ASSESSING CONTROL RISK

The Lakeside Company: Auditing Cases

4. ASSESSING CONTROL RISK

The CPA firm of Abernethy and Chapman was hired during the summer of 2012 to audit the financial statements of the Lakeside Company for the year ending December 31, 2012. Even though the year-end was nearly six months away, the firm began its preparation almost immediately.

Wallace Andrews, a manager, and Art Heyman, a staff accountant, both with Abernethy and Chapman, spent a number of days doing preliminary analyses at Lakeside’s headquarters. During this time, they also visited King and Company to review the audit documentation created during previous audits. Andrews and Heyman were looking for information that would assist in the assessments of both inherent risk and control risk.

In looking at the predecessor auditors’ documentation, Heyman was assigned to study the permanent file to learn more about the various accounting systems and internal control features that were in place at the Lakeside Company. While examining these documents, Heyman discovered an organization chart that King and Company had drawn to represent the client’s internal control (see Exhibit 4-1). He also found the symbols used by the previous auditors in flowcharting the company’s various systems (see Exhibit 4-2).

Heyman next came to a section of the permanent file entitled “Revenue and Cash Receipts Cycle—Distributorship.” Apparently, two people performed this portion of the audit work originally. The “Revenue Recognition” function had been described in narrative form (see Exhibit 4-3); whereas, the “Cash Receipts” section of the company was captured in flowchart form (see Exhibit 4-4). Heyman analyzed both of these systems in detail to familiarize himself with the organization and operations of the Lakeside Company.

After finishing the initial investigation of Lakeside, Andrews and Heyman held a discussion with Dan Cline, the audit partner who had been placed in charge of the actual engagement. This group met to discuss their understanding of the client’s internal control, a procedure necessary for audit planning purposes. They wanted to make a preliminary assessment of control risk, which is the auditor’s expectation that a material misstatement would not be prevented or detected on a timely basis by Lakeside’s internal control.

The auditor’s evaluation of control risk has a significant impact on the nature, timing, and extent of substantive auditing procedures. Thus, this assessment is made early in the examination. For example, if the auditors assume the maximum control risk, then the auditors will likely perform more extensive substantive tests using more

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experienced personnel. Conversely, if control risk is judged to be below the maximum level, the auditor may reduce the overall audit time and effort. However, to justify a lower assessment of control risk, additional tests of the controls are necessary. After identifying specific client policies and procedures that could prevent material misstatements, the auditors have to verify both the design of these controls and their effectiveness.

As part of the preliminary assessment of control risk, the auditor must come to an understanding of the five components of internal control. To focus attention on the five areas, Cline posed several questions to Andrews and Heyman:

∗ Has Lakeside established the proper environment for strong internal control? Is management aware of the importance of internal control? Does management work to ensure that internal control is constantly functioning in an appropriate fashion?

∗ Does the company have a risk assessment policy that identifies and analyzes relevant risks to achievement of its objectives? Does it have a policy for determining how these risks should be managed?

∗ Has the company established control activities, policies, and procedures such as the use of adequate documents? Do transactions have to be authorized? Are duties properly segregated to prevent irregularities?

∗ Are the company’s information and communication systems appropriately designed in order to allow for the proper identification, capture, and exchange of information in a form and time frame that enable people to carry out their responsibilities?

∗ Does the company have a process that monitors the quality of internal control performance over time?

DISCUSSION QUESTIONS

(1) What kinds of information should Andrews and Heyman have gathered during the preliminary stage of this audit in order to answer Cline’s questions about the internal control? What sources are available to the auditors to help understand the client’s internal control and assess its control risk?

(2) From the information provided to this point (including Exhibits 4-3 and 4-4), what answers can be given to Cline’s questions? Mention the strengths as well as any weaknesses that have been found that will have a bearing on the auditor’s assessment of control risk.

(3) After a preliminary assessment has been made of Lakeside’s control risk, what possible actions can be taken by the auditors?

(4) If the preliminary assessment of control risk indicates that the risk may be below the maximum level and that assessment would reduce overall audit time and effort, then the auditor must test those controls further to determine the appropriateness of

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(5) (1) (2)

their design and effectiveness. How is this testing of controls carried out in an audit?

