships.

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The Role of Stakeholders

The role of stakeholders in governance has been debated in the past, with some arguing that
stakeholders have no claim on the enterprise other than those specifically set forth in law or
contract. Others have argued that companies fulfill an important social function, have a societal
impact and, accordingly, must act in the broad interests of society. This view recognizes that
companies should, at times, act at the expense of shareholders. Interestingly, there is a
consensus that modern companies cannot effectively conduct their businesses while ignoring
the concerns of stakeholder groups. However, there is also agreement that companies which
consistently place other stakeholder interests before those of shareholders cannot remain
competitive over the long run.

THE INTERNATIONAL SCOPE OF GOOD CORPORATE GOVERNANCE

The OECD corporate governance framework is built on four core values:

Fairness: The corporate governance framework should protect shareholder rights and ensure
the equitable treatment of all shareholders, including minority and foreign shareholders. All
shareholders should have the opportunity to obtain effective redress for violations of their
rights.
Responsibility: The corporate governance framework should recognize the rights of
stakeholders as established by law, and encourage active co-operation between corporations
and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.
Transparency: The corporate governance framework should ensure that timely and accurate
disclosure is made on all material matters regarding the company, including its financial
situation, governance structure, performance and ownership.
Accountability: The corporate governance framework should ensure the strategic guidance
of the company, the effective monitoring of management by the Board, and the Board’s
accountability to the company and shareholders.

THE BUSINESS CASE FOR CORPORATE GOVERNANCE

Good corporate governance is important on a number of different levels. At the company level,
well-governed companies tend to have better and cheaper access to capital, and tend to
outperform their poorly governed peers over the long-term.

Companies that insist upon the highest standards of governance reduce many of the risks
inherent to an investment in a company. Companies that actively promote robust corporate
governance practices need key employees who are willing and able to devise and implement
good corporate governance policies. These companies will generally value and compensate
such employees more than their competitors that are unaware of, or ignore, the benefits of these
policies and practices. Such companies, in turn, tend to attract more investors who are willing
to provide capital at lower cost.

Generally, well-governed companies are better contributors to the national economy and
society. They tend to be healthier companies that add more value to shareholders, workers,
communities, and countries in contrast with poorly governed companies that may cause job
and pension losses, and even undermine confidence in securities markets.

Levels and Potential Benefits of Good Corporate Governance

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3
 Internal Control for Revenue Cycle

Introduction

Revenue and Receipts is a cycle about sales of goods or services and

collections of cash. The cycle is a combination of activities that take place when
a business process occurs – that is when a company sells a products or goods
to a customer. Cash is then received after the customer has received the goods
or services. Figure 2-1 depicts the overview of the revenue process.

Two major business functions are associated with the cycle:

a) Goods or services are sold to customers in exchange for promises of future payment;
b) Cash is collected from customers.

The cycle is also related to other transaction cycles (purchasing and

disbursement cycles, investing cycles and financing cycles), since it:

• Receives resources and information provided by the financing cycle; and

• Provides resources and information to the purchasing and disbursements
cycles and investing cycle.

Figure 2-1: Overview of the Revenue Process

Order from a
customer

Exchange of goods for

promise to pay

Payment of Cash

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Throughout the cycle, entries are made for sales, sales discounts, returns and allowances,
cash receipts, allowance for uncollectible accounts and write-offs of accounts. Documents
used in revenue and receipt cycle are:

1. Customer order - a customer’s declaration/instructions to purchase goods. This is in a form of

customer’s Purchase Order.
2. Sales order - compiled by the company’s own sales order clerk which record the goods ordered by
the customer.
3. Credit Approval Form – used to investigate the creditworthiness of the customer and authorizes
credit. This also used to establish the customer’s credit limit.
4. Open-Order Report – a report of all customer orders for which processing has not been completed.
This report should be reviewed regularly and should be investigated to determine if any goods
have been shipped but not billed or to determine why orders have not been filed.
5. Shipping Document – a document that manifests that goods are shipped to a customer. This
document generally serves as a bill of lading and contains information on the type of product
shipped, the quantity shipped and other relevant information.
6. Sales invoice – this represents formal notice to a customer for the amount and terms of payment
for the goods they ordered. This is also called bill.
7. Sales Journal – used to record the necessary information for each sales transaction.
8. Customer Statement– this document is usually mailed to a customer monthly. It contains the
details of all sales, cash receipts, and credit memorandum transactions processed through the
customer’s account for the period.
9. Accounts Receivable Subsidiary Ledger – contains an account and the details of transactions with
each customer. A transaction recorded in the sale journal and cash receipts journal is posted to
the appropriate customer’s account in the account receivable subsidiary ledger.
10. Aged trial balance of accounts receivable – this report summarizes all the customer balances in
the accounts receivable subsidiary ledger. Customers’ balances are reported in categories (i.e. age
of accounts receivable or days past due of accounts receivable). The aged trial balance of accounts
receivable is used to monitor the collection of receivables and to ensure that the details of the
account receivable subsidiary ledger agree with the general ledger control account.
11. Remittance Advice – this document is sent to the customer and contains information regarding
which invoices are being paid by the customer.
12. Cash Receipts Journal – used to record the entity’s cash receipts. The cash receipts journal contains
columns for debiting cash, crediting accounts receivable and crediting other accounts such as
scrap sales or interest income.
13. Credit Memorandum – used to record credits for the return of goods in a customer’s account or
to record allowance that will be issued to the customer. Its form is generally similar to that of a
sales invoice, and it may be processed through the system in the same way as a sales invoice.
14. Write-off Authorization – authorizes the write-off of an uncollectible account. This is normally
initiated in the credit department, with final approval for the write-off coming from the treasurer.
Depending on the entity’s accounting system, this type of transaction may be processed
separately or as part of the normal stream of sales transactions.

Documents used throughout the cycle are necessary to authorize, execute, and record a
transaction. These form an audit trail and are important source of audit evidence.

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The revenue and receipt cycle activities and controls vary from one entity to another and are
influenced by several factors. These factors include the nature of an entity’s industry, the
entity’s size and organizational structure, and the extent to which accounting information is
processed (manual or computer). However, the activities of most businesses that sell goods
are similar – customer order, credit approval, inventory control, shipping, billing, recording,
collection and returns.

The Major Function

The following summarizes the functions normally takes place in a typical revenue process:

Order Entry –

When a customer order is received, a sales order is prepared by an employee in the Customer
Order Department (Sales Department). The customer order department will check the
acceptability of terms (pricing, credit period and discount, if any) indicated in the customer’s
P.O.

Credit Authorization –
After the customer order department check the necessary terms, the sales order will be
forwarded to the Credit Department. The credit department will check the credit standing of
the customer by reference to the company’s correspondence. The credit authorization function
must determine that the customer is able to pay for the goods or services. Failure to perform
this function properly may result in bad debt losses. The credit authorization function also has
responsibility for monitoring customer payments. An aged trial balances of accounts
receivable should be prepared and reviewed by the credit function. Payment should be
requested from customers who are delinquent in paying for goods or services.

Inventory Control –
Approved sales orders are forwarded Inventory Control where the goods are released for
shipment. Goods transferred from inventory control to Shipping are accompanied by a copy
of the sales order bearing the approval of an inventory control employee authorized to release
goods from inventory.

Shipping –
Goods should not be shipped, nor should services be provided, without proper authorization.
The main control that authorizes shipment of goods or performance of services is payment or
proper credit approval for the transaction. Shipping personnel compare the goods received
from inventory with what is listed on the sales order and prepare shipping documents. When
goods are shipped, shipping personnel obtain a receipt for the goods from the common carrier
often take the form of a bill of lading. Bill of lading describes the goods shipped and represents
a contract between the seller and the carrier. Shipping will notify the Customer Order
Department that goods have been shipped, and Customer Order updates the unfilled order
file.

Billing –

After shipment, a copy of the shipping documents and a copy of the sale order approved by
the credit department and inventory control are sent to Billing. Billing personnel compare
shipping documents and sales order and prepare sales invoices and distribute it to Inventory
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Accounting, General Accounting and Accounts Receivable for recording. The main
responsibility of the billing function is to ensure that all goods shipped and all services provided
are billed at authorized prices and terms. The entity’s controls should prevent goods from
being shipped to customers who are not being billed. An open-order report should be prepared
and reviewed for orders that have not been filled on a timely basis.

Some companies prepare a remittance advice to accompany the sales invoice. A remittance
advice is intended to be returned with a customer’s payment and facilitates the company’s
handling and recording of cash receipts.

The billing also prepares daily sales summaries which are sent to General Accounting.
Inventory Accounting personnel determine the cost of goods described in each sales invoice
and update inventory records accordingly.

The billing function is also responsible for handling goods returned for credit. The key control
here is that a credit memorandum should not be issued unless the goods have been returned.
A receiving document (normally the receiving report) should first be issued by the receiving
department to acknowledge receipt of the returned goods.

Cash Receipts –
The collection function must ensure that all cash collections are properly identified and
promptly deposited intact at the bank. In a paper-based system companies may use a lockbox
system, in which customers’ payment are sent directly to the entity’s bank. The bank then
forwards a file of cash receipts transactions and remittance advices to the entity.

In situation where payments are sent directly to the entity, the checks are listed immediately
and be restrictively endorsed (for example, for deposit to BDO account number XXX) by Mail
Room personnel. One copy of the list of checks is forwarded to Accounts Receivable for
posting to individual customer accounts. All checks and another copy of list of checks are
forwarded to the Cash Receipts Department, where a daily bank deposit is assembled, cash
summaries are prepared, and cash records are updated. Separate list of totals are forwarded
to General Accounting for recording in the cash receipt journal and posting to the general
ledger.

Accounts Receivable –
The accounts receivable function is responsible for ensuring that all billings, adjustments and
cash collections are properly recorded in customers’ accounts receivable records. Any entries
in customers’ accounts should be made from authorized source documents such as sales
invoices, remittance advices, and credit memorandum. The accounts receivable function is
normally performed within the billing department or a separate accounts receivable
department.

Sales Return and Allowances –

Customer requests for adjustments on returned goods should be reviewed by personnel
independent of cash collection and recording (i.e. Customer Order Department). An approved
request is documented as a credit memorandum, copies of which are forwarded to Accounts
Receivable for posting and to Inventory Control. Control totals are forwarded to General
Accounting for recording and posting. Returned goods are handled through the Receiving
Department and returned to the warehouse along with a receiving report. Inventory Control
personnel match the receiving report with a copy of the credit memorandum.

Uncollected Accounts –
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Accounts Receivable personnel should review individual customer accounts periodically as a
check against unauthorized credit limits and proper monthly accounts receivable trial balances
for reconciliation with general ledger control accounts. In addition, accounts receivable
balances are aged periodically and reviewed by personnel independent of the Credit
Department. Delinquent accounts should be reviewed periodically by personnel who report to
the Treasurer and are independent of recording functions. When an individual customer
account is judged uncollectible, written authorization to write-off the account is sent to
Accounts Receivable and to General Accounting.

General Ledger –
The main objective of the general ledger function in terms of a revenue process is to ensure
that all revenues, collections and receivables are properly accumulated, classified, and
summarized in the accounts. The general ledger function is also normally responsible for
mailing the monthly customer account statement.

