Revenue & Receipts Cycle

Internal Controls &

Test of Controls
REFERENCES

Internal control knowledge

International Standard on Auditing (ISA) 315 &330

Identifying and assessing the risks of material misstatement
through understanding the entity and its environment and
responding thereto selected paragraphs
LEARNING
OUTCOMES
Revenue & receipts system; controls readdressed (Revision)
Mostly self study
1. Understand the internal control structure of the cycle including major
classes of transactions and affected accounts
2. Understand and describe the cycles functional areas
3. Design a system of controls for the revenue and receipt cycle
4. Identify and explain weaknesses in the control systems and make
recommendations for improvement
Auditors application
1. Understand the decision tree for deciding on when to follow a test of
control approach
2. Identify and describe the key internal controls on which to place
reliance
3. Understand the direction of testing when performing tests on the key
internal controls
4. Describe the test of control procedures
5. Understand the consequences of exceptions found during the testing of
internal controls
INTRODUCTION
TO THE CYCLE

Classes of transactions affected:

SALES and SALES RETURNS (revenue)

RECEIPT transactions (movements in cash & bank balances)

Account balances affected:

ACCOUNTS RECEIVABLE (Including trade debtors and

allowances for doubtful debts)
Consider:
2.1 Variation amongst entities
CASH and BANK 2.2 Cash sales
2.3 Credit sales
2.4 Legislation
BASIC FUNCTIONS
IN THE CYCLE
AN 10/2-10/3
Assumption: wholesale entity selling goods to customers on credit:

Receiving Warehousing
Invoicing
customer & Despatch of
customers
orders inventory

Receiving & Recording

Credit recording of sales and
management payments raising
from debtors debtors

Other: Sales returns & adjustments (credit notes);

Granting of discounts; Write-offs of bad debt
CONTROL ACTIVITIES
IN THE CYCLE

Categories of control activities

Approval and authorisation
What level of staff should Segregation of duties
approve/authorize? Between execution, authorization,
custody of asset, recording.

Isolation of responsibility
Employee acknowledges performing duty

Access and custody controls (security)

Protecting assets and information

Comparisons and reconciliations

Between what? Who performs it?
INFORMATION FLOW
IN THE CYCLE

Functional area and Accounting entries

documents/records prepared in general ledger

Credit management None

Credit application form

Order department None

Customer order
Internal sales order

Warehouse/despatch [Inventory items removed

Picking slip from inventory register.
Delivery note G/L entries depend on
periodic vs. perpetual].
INFORMATION FLOW
IN THE CYCLE

Functional area and Accounting entries

documents/records prepared in general ledger

Invoicing None
Customer invoice

Recording of sales Debit Trade debtors

Sales journal Credit Sales
Debtors ledger

Receiving cash None

Receipt
Deposit slip
Remittance register
INFORMATION FLOW
IN THE CYCLE

Functional area and Accounting entries

documents/records prepared in financial records
\

Recording of receipts Debit Bank

Cash book Credit Trade debtors
Debtors ledger

Sales returns and adjustments Debit (Returns)/sales

Goods returned voucher (GRV) Credit Trade debtors
Credit note
BOOKKEEPING
IN THE CYCLE

ISO Sales journal General ledger

DN INV
Debtors ledger

Remitt adv.
Cash book General ledger
Bank stmt.
Dep. slip
Receipt Debtors ledger

Trial balance
Reconciliations:
Bank recon: Bank statement & GL (cash book) Financial statements
Debtors recon: Debtors ledger & GL debtors control a/c
OBJECTIVES OF INTERNAL CONTROLS (REVISION)

Validity

Completeness
Accuracy

A proper accounting system and related internal controls

will achieve the control objectives of Validity, Accuracy and
Completeness of financial information.

Why does management want V, A and C of financial information?

