Auditing: Effective Internal Control

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Test Three – Out of Class Portion

Due Monday, April 30, 2012
1. Listed below are four interbank cash transfers, indicated by the letters a, b, c and d, of a client for late December 20X1, and early January 20X2. Your answer choice for the next two questions should be selected from this list.


For each of transfers a through d indicate whether cash is understated, unaffected, or overstated by the transfer and provide a brief example of what could cause the situation in which cash is either understated or overstated.  a. Unaffected.

b. Unaffected.
c. Understated. Although there are a number of possible situations, one is that in which a check is written on the disbursing bank on the last day of December with a credit to cash, and an associated debit to some expense account so as to decrease reported profits (and taxes) for the year. d. Overstated. One situation is that in which an employee has misappropriated funds during the year, and draw a check transferring funds to the account with the shortage so as to cover the shortage. As of December 31, the shortage is replaced, with no reduction as yet recorded in the account on which it is drawn.

2. Since financial investments are assets with a high degree of inherent risk, companies must establish effective internal control over their investments.

a. Describe the functions that should be segregated to provide good internal control over financial investments. b. Describe two other internal control policies that should be established for financial investments.  a. The functions that should be segregated with respect to financial investments are:

1. Authorization of purchases and sales,
2. Custody of the securities, and
3. Maintaining records of investments.

b. Other internal controls include (only two required):

Establishing formal investment policies.
Maintaining a complete detailed record of investments and revenue from investments. Registration of securities in the name of the company.
Periodic physical inspection.
Joint control over securities, or use of an independent custodian. Preparation of a budget of investment revenue.
Determination of appropriate accounting by competent personnel.

3. Confirmation of accounts receivable is presumptively mandatory audit procedure. In performing this procedure, auditors use positive confirmation requests or negative confirmation requests or a combination of both.

a. Describe three conditions which should exist for the auditors to use the negative form of request. b. If a response is not received to an initial positive confirmation request, describe the action that should be taken by the auditors, including a discussion of alternative auditing procedures.  a. Audit tasks requiring specialized skill or knowledge (only three required):

Identifying controls at service organizations that provide financial services for the client. Obtaining an understanding of information systems for securities and derivatives that are highly dependent on computer technology. Applying complex accounting principles.

Understanding the methods of determining fair values of financial investments'. Assessing inherent risk and control risk for assertions about derivatives used for hedging.

b. Derivatives are financial instruments that "derive" their value form other financial instruments, underlying assets, or indices.

c. Clients engage in financial derivative transactions for two major purposes:

Hedging--to hedge changes in value of an existing asset or liability or of a prospective future transaction. Speculating--to bet on the change in value of another financial instrument, an asset, or an index.

4. Internal control over sales transactions is very important to the effectiveness of an organization.

a. For effective control over credit sales, describe four major functions that should be segregated. b. In addition to adequate segregation of duties, describe two...
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