Figure 2-2 and 2-3 illustrates a typical flowchart of Revenue Process – from order of goods to
collection of accounts receivable. Figure 2-4 summarizes the typical function in Revenue
Process

Figure 2-2: Revenue and Receipt Cycle: Credit Sales

Customer Order Department Credit Department Inventory Control

Accept From
From
Customer Cust. Credit
Order Order Depart.

Prepare
Sales Order Sales Order Sales Order
Sales Order 2 Sales Order 2

1 1

Sales Order
Sales Order 6 Check availability of
Credit goods and release
Sales Order 5 Check goods to shipping

Sales Order 4

Sales Order
Sales Order 3
2
Sales Order
Opproved
To 1
Credit ?
Depart.
YES

To To
Shippin Shippin
g To Inv. g
Control

To
Billing
----
Inform the
To
Customer
To Cust.
Custom Order
er

Accept 8
Customer
Order
 Shipping Department Billing Department

From From From From

Cust. Inventor Cust. Shipping
Order y Control Order

Sales Order Sales Order Sales Order Sales Order

Shipping Doc. 2 1
3 1 4

Compare
Compare

Prepare Shipping Prepare Sales

Document, Ship Goods, Invoice and Sales
Notify Customer Order Summaries
Department

Sales Invoice 3
Sales Order
Shipping Doc. 3 3 Sales Order
Sales 4Summary 2

Sales Order Sales Summary 1

1
Shipping Doc. 2
Shipping Doc. 2
Shipping Doc. 1 Sales Order

Sales Invoice 2 1

To To
Carrier To Recording *
Billing To
(Accounting):
Depart. Custome
Inventory
r.
Accounting; General
Release Goods to Carrier Accounting; Accnts
and Obtain receipt. Notify Receivable
Cust. Order Depart. that
goods have been shipped

* Recording:
- Inventory Accounting: Enter cost information on sales invoice, update inventory records, and
forward sales invoice and related documents to General Accounting.
- General Accounting: Record sales and forward sales invoice and related documents to Accounts
Receivable
- Accounts Receivable: Post sale to customer’s account and file sales invoice and related
documents.

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Figure 2-3: Revenue and Receipt Cycle: Collection of Accounts

Mail Room Cash Receipts

Remittance From
Advice
Check Mail
Room

Endorsed checks Check

restrictively; Prepare List of Receipt 2
list of receipts

Checks Prepare deposit, Cash

Summaries; Update
List of Receipt 1 Cash Records
Remittance
Advice
List of Receipt 2
List of Receipt 2
Cash Summary 2

Cash Summary 1
To
Accnts. Checks
Receiv. To
Cash
Receipt
To
Bank
** Recording:
To recording: **
- General Accounting: Recording of cash receipt journal and Accnts Receivable,
posting to the general ledger. General Accounting

- Accounts Receivable: Posting to individual accounts

Figure 2-4: Summary of Major Function in Revenue Process

Sales Order Processing

• Begins with a customer placing an order
– The sales department captures the essential details on a sales order form.
• The transaction is authorized by obtaining credit approval by the credit department.
• Sales information is released to:
– Billing
– Warehouse/Store (stock release or picking ticket)
– Shipping (packing slip and shipping notice)
• The merchandise is picked from the Warehouse and sent to Shipping.
– Stock records are adjusted.
• The merchandise, packing slip, and bill of lading are prepared by Shipping and sent to the
customer.
– Shipping reconciles the merchandise received from the Warehouse with the sales
information on the packing slip.

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 • Shipping information is sent to Billing. Billing compiles and reconciles the relevant facts and
issues an invoice to the customer and updates the sales journal. Information is transferred to:
– Accounts Receivable (A/R)
– Inventory Control
• Accounts Receivable records the information in the customer’s account in the accounts
receivable subsidiary ledger.
• Inventory Control adjusts the inventory subsidiary ledger.
• Billing, Accounts Receivable, and Inventory Control submits summary information to the
General Ledger dept., which then reconciles this data and posts to the control accounts in the
General Ledger.

Cash Receipts Processes

• Customer checks and remittance advices are received in the Mail Room.
– A mail room clerk prepares a check prelist and sends the prelist and the
checks to Cash Receipts.
– The cash prelist is also sent to Accounts Receivable and the Controller.
• Cash Receipts:
– verifies the accuracy and completeness of the checks
– updates the cash receipts journal
– prepares a deposit slip
– prepares a journal voucher to send to General Ledger
• Accounts Receivable posts from the remittance advices to the accounts receivable
subsidiary ledger.
– Periodically, a summary of the postings is sent to General Ledger.
• General Ledger department:
– reconciles the journal voucher from Cash Receipts with the summaries from
Accounts Receivable
– updates the general ledger control accounts
• The Controller reconciles the bank accounts.

Internal Control Objectives and Potential Errors or Fraud

Transaction Authorization

Before accepting a customer’s sales order, the customer’s credit should be approved.
Otherwise, shipments could be made to poor credit risk customers, potentially resulting in
uncollectible receivables. Companies normally perform a credit check for all new customers
and prepare authorized customer lists, indicating maximum credit limit for each customer. This
list will be periodically updated to better assess the customer’s creditworthiness.

All sales-related allowances or adjustments should be made only in accordance with policies
authorized by management. This authority is normally in the form of credit memoranda which
is pre-numbered and controlled.

Transaction Execution

To encourage timely and accurate shipments, management should establish policies for
scheduling prompt shipment and for verifying that entered products are in stock.

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Following shipment, customer should be billed promptly, thereby avoiding losses arising either
from unbilled shipments or from delayed cash collections. To avoid unbilled shipments,
management should require prenumbered shipping documents and will be periodically
examined if the sequentially numbered documents result in a timely billing. Management also
should establish procedures to investigate unbilled shipments promptly.

Recording

All sales, cash receipts, and related transactions should be recorded at the correct amounts
in the proper period, and be classified properly within the accounts. Inaccurate recording will
lead to misstated account balances and financial statements. Management can control the
recording function be establishing written procedures, reconciling control totals and
periodically comparing actual results with budgets.

For the accurate recording and posting of sales, billings, and receipts, management should
also establish procedures to assure that recorded receivable balances fairly reflect as what is
purports to represent. To control the recording of receivables, management should periodically
substantiate and evaluate individual customer balances and reconcile supporting detailed
ledgers to the general ledger.

Access to Assets

Management attempts to safeguard assets by restricting access to cash-related records,

thereby controlling against loss or diversion of cash. Restricting access is critical throughout a
business organization most particularly for cash because it is liquid and highly susceptible to
theft or diversion. Normally, the cash receipt function is maintained in a centralized location that
is off-limit to unauthorized personnel.

Management also should limit physical access within Shipping, Billing and Inventory Control,
primarily to avoid the misappropriation of assets between or among related departments. For
example, shipping personnel should be restricted from inventory control, thereby minimizing
opportunities for unauthorized shipments.

Figure 2-5 illustrates the summary of internal control, test of controls, and the potential
misstatements for sales transactions. Figure 2-6 summarizes the internal control, tests of
controls, and the potential misstatements of cash receipt transactions.

Figure 2-7 summarizes the internal control objectives and the potential error or fraud.

Figure 2-5: Summary of Assertions, Possible Misstatements, Control Activities and Tests of
Controls for Revenue Transactions.

Assertions and Controls Tests of Controls Potential Misstatements

Existence or Occurrence: Recorded sales are for shipments actually made to customers.

1.Recording of sales is
supported by customer
orders, sales orders
approved by the credit
department, and approved
and executed shipping
documents.
Examine approved customer Sales that did not occur may
order, sales, order, shipping be recorded.
document, and copy of sales
invoice for a sample of entries
in the sales journal
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2.A clerk independent of
accounts receivable prepares
and mails monthly
statements to customers for
all trade accounts receivable
and follows up on any
complaints.
Completeness: All sales transactions that occurred are recorded.
3. Prenumbered shipping
documents are accounted for
to determine that a sales
invoice is prepared for all
shipments.
4. Prenumbered sales invoices
are accounted for to
determine that all sales are
recorded.
5. Procedures to ensure timely
recording of sales and proper
cutoff are established.
Rights and Obligations: Sales recorded represent only sales transactions.
6.Clerk checks sales order and
sales invoice for terms to
determine that transaction is
a sale rather than a
consignment.
Valuation or allocation: Sales are correctly billed and recorded.
7. For all goods shipped, goods
are counted and descriptions
and quantities are compared
to quantities and descriptions
on sales orders and shipping
documents prior to shipping.
8. Customer credit is approved
by a responsible official prior
to merchandise shipment.
9. Sales invoices are checked
for (a) proper pricing; (b)
mathematical accuracy; and
(c) terms.
10. The accounts receivable
subsidiary ledger
is balanced to the general
Observe procedure and
examine follow-up files.
Observe procedure. Examine
copy of invoices for a sample
of shipping documents
Observe procedure. Examine
entries for a sequence of sales
invoices in sales journal.
Inquire how procedures are
followed, observe procedures
being followed, and inspect
report on last shipments.
Observe procedure.
Observe procedure. For a
sample, examine signature on
documents evidencing
performance.
Examine sales order for
selected transactions.
Inquire about the updating and
use of approved price lists.
For a sample of invoices,
examine signature indicating
performance of task.
Errors in recording sales may
not be detected.
Goods may be shipped but not
billed.
Unrecorded sales may exist.
Sales transactions may be
recorded in the wrong period.
Consignment transactions may
be recorded as sales.
More or fewer goods may have
been shipped than ordered.
Customer return may occur.
Accounts receivable may be
uncollectible.
Sales/accounts receivable may
be overstated or understated.
Likelihood of errors in accounts
receivable increases.
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 ledger control account Observe procedure. Foot
regularly. subsidiary ledger.

Presentation and disclosure: Sales and accounts receivable are recorded to result in presentation
and disclosure in accordance with PAS.

11. An independent review Observe procedure. For a Revenues may be

is made of account coding sample of invoices, recheck misclassified.
for recorded sales. account coding.

Source: Kiger and Scheiner (1997), Auditing. 2nd Edition. Houghton Mifflin Company. Boston, MA

Figure 2-6: Summary of Assertions, Possible Misstatements, Control Activities and Tests of
Controls for Cash Receipts Transactions.

Assertions and Controls Tests of Controls Potential Misstatements

Existence or Occurrence: Recorded receipts represent actual collections of cash from customer.

1.A trustworthy employee Observe whether a prelisting is Cash receipt may be

prepares a prelisting of cash prepared and inquire of misappropriated.
receipts before further preparer about the procedures
processing. followed.

2. A validated deposit slip is For a sample of entries in the Cash receipt may be recorded
obtained for daily deposits cash receipts journal, reconcile that were not deposited.
and compared to the cash the total to validated deposit
receipts summary. tickets.

3. Duties of handling cash

receipts are segregated from Observe separation of duties Cash may be misappropriated
posting to accounts and inquire of personnel about and lapping may occur.
receivable. their responsibilities.

4. A bank reconciliation is Examine bank reconciliations Bank reconciliations may cover

prepared monthly by a
person not involved in
handling cash, accounts
receivable, or general ledger
records.
and determine that preparer shortages.
does not have conflicting
duties.

Completeness: All receipts are processed and recorded.

5. Prelisting of cash receipts Observe monitoring and Cash may be misappropriated.

and cash register procedures
are monitored.
6. Checks are restrictively
endorsed upon receipt.
7. Cash receipts are deposited
intact daily.
inquire of prelister and cash
register operator about
procedures.
Cash may be misappropriated.
Examine undeposited checks
for endorsement. Cash may be unrecorded or
misappropriated.
Observe the procedure and
inquire of personnel who
perform the procedure Cash may be misappropriated.

