0:00:08.000,0:00:16.066
In this video, we are going to get our hands a
little bit dirty and look at a transactional cycle
and walk through how we would audit it.
0:00:16.066,0:00:20.066
My hope is to expose you to how a
transactional cycle actually works,
0:00:20.066,0:00:25.033
and then discuss some of the audit procedures
we would use to nail down our assessment of
control risk.
0:00:25.033,0:00:29.066
In our next lesson, we will discuss substantive
procedures...
0:00:29.066,0:00:33.033
that are necessary to reduce detection risk
sufficiently to achieve our designed level of audit
assurance.
0:00:33.033,0:00:38.066
For this video, we are going to use the sales
cycle, which is typically comprised of the
following accounts:
0:00:38.066,0:00:45.066
Sales, returns, bad debt and allowances,
receivables, cash receipts, and commodity tax
collection.
0:00:45.066,0:00:51.000
Let’s first describe the sales cycle from cradle
to grave.
I want to make note of three things.
0:00:51.000,0:00:57.033
1.
Understand the types of documents and
journals.
This is to build up your vocabulary
0:00:57.033,0:01:05.066
2.
Understand how the process works- that is
how dollars find their way through the
accounting systems...
0:01:05.066,0:01:07.066
onto a set of financial statements.
0:01:07.066,0:01:14.000
3.
Understand how internal controls are overlaid
on processes to ensure integrity of the system.
0:01:14.000,0:01:19.066
So let's get started.
Sales often start with a
request for product.
0:01:19.066,0:01:24.000
In a retail store, the customer brings their
desired purchase to the checkout register.
0:01:24.000,0:01:27.033
In our hotel, a customer makes a reservation.
0:01:27.033,0:01:32.033
In a manufacturing business, a customer will
submit a sales order.
0:01:32.033,0:01:38.033
For cash based businesses, such as our
retailer, authorizing credit is not all that
important.
0:01:38.033,0:01:44.000
But for our hotel and manufacturer, we need to
confirm credit worthiness before accepting the
order.
0:01:44.000,0:01:48.000
If we plan on extending credit to these
customers,
0:01:48.000,0:01:54.033
this process becomes all the more important,
otherwise a credit card number would often do
the trick.
0:01:54.033,0:02:00.033
The next activity is to actually ship the goods, or
deliver the services, to our customer.
0:02:00.033,0:02:03.066
This isn’t an issue for a retailer.
0:02:03.066,0:02:08.000
For our hotel, we are delivering a service, so it
too isn’t much of an issue.
0:02:08.000,0:02:15.033
However, for our manufacturer, we are going to
have to pick the order and load it onto a truck for
delivery.
0:02:15.033,0:02:17.066
The documents you may find here include:
0:02:17.066,0:02:22.000
A picking slip which gives instructions to the
warehouse staff as to what the customer has
ordered.
0:02:22.000,0:02:27.033
A bill of lading from the carrier documenting what
has been been loaded onto the truck.
0:02:27.033,0:02:30.033
Once product is shipped, it needs to be
invoiced.
0:02:30.033,0:02:36.066
The billing department will prepare a customer
invoice with the quantity shipped at the price
agreed to.
0:02:36.066,0:02:40.066
At this point, the data starts getting recorded in
journals and ledgers.
0:02:40.066,0:02:49.066
The sales journal will summarize the sales
activity as we have now achieved revenue
recognition- that’s the credit side of the entry.
0:02:49.066,0:02:55.066
The debit goes to our accounts receivable
subledger to track the customer’s balance
outstanding.
0:02:55.066,0:02:59.066
At month end, we may send the customer an
account statement,
0:02:59.066,0:03:06.000
which will summarize activity in their account,
including their purchases less returns and
remittances.
0:03:06.000,0:03:13.033
For reporting purposes, you will see
management review what is called an aged trial
balance of accounts receivable.
0:03:13.033,0:03:17.033
This document lists both the balance
outstanding from each customer,
0:03:17.033,0:03:27.033
and how old the balance is, often grouping
balances into current (under 30 days), 30-60
days, 60-90 days, and over 90 days-
0:03:27.033,0:03:33.033
a very helpful report for managers to use to
manage working capital!
0:03:33.033,0:03:37.033
At some point, the customer will remit payment.
0:03:37.033,0:03:42.066
They may send cash (unlikely), a check, or an
electronic fund transfer.
0:03:42.066,0:03:46.033
Cash or equivalents get deposited at the bank.
0:03:46.033,0:03:51.033
A lock box is an arrangement whereby
remittances are sent directly to a bank for
deposit.
0:03:51.033,0:03:58.000
The collection of cash gets recorded in a cash
journal which debits cash and credits the
receivable subledger.
0:03:58.000,0:04:03.000
Now if a customer returns product, a credit
memo may be issued.
0:04:03.000,0:04:08.066
In the accounting system this too relieves the
customer account, with an offsetting debit to
inventory.
