13.

Application of Audit Process to Transaction Cycles Part 1

Revenue and Receipt Cycle (or Sales and Collection Cycle)

Typical Business Process
1. Customer orders goods from the entity through variety of channels (such as the customer filling out
the sales order physically or through the entity’s e-commerce platforms, orders via telephone or
email, or by providing their own purchase order to the entity).
2. The entity’s sales personnel will process the customer order by preparing the corresponding sales
orders.
3. The sale is approved by the credit department (this can be done manually or electronically such as
maintaining a pre-approved credit limit for the customer.)
4. The goods are then shipped to the customer.
5. The billing department (a part of accounting) prepares a sales invoice (a copy of which becomes
the customer’s “bill”). After the sales invoice is prepared, the sales journal, the general ledger, and the
accounts receivable subsidiary ledger are posted.
6. The customer pays the account with a check, and a remittance advice is enclosed to describe
which invoice the check is paying. As a preventive control, two individuals open the mail that includes
these customer remittances.
7. The checks are listed and sent to the cashier who daily deposits them in the bank (the checks
should not go to the accounting department, as that would give the accounting department custody of
assets [checks in this case] as well as recordkeeping responsibility). Another copy of the list of
checks and the remittance advices is sent to accounting to be used to post the cash receipts journal,
which is subsequently posted to the general and accounts receivable subsidiary ledgers.
Major Controls
Sales
• Credit granted by a credit department
• Sales orders and invoices prenumbered and controlled
• Sales returns are presented to receiving clerk who prepares a receiving report which supports
prenumbered sales return credit memoranda

Accounts Receivable
• Subsidiary ledger reconciled to control ledger regularly
• Individual independent of receivable posting reviews statements before sending to customers
• Monthly statements sent to all customers
• Write-offs approved by management official independent of recordkeeping responsibility (e.g., the
treasurer is appropriate)

Cash Receipts
• Cash receipts received in mail listed by individuals with no recordkeeping responsibility
§ Cash goes to cashier
§ Remittance advices go to accounting
• Over-the-counter cash receipts controlled (cash register tapes)
• Cash deposited daily intact (cash expenditures for the day should not be obtained from cash
collections but rather paid for separately through check issuance except for small expenditures for
which a petty cash fund is set up)
• Employees handling cash are bonded (a form of insurance to compensate the entity in case the
bonded employee commit theft or embezzlement)
• Lockbox, a post office box controlled by the company’s bank at which cash remittances from
customers are received. The bank collects customer remittances, immediately credits the cash to the
company’s bank account, and forwards the remittance advices to the company. A lockbox system is
considered an extremely effective control because company employees have no access to cash and
bank employees have no access to the company’s accounting records.
• Bank reconciliation prepared by individuals independent of cash receipts recordkeeping

Purchasing/Disbursement Cycle (or Acquisition and Payment Cycle)

Typical Business Process
1. The requesting department sends a purchase requisition to the purchasing department.
2. The purchasing department determines the proper quantity and vendor for the purchase and
prepares a purchase order. One copy of the purchase order is sent to the vendor. Another copy is
sent to the receiving department to allow receiving personnel to know that items received have been
ordered; however, the copy of the purchase order sent to receiving will not have a quantity of items
on it so as to encourage personnel to count the goods when they are received.
3. When the goods are received, a receiving report is prepared by the receiving department and
forwarded to the accounting department.
4. A vendor’s invoice or “bill” is received by the accounting department from the vendor. When the
accounting department has the purchase order, receiving report, and vendor’s invoice, the payment is
approved and then recorded in the purchases journal since evidence exists that the item was
ordered, received, and billed.
5. A check and remittance advice is subsequently sent to the vendor in accordance with the terms of
the sale. The purchase order, receiving report, and vendor’s invoice are stamped paid to prevent
duplicate payments.
Major Controls
Purchases
• Prenumbered purchase orders used
• Separate purchasing department makes purchases
• Purchasing personnel independent of receiving and recordkeeping
• Suppliers’ monthly statements compared with recorded payables
Accounts Payable
• Accounts payable personnel independent of purchasing, receiving, and disbursements
• Clerical accuracy of vendors’ invoices tested
• Purchase order, receiving report, and vendor’s invoice matched
Cash Disbursements
• Prenumbered checks with a mechanical check protector used
• Two signatures on large check amounts
• Checks signed only with appropriate support (purchase order, receiving report, vendor’s invoice).
Treasurer signs checks and mails them
• Support for checks canceled after payment
• Voided checks mutilated, retained, and accounted for
• Bank reconciliations prepared by individual independent of cash disbursements recordkeeping
• Physical control of unused checks

Personnel/Payroll Cycle
Typical Business Process
1. A separate personnel department (e.g. Human resource or HR department) maintains complete,
up-to-date records for each employee. Included in such records is information on level of education,
basic payroll information, experience, and authorization for any changes in pay rates.