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 8. A daily cash summary is
prepared and reconciled to
total of prelisting and over-
the-counter receipts and the
cash receipts journal.
9. The cash receipts journal
total is independently
reconciled to the total posted
to accounts receivable.
For selected days, trace totals
from cash receipts journal to
cash summary and validated
deposit ticket.
Credits posted to customers’
accounts may be overstated or
understated.
Observe the procedure and
inquire of personnel who
perform the procedure.

Valuation or allocation: Debits to cash and credits to accounts receivable are valued at amounts
received.

10. Cash receipts are For a sample of entries in cash A customer may be given
recorded at the amount receipts journal, examine credit for an amount greater
received. remittance advices. than payment

11. A responsible person For a sample of entries in cash A customer may take a larger
approves cash discounts receipts journal, examine discount than appropriate.
taken. remittance advices for
approval of discount taken.

Presentation and disclosure: Cash receipts transactions are recorded to result in presentation and
disclosure in accordance with PAS.

12. A supervisor approves Observe procedure. Examine Entries may be made to wrong
account classifications approvals by supervisor. accounts.
made in journalizing.

Source: Kiger and Scheiner (1997), Auditing. 2nd Edition. Houghton Mifflin Company. Boston,

Figure 2-7: Internal Control Objectives

Authorization Controls
• Proper authorization of transactions (documentation) should occur so that only valid transactions get
processed.
• Within the revenue cycle, authorization should take place when:
– a sale is made on credit (authorization)
– a cash refund is requested (authorization)
– posting a cash payment received to a customer’s account (cash pre-list)

Segregation of Functions - Three Rules

1. Transaction authorization should be separate from transaction processing.
2. Asset custody should be separate from asset record-keeping.
3. The organization should be so structured that the perpetration of a fraud requires collusion between
two or more individuals.

Segregation of Functions
• Sales Order Processing
– credit authorization separate from SO processing

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 – inventory control separate from warehouse
– accounts receivable sub-ledger separate from general ledger control account
• Cash Receipts Processing
– cash receipts separate from accounting records
– accounts receivable sub-ledger separate from general ledger

Supervision

• Often used when unable to enact appropriate segregation of duties.

• Supervision of employees serves as a deterrent to dishonest acts and is particularly important in the
mailroom.

Accounting Records
• With a properly maintained audit trail, it is possible to track transactions through the systems and to
find where and when errors were made:
– pre-numbered source documents
– special journals
– subsidiary ledgers
– general ledger
– files

Access Controls

• Access to assets and information (accounting records) should be limited.

• Within the revenue cycle, the assets to protect are cash and inventories and access to records such as
the accounts receivable subsidiary ledger and cash journal should be restricted.

Independent Verification
• Physical procedures as well as record-keeping should be independently reviewed at various points in
the system to check for accuracy and completeness:
– shipping verifies the goods sent from the warehouse are correct in type and quantity
– warehouse reconciles the stock release document (picking slip) and packing slip
– billing reconciles the shipping notice with the sales invoice
– general ledger reconciles journal vouchers from billing, inventory control, cash receipts, and
accounts receivable

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 Substantive Test: Cash and Cash Equivalents
Introduction

Much of the auditor’s work in during a financial statement audit consists of obtaining and
evaluating evidence about the assertions as embodied within the entity’s financial statements.
This chapter will discuss how each of the financial statements assertions – existence or
occurrence, completeness, accuracy, rights and obligation, presentation and disclosure,
classification, and valuation or allocation – is tested for audit of cash, accounts receivables
and sales.

After completing the tests of controls and assessing the level of control risk for an audit
engagement, auditors will perform substantive tests, which primarily test whether material
amount of errors or disclosure misstatement exist in the financial statements. Substantive tests
include tests of transactions, tests of details of account balances, and analytical procedures.

Test of Transactions

When performing substantive tests of transactions, auditors examine documents that were
created at the time of the initial processing of a transaction. Test of controls and substantive
test both use the same documents but for a different objectives. For example, a sales invoice
is used in a test of controls to determine whether it was signed or initiated by the person
designated to check the invoice prices against the current price list. In a substantive test of
transactions, an auditor determines whether the price on the sales invoice is accurate
according to the price list effective at the time of the sale. Auditors normally use tests of
transaction for testing of controls. When the result indicates that the control is effective, auditor
may choose not to perform substantive test of transaction.

Test of Details of Balances

Auditors use tests of details of balances to detect material misstatements in account balances.
These tests provide direct evidence about an account balance or a component of it. For
example, confirming a cash balance with the bank provides direct evidence of the cash
account.

Analytical Procedures –

This may be effective and efficient tests for assertions for which detailed evidence is not
available, or for which examination of detailed evidence will not detect misstatements. For
example, verifying individual sales invoices in the sales account may not identify an
understatement of sales. However, comparing average sales per day per store may suggest
that sales are understated.

Remember that financial statement assertions, together with the assessment of audit risk and
materiality, have a significant impact on the design of substantive tests. In planning

17
substantive tests, auditors consider the nature, timing, and extend of procedures to test
financial statement assertions.

Financial Statement Assertions as it relates to Audit Objectives

and Audit Procedures

PSA 500 (Redrafted), Audit Evidence, provides that the auditor should use assertions for
classes of transactions, account balances, and presentation and disclosures in sufficient detail
to form a basis for the assessment of risks of material misstatement and the design and
performance of further audit procedures. The auditor uses assertions in assessing risks by
considering the different types of potential misstatements that may occur, and thereby
designing audit procedures that are responsive to the assessed risks.

The auditor’s primary objective when performing substantive tests of cash receipts
transactions is to obtain evidence that assertions relating to cash receipts are valid.

Completeness
Completeness assertion addresses whether cash transaction that should be presented in the
financial statements actually are presented. Completeness is generally tested by examining
documentation and by applying analytical procedures, such as making comparisons among
related accounts. For cash, completeness is tested by performing analyses of accounts
(reconstruction of accounts) and by testing cut-off, which determines whether transactions
are recorded in the proper accounting period. Auditors test completeness for cash balances
by examining cut-off bank statements to assure that all receipts and disbursements are
recorded in the proper period, and by examining bank reconciliations (proof of cash) and
records of intercompany and interbank transfers.

Assertions are expressed or implied representations by management that are reflected in the financial
statement components.

Existence or Occurrence
Existence means that assets, liabilities, and equity interests exist while occurrence means that
transactions and events that have been recorded have occurred and pertain to the entity.
Existence is normally tested by physical observation or confirmation with outside parties.
The existence of cash deposit is tested by confirming bank balances with banks, and the
existence of cash on hand can be observed physically and counted. Also, auditors use cut- off
testing to determine whether recorded transactions are recorded in the proper period. Cutoff
is related to both the existence or occurrence and the completeness assertions and is
concerned with whether transactions executed near at end of the accounting period are
recorded in the proper period.

Rights and Obligations

Rights and obligations state that the entity holds or controls the rights to assets, and liabilities
are the obligations of the entity. Auditor tests rights by examining documentation and through
confirmation and inquiries. Rights to cash are tested primarily by conforming balances and
deposit terms with banks. This term may be the compensating balance of the demand deposit.

18
Valuation or Allocation

Valuation or allocation means that assets, liabilities, and equity interests are included in the
financial statements at appropriate amounts and any resulting valuation or allocation
adjustments are appropriately recorded. Auditors test valuation by examining documentation,
confirming, observing, performing mechanical tests, and making inquiries. Recorded values
for cash are tested by confirming balances with banks, by verifying the mathematical accuracy
of recorded cash balances, and by examining the details within cut-off bank statements.

Presentation and Disclosure

Presentation and disclosure means that financial information is appropriately presented and
described, and disclosures are clearly expressed. Auditor addresses this assertion by
comparing an entity’s financial statements presentation and disclosures with those required
by Philippine Accounting Standards issued by the Financial Reporting Standards Council.

Audit Procedures

Audit procedures are the methods or acts that auditors use to gather evidence to determine
the fairness or validity of financial statement assertions. PSA 500 (Redrafted), Audit Evidence,
states that The auditor should obtain sufficient appropriate audit evidence to be able to draw
reasonable conclusions on which to base the audit opinion.

“Audit evidence” is all the information used by the auditor in arriving at the conclusions on
which the audit opinion is based, and includes the following:

a. information contained in the accounting records underlying the financial statements; and
b. other information.

Accounting records generally include

• the records of initial entries and supporting records, such as checks and records of electronic
fund transfers;
• invoices;
• contracts;
• the general and subsidiary ledgers, journal entries and other adjustments to the financial
statements that are not reflected in formal journal entries; and
• records such as work sheets and spreadsheets supporting cost allocations, computations,
reconciliations and disclosures.

Other information that the auditor may use as audit evidence includes
• minutes of meetings;
• confirmations from third parties;
• analysts’ reports;
• comparable data about competitors (benchmarking);
• controls manuals;
• information obtained by the auditor from such audit procedures as inquiry, observation, and
inspection; and
• other information developed by, or available to, the auditor that permits the auditor to
reach conclusions through valid reasoning.

Inspection
Inspection consists of examining records or documents, whether internal or external, in paper
19
form, electronic form, or other media. Inspection of records and documents provides audit
evidence of varying degrees of reliability, depending on their nature and source and, in the
case of internal records and documents, on the effectiveness of the controls over their
production. An example of inspection used as a test of controls is inspection of records or
documents for evidence of authorization.

According to Kiger and Scheiner (1997), auditors apply four different inspection techniques:
physical examination of assets, examination of documents and records, mechanical accuracy
tests, and analytical procedures.

Physical Examination: An auditor physically examines a tangible asset to directly verify its
existence, physical condition, quality, propriety of its description, and quality. Counting is one
type of physical examination. For example, auditor counts petty cash fund to determine the
amount on hand at a particular time, gaining evidence about the existence of that cash.

Examination of Documents and Records: The auditor follows a trail of transaction based on
an entity’s accounting system in gathering evidence from documents and records. This is what
we called audit trail. Vouching and tracing are two commonly performed procedures that
involve examination of documents and records. Vouching is examining the documents that
served as a basis for recording the transaction (existence). It usually starts with a recorded
transaction and works back to the documents. For example, inspecting the cancelled check, the
vendor’s invoice, the receiving report, and the purchase order for a cash payment recorded in
the cash disbursement journal. In doing so, an auditor will be alerted of missing documents. If
the auditor cannot find a shipping document to support a sale recorded in the sales journal,
the transaction may be fictitious.

Tracing is examining whether source documents have been properly recorded in the
accounting records (completeness). Tracing is performed by selecting a shipping document
and following it to the appropriate sales invoice, to the entry in the sales journal, and finally to
a subsidiary accounts receivable accounting. When tracing transaction, an auditor should be
alerted for unrecorded transactions. If auditor finds a customer order, sales invoice and
shipping document but does not find a transaction recorded in the sales journal, the record is
incomplete.

Mechanical Accuracy Test (also called reperformance procedures): Footing, cross-footing,

and checking extensions are examples of this test. These are checks of work performed by
others, such as verifying client computations and checking the transfer of data.