0:04:08.066,0:04:15.000
Bad debts arise when customers don’t pay us.
The allowance is a provision for anticipated bad
debt.
0:04:15.000,0:04:21.066
A write off is applied against the provision once
the company loses all hope of collecting the
account from the customer.
0:04:21.066,0:04:26.066
Now to finish off our story, subledgers and
journals roll into the general ledger,
0:04:26.066,0:04:31.033
either on a transaction-by-transaction basis, or
often on a batch basis.
0:04:31.033,0:04:37.000
A batch basis simply means that transactions
are aggregated [by batch] and posted as single
entry in the G/L.
0:04:37.000,0:04:42.000
The general ledger balances at the end of the
period become your trial balance.
0:04:42.000,0:04:47.000
Your trial balance will then get grouped,
matching up like accounts for reporting
purposes.
0:04:47.000,0:04:51.066
And the grouped trial balance will enable you to
draft your income statement and balance sheet.
0:04:51.066,0:04:58.066
From there, you can draft the rest of your
financial statements.
This is your financial
reporting process.
0:04:58.066,0:05:03.066
And I emphasize process because we have not
yet talked about controls whatsoever.
0:05:03.066,0:05:04.066
Don’t get these confused.
0:05:04.066,0:05:11.000
Let’s go back and talk about controls that
overlay the sales process.
0:05:11.000,0:05:17.066
We have already spent a lot of time talking
about internal controls in earlier lessons so I’ll
try to keep this discussion brief,
0:05:17.066,0:05:21.000
but hopefully, you will begin seeing the pieces
falling into place.
0:05:21.000,0:05:27.000
The starting point for all cycles will be to
consider entity level controls and general
computer controls.
0:05:27.000,0:05:34.066
For example, if you have a highly driven sales
organization with significant emphasis placed on
growing sales,
0:05:34.066,0:05:36.033
this may lead to a management bias.
0:05:36.033,0:05:40.066
This could motivate sales people to conjure up
sales,
0:05:40.066,0:05:42.066
or the credit people to accept less creditworthy
customers.
0:05:42.066,0:05:51.033
So always remember to consider the control
environment before you get into the details as
this has a pervasive effect.
0:05:51.033,0:05:57.066
At the customer order stage, we will want to
have some controls over ensuring that the order
is input accurately.
0:05:57.066,0:06:03.033
Remember those annoying red text warnings
you get on websites when you miss completing
a field.
0:06:03.033,0:06:07.066
That’s an input control, which helps to cover off
the accuracy assertion.
0:06:07.066,0:06:13.066
In our retailer, we will want to have other controls
such as a bar code scanners that do the same
sort of thing.
0:06:13.066,0:06:20.033
For our manufacturer, credit approval is a key
control as this prevents us from taking on
customers that lack creditworthiness.
0:06:20.033,0:06:24.033
This control helps with our valuation assertion.
0:06:24.033,0:06:29.033
In the warehouse, the shipping documents will
be tracked and ideally serially numbered.
0:06:29.033,0:06:38.000
If these documents are tracked and compared to
sales invoices- either manually or electronically,
this helps ensure completeness of sales.
0:06:38.000,0:06:44.000
Occurrence is validated by ensuring that only
those orders that are actually shipped get
recorded as sales.
0:06:44.000,0:06:48.066
So if an order is say backordered, it should not
show up in the sales journal.
0:06:48.066,0:06:56.066
Segregation of duties is an important control
which prevents any self review bias as well as
protects the organization from theft.
0:06:56.066,0:07:01.033
Those handling the cash remittances should not
be the same as those maintaining the
subledger.
0:07:01.033,0:07:05.000
Those handling the invoicing should not have
custody of the assets.
0:07:05.000,0:07:12.000
Management’s review of the aged receivable
listing helps ensure that the allowance and bad
debts have been adequately considered-
0:07:12.000,0:07:15.066
this is your valuation of receivable assertion.
0:07:15.066,0:07:19.033
The customer statements act as a control of
sorts.
0:07:19.033,0:07:27.033
Not all company’s send customer statements,
but for those who do, one added advantage is
that if a customer notices something is amiss-
0:07:27.033,0:07:32.066
like a payment has not been applied to their
account or they are being charged for something
they didn’t order-
0:07:32.066,0:07:34.066
rest assured that they will call you.
0:07:34.066,0:07:39.066
So this helps to ensure both occurrence of sales
and existence of accounts receivable.
0:07:39.066,0:07:43.000
The issuance of credit notes and the write off of
bad debts is important from a control stand
point,
0:07:43.000,0:07:49.000
so again, segregation and authorization controls
must be in place.
0:07:49.000,0:07:55.000
I think I’ve given you enough examples so that
you begin to understand how controls are
overlaid on the sales process
0:07:55.000,0:07:58.033
to achieve management’s assertions, and our
audit objectives.