Why is an auditor interested in whether controls achieve V, A, C?
AUDIT APPROACH
(REVISION) Textbook 5/26-27

Tests of Controls Substantive Procedures

Performed to obtain audit Performed to obtain evidence to

evidence of: detect material misstatements in the
The suitability of the design financial statements
of the accounting and internal
control system
The effective operation of Consist of:
the system throughout the Tests of detail of transactions,
period of reliance. balances and disclosures;
Analytical procedures

Conclude on the Conclude on the

Control Objectives Management Assertions
TESTS OF CONTROLS
- INTRODUCTION

Tests of controls must be performed when (ISA 315, para. 08):

Risk assessment includes an expectation that controls

are operating effectively

Risks identified for which substantive procedures alone

do not provide sufficient appropriate evidence

However, even if test of control approach followed, substantive

procedures are compulsory for each material class of
transactions, account balance and disclosure (ISA 330, para. 18)
TESTS OF CONTROLS
- NATURE

Purpose of audit procedures (including tests of controls):

Are the financial statements fairly presented?
:: Focus is thus on the recorded financial information ::

Are there controls in place that can achieve fair presentation through
Validity,
Accuracy and
Completeness
of recorded financial information?

If so, perform test procedures on those controls to determine whether:

there is evidence of the control having taken place;
the control operated effectively as intended.
TESTS OF CONTROLS
- NATURE

Perform tests of controls by applying the following procedures:

Inquiry
Observation Evidence control took place
Inspection

Reperformance Evidence control operated effectively

Example:
Managers signature on bank recon as evidence of review: Really
reviewed? Reviewed it appropriately?

Therefore, reperform to obtain evidence on operating

effectiveness of the control.
TESTS OF CONTROLS
- NATURE
Direction of testing NB
When we select a sample for testing from where do we make the
selection ?

Validity & Accuracy:

the population is the transactions already recorded
from recorded transaction to source document.
i.e. journals/books of prime entry such as the sales journal to the invoice

Completeness:
the population is the first record or source document of the transaction
from source document to the recorded transaction
i.e. delivery note to the recorded entry in the sales journal, thus

Applying an incorrect direction of testing when answering a

question will lead to an irrelevant/incorrect answer.
TESTS OF CONTROLS
- EXTENT

Extent = How much to test

The more reliance placed on controls, the more tests of
controls to perform on those controls in order to
JUSTIFY the reliance.

However, not test ALL controls (impractical and costly)

Test only KEY controls (those wish to place reliance on)

ISA 315, para. A60: Not all controls are relevant to the
auditors risk assessment.

Which controls are KEY?

Key = measure of extent to which the control addresses the risk
involved.
TESTS OF CONTROLS
- EXTENT

Which controls are KEY?

Example: consider RISK OF INCOMPLETE recording of sales

transactions in sales journal:

Control 1: Invoices are pre-printed and sequentially numbered

vs.
Control 2: The senior bookkeeper reviews the sequential
numbering of invoices recorded in the sales journal and follows
up on missing entries.

Which is KEY control?

Distinguish between key controls and

mere supporting (indirect) controls!
TESTS OF CONTROLS
- TIMING
Timing = When to test

Tests of control can be performed several months before year end

(interim audit).

Advantages of this include:

Time & opportunity to amend the substantive audit program

(in case exceptions found and reliance not justified);

Reduce time pressure during final audit.

However, the auditor needs evidence about the operation of controls

throughout the year (ISA 330 para 12).

Thus also test intervening months between interim and year-end.

TESTS OF CONTROLS
- EXCEPTIONS

Exceptions occur when a internal control procedure is:

not applied
not applied correctly and consistently
applied by an unauthorised person

NOTE: An exception in a transaction of R 1 million carries the same

weight as an exception in a transaction of R 1. Why?

Accordingly, tests of controls are NOT value orientated! The control

is tested, and not the underlying financial value.

What if exceptions in internal controls are found by auditor?