Analytical Procedures: This is based on the premise that plausible data relationships can be
expected to continue unless specific conditions cause changes in them. This was discussed
in the previous chapter.

Observation
Observation consists of looking at a process or procedure being performed by others, for
example, the auditor’s observation of inventory counting by the entity’s personnel, or of the
performance of control activities. Observation provides audit evidence about the performance
of a process or procedure, but is limited to the point in time at which the observation takes
place, and by the fact that the act of being observed may affect how the process or procedure
is performed.

Inquiry
Inquiry consists of seeking information of knowledgeable persons, both financial and
20
nonfinancial, within the entity or outside the entity. Inquiry is used extensively throughout the
audit in addition to other audit procedures. Inquiries may range from formal written inquiries to
informal oral inquiries. Evaluating responses to inquiries is an integral part of the inquiry
process.

External Confirmation
An external confirmation represents audit evidence obtained by the auditor as a direct written
response to the auditor from a third party. External confirmation procedures frequently are
relevant when addressing assertions associated with certain account balances and their
elements. However, external confirmations need not be restricted to account balances only.
For example, the auditor may request confirmations of the terms of agreements or transactions
an entity has with third parties; the confirmation request may be designed to ask if any
modifications have been made to the agreement and if so, what the relevant details are.

External confirmation procedures also are used to obtain audit evidence about the absence of
certain conditions, for example, the absence of a “side agreement” that may influence revenue
recognition.

Footing – rechecking of the addition of a column; Cross-footing – rechecking of totals of a set of self-
balancing columns. Checking extensions – rechecking of multiplication, such as the calculation of price times
quantity on a sample invoice.

21
 Audit of Cash and Cash Equivalents

Audit Program for Cash and Cash Equivalents

The following are the typical steps performed by auditor in the audit of cash. Selection of the
most appropriate procedures for a particular audit will depend on the nature of the controls
that have been implemented by the company and by the result of the auditor’s risk assessment
process.

A. Use of the understanding of the client and its environment to consider inherent risks related to
cash.
B. Obtain understanding of internal control over cash.
C. Assess the risks of material misstatement and design further audit procedures.
D. Perform further audit procedures – tests of controls.
1. Tests the accounting records and reconciliations by reperformance.
2. Compare the details of a sample of cash receipts listings to the cash receipts journal,
accounts receivable postings, and authenticate deposit slips.
3. Compare the details of a sample of recorded disbursements in the cash payments journal to
accounts payable postings, purchase orders, receiving reports, invoices, and paid checks.
E. If necessary, revise the risk of material misstatement based on the results of the tests of controls.
F. Perform further audit procedures – substantive procedures for cash transactions and balances
1. Obtain analyses of cash balances and reconcile them to the general ledger.
2. Send standard confirmation forms to financial institution to verify amounts on deposit.
3. Obtain or prepare reconciliations of bank account as of the balance sheet date and consider
the need to reconcile bank activity for additional months.
4. Obtain cut-off bank statement containing transactions of at least seven business days
subsequent to balance sheet date.
5. Count and list cash on hand.
6. Verify the client’s cut-off of each receipts and cash disbursements.
7. Analyze bank transfers for the last week of audit year and the first week of following year.
8. Investigate any checks representing large or unusual payments to related parties.
9. Evaluate proper financial statement presentation and disclosure of cash.

Internal Control Over Cash Transactions

In developing the most efficient control procedures, it is necessary to make a detailed study
of the operating routines of the individual business. But it is also necessary to note that there
are some generally guidelines to good cash-handling practices in all types of business. These
universal rules for achieving internal control over cash may be summarized as follows:

1. Do not permit any one employee to handle a transaction from beginning to end.
2. Separate cash handling from record keeping.
3. Centralize receiving of cash as much as possible.
4. Record cash receipts immediately.
5. Encourage customers to obtain receipts and observe cash register totals.
6. Deposit each day’s cash receipts intact.
7. Make all disbursements by check, with the exception of small expenditures from petty cash.
8. Have monthly bank reconciliation prepared by employees not responsible for the issuance of
checks or custody of cash. The completed reconciliation should be reviewed promptly by an
appropriate official.

22
This chapter will deal only on substantive procedures for cash transactions and balances.
Discussion on risk assessment procedures and internal control for cash were already
discussed in the previous chapters.

Obtain Analyses of Cash Balances and Reconcile them to the General Ledger

The auditor will obtain a schedule (lead schedule) that lists all of the client’s cash accounts.
This schedule will typically list the bank, the account number and other relevant information,
and the year-end balance per books. This list will also include cash on hand and the sources
of this cash on hand. The auditor will trace and reconcile all accounts to the general ledger as
necessary.

Send Standard Confirmation Forms to Financial Institution to Verify Amounts on Deposit. One of the
objectives of the auditor’s work on cash is to substantiate the existence of the amount of cash as
shown on the statement of financial position. A direct approach to this objective is to confirm
mounts on deposit and obtain or prepare reconciliations between bank statements and the
accounting records.

The auditors confirm cash deposits and other related transactions as of the year-end with
banks in a manner similar to that used to confirm accounts receivable. A standard bank
confirmation form is presented in figure 3-1. Information identifying accounts and loans and
their balances is normally included on the form to assist the financial institution in completing
it. Thus, this form is primarily used to corroborate the existence of recorded information.

However, auditors generally send a confirmation request to all bank (not just a sample of it)
with which the client has dealt during the period even if the account has been closed. This
practice provides the auditor with evidence regarding the completeness assertion of cash. The
standard bank confirmation also provides the auditor information on bank loans or lines of
credit with a bank that require borrowers to maintain compensating balance or a collateral or
lien for a loan. This procedure addresses several assertions like rights and obligation and
presentation and disclosure.

Obtain or Prepare Reconciliations of Bank Account as of the year-end and Consider the Need to
Reconcile Bank activity for Additional Months.

Reconciliation of the balance per bank statement with the balance per the company’s
accounting records is required to determine the company’s cash position at the close of the
accounting period. If the client has made the year-end reconciliation, there is no need for
duplicating the work. However, the auditors should examine the reconciliation in detail to
satisfy themselves that it has been properly prepared. Below are the typical steps in obtaining
or preparing reconciliation:

1. Check arithmetical accuracy of reconciliation

2. Trace balance per book to the general ledger balance or cash account.
3. Trace balance per bank to bank statement and compare with amount confirmed by bank.
4. Establish authenticity of reconciling items by reference to their respective sources like bank
debit/credit memorandum and duly approved journal vouchers.
5. Investigate check outstanding for a long period of time:
a. Consider adjustment, specially if the check is already stale.
b. Consider the possibility of an erroneous preparation of the check.
23
 6. Investigate any unusual reconciling item.
7. Where internal control is weak over cash, consider preparing a proof of cash reconciliation

Figure 3-1: Standard Bank Confirmation Request

BANK CONFIRMATION REQUEST

XYZ & Company, CPAs

Davao City

1. We hereby report that at the close of business on , our records showed

the following balances to the credit of .

AMOUNT DESCRIPTION OF INTEREST RESTRICTED ON

ACCOUNT RATE PAID WITHDRAWAL OF
UP TO ACCOUNT AND OTHER
REMARKS
Regular Checking
Account
Savings Deposits
Time Deposits
Others (Specify)
2. We further report that the above mentioned client was directly liable to us by way of loans,
acceptances, over-drafts, etc. at the close of business on that date as follows:
AMOUNT DESCRIPTION DATE DUE INTEREST DESCRIPTON
OF LIABILITY GRANTED DATE RATE PAID OF
UP COLLATERALS,
TO LIENS,
ENDORSERS,
ETC. OTHER
REMARKS
Overdrafts
Loans
Acceptances
Trust Receipts
Others (specify)

3. Contingent Liabilities
AMOUNT DESCRIPTION OF NAME DATE DUE REMARKS
ACCOUNT OF OF DATE
MAKER NOTE
Endorsers of Notes
Discounted
Guarantor of Notes
Others (Specify)

4. Details of total unused letters of credit of said bank on that date were

ACCOUNT AMOUNT
FOREIGN PESO
CURRENCY
Import Letters of Credit
Domestic Letters of Credit
Marginal Deposit

5. Other accounts with the bank client as at the above mentioned date were as (details attached)

a. Securities held for safekeeping

24
 b. Items held for collection
c. Trust account
d. Others (specify)

Except as stated above, according to our records, said client had no other account with us.
Yours truly,
(Bank)

By:

Obtain Cut-off Bank Statement Containing Transactions of at Least Seven Business Days Subsequent
to Year-end

A cut-off statement is a bank statement for the first 7-10 business days after year-end. Its
primary purpose is to help auditors to verify reconciling items on the year-end bank
reconciliation. Tests performed using a cut-off statement include verifying that outstanding
checks have been completely and accurately recorded as of year-end, and that deposits in
transit have cleared within a reasonable period. The statement is sent directly by the bank to
the auditor.
The test of cash cut-off addresses the existence and completeness assertions, and questions whether
recorded transactions are recorded in the proper accounting period. This test reconciles internal
documents created by the client (i.e., cash journals, general ledger, and bank reconciliations) with
external documents created by the banks (i.e., year-end bank statements, cut-off bank statements,
and returned bank confirmations).

Below are auditor’s typical procedures:

Obtain cut-off bank statement showing the client’s transactions, with the bank at least one
week after year-end and
a. Trace year-end reconciling items like:
i. Deposit of the year-end undeposited collections.
ii. Completeness of year-end outstanding checks
iii. Corrections of bank errors.
b. Examine supporting documents of year-end outstanding checks that did not clear in the cut-
off bank statement.
c. Consider necessity of preparing a proof of cash.

Count and List Cash on Hand

Cash on hand consists of undeposited cash receipts, change funds, and petty cash fund. Cash
count provides direct evidence about existence of cash on hand balances at year-end.
Whenever auditors make a cash count, they should insist that the custodian of the funds be
present throughout the count. At the completion of the count, the auditors should obtain from
the custodian a signed and dated acknowledgement that the funds were counted in the
custodian’s presence and were returned intact by the auditors. This prevents the custodian
from accusing the auditor of being responsible for any shortage that is identified. Figure 3-2
presents a sample of cash count sheet.

The following are the typical activity during cash count:

25
 Conduct a cash count of undeposited collections, petty cash fund and other funds on hand.
a. Obtain custodian’s signature to acknowledged return of items counted.
b. Reconcile items counted with general ledger balances.
c. Trace undeposited collections counted to bank reconciliation.
d. Follow up disposition of items in cash counted:
i. Undeposited collection should be traced to bank deposits.
ii. Checks accommodated in petty cash should be deposited after the count to establish its
validity.
iii. IOUs in the petty cash fund should be confirmed and traced to collections in the next
payroll period.
iv. Expense vouchers should be traced in the succeeding replenishment voucher.
e. Coordinate cash count with count of marketable securities and other negotiable assets of the
client
f. Obtain confirmation of year-end fund balances of cash not counted in branches or other
offices.

Surprise Element
The cash count should be on a surprise basis. The custodian should not be given an idea as
to when a cash count is to be conducted. This procedure may uncover defalcation and will
keep the custodian on-guard in exercising their functions, thus, contributing to the efficiency
of the company’s operations.