2. Timekeeping and recording

a. The firm’s factory direct labor personnel use a time clock (or biometric machine) to time in each
and out each working day or shift. Their employee clock card or record will show the total hours
worked each day.
b. These direct labor personnel also fill out job time tickets for each job they work on each day. At the
end of each week their supervisor compares job time tickets with employee clock cards or records
that have already been signed by the employees.
c. Salaried and other employees fill out weekly time summaries indicating hours worked.

3. The payroll accounting department will use the information from timekeeping (for the hours worked
by the employees) and the records from the human resource department (for the authorized rates of
employees) for the proper computation of the payroll for the period.

4. Payroll accounting department will prepare the payroll journal and the unsigned payroll checks (or
debit advice).

5. The checks are then signed by the treasurer and distributed by an independent paymaster who has
no other payroll functions (or the debit advice is sent to the bank maintaining the payroll account of
the entity).

6. The summary payroll entry is then posted to the general ledger in the accounting department.
• The internal auditing department periodically compares the payroll department’s file on each
employee with that in the personnel department’s file to determine that no unauthorized changes in
payroll records have been made.
• Employees with cash handling and recordkeeping responsibilities should be covered by fidelity
bonds, a form of insurance which protects an employer against losses caused by dishonest
employees (fidelity bonds also serve as a control when new employees are hired since the insurer will
typically perform a background check on prospective employees).

Major Personnel and Payroll Controls

• Segregate: Timekeeping; Payroll Preparation; Personnel; Paycheck Distribution
• Time clocks used where possible
• Job time tickets reconciled to time clock cards
• Time clock cards approved by supervisors (overtime and regular hours)
• Treasurer signs paychecks
• Unclaimed paychecks controlled by someone otherwise independent of the payroll function (locked
up and eventually destroyed if not claimed). In cases in which employees are paid cash (as opposed
to checks) unclaimed pay should be deposited into a special bank account.
• Personnel department promptly sends termination notices to the payroll department.

Inventory/Production Cycle (or Inventory and Warehousing Cycle)

Typical Business Process
Inventories and production fit under the first two cycles. However, due to the unique nature of
inventories, separate coverage is warranted. Two cases will be considered here: a nonmanufacturing
entity and a manufacturing entity.

Trading/Retail
1. A retailer is an entity who purchases products from a wholesaler and then sells the goods to the
public.
2. As in the acquisitions and payments cycle, purchase requisitions and purchase orders are used
and controlled to purchase the inventory items that are of a “finished goods” nature.
3. Likewise, when ordered goods are received, a receiving report is filled out by personnel in the
receiving department.
4. Perpetual inventory records are maintained for large amount items. The entity has calculated
economic reorder points and quantities. When quantities on hand reach the reorder point, a purchase
requisition is prepared and sent to the purchasing department that places the order.
5. At the end of the year, a physical inventory is taken during which items on hand are counted. In the
case of items for which perpetual records exist, the perpetuals are corrected for any errors—large
errors should be explained. For items without perpetual records, the total on hand is used to adjust
the cost of goods sold at year-end (Beginning inventory + Purchases – Ending inventory = Cost of
goods sold).

