Internal Control

Question 1

What is the purpose of performing a walkthrough?

Answer 1

Obtain some feedback as to whether the way the auditor has understood (and documented) the entity’s internal controls is consistent with the way the entity is actually processing such transactions.

Question 2

List the disadvantages of Internal Control Questionnaires (ICQs) to document the auditor’s understanding of internal controls.

Answer 2

1. These are generic and not tailored to any client specifically; 2. Irrelevant questions may annoy clients; 3. Client might conceal deficiencies by incorrect answers.

Question 3

Define transaction cycle.

Answer 3

A group of essentially homogeneous transactions, that is, transactions of the same basic type.

Question 4

List the advantages of Internal Control Questionnaires (ICQs) to document the auditor’s understanding of internal controls.

Answer 4

1. Can have a standard form for many clients; 2. Deficiencies are easily indicated by “no” answers.

Question 5

List the advantages of narratives (memos) to document the auditor’s understanding of internal controls.

Answer 5

1. Tailored to client; 2. Can be as detailed or as general as desired; 3. Easy to prepare; 4. Easy to read.

Question 6

Identify 3 procedures an auditor might perform to obtain an understanding of internal controls?

Answer 6

1. Inquiry of appropriate personnel 2. Observation of client’s activities 3. Review entity’s documentation of internal controls.

Question 7

List the advantages of using flowcharts to document the auditor’s understanding of internal controls.

Answer 7

1. Systematic approach with emphasis on important accounting records 2. Tailored to client 3. Fairly easy for others to review and understand 4. Easy to update from year to year.

Question 8

Identify 3 ways auditors might document their understanding of internal controls?

Answer 8

1. Flowcharts of transaction cycles; 2. Internal control questionnaires; 3. Narrative write-ups (memos).

Question 9

List the disadvantages of flowcharts to document the auditor’s understanding of internal controls.

Answer 9

1. Tedious and time consuming to initially prepare; 2. Might fail to recognize deficiencies by getting overly absorbed in details.

Question 10

List the disadvantages of narratives (memos) to document the auditor’s understanding of internal controls.

Answer 10

1. Writing such a memo is rather unstructured, lacking a systematic approach; 2. It may be rather easy to overlook relevant internal control issues.

Question 11

When should the auditor assess the operating effectiveness of internal control?

Answer 11

Whenever the auditor contemplates a reliance strategy (which means the same thing as “assessing control risk at less than the maximum level”) and only after performing the appropriate tests of control.

Question 12

Identify 3 inherent limitations of internal controls?

Answer 12

1. Cost of controls should not exceed expected benefits 2. Mistakes may occur due to carelessness, fatigue, misjudgments, etc. 3. Segregation of duties may break down due to collusion or management override of internal controls.

Question 13

When should the auditor assess the design effectiveness of internal control?

Answer 13

In planning every audit under GAAS, as a basis for determining the nature, timing, and extent of further audit procedures.

Question 14

Identify 2 reasons for assessing control risk at the maximum level.

Answer 14

1. The auditor believes that the design of internal control is ineffective; or 2. The auditor believes that reliance on internal control (and performing applicable tests of control) is not an efficient audit strategy compared to a wholly substantive audit approach.

Question 15

Identify the five interrelated components of internal controls.

Answer 15

1. Control Environment 2. Risk Assessment 3. Control Activities 4. Information and Communication systems 5. Monitoring.

Question 16

What is meant by the term monitoring (as it relates to internal controls)?

Answer 16

The policies and procedures involving the ongoing assessment of the efectiveness of internal control over time.

Question 17

Define the term risk assessment procedures.

Answer 17

Procedures performed to obtain an understanding of the entity and its environment, including its internal control.

Question 18

What is meant by the term control environment?

Answer 18

The policies and procedures that determine the overall control consciousness of the entity, sometimes called “the tone at the top.”

Question 19

Identify 3 risk assessment procedures that might be used by an auditor to obtain an understanding of the entity and its environment, including its internal control.