Verify the Client’s Cutoff of Cash Receipts and Cash Disbursements

An accurate cut-off of cash receipts and cash disbursements at year-end is essential to a
proper statement of cash. The statement of financial position figure for cash should include all
cash received on the final day of the year and none received subsequently. Since it is
impossible for the auditor to visit every client’s place of business on the last day of the year,
nor is their presence at this time normally essential to a satisfactory verification of cash,
auditors can verify the cut-off of cash receipts by determining that deposits in transit as shown
on the year-end bank reconciliation appear as credits on the bank statement on the first
business day of the following year.

The auditors should be aware of possible window dressing related to cash transactions. For
example, if the cash receipts are not deposited daily, cash received for a few days after the
close of the year may be included in a deposit dated as of year-end, thus overstating the cash
balance at year-end.

Analyze Bank Transfer for the Last Week of the Audit Year and the First Week of the Following Year

The purpose of this procedure is to disclose overstatement of cash balances resulting from
kiting. Kiting, in which cash is counted twice by using the float in the banking system, is
possible only when an entity has more than one bank account and one employee is
responsible to issue checks and record disbursement.

Auditors can detect manipulations of this type by preparing a schedule of bank transfer for a
few days before and after the year-end. Illustration 3-2 presents a typical bank transfer
schedule. This working paper lists all bank transfers and shows the dates that the receipts and
disbursement of cash were recorded in the cash journals and on the bank statements.
Consider the following illustrations.

26
Figure 3-2: Cash Count Sheet
CASH COUNT SHEET

Company:
Name of Fund:

Cash Count Date:

Denomination Quantity Amount TOTAL
BILLS: P 1,000.00
500.00
200.00
100.00
50.00
20.00 P
COINS: P 10.00
5.00
1.00
0.25
0.10
0.05
CASH ITEMS:
Checks and PMOs for deposit
Postdated checks

Disbursement not yet reimbursed

Advances or IOUs
Others

AMOUNT OF FUNDS PER COUNT P

AMOUNT OF FUNDS PER BOOKS OR RECEIPTS
CASH SHORT OR OVER P

I hereby acknowledged that the above fund of P was counted in my presence by

, representing of XYZ Co., CPAs on , from to
A.M./P.M. and was returned to me intact. There are no other funds in my possession for which I
am accountable to or funds left in my custody by other parties except
as noted below:

Other Funds: (Simultaneously controlled or counted)

Name Amount

CUSTODIAN:

Signature Over Printed Name

27
The following are the procedure to detect kiting:

1. Prepare a schedule of interbank fund transfer a week before and after year-end. Ascertain
whether fund transfers were recorded in the proper period. Use the format in illustration 3-2.
2. Examine fund transfer checks returned with the cut-off bank statement. Trace date of check
and date of negotiation to date the fund transfer was recorded in the cash receipts and cash
disbursements register.

Investigate Any Checks Representing Large or Unusual Payments to RelatedParties

Any large or unusual checks payable to directors, officers, employees, and affiliates should be
carefully reviewed by the auditors to determine whether the transactions were properly
authorized and recorded and are adequately disclosed in the financial statements. To provide
assurance that cash disbursements to related parties were authorized transactions and were
properly recorded, the auditors should determine that such transaction has been charged to
the proper account, is supported by adequate vouchers or other documents, and was
specifically approved in advance by an officer other than the one receiving the funds.

Evaluate Proper Financial Statement Presentation and Disclosure of Cash

The statement of financial position figure for cash should include only those amounts that are
available for use in current operations. A bank deposit that is restricted in use should not be
included in cash. Maintaining a compensating balance should be disclosed.

Accounting Concepts: Cash and Cash Equivalents

✓ Cash consists of
o Currency, coin, and available fund on deposit at the bank (i.e. payroll fund, dividend fund) or
on hand (i.e. petty cash fund, change fund).
o Negotiable asset such as money orders, customers’ certified checks, manager’s check and
alike.
o Bank drafts.

✓ Cash Equivalents are short-term, highly liquid investments that are both (a) readily convertible to
know amounts of cash, and (b) so near their maturity that they present insignificant risk of changes
in interest rates. Generally only investments in debt securities with original maturity of 3 months
or less before its maturity qualify under this definition.

✓ For items be classified as cash, the following requisites must present:

a. The item must be readily available for the payment of current obligation or for the day- to-
day operation of the company; and
b. It must be free from any contractual restriction that limits its use in satisfying debts.
✓ Funds are cash set aside for a particular purpose. These are used to handle more expeditiously
the payment of certain obligation, to maintain better control over such expenditures and to earn
revenue on the fund invested.

✓ Two General Types of Funds:

a. Those in which cash set aside to met specific current obligations (classify as cash), and
b. Those that are not directly related to current operations and therefore in the nature of long-
term investments.

28
PETTY CASH FUND

Determination of Cash Short/Over

Total Cash Accounted for Less:
Cash Accountabilities Cash
Short/Over

What is Total Cash Accounted For? What it comprises?

Total Cash Accounted for are items found in the petty cash box during the time of cash count.

BANK RECONCILIATION

Steps to follow in Reconciliation

1. Determine the balance per bank statement as of the end of the reconciling period. This is the last
figure under the balance column of the bank statement. If this balance is nor readily available, it is
computed by adding the beginning balance per bank statement and all bank credits, and deducting
all the bank debits from the total thereof.

2. Determine the balance per deposit’s books as of the reconciling period. This is arrived at by adding
the beginning balance of the cash in bank account and cash receipts, and deducting the cash
disbursements from the total thereof.

3. Compare the receipts or debits per cash receipts journal with the deposits or credits per bank
statement.

4. Compare the disbursements or credits per check register with the checks encashed and cleared
or debits per bank statement.

5. Note and analyze all the discrepancies discovered during the comparisons made in steps 3 and 4
above. These discrepancies are reconciling items resulting from timing difference or errors.

Four Timing Differences:

1. Items credited in the bank statement but not yet debited in the depositor’s books.
Examples are: a. Collections made by the bank fro the account of the depositor.
b. Loans granted by the bank.
c. Interest income

2. Items debited in the bank statement but not yet credited in the depositor’s books.
Examples are: a. Service charges
b. Repayment of loans
c. Checks returned by the bank

3. Items debited in the depositor’s books but not yet credited in the bank statement.
Examples are: a. Unrecorded deposits.
b. Undeposited collections
29
4. Items credited in the depositor’s books but not yet debited in the bank statement.
Examples are: a. Outstanding checks

Reconciling Items Resulting from Errors

In analyzing errors, determined:

1. Who committed the error? If the error was committed by the bank, show the error as a reconciling
item under the balance per bank, if the error was committed by the depositor; show it as
reconciling item under the balance per books.
2. What is the effect of the error on the balance? If the error overstated the balance, subtract the net
effect of the error from the overstated balance. If the error understates the balance, add the net
effect of the error to the understated balance.

Missing Reconciling Items

To determine the missing amounts in the reconciliation, the following computations or formulas
are given:
Computation of Book Balance:
Beginning balance xxx
Add: Book debits or Cash receipts xxx
Total xxx
Less: Book credits or Cash disbursements xxx
Ending balance xxx

Computation of Bank balance:

Beginning balance xxx
Add: Bank credits or deposits xxx
Total xxx
Less: bank debits or withdrawals xxx
Ending balance xxx

Computation of Deposits in Transits:

Beginning balance xxx
Add: Book Debits or Cash receipts xxx
Total xxx
Less: Bank Credits excluding CMs xxx
Ending balance xxx

Computation of outstanding checks:

Beginning balance xxx
Add: Book Credits or Cash disbursement xxx
Total xxx
Less: Bank debits excluding DMs xxx
Ending Balance xxx

30
 Substantive Test: Trade and Other Receivable
Introduction

The result of the auditor’s testing of internal control for the revenue cycle directly impact
detection risk. This detection risk directly affects the level of substantive procedures that will
be required for the accounts affected by this process. This includes balance sheet accounts
such as accounts receivable, allowance for doubtful accounts and cash, as well as income
statement accounts such as sales, doubtful accounts, and sales returns and allowances.

As discussed previously, the auditor uses substantive procedures to detect material

misstatement in the financial statements. These substantive tests include tests of transactions,
tests of details of account balances, and analytical procedures. In this unit, the focus of
substantive testing is in the accounts receivable and sales.

Audit of Receivables and Sales

The following steps indicate the general pattern of work performed by the auditors in the
verification of receivables and sales. Selection of the most appropriate procedures for a
particular audit will depend on the nature of the controls that have been implemented by the
company and by the result of the auditor’s risk assessment.

A. Use of the understanding of the client and its environment to consider inherent risks related to
receivables and sales.
B. Obtain understanding of internal control over receivables and sales.
C. Assess the risks of material misstatement and design further audit procedures.
D. Perform further audit procedures – tests of controls.
1. Examine significant aspects of a sample of sales transactions.
2. Compare a sample of shipping documents to related sales invoices.
3. Review the use and authorization of credit memoranda.
4. Reconcile selected recorded cash invoice and sales invoice with sales journals.
5. Examine evidence of review and approval of revenue estimates.
E. If necessary, revise the risk of material misstatement based on the results of the tests of controls.
F. Perform further audit procedures – substantive procedures for cash transactions and balances
1. Obtain an aged trial balance of trade accounts receivable and analyses of other accounts
receivable and reconcile to ledgers.
2. Confirm receivables with debtors.
3. Review the year-end cut-off of sales transactions.
4. Perform analytical procedures for accounts receivable, notes receivable, and revenue.
5. Verify interest earned on notes and accrued interest receivable.
6. Review significant year-end sales contracts for unusual terms.
7. Determine the adequacy of the client’s allowance for uncollectible accounts.
8. Ascertain whether any receivables have been hypothecated (pledged).
9. Investigate any transactions with or receivables from related parties.

Obtain an aged trial balance of trade accounts receivable and analyses of other accounts receivable
and reconcile to ledgers.

The schedule aged trial balance of trade accounts receivable at the audit date is commonly
prepared by employee of the client for the auditors. This schedule displays the aging of
customers’ accounts and the estimate of probable credit losses. Classifying the customers’
accounts into current and past due categories is the essential feature of the aging procedures.
The usual methods of aging a customers’ accounts are:
31
 • First-in, first-out basis
• Specific invoice basis

Under the first-in, first-out method, every credit to a customer’s account is applied to the
earliest unpaid invoice while under the specific invoice basis, credits are matched against a
particular invoice. However, any unmatched credit is applied to the earliest unpaid invoice.

Suppose Letecia Services, Inc., developed the following data on doubtful accounts:

Aging Category* Percentage of Doubtful Accounts

Less than 30 days 1%
30 – 60 days 2%
60 – 90 days 5%
Over 90 days 10%

*The aging category can be days past due or days old of receivables.

The allowance for doubtful accounts can be determined in the following manner:

Aging Category* Accounts % of Required

Receivables Doubtful Accounts Allowance
Less than 30 days 2,500,000 1% 25,000
30 – 60 days 1,100,000 2% 22,000
60 – 90 days 900,000 5% 45,000
Over 90 days 500,000 10% 50,000
142,000

It is important to remember that the allowance for doubtful accounts is affected by client’s
credit-granting and cash collection policies. In verifying the adequacy of the allowance for
doubtful accounts, the auditor starts by assessing the client’s policies for granting credit and
collecting cash. The auditor normally assesses the adequacy of the allowance account by:

• Examining the aged trial balance for amounts that have been outstanding for long period. The
probability of collecting these accounts can be assessed by discussing hem with the credit
manager.
• Examining the client’s prior experience with uncollectible accounts. By maintaining good
statistics on doubtful accounts, the client can determine what percentage of each ageing
category will become uncollectible.