I.e. impact on audit approach?
ANSWERING TEST OF CONTROL QUESTIONS IN THE CYCLE

1. Identify key control in scenario (i.e. controls youd rely on for purpose
of concluding on fair presentation of financial information)

2. Identify control objective applicable (V, A and/or C)

3. Determine direction of testing (recorded financial information to

supporting doc or supporting doc to recorded financial information)

4. State selection and source of sample (e.g. sales journal / invoices)

5. Consider hierarchy of audit evidence reliability (source, nature)

6. Formulate and describe test of control procedure

inquire, observe, inspect: evidence that control took place
reperform: test operating effectiveness of control.

[Audit verb] [Party/Process/Document] [Purpose]

 EXAMPLE
YOU ARE REQUIRED TO: Identify internal control procedures present in the system
that you would wish to place reliance on, and describe test of control procedures you
would perform to obtain reliable evidence about the performance of each control
identified.
SYSTEM
You are the senior in charge of the audit of Office Space (Pty) Ltd, a wholesale
company which sells office furniture. During the planning phase of the current audit
you established that the system for the processing of sales is as follows:

Sales Orders
Orders are received from retailers across the country. The majority of orders are
faxed to the company, while some are received by phone. A sales order clerk writes
out a sequentially numbered internal sales order (ISO) for both the fax and
telephone orders. A second sales order clerk checks the calculations on the ISO back
to the faxes received.

Credit Control
The sequentially numbered ISOs are, from time to time, passed to the credit
controller during the day who confirms that the customer is still within his/her
credit limit and authorizes the sale by signing the order. The ISOs are given back to
the sales order clerk who transfers a copy of the ISO to the head of stores.
Suggested solution: Office Space (Pty) Ltd
Internal control Test of control
procedure
1. Credit control: 1.1. Select a sample of sales transactions
Credit controller recorded in sales journal, follow through to
assesses the the supporting invoice and:
credit-worthiness 1.1.1 Inspect the corresponding ISO for
of each customer the approval signature of the credit
and authorizes controller.
each sale by (Note: direction of testing)
signing the ISO.
1.2. Enquire of management regarding the
(Validity of sales : reliability of the credit control function.
Authorization)
1.3. Enquire of the credit controller regarding his
function and the likelihood of fictitious/invalid
orders getting past him/her.

1.4. Reperform the creditworthiness check to

confirm the check was properly performed by
the credit controller (operating effectiveness).
Warehousing and Dispatch

The head of stores, on the authority of the signed ISO, requests a store man to pick
the goods from the store and authorizes the store man to transfer the goods to the
dispatch clerk. The head of stores agrees the ISO to the goods actually picked, then
stamps the order "filled" and signs it.

The dispatch clerk prepare a sequentially pre-numbered delivery note for each
order. The delivery note and the ISO are cross-referenced. The fast copy remains in
the delivery note book and the two top copies are torn out and packed, with the
boxed goods, into the delivery truck.

Gate control personnel conduct checks on the trucks leaving the premises by
checking that all goods in the truck appears on the delivery note accompanying the
goods.

The top copy of the delivery note is left with the customer and the second copy is
signed by the customer to be returned to the invoicing section.
 Internal control procedure Test of control
2. Gate control 2.1 Observe the checking of trucks and
Gate personnel conduct goods by gate control personnel.
checks on goods leaving 2.2 By reperformance, select trucks
the premises. leaving the premises and compare the
content with the accompanying delivery
(Completeness of note.
sales) 2.3 Enquire of management as to the
reliability of the gate control and any
problems which may have occurred.
2.4 Enquire of the gate control personnel
regarding their function to ensure
they understand what is expected of
them.
3. Customers are required 3.1 For the sample of sales invoices
to sign delivery notes as selected in 1.1 above:
acknowledgement of agree by inspection of the invoice
receipt of goods. the corresponding customer signed
delivery note to confirm evidence
(Validity of sales : of the customer s
Authenticity) acknowledgement of receipt.
(Note: direction of testing)
Invoicing
On the basis of the information on the delivery note and an authorized price list, an invoicing
clerk prepares a sequentially pre-numbered invoice. The invoice and the delivery note are
cross referenced. The details and casts and extensions on the invoice are checked by the
invoicing supervisor who signs the fast copy as evidence of this check. The top copy is then
mailed to the customer.

