Effective Internal Control

1 January 2017

Listed below are four interbank cash transfers, indicated by the letters a, b, c and d, of a client for late December 20X1, and early January 20X2. Your answer choice for the next two questions should be selected from this list. For each of transfers a through d indicate whether cash is understated, unaffected, or overstated by the transfer and provide a brief example of what could cause the situation in which cash is either understated or overstated. a. Unaffected. b. Unaffected. c. Understated.

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Although there are a number of possible situations, one is that in which a check is written on the disbursing bank on the last day of December with a credit to cash, and an associated debit to some expense account so as to decrease reported profits (and taxes) for the year. d. Overstated. One situation is that in which an employee has misappropriated funds during the year, and draw a check transferring funds to the account with the shortage so as to cover the shortage. As of December 31, the shortage is replaced, with no reduction as yet recorded in the account on which it is drawn.

Since financial investments are assets with a high degree of inherent risk, companies must establish effective internal control over their investments. a. Describe the functions that should be segregated to provide good internal control over financial investments. b. Describe two other internal control policies that should be established for financial investments. a. The functions that should be segregated with respect to financial investments are: 1. Authorization of purchases and sales, 2. Custody of the securities, and 3. Maintaining records of investments. b. Other internal controls include (only two required):

Establishing formal investment policies. Maintaining a complete detailed record of investments and revenue from investments. Registration of securities in the name of the company. Periodic physical inspection. Joint control over securities, or use of an independent custodian. Preparation of a budget of investment revenue. Determination of appropriate accounting by competent personnel. 3. Confirmation of accounts receivable is presumptively mandatory audit procedure. In performing this procedure, auditors use positive confirmation requests or negative confirmation requests or a combination of both.

Describe three conditions which should exist for the auditors to use the negative form of request. b. If a response is not received to an initial positive confirmation request, describe the action that should be taken by the auditors, including a discussion of alternative auditing procedures. a. Audit tasks requiring specialized skill or knowledge (only three required): Identifying controls at service organizations that provide financial services for the client. Obtaining an understanding of information systems for securities and derivatives that are highly dependent on computer technology.

Applying complex accounting principles. Understanding the methods of determining fair values of financial investments’. Assessing inherent risk and control risk for assertions about derivatives used for hedging. b. Derivatives are financial instruments that “derive” their value form other financial instruments, underlying assets, or indices. c. Clients engage in financial derivative transactions for two major purposes: Hedging–to hedge changes in value of an existing asset or liability or of a prospective future transaction.

Speculating–to bet on the change in value of another financial instrument, an asset, or an index. . Internal control over sales transactions is very important to the effectiveness of an organization. a. For effective control over credit sales, describe four major functions that should be segregated. b. In addition to adequate segregation of duties, describe two other internal controls over sales transactions. a. Functions that should be segregated to provide for effective internal control over sales transactions include (only four required): Authorization of sales. Credit approval. Issuance of merchandise from stock. Shipping of merchandise. Billing of accounts.

Maintenance of accounting records. b. Other internal controls over sales transactions include (only two required): Verification of invoices. Prenumbered shipping documents that are accounted for by the billing department. Credit approval obtained prior to shipment of goods. Mailing of monthly customer statements. Control over written-off receivables. 5In auditing a client’s inventory, the auditors must be concerned with the detection of goods that are both damaged and obsolete. a. Why are the auditors concerned with detecting damaged and obsolete goods?

How do the auditors test for damaged goods in the client’s inventory? c. How do the auditors test for obsolete goods in the client’s inventory? a. Auditors are concerned about detecting damaged and obsolete inventory because the recorded cost of these goods may be significantly greater than their net realizable value. b. Auditors test for damaged goods by inquiry of client personnel and observation during the client’s physical inventory. c. Tests for obsolescence include: 1. Review of perpetual inventory records, 2. Analytical procedures, such as calculation of ratios, such as inventory turnover, and 3.

Inquiry of client personnel. 6. Observation of a client’s inventory is a presumptively mandatory audit procedure. a. What part should the auditors play in planning the physical inventory? b. Describe the procedures performed by the auditors during their observation of a client’s physical inventory. c. Why do the auditors document their inventory test counts in their working papers? a. The auditors should review the client’s planning of the physical inventory and make suggestions for improvement. b. During the inventory observation the auditors: 1.

Evaluate whether the inventory procedures are followed that assure that all items are counted and nothing is counted twice. 2. Be alert for goods that appear to be damaged or obsolete. 3. Obtain information to test the client’s cutoff of purchases and sales. 4. Make test counts and record them in their working papers. 5. Make inquiries regarding goods on consignment. 6. Obtain tag control information and record the information in the working papers. c. The auditors document their test counts in the working papers to later test the accuracy of the final inventory listing.

Plant and equipment are not as inherently risky as are other assets, such as inventories and accounts receivable. However, a company should still endeavor to maintain effective internal control over plant and equipment. a. Describe the principal purpose of internal controls relating to plant and equipment. b. List and describe four major controls applicable to plant and equipment. a. The principal purpose of internal controls relating to plant and equipment is to obtain maximum efficiency from the dollars invested in plant assets.

The following are major internal controls for plant and equipment (only four required): Use of a plant budget to forecast and control acquisitions and retirements. Maintaining subsidiary ledger of property. Establishing a system of authorizations for acquisitions. A written statement of company policy distinguishing between capital and revenue expenditures. A policy requiring all purchases of plant and equipment through normal purchasing and receiving procedures. Periodic physical inventories. A system of retirement procedures, including serially numbered retirement work orders.

Auditors should obtain evidence that there are no significant amounts of unrecorded retirements of property, plant and equipment. a. Describe two ways that the auditors obtain evidence that there are no significant amounts of unrecorded retirements of property (land). b. Describe three ways that the auditors obtain evidence that there are no significant amounts of unrecorded retirements of equipment. a. The auditors obtain evidence that there are no significant amounts of unrecorded retirements of property by (only two required):

Examination of property tax bills. Vouching rent receipts from lessees. Examination of payments to mortgagee or trustee. b. The auditors obtain evidence that there are no significant amounts of unrecorded retirements of equipment by (only three required): For major purchases, investigate related retirements. Analyze the Miscellaneous Revenue account to locate cash proceeds from sale of equipment. For discontinued operations, investigate related retirements. Inquire of executives and supervisors. Investigate reductions in insurance coverage.

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