While evaluating an internal control system, the auditor may discover a personal problem which can lead to a dysfunction in the system. For example, assume that when Art Heyman, the staff auditor, is sitting at Ms. Luck’s desk, he sees a picture of Stan Wisdon. In addition, she volunteers that “a recent trip to Las Vegas with Stan” was a disaster. “Stan, who can barely pay his bills as it is, shouldn’t have lost all that money. He is going to have to sell his car, I guess.” What should Art Heyman do in this situation? Discuss the auditor’s options.

EXERCISES

To gain an understanding of the client’s present accounting systems, the firm of Abernethy and Chapman has a policy that all systems must be recorded in either a memo (i.e., narrative) format or a flowchart format. By using these formats, staff members are able to achieve a more effective and a more efficient understanding of the design of each system.

2. a) Based on Exhibit 4-3 (a memo explanation of the Revenue Recognition section of the Revenue and Cash Receipts cycle), prepare a flowchart to provide a graphic display of this Use the flowchart symbols that appear in Exhibit 4-2. [Case4-1a.doc or CASE4.xls]
3. b) Analyze Exhibit 4-4 (a flowchart representation of the Cash Receipts procedures), and prepare a written memorandum to accompany and explain this particular That is, convert the flowchart to a narrative description. [Case4-1b.doc]

At the firm of Abernethy and Chapman, after the memo and flowchart have been prepared, a preliminary analysis is made of the internal control policies and procedures found in the system. The auditor is searching for weaknesses within the structure of the system as well as any particularly strong features that would reduce control risk. [Case4-2.doc].

5. a) To assist the auditor in evaluating a system, Abernethy and Chapman utilizes the internal control questionnaire presented in Exhibit 4-5. Complete this document based on the flowchart in Exhibit 4-4, representing the Cash Receipts section of the Revenue and Cash Receipts
6. b) Abernethy and Chapman use a Control Matrix to establish the existence of controls related to each audit Complete the Control Risk Matrix in

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Exhibit 4-6. Be especially careful to note any internal control weaknesses or strengths that may be indicated. The first item has been completed for you.

(3) Rogers has stated that he wants the auditing firm to help improve Lakeside’s accounting systems. Exhibit 4-3 identifies the revenue recognition procedures currently used in connection with distributorship sales. List the improvements that could be made to this system. [Case4-3.doc]

APPLY YOUR RESEARCH

Use library resources such as searchable databases to research the following topic.

(1) Assume that an auditing firm has assessed the control risk of a new client to be below the maximum. Write a report describing the factors that could have led to this judgment. Also, indicate the various effects that this evaluation could have on the audit testing process, including tests of controls and substantive tests.

CONSULTING PARTNER REVIEW

Bob Zimmerman, the consulting partner on the Lakeside engagement, is concerned about the following issues and would like for you to respond to them. The audio clips are available online at www.prenhall.com/arens.

(1) Documenting the auditor’s understanding of a system.

(2)	Are tests of controls really necessary? THE IMPACT OF SARBANES-OXLEY

(1) Lakeside’s consideration of an initial public offering would require significant changes in Lakeside’s organizational structure and governance, including the structure and operation of the board of directors and the need to assess the functioning of the company’s internal control systems. Discuss these topics and make specific recommendations to Lakeside.

(2) Discuss the assessment of control risk for audit clients that are public companies. If Lakeside were to become a public company, what impact would that have on Abernethy and Chapman’s assessment of Lakeside’s control risk and the evaluation of internal control?

