Exam 7: Understanding and Testing the Clients System of Internal Controls

Tests of controls will usually be carried out

Narratives involve the auditor describing in words each step of the flow of transactions from start to finish.

(Reproduced from: CICA UFE Question 2009 - Paper 2 - Question 3) Bazaar buys computers, parts, and related equipment and resells them at a mark-up to a loyal base of corporate customers. Competition is growing, but the market is favourable, and Bazaar offers excellent customer service, giving it a competitive advantage. The owner is very involved in most of the important operating decisions. His capable assistant steps in when necessary. The owner plans to implement a code of ethics at some point and also wishes to improve certain controls. Bazaar is a medium-sized private company that operates multiple warehouses, each carrying a mix of inventory items. The first type of inventory, which can be quite costly, consists of specialized computer hardware, desktop computers, and laptop computers. The turnover rate for this inventory is high since new technology is always emerging. Because the company orders months in advance, Bazaar occasionally overestimates demand. After three or four months, products are difficult to sell, but they are kept because most cannot be returned to the supplier, and Bazaar is reluctant to hold liquidation sales for fear they would negatively affect the sales at regular prices. The second type of inventory, parts and peripherals, generates a significant portion of Bazaar's sales. This category includes items such as monitors, printers, and toner cartridges. The third type of inventory includes software packages ranging from sophisticated operating systems to games. This inventory can be returned to suppliers if unsold after a certain period. This year, Bazaar implemented an integrated computer system to manage the general ledger as well as inventory, purchases, and sales. Sales representatives enter orders into the sales database, and can modify the information, including quantities and selling prices. Any changes are usually made to orders before shipping. Problems result if representatives make changes after shipping, since they should issue credits instead. The timing differences create reconciliation problems for both customers and Bazaar when settling invoices. Also, sometimes credits have been issued in error. For example, the owner described one example where a credit was issued for a price adjustment made by a sales representative. The supporting paperwork stated that the credit had been issued in error (which seems to happen often) and the refund cheque was cancelled. However, the details of the refund cheque could not be located. When asked, the clerk said he left the cheque copies on his desk and the next morning they were gone. He gave up looking for them. Electronic purchase orders require authorization from either the owner or his assistant through the use of a personal identification number (PIN). Each user has a specific PIN. Orders greater than $5,000 require the owner's authorization. Occasionally, the owner is not available. He has given one of the accounting clerks he trusts his PIN to be used for emergency situations. Before making a payment, the accounting department matches the invoice to the authorized purchase order and the receiving slip. Other Information: The owner noted that Bazaar's costs seem higher than expected, particularly since this year he decided to pay suppliers faster in order to benefit from discounts. According to his calculation, the cost of goods sold should have decreased by around 2% over last year, since most suppliers offer discounts and did not increase prices. Instead, he noted a 3% increase in costs. The sales mix has not changed significantly from previous years. Purchases increased and were distributed across the inventory types in amounts similar to the overall sales mix. To help retain the sales team, stock options were given this year for the first time as an added form of compensation. The options are available of Bazaar's net income after tax is at least $5 million per year. Customers have 30 days to pay invoices, but most take advantage of a 2% discount offered for payment within 10 days. Customers make payments in full payments and discounts are reimbursed later by system-generated cheques. Cheques may be issued with or without supporting documentation. The owner noted he just received a memo from a clerk at one of the warehouses. It says the amount of damaged inventory has been gradually increasing over the past eight months. The clerk suggests this is because the forklift is not operating properly and items are being dropped as they are loaded for shipment. He wants the forklift replaced. He asks what he should do with the damaged inventory that has been piling up in a corner of the warehouse. He suggests holding a liquidation sale to get rid of it, Required: a) Assess and conclude on inherent risk. Be sure to discuss items that both increase and decrease risk for a balanced discussion. b) Assess and conclude on the control risk. c) Based on your inherent and control risk assessment, conclude on detection risk. d) Based on the risk assessment, what type of audit strategy should be implemented? e) Identify five control weaknesses at Bazaar. For each weakness, indicate the implication and make a specific recommendation how Bazaar can fix it. f) What is the auditor's responsibility with respect to fraud when performing a financial statement audit? Assess the fraud risk at Bazaar and indicate what should be done when planning the audit.

Attribute sampling is a sampling technique used to reach a conclusion about the total dollar amount of misstatement in an account balance.

An internal control exception is

A computer program that will not allow a sale to be processed if a customer has exceeded its credit limit is an example of a

Internal control is intended to provide reasonable assurance about the achievement of an entity's objectives.

