- 15 Marks
Question
Reliable Limited is into wholesale and retail supply and distribution of stationeries to companies and educational institutions. The company maintains business relationships with other enterprises that are owned by close friends and relatives. The books of account of the company were kept manually and in simple Excel. The company had only a staff member in the accounts department since it is a small business operation.
A review of the company’s operations shows that inventory of stationeries purchased was not properly valued due to incomplete recording of purchases made. Although bank statements are obtained, the balances on the bank statements were not reconciled with the cash book.
Cash from sales made was not banked intact, and expenses relating to cash takings from the till were not all recorded or properly monitored. Added to this, goods bought from related parties were sometimes overvalued as suppliers made frivolous claims which could not be disputed due to poor record keeping. The Managing Director and owner of the company has been sick for some time, and the wife concentrated more on her own business, leaving the operations of the company to a relation who is not well educated. Available evidence revealed that invoices and vouchers of the company were approved without management review, and the procedure or selection of suppliers was not transparent.
The company has just won a contract for the supply of stationeries in one of the states in the Federation, and it was found that there was inadequate cash flow to execute the contract. The manager of the company informed the Managing Director’s wife of the development, and it was agreed that a bank loan would be needed. On approaching the bank, updated financial statements of the company were requested to determine the financial health of the business and ability to repay the loan when due.
Your firm has been appointed as auditors of the company with a stipulated deadline to complete the audit so that the company could meet the bank’s conditions. The firm has conducted a preliminary review of the operations of the company, and some control gaps have been noted.
Required:
a. Discuss suitable control activities that will be required in the above scenario and how you will assess the degree of effectiveness of the internal control systems.
(10 Marks)
b. Identify and explain what the external auditors are expected to do during the course of the above audit.
(5 Marks)
Total: 15 Marks
Answer
a. Suitable control activities and the assessment of its degree of effectiveness include:
- Authorisation Controls: All significant transactions must be authorised by a manager at an appropriate level within the organisation.
- Physical Controls Over Assets: These controls are essential for safeguarding assets from unauthorised use, theft, or damage. An example is limiting access to inventory areas to a restricted number of authorised personnel.
- Arithmetic Controls: Checks on the arithmetical accuracy of processing. For instance, verifying supplier invoices to ensure the payable amount has been calculated correctly.
- Accounting Controls: These controls ensure the accuracy or completeness of records within accounting procedures, such as using control account reconciliations to verify the accuracy of trade receivables or payables totals.
- Management Controls: Controls applied by management, including the supervision of subordinates, review of performance, and control reporting, which may involve management accounting techniques like standards setting, variance analysis, and budgetary control.
- Segregation of Duties: Dividing work between individuals so that the tasks of one individual check those of another, reducing the risk of error or fraud.
The effectiveness of the internal control system depends on two factors:
- Design of the Internal Control System: This examines if the control system can prevent or detect and correct material misstatements. It considers whether internal controls appear adequate and effective “on paper.”
- Implementation of Controls: Controls must be implemented properly to be effective. This involves determining if the controls are properly operated by management and other employees.
Based on this evaluation, the auditor can assess control risk, which may lead to:
- A high control risk assessment, where the auditor would likely choose a substantive testing approach rather than a systems-based approach, focusing on detailed testing of transactions and balances.
- A low control risk assessment, where the auditor must be confident in both the design and practical operation of the controls to perform a systems-based audit. This involves carrying out tests of controls to ensure reliability.
b. In the course of the audit, ISA 315 requires the auditors to:
- Gain an Understanding of the five components of the client’s internal control system.
- Document Relevant Features of the control systems.
- Consider Relevance to the Audit: Note that not all financial reporting controls are relevant to the audit; this is based on the auditor’s professional judgement.
- Confirm Understanding by performing walk-through procedures for each major transaction type (e.g., sales, purchases, payroll).
- Conduct Walk-Through Testing: This involves selecting a small sample of transactions and tracing them through various processing stages to verify understanding of the process.
- Assess Effectiveness of Controls: Determine to what extent the auditor can rely on these controls for the audit purposes.
- Topic: Internal Audit and Corporate Governance
- Series: NOV 2023
- Uploader: Dotse