Below are the typical steps in ageing of accounts receivable:

Obtain a list of aged accounts receivables balances from the subsidiary ledger and
a. Foot and cross-foot the list.
b. Check if the list reconciles with the general ledger control account.
c. Trace individual balances to the subsidiary ledger.
d. Test the accuracy of the aging.
e. Adjust non-trade accounts receivable erroneously included in customers’ accounts.
f. Investigate and reclassify significant credit balances.

32
Confirm receivables with debtors.
PSA 505 (Revised and Redrafted), External Confirmation, define (external) confirmation as an
audit evidence obtained as a direct written response to the auditor from a third party (the
confirming party), in paper form, or by electronic or other medium. Direct communication with
debtors is the most essential and conclusive step in the verification of accounts and notes
receivable. By confirming an accounts receivable, the auditors prove that the receivable and
the customer exists and it also provide some assurance that no lapping or other manipulation
affecting receivables is being earned on at the financial statement date. Confirmation offers
limited evidence on the completeness and valuation assertions since only recorded amounts
are confirmed, and debtors may acknowledge debts even though they are not able to pay
them.

Receivable balances are usually confirmed as of the financial statement date. It may be
appropriate to confirm receivables at interim dates when the auditor is satisfied that internal
control is effective and when the balances in receivables and sales accounts can be reconciled
from the interim confirmation date.
PSA 500, par. 7 opines that when using external confirmation procedures, the auditor shall
maintain control over external confirmation requests, including:
(a) Determining the information to be confirmed or requested;
(b) Selecting the appropriate confirming party;
(c) Designing the confirmation requests, including determining that requests are properly addressed
and contain return information for responses to be sent directly to the auditor; and
(d) Sending the requests, including follow-up requests when applicable, to the confirming party.

Positive Confirmation

A positive external confirmation request asks the confirming party to reply to the auditor in all
cases, either by indicating the confirming party’s agreement with the given information, or by
asking the confirming party to provide information. A response to a positive confirmation
request ordinarily is expected to provide reliable audit evidence.

There is a risk; however, that a confirming party may reply to the confirmation request without
verifying that the information is correct. The auditor may reduce this risk by using positive
confirmation requests that do not state the amount (or other information) on the confirmation
request, and ask the confirming party to fill in the amount or furnish other information. On the
other hand, use of this type of “blank” confirmation request may result in lower response rates
because additional effort is required of the confirming parties. Figure 4-1 illustrates a sample
of a positive confirmation request.

In the case of non-response, the auditor shall perform alternative audit procedures to obtain
relevant and reliable audit evidence. The following may be use by the auditor:

a. Examining subsequent collections and ascertaining if such collections pertain to the

unconfirmed receivables.
b. Examining the supporting documents, like customers’ orders, shipping documents,
customers’ correspondence.

The nature and extent of alternative audit procedures are affected by the account and
assertion in question. A non-response to a confirmation request may indicate a previously
unidentified risk of material misstatement. In such situations, the auditor may need to revise
the assessed risk of material misstatement at the assertion level, and modify planned audit
procedures. For example, fewer responses to confirmation requests than anticipated, or a
33
greater number of responses than anticipated, may indicate a previously unidentified fraud
risk factor that requires evaluation.

Negative Confirmation

Negative confirmations provide less persuasive audit evidence than positive confirmations.
Accordingly, the auditor will not use negative confirmation requests as the sole substantive
audit procedure to address an assessed risk of material misstatement at the assertion level
unless all of the following are present:

(a) The auditor has assessed the risk of material misstatement as low and has obtained sufficient
appropriate audit evidence regarding the operating effectiveness of controls relevant to the
assertion;
(b) The population of items subject to negative confirmation procedures comprises a large number
of small, homogeneous, account balances, transactions or conditions;
(c) A very low exception rate is expected; and
(d) The auditor is not aware of circumstances or conditions that would cause recipients of negative
confirmation requests to disregard such requests.

The failure to receive a response to a negative confirmation request does not explicitly indicate
receipt by the intended confirming party of the confirmation request or verification of the
accuracy of the information contained in the request. Accordingly, a failure of a confirming
party to respond to a negative confirmation request provides significantly less persuasive audit
evidence than does a response to a positive confirmation request.

Confirming parties also may be more likely to respond indicating their disagreement with a
confirmation request when the information in the request is not in their favour, and less likely
to respond otherwise. For example, customer may be more likely to respond if they believe
that the balance in their account is understated in the confirmation request, but may be less
likely to respond when they believe the balance is overstated. Therefore, sending negative
confirmation requests to customer accounts may be a useful procedure in considering whether
such balances may be understated (existence), but is unlikely to be effective if the auditor is
seeking evidence regarding overstatement (completeness). Figure 4-2 presents a sample of
a negative confirmation request.

Below is the summary of confirming accounts receivables:

Confirm accuracy of individual balances by direct communication with customers.

a. Investigate exceptions reported by customers and discuss with appropriate officer for
proper disposal.
b. Send a second request for non-reply of request from the customer.
c. If the second request still does not produce a reply, perform alternative procedures like
1. Reviewing collections after year-end.
2. Checking supporting documents.
3. Discussing the account with appropriate officer.
d. Discuss with appropriate officer, confirmation request returned by the post office and
perform alternative procedures
e. Prepare summary of confirmation results

Review the year-end cut-off of sales transactions

Inflating the amount of sales for the year by holding open the sales journal beyond the financial
34
statement date is one of the methods in fiddling the accounting records. Sales cut-off is
particularly important because a client may intentionally include in the current year significant
sales made in the following year to present a more favorable financial picture than actually
exists. This practice is known as window dressing.

To guard against errors in the cut-off of sales records, the auditors should compare the sales
recorded for several days before and after the cut-off with the sales invoices and shipping
documents. The effectiveness of this step is largely dependent upon the degree of segregation
of duties between the shipping, receiving, and billing functions. If the three functions were
independently controlled, it is unlikely that records in all these departments will be manipulated
to disguise shipments of one period as sales of the preceding period.

The following situations will alert the auditor to investigate:

a. Unusually large increase in year-end sales. This might be indicative of bill and hold transactions,
in which sales are recorded but goods are not shipped. Using the bill-and- hold basis is sometimes
regarded as a controversial practice because allowing the seller to receive payment now, but
making them wait a length of time before transferring the product could be used to inflate
revenues meant for subsequent periods.

Figure 4-1: Positive Confirmation Request

Charmaine Corporation
McArthur Highway, Davao City

Mark B, Lee
Bo. Pampanga, Davao City Sir:

Our auditors, ARR and Company, CPAs, are currently examining our financial statements. To facilitate the audit,
please confirm the balance due us as of December 31, 2013, which is shown on our records as P213,400.50.

Indicate in the space below if this amount is in agreement with your records. If there are exceptions, please
provide any information that will assist the auditors in reconciling the difference.

Please mail your reply directly to our auditors. A stamped, self-addressed envelope is enclosed for your
convenience.

Very truly yours,

Charmaine Corporation
By:
(SGD) Ms. Charmaine Pasignasigna

ARR and Company, CPAs

The amount shown above amounting to P213,400.50 is correct as of December 31, 2013, with the following
exception (if any):

35

Signed
By
Figure 4-2: Negative Confirmation Request
Charmaine Corporation
McArthur Highway, Davao City
Mark B, Lee
Bo. Pampanga, Davao City Sir:

Please examine the accompanying statement of account as of December 31, 2013. If it does not agree with
your records, please report any difference to our auditors.

C.M. Recto Avenue, Davao City

A business reply envelope requiring no postage is enclosed for your convenience.

THIS IS NOT A REQUEST FOR PAYMENT

b. Large increases in revenue and receivables along with increases in gross profit margins that are
inconsistent with the client’s experience or industry averages.

c. Substantial sales returns following the financial statement date that might indicate inventory
shipped to customer without a customer order for those goods or channel stuffing. Channel
stuffing is an illegal practice in which a company willfully sells more of its product to distributors
than the distributors can sell to customers. The company makes these sales on credit, which
temporarily boosts its accounts receivable and by extension its current assets. This makes the
company look healthier than it really is which can raise its stock price. Eventually, when the
distributors are unable to sell the product they return it to the company instead of paying, which
reduces the accounts receivable and brings the company's balance sheet in line with reality.

In summary, the following are the steps to test propriety of cut-off:

a. Examine sales recorded and shipments made a a week before and after the financial
statement date and ascertain whether the sales were recorded in the proper period.
b. Investigate large amounts of sales returned shortly after the financial statement date.

Perform analytical procedures for accounts receivable, notes receivable, and revenue
Analytical procedures are performed by auditors to identify accounts that require additional
investigation or to determine that the account is behaving as expected and therefore requires
no additional testing. For example, if the number of days’ sales in accounts receivable has
averaged 35 days for each of the past 5 years but is 45 days this year, the auditor should
devote additional attention to the audit of the collectability of accounts receivable. Figure 4-3
summarizes analytical procedures that auditors frequently perform for revenue cycle. It should
be noted that analytical procedures will not necessarily detect material misstatement of the
financial statements. Rather, the procedures will detect an auditor’s attention to accounts or
balances requiring additional substantive tests.

36
Figure 4-3: Analytical Procedures for Sales and Collections

Overstatement or understatement of sales

1. Compare the sales amount and gross profit percentage for product lines by month and with
those of previous years.
2. Compare the gross profit with industry data.

Overstatement or understatement of sales returns and allowances

3. Compare sales returns and allowances as a percentage of gross sales with previous years’
experience.

Overstatement or understatement of allowance for doubtful accounts

4. Compare the accounts receivable turnover with the rate for previous years and with industry
data.
5. Compare uncollectible accounts expense as a percentage of sales with the rate for previous
years and with industry data.
6. Compare the allowance accounts as a percentage of accounts receivable with the percentage for
previous years and with industry data.
7. Compute the percentage as accounts receivable by age category and compare with previous
years’ data.
8. Compare written-off accounts that were outstanding at the end of the previous year with the
allowance for uncollectible accounts to evaluate the adequacy of the previous allowance.

Errors in individual customer’s accounts receivable

9. Compare individual customer balances with balances of the previous year.

Source: Kiger and Scheiner, Auditing, 2nd Edition Houghton Mifflin Company

Verify interest earned on notes and accrued interest receivable

Independent computation by the auditors of the interest earned during the year on notes
receivable is the most effective verification of the interest earned account. The working paper
used to analyze notes receivable should show the interest rate and date of issuance of each
note. Below is the sample of the working paper:

Maker Issue Date Interest INTEREST

of the Note Rate Accrued - Earned Collected Accrued -
beg end

Legend: Accrued – beg – taken from the preceding year’s audit working papers.

Earned – computed from the terms of the notes.

Collected – traced to cash receipts records.

Accrued – end – computed by the auditor

Review significant year-end sales contracts for unusual terms

37
Changing the terms of sales contracts is a common practice of the client’s management to
boost the level of sales at year-end. This modification may affect the collectability of the
accounts receivable, returns, and the amount of sales to be recognized at year-end. Thus the
auditors should carefully review any significant year-end sales for unusual pricing, billing,
delivery, and return.