Answer 19

1. Inquiries of management and others; 2. Observation and inspection; 3. Analytical procedures.

Question 20

What is meant by the term risk assessment?

Answer 20

The policies and procedures involving the identification, prioritization, and analysis of relevant risks as a basis for managing those risks.

Question 21

What is meant by the term control activities?

Answer 21

The policies and procedures that help ensure that management directives are carried out especially those related to (1) segregation of duties, (2) physical controls, (3) authorization of transactions, (4) performance reviews, and (5) information processing.

Question 22

What are the three objectives of internal control as identified in the definition of internal control?

Answer 22

1. Reliability of financial reporting 2. Effectiveness and efficiency of operations 3. Compliance with applicable laws and regulations.

Question 23

What is meant by the term information and communication systems?

Answer 23

The policies and procedures related to the identification, capture, and exchange of information in a form and time frame that enable people to carry out their responsibilities.

Question 24

Define “internal control.”

Answer 24

A process - effected by those charged with governance, management, and other personnel - designed to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations.

Question 25

What specific matters should the auditor document regarding the auditor’s assessment of the risks of material misstatement?

Answer 25

The discussion with key members of the audit team about the risks of material fraud and errors; The major elements of the understanding of the five components of internal control; The assessment of the risks of material misstatement (at the financial statement and relevant assertion levels) and the basis for that assessment; and The risks identified and the related controls the auditor evaluated.

Question 26

When must tests of control be performed?

Answer 26

When the auditor’s risk assessment includes an “expectation of the operating effectiveness of controls.” Note that this is frequently referred to as “relying” on internal control as a partial basis for the auditor’s conclusions, or “assessing control risk at less than the maximum level.”

Question 27

Define the term significant risks.

Answer 27

Risks that the auditor believes require special audit consideration.

Question 28

List some examples of appropriate responses by the auditor to risks of material misstatement at the financial statement level.

Answer 28

Assign more experienced staff to the engagement; Provide closer supervision; Use specialists; Use more unpredictable audit procedures.

Question 29

What is the auditor’s responsibility for assessing the risk of material misstatement?

Answer 29

The auditor should identify and assess the risks of material misstatement (1) at the financial statement level and (2) at the relevant assertion level related to classes of transactions, account balances, and disclosures.

Question 30

What is meant by the term deficiency in design?

Answer 30

When a control necessary to meet the control objective is missing, or when the control objective is not always met, even if the control operates as designed.

Question 31

Define material weakness.

Answer 31

A deficiency (or combination of deficiencies) in internal control such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented or detected and corrected on a timely basis.

Question 32

Define “significant deficiency.”

Answer 32

A deficiency (or combination of deficiencies) in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance.

Question 33

Describe the auditor’s requirements for communicating deficiencies in an entity’s internal controls?

Answer 33

1. The auditor must communicate in writing the significant deficiencies (including material weaknesses) identified in the audit; 2. The auditor may choose to communicate lesser matters, too.

Question 34

What is meant by the term deficiency in operation?

Answer 34

When a properly designed control does not operate as designed, or when the person performing the control does not have the authority or competence to effectively perform the control.

Question 35

Describe the timing of the required communication of significant deficiencies in internal control.

Answer 35

Under AICPA professional standards, written communication is required no later than 60 days after the audit report release date (including matters communicated orally during the audit)

Question 36

What is meant by the objectivity of the internal audit function?

Answer 36

The organizational level to which internal auditors report (organizational status).

Question 37

Identify 2 audit procedures used to assess the relevance of an entity’s internal audit activities.

Answer 37

1. Inquire about the internal audit function’s organizational status, any limitations applicable to internal audit activities, and adherence to applicable professional standards 2. Review documentation of internal auditors’ processes and selected work products.

Question 38

Identify the 2 characteristics of the internal auditor that the auditor should evaluate before relying on the internal auditor’s work.

Answer 38

1. Competence 2. Objectivity.

Question 39

What is meant by the competence of internal auditors?