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Representative District A

Representative District B

Representative District C

Representative District D

Representative District E

Representative District F

Bob Short Assistant

Brendan Davis Treasurer

Jan Luck Assistant

S.A. Sweet Accountant

Mark Hayes Controller

S. Wisdon Assistant

Warehouse Crew

Maintenance Staff

Edward Thomas Vice President Inventory

Exhibit 4-1

Lakeside Company

Organization Chart

Benjamin Rogers

President

Assistant to the

George Miller

President

Carol Howell

Vice President

Sales

C.A. Land Assistant

Manager Store 1

Manager Store 2

Manager Store 3

Manager Store 4

Manager Store 5

Manager Store 6

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Manual Operation

Off-page Connector

Flow Lines

Exhibit 4-2

King and Company

Manual System

STANDARD FLOWCHART SYMBOLS

Terminal Document

Permanent File Temporary File Decision

On-page Connector

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Exhibit 4-3

CLIENT COMPANY: Lakeside Company

SYSTEM: Revenue and Cash Receipts Cycle – Distributorship MEMO PREPARATION: Horace Clarke – December 2, 2011 SYSTEM REVIEW AND UPDATE:

Part A – Revenue Recognition – Distributorship

All distributorship sales are made by telephone. Either the customer or a Lakeside representative calls in each order. The Sales Division immediately records the incoming data on a prenumbered invoice, which serves initially as a sales order form. This document is prepared in five copies, with the last three being retained by the Sales Division in a temporary file by invoice number. The first copy is sent to Stan Wisdon, in the Inventory Department, who verifies the availability of the purchased items. If the merchandise is in the warehouse, it can be sent out almost immediately. However, if any items must be ordered from Cypress, the waiting time may be as long as three weeks. Wisdon estimates the ship-out date, completes and initials the sales invoice, and returns it to the Sales Division.

The second copy of the sales invoice goes to George Miller, assistant to the president. Miller maintains the accounts receivable subsidiary ledger. He also keeps a list of approved customers with maximum credit limits. However, acceptance of new customers and changes in available credit are decisions made solely by Mr. Rogers, the president. Before approving any sale, Miller checks the current age of the customer’s accounts receivable balance. If the store is on the approved list, is under the credit limitation, and has no overdue balances, Miller initials the sales invoice and returns it to the Sales Division. If, for any reason, Miller cannot approve the sale, the invoice is forwarded to Rogers, who reviews all pertinent information. He then makes a final decision as to whether to accept or reject the order. Rogers indicates his decision on the invoice and forwards it to the Sales Division. If the order is rejected, the customer is contacted and all copies of the sales invoice are attached and placed in a permanent file by invoice number.

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Exhibit 4-3 (Continued)

For approved orders, the Sales Division matches all five copies of the sales invoice. The approximate shipping date is indicated on the fifth copy and mailed to the customer as a confirmation. The first copy is initialed by C. A. Land in the Sales Division and returned to Wisdon in the Inventory Department as approval for making the shipment. The other three copies of the sales invoice are stamped “Approved” and remain in the Sales Division in a temporary file by invoice number.

Upon receiving the approved sales invoice, the Inventory Department packs and ships the merchandise, and Wisdon prepares a five-copy bill of lading. One copy is included with the shipment, while the second copy is mailed to the customer. The third copy is routed to the Controller’s Office. The fourth copy of the bill of lading goes to the Sales Division, with the final copy being retained by the Inventory Department. It is stapled to the first copy of the sales invoice and placed in a permanent file, by bill of lading number.

When the third copy of the bill of lading is received by Ms. Luck in the Controller’s Office, the quantity of inventory, its description, the bill of lading number, and the date of shipment are recorded in an inventory sales journal. Having entered the appropriate information, Luck places the bill of lading in a temporary file by sales invoice number, which has been manually recorded on the document. Lakeside uses the services of an outside computer center to maintain a perpetual inventory record. At the end of each week, Luck forwards information on all sales and purchases to the center, which then processes the data and returns updated records to the company.

When the fourth copy of the bill of lading is received in the Sales Division, Land matches it with the three approved copies of the sales invoice. He compares the quantity and description of the order with the items that were shipped. If they agree, he prices each sale from an updated price list that is maintained by the Sales Division. The sales invoices are then extended, footed, and the due date is added. The fourth copy of the bill of lading is attached to the second copy of the sales invoice and filed in a temporary file by due date. The third copy of the approved sales invoice is sent to Miller, assistant to the president, while the fourth copy goes to the Controller’s Office. Miller uses his copy to update the accounts receivable subsidiary ledger and then files the sales invoice in a permanent file by customer name. The Controller’s Office matches the sales invoice to the bill of lading, verifies the pricing against an updated price list, and mathematically checks the extensions and footings.