0:07:58.033,0:08:05.000
A well designed system of internal controls will
have a mix of preventative and detective
controls,
0:08:05.000,0:08:08.000
which may be manually or electronically
performed.
0:08:08.000,0:08:14.033
Our role as auditors will be to identify the
controls which best address each of our
objectives.
0:08:14.033,0:08:19.033
For argument sake, let’s just focus on the
existence and valuation of accounts receivable.
0:08:19.033,0:08:25.066
We can go through our internal control
documentation and identify key controls that
address those particular control objectives.
0:08:25.066,0:08:33.000
Maybe our bad debt allowance is system
generated based on the aging of the receivables,
in which case we will want to rely...
0:08:33.000,0:08:39.066
on the system’s ability to age receivables
properly and would identify a processing control
in the application.
0:08:39.066,0:08:43.033
For the existence assertion, the customer
statements may be the key control.
0:08:43.033,0:08:48.066
But how do we know that someone is not just
pulling out the statements going to fictitious
customers before they are mailed.
0:08:48.066,0:08:56.000
Well, in this case, we would need to ensure
adequate segregation of duties and would
identify that as a key control.
0:08:56.000,0:09:02.033
Perhaps that control, in and of itself is not
enough for us to reach our warm happy place.
0:09:02.033,0:09:07.033
Maybe we need to identify the controls over
ensuring all shipments get invoiced as our key
control.
0:09:07.033,0:09:10.000
Does that make you feel better now?
0:09:10.000,0:09:16.000
It’s a judgement call as to how many controls
and which controls you identify as key controls.
0:09:16.000,0:09:17.000
Do you remember what happens next?
0:09:17.000,0:09:22.033
That’s right, you need to assess control risk
which again is based on your judgement.
0:09:22.033,0:09:29.033
We will just pretend that this client has a well
thought out and implemented system of internal
controls and for this reason,
0:09:29.033,0:09:31.000
we will assess control risk as low.
0:09:31.000,0:09:36.066
If we had weaknesses, we would have to assess
control risk for those audit objectives differently,
0:09:36.066,0:09:40.066
and tailor our audit approach accordingly.
0:09:40.066,0:09:43.000
Most of this stuff happens during audit planning
stage.
0:09:43.000,0:09:47.000
Now we get to either the interim fieldwork or
yearend fieldwork.
0:09:47.000,0:09:48.000
What happens now?
0:09:48.000,0:09:51.000
That’s right, we have to test the controls to
support our reliance.
0:09:51.000,0:09:56.066
For our system aging control, we could test the
control in a variety of ways.
0:09:56.066,0:10:00.033
We might manually reperform the aging analysis
ourselves.
0:10:00.033,0:10:06.033
Or we could process some dummy invoices with
different dates to test the aging algorithm in the
system.
0:10:06.033,0:10:11.066
To test segregation of duties, we could observe
the tasks being performed.
0:10:11.066,0:10:15.066
We could make inquiries about the performance
of these tasks throughout the period.
0:10:15.066,0:10:24.066
Again, these kind of feel like weak sources of
evidence to me in and of themselves, so we
should also look at a second key control to test.
0:10:24.066,0:10:30.000
We were going to test to ensure all receivables
actually existed by vouching them back to the
shipping documents.
0:10:30.000,0:10:34.066
So here, the test of control might be to take a
sample of sales invoices,
0:10:34.066,0:10:40.033
and ensuring that shipping documents are
attached signifying that the person who enters
the sales
0:10:40.033,0:10:44.033
has only entered sales only when they had
appropriate shipping evidence.
0:10:44.033,0:10:47.033
If our finding support our beliefs about control
risk,
0:10:47.033,0:10:49.066
then we will move on to perform our substantive
work.
0:10:49.066,0:10:56.000
Otherwise, we may need to return to the audit
plan and recalibrate our audit approach for any
surprise deficiencies noted.
0:10:56.000,0:11:03.000
Now, keep in mind, I’ve just picked out a small
sample of some of the work that an auditor
would actually perform for illustrative purposes.
0:11:03.000,0:11:10.066
In fact, while the amount of work performed is a
matter of auditor judgement, it is likely that if
you want to achieve a low control risk...
0:11:10.066,0:11:15.033
assessment, you will need to make damn sure
the controls are effectively working throughout
the period.
0:11:15.033,0:11:22.033
But hopefully, this is enough to give you an idea
as to what this looks like and then when you get
the opportunity,
0:11:22.033,0:11:29.033
you can apply this same thinking to all the audit
objectives of interest for the sales cycle and for
other cycles.
0:11:29.033,0:11:38.033
So before we go, let me just show you one form
out of the CICA Professional Enagement Manual
that could be used to document these findings.
0:12:51.066,0:12:53.033
So until next time,
0:12:53.033,0:12:55.033
don’t stop until you get to the top and when you
get to the top, don’t stop.