Answer 39

The internal auditors’ education, certification, professional experience, etc.

Question 40

What is meant by the term transaction cycle.

Answer 40

A group of essentially homogeneous transactions, that is, transactions of the same type.

Question 41

Why do auditors emphasize transaction cycles?

Answer 41

Control risk is generally constant within a particular category of transactions as all transactions are processed the same way. So, the transaction cycle is the highest level of aggregation for which control risk may be viewed as a constant.

Question 42

List the 3 categories of incompatible functions associated with segregations of duties.

Answer 42

Authorization of transactions (execution function); Accounting (recordkeeping function); Access to assets (custody function).

Question 43

List some examples of major transaction cycles.

Answer 43

1. Revenue/receipts; 2. Expenditures/disbursements; 3. Payroll; 4. Inventory (especially for manufactured inventory); 5. Fixed assets; 6. Investing/financing.

Question 44

How should employee responsibilities be allocated to facilitate a proper segregation of duties in the revenue/receipts (sales transactions) cycle?

Answer 44

1. Independent employee should review customer statements 2. Credit to customers is granted by independent department 3. Returns are accounted for by independent clerk in shipping/receiving area.

Question 45

Identify the key accounting documents in the revenue/receipts (sales) transaction cycle, each of which should be pre-numbered.

Answer 45

1. Sales invoices; 2. Shipping documents for outbound shipments; 3. Receiving documents for inbound shipments including sales returns.

Question 46

Identify the objectives of internal control related to revenue/receipts (sales transactions).

Answer 46

1. Goods and services provided in accordance with management’s orders 2. Terms of sale are in accordance with management’s orders 3. Credit terms and limits are properly established 4. Deliveries of goods and services result in accurate and timely billings 5. Sales discounts and billings are in accordance with management’s authorization.

Question 47

Describe management’s role in the execution of transactions controls in revenue/receipts (sales).

Answer 47

1. Management should review terms of sale and note approval. 2. Management should establish general approval of sales within certain limits and specifically approve sales over those limits. 3. Management should approve all adjusting journal entries.

Question 48

List 2 access controls applicable to the revenue/receipts (sales transactions) business process.

Answer 48

1. Computer passwords limit access 2. Cash receipts are handled by someone without access to accounts receivable record keeping.

Question 49

List access controls that can be used in the Cash Receipts business cycle.

Answer 49

1. Employees with access to cash should be bonded 2. Access to cash receipts should be limited to those authorized.

Question 50

What comparison techniques can be used by the auditor to ensure appropriateness of transactions in the Cash Receipts business cycle?

Answer 50

1. Initial cash receipts listing (remittance listing) compared to total recorded in cash receipts journal and to bank deposit 2. Cash accounts reconciled to bank statements by independent person.

Question 51

List the internal control objectives related to the Cash Receipts business cycle.

Answer 51

1. Access to cash receipts records and accounts receivable records is limited to authorized personnel 2. Detailed cash and account balance records are reconciled with control accounts and bank statements monthly 3. All cash receipts are recorded in period received.

Question 52

List some procedures used to ensure segregation of duties in the Cash Receipts business cycle.

Answer 52

To ensure segregation of duties, the following activities should be handled separately (by separate individuals): 1. Opening mail, handling checks received, and preparing remittance listing 2. Making deposit (daily) 3. Applying payments received to customer accounts 4. Preparing bank reconciliation on a timely basis.

Question 53

What control mechanisms can be used to ensure the appropriate execution of transactions in the Cash Receipts business cycle?

Answer 53

1. Adjusting journal entries should be approved by management 2. Bank reconciliations should be reviewed by management.

Question 54

Describe management’s role in the execution of transactions controls over cash disbursements in the expenditures/disbursements transaction cycle.

Answer 54

1. All adjusting entries approved by management; 2. Only authorized personnel should be able to place an order for goods and services on the entity’s behalf; 3. The department requesting the purchase should approve the goods or services received before payment is made.