Manufacturing
1. The case of the manufacturing entity is somewhat more involved.
a. There are three types of inventory accounts involved.
b. First, supplies and raw materials are purchased from suppliers in much the same manner as
described above for the nonmanufacturing firm.
c. Second, work in process is the combination of raw materials, direct labor, and factory overhead.
d. Third, when the items in process have been completed, they are inspected and transferred at their
cost (typically standard cost) to finished goods.
e. Finally, when the goods are sold, the entry is to credit finished goods and to debit cost of goods
sold.
2. Work in process is controlled through use of a standard cost system as described in cost
accounting courses.
a. Raw materials are those that typically can be directly identified with the product (e.g., transistors in
a radio).
b. Direct labor is also identified with the product (e.g., assembly line labor).
c. Overhead includes materials not specifically identified with the product (amount of glue used) and
supervisory, non-administrative labor.
d. Variances may be calculated for all three components—raw materials, direct labor, and overhead.
Variances will be allocated between cost of goods sold and ending inventory (finished goods and
work in process) based on the proportion of items sold and those remaining in inventory, although
any “abnormal” waste will be directly expensed. This allocation is necessary because generally
accepted accounting principles require that the entity report inventory based on the lower of actual
cost and net realizable value—not standard cost.

Major Inventory and Production Controls

• Perpetual inventory records for large items
• Prenumbered receiving reports prepared when inventory received; receiving reports accounted for
• Adequate standard cost system to cost inventory items
• Physical controls against theft
• Written inventory requisitions used
• Proper authorization of purchases and use of prenumbered purchase orders

Investing Cycle: Property

Typical Business Process: Property, Plant and Equipment
1. Property, plant, and equipment acquisitions require board of directors’ approval for purchases over
a certain amount. Otherwise, the purchase is handled similarly to a merchandise purchase.
2. As in the case of merchandise purchases, the item is recorded as an addition when some form of
purchase authorization is present with a vendor’s invoice and a receiving report.
3. The company then selects an appropriate life and depreciation method (e.g., straight- line, sum-of-
the years’ digits, double-declining balance).
4. Depreciation entries are made in the general journal with a debit to depreciation expense
(manufacturing overhead for manufacturing equipment) and a credit to accumulated depreciation.
5. The company should also have controls to determine that repair and maintenance expenses have
not been capitalized.
6. Asset retirements are recorded by removing the asset and accumulated depreciation from the
general ledger— a gain (loss) may occur on the transaction.
7. In the case of an exchange of assets, the entity has policies to determine that GAAP is properly
followed in recording the transaction.

Major Property, Plant, and Equipment Controls

• Major asset acquisitions are properly approved by the firm’s board of directors and properly
controlled through capital budgeting techniques.
• Detailed records are available for property assets and accumulated depreciation.
• Written policies exist for capitalization vs. expensing decisions.
• Depreciation properly calculated.
• Retirements approved by an appropriate level of management.
• Physical control over assets to prevent theft.
• Periodic physical inspection of plant and equipment by individuals who are otherwise independent of
property, plant, and equipment (e.g., internal auditors).

Investing Cycle: Security

Typical Business Process: Debt and Equity Investments
Investments may be categorized as marketable securities and long-term investments. Purchases are
recorded proper amounts.

Major Investment Controls

• Segregation of duties among the individuals authorizing purchases and sales of securities,
maintaining custody of the securities, and maintaining the records of securities
• Use of an independent agent such as a stockbroker, bank or trust company to maintain custody of
securities
• Securities not in the custody of an independent agent maintained in a bank safe-deposit box under
the joint control of the treasurer and one other company official; both individuals should be present to
gain access
• Registration of securities in the name of the company
• Detailed records of all securities and related revenue from interest and dividends
• Periodical physical inspection of securities by individuals with no responsibility for the authorization,
custody, or recordkeeping for investments

Financing Cycle (or Financing and Repayment Cycle)

Typical Business Process
1. This cycle includes issuance and repurchase of debt (bank loans, mortgages, bonds payable) and
shares of stocks, and payment of interest and dividends.
2. Debt and capital stock transactions should be authorized by the board of directors.
3. Often an independent trustee issues bonds, monitors company compliance with the provisions of
the debt agreement, and pays interest.
4. For share capital transactions, corporations may either employ an independent stock registrar and
a stock transfer agent, or handle their own transactions.
5. Generally, internal control is stronger when a stock registrar and a stock transfer agent are used. A
stock registrar’s primary responsibility is to verify that stock is issued in accordance with the
authorization of the board of directors and the articles of incorporation; the stock transfer agent’s
primary responsibility is maintaining detailed stockholder records and carrying out transfers of stock
ownership.

Major Financing Controls

• Debt and equity transactions are properly approved by the company’s board of directors.
• An independent trustee handles bond transactions.
• A stock registrar and a stock transfer agent handle capital stock transactions.
• Canceled share certificates are defaced (cancelled) to prevent their reissuance.