Explain the key elements of the control environment.

Which of the following statements is correct?

The greater the degree of reliance on an internal control, the less they test the control to provide the required assurance.

(Reproduced from ICAO - 2006 - Practice Test 2 - Question 3) Definition Electronics (Definition) is one of Canada's leading retailers of home video and audio equipment. Ten years ago, Definition began as a local electronics store. It has rapidly grown and it now operates 11 stores across the country and it employs over 200 people. You, CPA, recently joined as a financial analyst in January 2020. It is your first day on the job and you meet with John Gomery, Definition's controller. John explains that he believes because of the rapid growth, there are significant control weaknesses. Part of the issue is they are using an old proprietary software system called "eDef". He goes on to tell you how the system works and you note the following: eDef is used to manage inventory and record sales and purchases. The primary activities used on a daily basis include: -Recording of sale transactions. Definition does not use cash registers. Salespeople use networked PCs to record sales in eDef. eDef calculates sales taxes and generates invoices. It updates the inventory on hand at the same time. -Recording returns. A merchandise return results in a refund issued to the customer. However, the item is not added back into inventory as the owner feels very strongly about not selling opened packages. Returned inventory is tracked manually in a spreadsheet on the server and periodically sold through a clearance sale or on eBay. There is no separate return module. Returns are recorded as negative sales transactions and the system has been programmed not to update inventory quantities for such transactions. -Recording inventory purchases. eDef automatically generates purchase order when the on-hand quantity for any given SKU falls below a preset limit. When the inventory is received, the quantity on hand can be updated only if an open purchase order exists. -Calculation of commissions. On a monthly basis, eDef calculates sales staff's commissions. Definition's salespeople earn a low base salary and a 5% commission on their net sales. At month-end, Definition's accounting staff download sales and inventory transactions from eDef into Quicken, a small business accounting system. They prepare financial statements which are required by the bank within 15 days of month-end. -eDef and the hardware it runs on have lately been unable to cope with the volume of transactions recorded in multiple locations. It has crashed 4 times last month, each time for at least 3 hours. The controller goes on to discuss the policies currently in place. They are as follows: 1. All merchandise may be returned within 30 days of sale. Whenever possible, the return should be processed by the salesperson that made the original sale in order to maintain the customer relationship. 2. The store manager counts all inventory weekly. An eDef report is generated and the manager then counts the items in the store based on the report. Any discrepancies should be reported to George. 3. Salespeople may, based on their judgment, reduce prices by up to 10% for repeat customers. 4. Daily sales journal by salesperson is generated by eDef and reconciled to the daily cash receipts (or credit card slips) by the store manager. The journal reflects both sales and returns. 5. Salespeople can edit sales records from the same day (in case they make a mistake they discover after the invoice is printed). At the end of the day, once the sales journal is reconciled, the store manager "locks" the day's records. Subsequent changes must be processed as either additional sales or returns. 6. If the system is temporarily down, salespeople are instructed to prepare invoices using a Microsoft Word template (which to the customer looks like a regular Definition invoice) and keep a copy of it. When the system is back up, the store manager enters these manual invoices into eDef using the normal sales module. 7. Salesperson commission (based on net sales) is paid monthly. Store manager bonus (based on store net sales) is paid quarterly. Required: Identify the control weaknesses at Definition. For each item, address the implication of the weakness and make a recommendation.

As part of her annual review Roma Lazor reviews her client's draft financial statements to assess that transactions appear to be charged and recorded in the correct account. This best describes which control objective(s)?

Teja Gaudette decided to list several questions for herself about factors that influence management's attitudes towards internal control so as to assure herself that she could have More confidence in management's abilities and integrity. When she was finished, which control Environment element did she tick off on her working papers?

A sampling technique used to reach a conclusion about a population in terms of a rate of occurrence is known as

Transaction-level controls are implemented by businesses to reduce the risk of misstatements due to error or fraud and to ensure that processes are operating effectively.

The more complex the client's operations and its internal controls, the less experienced the auditor who performs the work needs to be.

Harry Karas was involved in getting a big picture of his client's entity controls. He went about finding out whether periodic evaluations of internal control are made and determining The extent to which personnel, in carrying out their regular duties, obtain evidence as to Whether the system of internal controls continues to function. These activities are part of

Control risk refers to the risk that the auditor's testing procedures will not be effective in detecting a material misstatement.

In trying to determine whether there is a need for additional detailed tests of controls, which of the following factors are considered?

Which of the following is an element of the control environment?