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Exhibit 4-3 (Continued)

The sales invoice is then recorded in the Sales Journal as a debit to Accounts Receivable and a credit to Sales. Sales figures are also classified by geographic district so that commissions can be appropriately accrued. Lakeside representatives receive a percentage of every sale made within a specified territory. After the sale is recorded, the bill of lading is placed in a permanent file by customer name. The controller then mails the sales invoice to inform the customer of the amount payable, the due date, and the discount terms. According to the invoice, payment should be made by check (payable to “Lakeside Company”). The customer is also asked to return the bottom portion of the sales invoice, which indicates the customer’s name, the sales invoice number, the gross amount payable, the discount terms, and the due date.

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PF-12 Prepared JCD Reviewed JVB Reviewed EVK

9/10/12 11/11/12 12/10/12

Controller’s Office

Sales Division

Treasurer’s Office

Assistant to President

Deposit Slip 2 Deposit Slip 1 Check

Invoice Slip Check

Note A

4 3 2

Remittance List Invoice Slip

To Bank

Remittance List 4

To Sales

Date

Validated Deposit Slip 1

Remittance List

From Sales

Note C

Accts Rec. Subs. Ledger

Date

Note E

Remittance List Bank Statement Deposit Slip 1 Bank Reconciliation

From Bank

Bank Statement

3 2 Remittan ceList Invoice Slip

Due Date

Validated Deposit Slip 1

Bill of Lading 4

Sales Invoice 2

Note B

Remittance List 2

Note D

Cash Receipts Journal

Remittance List 2

Date

Date

3 2 Remittance List 1

Date

Bill of Lading 4 Sales Invoice 2 Invoice Slip

Inv. No.

From Customer

From Sales

To Asst.

To Contr.

From Treas.

Exhibit 4-4

Client: Lakeside Company

System: Revenue and Cash Disbursements Cycle – Distributorship Cash Receipts

Notes

From Treas.

1. Stamp each check “For Deposit Only,” prepare bank deposit slip in duplicate and four-part cash remittance list indicating customer name, amount paid and invoice number.
2. Match the individual sales invoice slips with sales invoice and bill of lading. Calculate appropriate discount and record on each copy of cash remittance list.
3. Compare bank deposit slip total to cash remittance list total. Randomly reconcile individual items. Update accounts receivable subsidiary ledger.
4. Refoot cash receipts and sales discounts. Record journal entry in cash receipts journal.
5. Prepare monthly bank reconciliation. Spot check cash remittance list totals and dates against bank statement.

To Asst.

Date

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Exhibit 4-5

Abernethy and Chapman INTERNAL CONTROL – PRELIMINARY ANALYSIS

CLIENT:  SYSTEM: DATE: PREPARED BY:

_____ ____ ____

List each document found in this system, the number of copies, and whether it is prepared internally or externally.

Answer each of the following questions. For each “No” answer, comment on whether an internal control weakness is indicated.

QUESTION	YES	NO	COMMENT
(1) Is each document within this system pres numbered?
(2) Is the authority for completing each document clearly delineated?
(3) Are all documents subsequently reviewed by an independent party within the company?
(4) Are appropriate procedures clearly spelled out for completing and reviewing each document?

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	In the space below, indicate any other specific internal control features that have been built into this system.

QUESTION	YES	NO	COMMENT
(5) Is the record( keeping function independent of the custody function at all points throughout the system?
(6) Are all mathematical computations independently verified?
(7) Does record( keeping begin at the origin of the transaction?
(8) Are all transactions authorized?

(9)

(10) In the space below, indicate any other specific internal control weaknesses that appear to be present in this system.

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Exhibit 4-6

Abernethy and Chapman

INTERNAL CONTROL – Control Risk Matrix – Revenue Cycle Client: Lakeside

Internal Control		Revenue Transaction-Related Audit Objectives
	Sales orders recorded on preS numbered forms.		L
	Assessed Control Risk

H = high risk, M = moderate risk, L = low risk

Note: Each deficiency needs to be evaluated by identifying compensating controls, potential misstatements, materiality, and the effect on audit evidence.