Determine the adequacy of the client’s allowance for uncollectible accounts

Accounts receivable should be valued at the net realizable value of the accounts. This net
realizable value is ultimately the amount that will be collected from outstanding accounts.
Although, neither the auditor nor management may be able to determine the certainty the
amount of collectible, the auditor should attempt to evaluate the collectability of the accounts
and adequacy of the allowance for uncollectible accounts. The following procedures may be
used by the auditors both in developing an estimate and in evaluating the reasonableness of
management’s estimate:

a. Compare the details of the aging of accounts receivable to prior year’s aging.
b. Investigate the credit ratings for delinquent and unusually large accounts.
c. Review confirmation exceptions for an indication of amounts in dispute as to possible
uncollectible accounts.
d. Summarize in a working paper those accounts whose collectability is doubtful based on the
preceding procedures.
e. Review with the credit manager the current status of significant doubtful accounts, ascertaining
the collection action taken and the opinion of the credit manager as to ultimate collectability.
f. Compute relationships, such as the number-of-days’-sales in accounts receivable and the
relationship of the valuation allowance to (1) accounts receivable and (2) net credit sales.
g. Compare the ratios above to comparable ratios for prior years and industry averages, and
investigate any unexpected results.

Accounting Concepts: Receivables and Sales

• Receivables are claims held against customers and other for money, goods, or services. For
financial statement purposes, receivable are classified as either current (short-term) or non-
current (long-term). Current receivables are expected to be collected within a year or during the
current operating cycle, whichever is longer. Receivables are further classified in the balance sheet
as either trade or nontrade receivables.

• Recognition of Account Receivables. In most receivables transactions, the amount to be

recognized is the exchange price between the two parties. The exchange price is the amount due
from the debtor (a customer or a borrower). Two factors that may complicate the measurement
of the exchange price are (a) the availability of discounts (trade and cash discounts) and (b) the
length of time between the sale and the due date of payments (the interest element).

• Trade discounts (quantity discount) are discounts based on the list or catalog price. Such discounts
are used to avoid frequent changes in catalogs, to quote different prices for different quantities
purchased, or to hide the rue invoice price from competitors. This kind of discount normally
express in less n%.

• Cash discount are offered as an inducement for prompt payment. They are communicated in
terms that read, for example, 2/10, n/30. Companies that fail to take cash discounts are usually not
employing their money advantageously. An enterprise that receives a 1% reduction in the sales or
38
 purchase price for payment within 10 days, total payment due within 30 days, is effectively earning
18.25% [,01 / (20/365)], or at least avoiding the rate of interest cost.

• Ideally, receivables should be measured in terms of their present value, that is, the discounted
value of the cash to be received in the future. In considering the time value of money, our P1 today
will be less than in the future. The profession specifically excludes from the present value
considerations “receivables arising from transactions with customers in the normal course of
business are due in customary trade terms not exceeding approximately one years.”

RECEIVABLE FINANCING

Use of Accounts Receivable to Obtain Immediate Cash

Companies usually collect receivable in the normal manner. However, to get immediate cash,
companies often sell accounts receivable. They also may borrow money and pledge accounts
receivables as collateral for the loan. Such transfer arrangement to advance the cash inflow
from accounts receivable invoice a wide range of contracts referred to as factoring, selling,
assigning, or pledging receivables.

A sell of receivables, or borrowing money on them; will either be (a) with recourse or (b) without
recourse. With recourse means that the transferor (i.e, the borrower) of the accounts
receivables agrees to reimburse the transferee (i.e., the lender) for contractually specified
collection losses. These include (a) failure of the customers to pay their accounts in full and
(b) adjustments to the receivables for cash discounts and sales returns. Thus, without
recourse means that the transferor assumed no obligation to guarantee such losses, the
transferee must assume the collection losses.

lso, the agreement to transfer accounts receivable for early cash will specify either (a)
notification or (b) non-notification. Notification means that the debtors (i.e., the customers)
are notified of the transfer and that they will be billed and must make payments on the
receivables directly to the transferee. Non-notification means that the debtors are not notified
on the transfer; thus, they will continue to be billed by, and make payments on the receivables
to the transferor. The transferor has the responsibility to remit the cash to the transferee as
collected.

Accounting for the transfer of Accounts Receivable

For the transferor’s accounting purposes, a transfer of accounts receivables to obtain early
cash must be classified as either as “sale” or “borrowing” transaction. A transfer is categorized
as:

A. A sale of the receivable, similar to the sale of any other assets for cash, if all of the following
conditions are met:
1. The transferor surrenders control of the future economic benefits of the receivables
(controls is absent if transferor retains a later repurchase option).
2. The transferor’s obligation under the recourse provision can be reasonably estimated
(e.g., bad debt losses, collection expenses, discounts, and repossessions).
3. The transferee cannot require the transferor to repurchase the receivables except pursuant
to the recourse provisions.

B. A borrowing transaction and the recording of a liability for the amount of cash received if any one
of the three conditions listed above is not met. In this situation, the receivables involved remain
39
 in the account of the transferor as “pledged” assets to support the loan agreement.

Transfers with recourse typically qualify as either a sale transaction or a borrowing transaction
with neither clearly dominating. Transfers without recourse usually qualify as a sale
transaction. They usually involve a high discount rate (and a consequent loss on sale).

PRO-FORMA ENTRY OF ACCOUNTS RECEIVABLE TRANSACTIONS

Recording of Credit Sales Accounts receivable xxx

Sales xxx

Collection of Receivable Cash xxx

(without discount) Accounts Rec. xxx

Collection of Receivable Cash xxx

(with discount) Sales discount xxx
Accounts Rec. xxx

Recognition of Bad debts Bad debts expense xxx

(Allowance method) Allow. For Bad debts xxx
Recognition of bad debts Bad debts expense xxx
(Direct write-off method) Accounts Rec. xxx

Write-off accounts Allowance for bad debts xxx

Accounts Rec. xxx

Recovery of accounts written-off Accounts Receivable xxx

Allow. for bad debts xxx

Cash xxx
Accounts Rec. xxx
To record the collection of accounts written-off

Accounts receivable being No journal entry since receivable is only use as

use as pledge for a loan lien. The entry to record in this transaction is not
due to receivable being pledged but on the proceeds of
the loan.
Cash xxx
Notes Payable xxx

Customer paid accounts Notes receivable xxx

through issuance of notes Accounts rec. xxx

*if note receivable is dishonored Accounts receivable xxx

Notes receivable xxx
Interest income xxx

Notes Receivable discounting Cash xxx

without recourse Loss on NR Discounting xxx
Notes Receivable xxx
Interest income xxx

Notes receivable discounting with recourse

40
 - Conditional Sales Cash xxx
Loss on NR discounting xxx
NR-discounted xxx
Interest income xxx

- Secured borrowing Cash xxx

Interest expense xxx
Liability on NR discounted xxx
Interest income xxx

*if note receivable is dishonored Accounts receivable xxx

(previously discounted) Cash (MV + protest fee) xxx

NR-discounted/Liab. on NR disc. xxx

Notes receivable xxx

41
 Internal Control for Purchases Cycle and
Substantive Test for Inventory and Cost of Sales
Introduction

Purchases and Disbursement is a cycle about purchasing, receiving, storing, issuing,

processing, shipping of goods and payment of cash. The cycle is a combination of activities
that take place when a business process occurs – that is, when a company purchase goods
from a vendor. Cash is then paid to the vendor for the acquired goods or services. Figure 5- 1
depicts the overview of the revenue process.

Two major business functions are associated with the cycle:

c) Goods or services are acquired from vendor in exchange for promises of future payment;
d) Cash is disbursed to the vendors.

The cycle is also related to other transaction cycles (purchasing and disbursement cycles,
investing cycles and financing cycles), since it:

• Receives resources and information provided by the financing cycle; and

• Provides resources and information to the purchasing and disbursements cycles and
investing cycle.
Figure 5-1: Overview of the Purchase Process

Order to a vendor

Exchange of goods
for promise to pay

Payment of Cash

The objective in the audit of the purchases and disbursement cycle is to evaluate whether
the accounts affected by the acquisitions of goods and services and the cash disbursements
for those acquisitions are fairly presented in accordance with the applicable accounting
framework. There are three classes of transactions included in the cycle:

1. Acquisition of goods and services

2. Cash disbursements
3. Purchase returns and allowances and purchase discounts

Throughout the cycle, entries are made for purchases, purchase discounts, returns and
allowances, inventory, cash disbursements, and cost of sales accounts. Documents used in
acquisition and disbursement cycle are:

1. Purchase Requisition – is a request of goods and services by an authorized employee. This

may take the form of a request for acquisition as materials, capital expenditures, and

42
 other needed acquisition of a unit in the company.
2. Purchase Order – is a document used to order goods and services from vendors. It
includes the description, quantity, and related information for goods and services the
company intends to purchase and is often used to indicate authorization of the acquisition.
3. Receiving Report – Is a document prepared by the company at the time goods are
received. It includes a description of the goods, the quantity received, the date received,
and other relevant data. The receipt by the company of goods or services from the vendor
is a critical point in the cycle because it is when most companies first recognize the
acquisition and related liability on their records. That is why when goods are received,
adequate control requires examination for description, quantity, timely arrival, and
condition of the goods.
4. Vendor’s Invoice – is a document received from the vendor and shows the amount owed for an
acquisition. It indicates the description and quantity of goods and services received, price, cash
discount terms, date of the billing, total amount due, and the freight charges (if applicable). The
vendor’s invoice is important since it indicates the amount recorded in the acquisition transaction
file.
5. Debit Memo – is a document received from the vendor and indicates a reduction in the amount
owed to a vendor because of returned goods or an allowance granted. It often takes the same
form as a vendor’s invoice, but it supports reduction in accounts payable rather than increase it.
6. Cash/Check Voucher (Voucher Packet/Package) – is used to establish a formal means of recording
and controlling acquisitions, primarily by enabling each acquisition transaction to be sequentially
numbered. Vouchers include a cover sheet or folder for containing documents and a package of
relevant documents such as the purchase order, copy of the packing slip, receiving report, and
vendor’s invoice. After payment, a copy of the check is added to the voucher package.
7. Purchase Journal – this report is generated from the purchase transaction file and typically includes
the vendor name, date, amount, and account classification for each transaction,
such as repair and maintenance, inventory, or utilities.
8. Accounts Payable Subsidiary Ledger – it records acquisitions, cash disbursements, and
acquisition returns and allowances transactions for each vendor. The total of the individual
account balances in the subsidiary ledger equals the total balance of accounts payable in
the general ledger. Therefore, the total of unpaid vendor’s invoices in the subsidiary ledger
equals total accounts payable.
9. Accounts Payable Trial Balance – is a listing that includes the amount owed to each vendor
or for each invoice or voucher at a point in time. It is prepared directly from the accounts
payable subsidiary ledger.
10. Check – document used to pay for the acquisition when payment is due. In most cases, 11.
checks are recorded in a cash disbursements transaction file.
Cash Disbursements Journal – a report generated from the cash disbursements
transaction
general that includes all transactions for any time period. The same transactions,
ledger.
including all relevant information, are included in the accounts payable master file and
Documents used throughout the cycle are necessary to authorize, execute, and record a
transaction. These form an audit trail and are important source of audit evidence.