Recording of Sales
The fast copy of the invoice is recorded, in number order, in the sales journal by the accounts
receivable clerk. On a daily basis, the senior bookkeeper checks each sales entry in the sales
journal by comparing the recorded amount to the invoiced amount. He ticks the entry as
evidence of performing the check.

The delivery note is then filed with a copy of the invoice in number order and the sequence
thereof is checked by the invoicing supervisor to ensure all delivery notes have been
invoiced. He signs completed batches as evidence of the check.
 Internal control procedure Test of control
4. Invoicing 4 For the sample of sales invoices selected in 1.1
The senior bookkeeper above:
agrees the amounts 4.1 Inspect the entry in the sales journal for
recorded in the sales evidence of the senior bookkeepers tick
journal with the amounts evidencing his check on the recorded amount.
on the invoices and ticks
each entry in the sales 4.2 Follow the entry through to the invoice and
journal as evidence of inspect the invoice for the signature of the
performing the check. invoice supervisor indicating her check on
mathematical accuracy.
The details and casts and
extensions on the invoice By reperformance, test the operating effectiveness
are checked by the of the controls as follows:
invoicing supervisor who
signs the fast copy as 4.3 the quantity from the delivery notes have been
evidence of this check. correctly carried across to the invoice;
4.4 the prices on the invoices are in accordance with
(Accuracy of revenue) the authorized price list;
4.5 each invoiced amount has been correctly
recorded in the sales journal;
4.6 casts and extensions are correct on invoice and
in the sales journal.
 Internal control procedure Test of control
5. Invoicing: 5.1 Inspect the batches of the delivery
The delivery note is filed notes in the invoicing section for
in number order with the signature of the invoicing
invoice and the supervisor indicating the sequence
sequence thereof is check for completeness of invoiced
checked by the invoicing delivery notes.
supervisor, who signs
completed batches as 5.2 Reperform the sequence check on
evidence of the check. delivery notes.

(Completeness of Select a sample of delivery notes and,

revenue) using the cross-referencing, inspect
the corresponding fast copy invoice,
and trace the invoice to the sales
journal.
(Note: direction of testing)
END

Thank you!
Dankie!
Enkosi Kakhulu!!
ANSWER TECHNIQUE

When answering weakness questions, remember the following:

Read the scenario and the required very carefully!

Know the difference between identify, explain and recommend.

Weakness should be in detail and must be relevant to the scenario and required.

Explanation should explain what can go wrong/what are the risks involved.

Recommendation must be in detail : specify the actual control procedure and

not simply the control objective:
e.g. All sales should be recorded (control objective)
vs.
Sequential numbering of recorded invoices in the sales
journal should be reviewed by Mr A Countant on a
regular basis for missing numbers (control procedure)
ANSWER TECHNIQUE
(CONTINUED)

The following is not acceptable when answering weakness questions:

Stating the control activity category as a weakness (e.g. No division of duties)

rather than the control weakness in the activity itself (e.g. Person receiving orders
from customers also ships inventory items to customers).

Making vague references to responsibility levels, e.g. stating a control procedure

should be performed by a second clerk or a senior staff member if the scenario
clearly indicates the titles of the positions in the entity and the staff members
names. (e.g. financial accountant/Mr A Countant).

Making assumptions that are not relevant to the scenario or the type of business.

Allocating tasks to incorrect levels of authority, e.g. financial manager should

perform the bank reconciliation while there clearly is a bookkeeping clerk
available to do so. Clerks are the staff performing most functions and executing
most controls! Senior staff and management approve, authorize and review etc.