Question 55

List some procedures used to ensure segregation of duties in the Expenditure business cycle.

Answer 55

1. Separate purchasing department 2. Purchasing personnel independent from receiving and recording 3. Bank reconciliations are prepared by someone not having other involvement in handling cash receipts, disbursements, or record-keeping.

Question 56

List 2 access controls applicable to the expenditures/disbursements transaction cycle.

Answer 56

1. Cash disbursement employees should be bonded; 2. Access to cash disbursements or related documents should be limited to authorized personnel.

Question 57

Identify the objectives of internal control related to the expenditures/disbursements transaction cycle.

Answer 57

1. Disbursements are for authorized expenditures as approved by management. 2. Disbursements are recorded at the proper amounts and classifications. 3. The supporting accounting records are agreed to the general ledger accounts. 4. Any adjusting journal entries are authorized by management. 5. Access to cash and disbursement records is limited to authorized personnel.

Question 58

What is the difference between an accounts payable system and a vouchers payable system?

Answer 58

An accounts payable system aggregates payables to identify the total owed to any individual vendor. A vouchers payable system keeps track of individual transactions for which payment is owed without summarizing the totals by vendor.

Question 59

What comparison techniques can be used by the auditor to ensure appropriateness of transactions in the Expenditure business cycle?

Answer 59

1. Compare suppliers’ monthly statements with recorded payables 2. Compare purchase order to receiving document to vendor’s invoice.

Question 60

Identify 3 access controls applicable to the payroll transaction cycle.

Answer 60

1. Access to personnel files should be limited to authorized personnel. 2. Access to payroll checks should be limited to authorized personnel. 3. Personnel with access to payroll checks should be bonded.

Question 61

Describe management’s role in the execution of transactions controls in the payroll transaction cycle.

Answer 61

1. Payroll should be reviewed and approved by a responsible official. 2. Computations should be verified by an independent person. 3. Overtime payments should be approved by management. 4. Payroll for management should be appropriately reviewed and approved.

Question 62

What comparisons should be made within the entity to ensure the appropriateness of payroll transactions?

Answer 62

1. Payroll information should be periodically matched to information in personnel files; 2. Payroll checks should be compared to entries on the payroll register; 3. Amounts on the payroll register should be agreed to the applicable general ledger accounts.

Question 63

Identify the objectives of internal control related to the production/manufacturing inventory transaction cycle.

Answer 63

1. Resources obtained and used are accurately recorded timely 2. Transfers of finished goods are accurately recorded 3. Related expenditures are appropriately classified 4. Access to inventory is restricted to authorized personnel 5. Comparisons are made of actual inventory to recorded amounts.

Question 64

Identify the objectives of internal control in the fixed assets transaction cycle.

Answer 64

1. Transactions are recorded accurately in accordance with management’s authorization. 2. Estimates used to record depreciation, etc. are reasonable and consistent over time. 3. Assets are safeguarded with appropriate property insurance is in force. 4. Supporting details records are properly maintained. 5. Management should approve any adjusting journal entries.

Question 65

Identify the objectives of internal control in the investing/financing transaction cycle.

Answer 65

1. Transactions are recorded accurately in accordance with management’s authorization. 2. Investment assets should be reasonably secure from loss. 3. Supporting detailed records should be maintained and compared to general ledger. 4. Management should approve any adjusting journal entries.

Question 66

Describe management’s role in the execution of transactions controls in the production/manufacturing inventory transaction cycle.

Answer 66

1. Acquisition and distribution of inventory should be in accordance with management’s authorization; 2. Should establish general approval of transactions with specified limits and require specific approval for amounts over those limits; 3. Management should approve any adjusting journal entries.

Question 67

How should employee responsibilities be allocated to facilitate a proper segregation of duties in the production/manufacturing inventory transaction cycle.?

Answer 67

1. Separate authorization, bookkeeping (recording), and custody of inventory 2. Sales returns should be counted by receiving clerk, who prepares an appropriate receiving document.