Applying the Audit Process: Controls, Risk, and Procedures

Introduction to the Audit Objectives Framework

The audit process is structured around clearly defined objectives that guide the auditor in evaluating whether financial transactions are recorded accurately and completely. For the sales and collection cycle, the six transaction-related audit objectives are existence, completeness, accuracy, timing, classification, and posting and summarization. Each objective requires specific internal controls and corresponding audit procedures.

The following internal controls correspond to each of the six transaction-related audit objectives over sales:

Internal Controls for Each Transaction-Related Objective

Existence: Pre-numbered sales invoices are made in duplicate, and duplicate copies along with supporting customer orders and bills of lading are stored in an easily retrievable electronic file. Duties are segregated so that sales recording and authorization are performed by different clerks in the order and credit departments.

Completeness: Pre-numbered documents — including sales order forms, invoices, and bills of lading — are available in sequence.

Accuracy: An approved commodity price list is available for use by billing staff, and invoice totals are calculated with the help of computer software to ensure accuracy in generated invoices.

Classification: Transactions are accurately classified in the respective journals and ledgers.

Timing: There is a clear sequence of shipping documents, dates match, and all entries are properly recorded.

Posting and Summarization: The accounts receivable master file and the general ledger are reconciled and subjected to regular internal audits.

For each internal control identified above, the following tests of controls verify whether the control operates effectively in practice:

Existence: Check whether pre-numbered sales invoice duplicates are supported by customer orders and bills of lading. Verify that duties are segregated so that sales recording and authorization are performed by different employees.

Tests of Controls and Substantive Tests of Transactions

Completeness: Check whether pre-numbered shipping documents — including invoices and bills of lading — are available in sequence and are all used and accounted for.

Accuracy: Check whether the approved commodity price list is accurate, with clear information on allowable discounts, and whether totals are calculated using computer software to ensure accuracy.

Classification: Check whether transactions are accurately classified in the respective ledgers and journals.

Timing: Check whether there is a clear sequence of shipping documents and whether dates match and are properly recorded.

Posting and Summarization: Check whether the accounts receivable master file and the general ledger are properly reconciled.

For each transaction-related objective, the following substantive tests of transactions are appropriate given the internal controls in place:

Existence: The auditor (i) traces sales journal entries to the corresponding shipping documents to check whether there are recorded sales that were not shipped; (ii) examines cancelled shipping documents to check for sales records that may have been made more than once; and (iii) checks the degree of segregation of duties to verify that the people recording sales are not the same ones authorizing them, minimizing the risk of sales to fictitious persons.

Completeness: The auditor checks for potential misstatements by tracing customer orders to the corresponding sales invoices and tracing entries in the sales journal to the accounts receivable master file and general journal.

Accuracy: A fundamental test is to examine sales journal entries and compare the totals of selected transactions with the total postings to the accounts receivable master files and general journal.

Classification: The auditor examines duplicate sales invoices to check whether cash and credit sales are classified in their proper accounts. This would reveal misstatements such as sales of operating assets wrongly classified as sales revenue rather than recorded in the general journal.

Timing: A fundamental test is to compare the dates when a sale is recorded in the sales journal to the date on the bill of lading and sales invoice. Billing should occur when ownership is transferred to the customer.

Posting and Summarization: The auditor verifies and cross-verifies the sales journal against the totals posted in the general ledger using audit software to check for accuracy and consistency.

Client Business Risk and Acceptable Audit Risk

Existence
Internal Controls: Pre-numbered sales invoice duplicates are available, supported by customer orders and bills of lading. Duties are segregated so that sales recording and authorization are performed by different clerks in the order and credit departments.
Substantive Tests: (i) Trace sales journal entries to corresponding shipping documents to check whether there are recorded sales that were not shipped. (ii) Examine cancelled shipping documents to check for sales records that may have been made more than once. (iii) Verify segregation of duties.

Completeness
Internal Controls: Pre-numbered documents — including sales order forms, invoices, and bills of lading — are available in sequence and are all used and accounted for.
Substantive Tests: Trace customer orders to the corresponding invoices and entries in the sales journal to the accounts receivable master file and general journal.

Accuracy
Internal Controls: An approved commodity price list is accurate. Invoice totals are calculated with the help of computer software to ensure accuracy.
Substantive Tests: Examine sales journal entries and compare the totals of selected transactions with the total postings to the accounts receivable master files and general journal.

Classification
Internal Controls: Transactions are accurately classified in the respective journals and ledgers.
Substantive Tests: Examine duplicate sales invoices to check whether cash and credit sales are classified in their proper accounts.

Timing
Internal Controls: There is a clear sequence of shipping documents; dates match and are properly recorded.
Substantive Tests: Compare the dates when sales are recorded in the sales journal to the dates on the bill of lading and sales invoice.

Posting and Summarization
Internal Controls: The accounts receivable master file and the general ledger are reconciled and subjected to regular internal audits.
Substantive Tests: Verify and cross-verify the sales journal against the totals posted in the general ledger using audit software to check for accuracy and consistency.

Business risk is the risk resulting from significant conditions, circumstances, events, or actions that may affect the client's business (IFAC, 2010). Several factors influence Smalltown Regional Hospital's business risk.

First, the client has several large loans payable to local banks that are reluctant to extend more credit. This creates a heightened risk of revenue overstatement as management attempts to present the hospital as a going concern in order to secure additional financing. Second, a modern hospital is under construction in the nearby city, raising serious questions about the client's long-term sustainability. Third, the hospital faces a threat to its revenue streams: it relies on county support to make up deficits, but the county has reported its own deficits over the past year due to high unemployment. Finally, the client faces reputational and operational risk from deficient record-keeping.

Given the hospital's significant business risk and the fact that previous audits have revealed misstatements, the auditor should apply a low acceptable audit risk — meaning greater assurance must be obtained before issuing an opinion.