43
The Major Function

The following summarizes the functions normally takes place in a typical purchase process:

Purchasing Function –

A purchase transaction begins with the issuance of a properly approved Purchase Requisition
(PR) by the requesting unit that needs the goods or services. A copy of the PR is sent to the
purchasing department to provide a basis for preparing the serially numbered Purchase Order
(PO). The requisition should include the precise description of the type and quantity of the
goods or services desired.

Copies of the PO should be forwarded to the accounting and receiving departments. The copy
sent to the receiving department should have the quantities blacked out to increase the
likelihood that the receiving department personnel will really make an independent counts of
the goods received. The PO are only issued after compliance with extensive procedures for:
a. Determining the need for the item,
b. Obtaining competitive bids, and
c. Obtaining approval of the financial aspect of the commitment.

Receiving Function –
All goods received by the company – without exception – should be cleared through a
receiving department that is independent of the purchasing, storing, and shipping
departments. The receiving department is responsible for:
a. The determination of quantities of goods received,
b. The detection of damaged or defective merchandise,
c. The preparation of a Receiving Report (RR); and
d. The prompt transmittal of goods received to the store (warehouse) department.

Storing Function (Warehouse) –

As goods are delivered to store (warehouse), they are counted, inspected, and receipted for.
The stores department then notifies the accounting department of the quantities received and
placed in stock. In performing these functions, the stores department makes an important
contribution to overall control of inventories. By signing for the goods, it fixes its own
responsibility, and by notifying the accounting department of actual goods stored, it provides
verification of the receiving department’s work.

Issuing Function –
The stores department, being responsible for all goods under its control, has reason to insist
that a prenumbered purchase requisition be issued for all items passing out of its hands to
serve as a signed receipt from the department accepting the goods. Requisitions are usually
prepared in triplicate. The department making the request retains one copy; another serves
as the stores department’s receipt; and the third copy is a note to the accounting department
for cost distribution.

Accounts Payable –
The accounts payable department processes invoices to ensure that all goods and services
received are recorded as assets or expenses and that the corresponding liability is recognized.
They should match purchase orders to receiving reports and vendor invoices as to terms,
quantities, prices, and the accuracy of extension (cross-footing) and footing of the amount
44
due.

Disbursements –
The disbursement function is responsible for preparing and signing checks for paying vendors.
The voucher must have all the necessary supporting documents like the receiving report,
purchase order and vendor’s invoice to verify that the disbursement is for a legitimate purpose.
The purchase order will signify that the purchase was authorized by the entity and the amount
paid is solely based on the items received by the enterprise as manifested in the receiving
report. The vendor’s invoice would be the basis in determining the price of the items received
by the entity. To reduce the possibility that the invoice will be paid twice, all documents
attached in the voucher should be marked “PAID” or “CANCELED” by the one who signed the
check last, which is in this case, the treasurer or any from the treasury department.

Segregation of Duties

Below is the summary of segregation of duties for the purchasing process functions:

Purchasing Process Purchasing Receiving Accounts Disbursement

Functions Payable
Preparation and approval of /
purchase order
Receipt, counting, and /
inspection of purchased items
Receipt of vendor invoices /
and matching them with
supporting documents
Updating of accounts payable /
records
Preparation of checks /
Signing and mailing of checks /

The purchasing function should be segregated from the requisitioning and receiving function
– this is to avoid fictitious or unauthorized purchases. If the requisition, purchasing, and
receiving is being handled by one individual, theft of goods and payment for unauthorized
purchases may happen.

The disbursement function should be segregated from the accounts payable function – this is to avoid
unauthorized payment. If the disbursement function has access in the accounts payable records,
checks may be issued for the fictitious documents for payment. This result in theft of the entity’s cash.

The accounts payable function should be segregated from the general ledger function – this is to avoid
concealment of any defalcation. General ledger and subsidiary ledger (in this case the accounts
payable) should be handled by a different persons to avoid concealment of fraud. Defalcation would
normally be detected by reconciling subsidiary ledger with the general ledger control account

45
Figure 5.2 - Purchases and Cash Disbursement Cycle Flow Chart Purchasing

Receiving

From From
Requisition Purchasing
ing Dept.

Purchase Blind PO 3
Requisition (PR)

File
Goods
Rec’d

Prepare Purchase
Order (PO)

PR
PO 5 Count Goods,
Prepare Receiving
PO 4 Report and Update
Receiving Log
PO 3

PO 1 PO 2 Receiving Log
PO 3

To RR 3
Accnt.
To Payable RR 2
Vendor

To To
Requisitio Accnt.
ining Payable
Dep.

Fil
e

Matched with PO 4, To
Fil Filed in Purchasing
g
Receiving e
(blind
copy)

46
 Accounts Payable Cash
Disbursement

From From From From

Purchasi Receivin Mailroo Accnts.
ng g m Payable

Receiving Requisition
Requisition Invoice
Report 1
Purchase Order PO 5

RR 1

Invoice
Voucher
Compare

Review; Prepare
check and daily
summary
Prepare voucher and
daily summary

Requisition Checks signed and

voucher package
PO 5
cancelled

RR 1

Summary 2 Requisition
Invoice
Check PO 5
Voucher

Daily Summary Summary 1 RR 1

Invoice

To Gen.
Acctg. &
To AP
General
Accounti
ng To
vendor

Fil To Cash
e disb. by
date due Fil Fil
e e

47
Audit of Inventory and Cost of Goods Sold

The following steps in verification of inventories and cost of sales:

a. Consider the inherent risk, including fraud risk factors.

b. Consider internal control over inventories and costs of sales.
1. Obtain an understanding of internal control over inventories and cost of sales.
2. Assess control risk and design additional tests of controls and substantive tests for inventories
and cost of sales.
3. Perform additional tests of controls for those controls which the auditor plan to consider to
support their planned assessed levels of control risk like examine significant aspects of a sample
of purchase transactions.
4. Reassess control risk and modify substantive tests for inventories and cost of sales
c. Perform substantive tests of inventories and cost of sales
1. Obtain listings of inventories and reconcile to ledgers.
2. Evaluate the client’s planning of physical inventory.
3. Observe the taking of physical inventory and make test counts.
4. Review the year-end cutoff of purchases and sales transactions.
5. Obtain a copy of the complete physical inventory, test its clerical accuracy, and trace test
counts.
6. Evaluate the bases and methods of inventory pricing.
7. Test the pricing of inventories.
8. Perform analytical procedures.
9. Determine whether any inventories have been pledged and review purchase and sales
commitments.
10. Evaluate financial statement presentation of inventories and cost of goods sold, including
adequacy of disclosure.

Obtain Listings of Inventories and Reconcile to Ledgers

Observe the Taking of Physical Inventory and Make Test Counts
Obtain a Copy of the Completed Physical Inventory, Test its Clerical Accuracy, and Trace Tests
Counts

The auditor will obtain a schedule of listings of inventories that will be reconciled to both the
general ledger and the subsidiary ledger. This will address the specific audit objective on
valuation and accuracy assertions. From the listing, the auditor should test the extensions and
footings on the final inventory. This process may provide the test of clerical accuracy in the
totals of the inventory list.

During the inventory observation, the auditors will make test counts of selected inventory
items. The extent of the test counts will vary widely, depending on levels of assessed risk of
material misstatement and the materiality of the client’s inventory.

In taking of inventory counting, the prenumbered inventory tags are usually attached to each
lot of goods. The design of the tag or sheet and the procedures for using it are intended to
guard against two common issues in inventory counting – a) the accidental omission of goods
from the count and b) the double counting of goods. The actual counting, the filling in of
inventory tags, and the pulling of these tags are done by the client’s employees. While the
tags are still attached to the goods, the auditors will do test counts, usually on a sampling
basis. The auditor will list in their working paper the tag numbers for which test counts were
made. The employee of the company will not pull the inventory tags until the auditor declared
48
the lot of goods as cleared. “Cleared” means that the auditor is satisfied
with the accuracy of the count.

The auditor should also trace to the completed physical inventory their test
counts made during the observation of physical inventory. The auditor
should be alert during the tracing for any indications that the tags have been
altered or that fictitious inventory tags have been created. The auditor
should also make sure to reconcile prenumber inventory tags that were
used, unused, or voided. This is to make sure that no omitted from the listing
or include items that were not present during the physical inventory.

Evaluate the Bases and Methods of Inventory Pricing

Test the Pricing of Inventories

The auditors are responsible for determining that the bases and methods of
pricing inventory are in accordance with generally accepted accounting
principles. The investigation of inventory pricing often will emphasize the
following three questions:

1. What method of pricing does the client use?

2. Is the method of pricing the same as that used in prior years?
3. Has the method selected by the client been applied consistently and
accurately in practice?

For the first question – the method of pricing – a long list of alternatives is
possible, including such methods as cost or market, whichever is lower; the
retail method; and quoted market price (for metals and commodities traded
in a stock exchange). The cost method includes first-in, first-out (FIFO),
specific identification, weighted average, and standard cost.

The second question raised concerns a change in method of pricing

inventory from one year to the next. The nature and justification of the
change in method of valuing inventory and its effect on income should be
disclosed in accordance with the accounting standard.

The third question posted deals with consistent accurate application in

practice of the method of valuation adopted by the client. To answer this
question, the auditors must test the pricing of a representative number of
inventory items.

The testing of prices applied to inventories of raw materials, purchased

parts, and supplies by a manufacturing company is similar to the testing of
prices of merchandise in a trading business. In both cases the cost of
inventory items, whether FIFO, weighted average, or specific identification,
is readily verified by reference to purchase invoices.

As a general rule, inventories should not be carried at an amount in excess

of net realizable value. The LCNRV test generally involves comparing the
recorded cost of a sample of inventory items with the items’ net realizable
values.

Review the Year-End Cutoff of Purchases and Sales Transactions

An accurate cutoff of purchases is one of the most important factors in 49

verifying the existence and completeness of the year-end inventory.

Assume that a shipment of goods costing P10,000 is received from a

supplier on December 3, but the purchase invoice does not arrive until
January 2, and is entered as a January transaction. If the goods are
included in the December 31 physical inventory but there is no December
entry to record the purchase and the liability, the result will be an
overstatement of both net income for the year and retained earnings and an
understatement of accounts payable, each error being in the full amount of
P10,000.

An opposite situation may arise if a purchase invoice is received and

recorded on December 31, but the merchandise covered by the invoice is
not received until several days later and is not included in the physical
inventory taken at the year-end. The effect on the financial statements of
recording a purchase without including the goods in the inventory is to
understate net income, retained earnings, and inventory.
How can the auditors determine that the liability to suppliers has been
recorded for all goods included in inventory? Their approach is to examine
on a test basis the purchase invoice and receiving reports for several days
before and after the inventory date. Each purchase invoice in the files should
have a receiving report attached; if an invoice recorded in late December is
accompanied by a receiving report dated December 31 or earlier, the goods
must have been on hand an included in the year-end physical inventory.
However, if the receiving report carried a January date, the goods were not
included in the physical count made on December 31.

Adjustments to achieve an accurate cutoff of purchases, should be made

by the client’s staff; the function of the auditors should be to review the cutoff
and determine that the necessary adjustments have been made.

Perform Analytical Procedures

Material misstatements of inventory may be disclosed by analytical

procedures designed to establish the reasonableness of the amount of the
inventory at year-end. When gross profit margin is uniform over the years,
analytical procedures might be an effective tool in estimating inventory at
year-end. Any major difference between the ending inventory estimated
using the gross profit method and the count of inventory at year-end should
be investigated.

50