Question

SECTION C Case Study (Total 20 marks)
Assessing Control Risks
(A) Kumud Pty Ltd is a major manufacturer of industrial machinery. Detailed below is a
description of its purchasing and payments system.
(i) When the stores department requires items to be purchased, they issue a three-part prenumbered
purchase requisition that needs to be approved by the store’s manager. Copy 1
is sent to the purchasing department, Copy 2 is sent to the accounts payable department
and Copy 3 is filed in the stores department.
(ii) On receipt of an approved purchase requisition, the purchasing department issues a fivepart
pre-numbered purchase order. Copy 1 is sent to the supplier, Copies 2 and 3 are
forwarded to the receiving department, Copy 4 is forwarded to the accounts payable
department and Copy 5 is filed in the purchasing department.
(iii) When goods are received, the receiving department logs in the shipment by stamping
“order received” on its two copies of the purchase order, which then forms its receiving
record. One copy of the receiving record is filed in the receiving department and the other
is forwarded to the accounts payable department.
(iv) The accounts payable department checks that there is a purchase requisition, purchase
order and receiving record for each supplier invoice and then approves it for payment.
(v) The accounts payable department prepares a pre-numbered disbursement voucher and
forwards it along with the supplier’s invoice, purchase requisition, purchase order and
receiving record to the financial accountant.
(vi) The financial accountant prepares a cheque for each supplier, signs the cheque and
records it in the cash disbursements journal. The cheque is immediately mailed to the
supplier. Supporting documentation is returned to accounts payable for filing.
(vii) At the end of the month, the assistant accountant undertakes a sequence check of all
accountable forms. The financial accountant receives the monthly bank statement,
prepares a bank reconciliation and investigates any reconciling items.
11
Required:
(a) Identify any five (5) internal control weaknesses in Kumud’s internal control concerning
the purchases and payments functions. Explain why each one is a weakness.

(b) Explain the process the auditor can use in assessing control risks. ( 3 marks)
(c) What will be your assessment of internal controls relating to Kumud’s purchases and
payments system?

(B) You are the audit senior on the audit of Action Games Ltd (AGL), a large retailer of
computer games. Although each sale is of relatively low value, the company has a very high
sales volume. You have just completed your review of AGL's internal controls over sales for
your audit for the year ended 30 June 2015. Based on your review, you have concluded that
AGL's internal control over sales is excellent. As a result, you have suggested an audit strategy
for sales of extensive testing of the controls and, if they prove to be effective, relying solely on
those controls to gain reasonable assurance that the sales information is fairly stated. However,
your audit manager has asked you whether you have considered the inherent limitations of
internal control in designing your audit strategy.
Required:
(a) Explain the audit manager’s concern.
(b) What would be a more appropriate audit strategy? Justify your answer.

Answer 1

Answers:-

1. ) Assessing internal control risks of Kumud Pty Ltd:-

1. Weakness in internal control:-

1. No checking of receiving department:- There is no checking over the no. of the quantity actually received by the receiving department. Purchasing officer, as well as Payable manager solely, relies on the receiving manager regarding of quantity received.

2. No Quality check:- Though purchase requisition has been made and approved, there is no direct communication link between the receiving department and production department. There is no inspection of the quality received.

3. No counter inspection of invoice:- Since the invoice is directly received by the payable department, which is endorsed to financial accountant based under a pre-numbered disbursement voucher. There no checking of invoice by purchasing department regarding the description and quality of items ordered.

4. No monthly comparison Credit ledger and control accounts:-  There is no monthly or weekly comparison of payment ledger and control accounts. This lead stuck task at the closing time. No procedure has been put in to detect fraud caused by management.

5. No appropriate evidenced to evaluate whether the internal check has been conducted:- Internal check is conducted to early determining accounting error or frauds.

2. The process to assess control risk:-

Control Risk:- Control risk is the risk that material error or misstatement cant be detected or prevented by entity internal control on a timely basis.

Assessment of control risk is much of professional judgment. The auditor should:-

- Identify the misstatement that could occur and level of control risk:-

For determination of the level of control risk, he should adopt risk assessment procedures (inquiries, analytics, walk-through test, etc.). base upon his result of risk assessment procedures, how should cast rating to the overall control risk.

The rating can be at High level or Low level.

- Perform test to control:-

Test of control is performed to evaluate the operating effectiveness of the entity’s internal control and to decide nature, time and extent of his substantive audit procedures.

If Control Risk (CR) is high, internal control can’t be considered as effective and requires more substantive audit procedures by the auditors.

If Control Risk(CR) is low, internal control can be termed as operating effectively and the auditor can cast normal substantive audit procedures.

Level of Control Risk (CR)	Assertion regarding internal control (IC)
High level	Internal control (IC) is not operating effectively, the auditor should perform more substantive audit procedures.
Low level	Internal control (IC) is operating effectively, the auditor can perform general audit procedures.

3. Our assessment of internal control of KUMUD PTY LTD:-

Though kumud pty ltd has put in place internal control regarding purchase and payment cycle, it had restricted internal communication between different horizontal level. More emphasis has been put in place on the discretion of departmental head.

And also there is more hierarchy of business model then requires. There are more expenses over stationery include in the different head which can be controlled.

It can merged purchase department with receipt department and convert the payroll department to a subdivision of the finance department.

Leading to more accurate handling of purchasing, receipt, and quality.

2. Assessing internal control of Action Games Ltd.:-

a.) Inherent Limitation of Internal control:-

Costly Benefit Analysis:- Generally management considered that the cost of internal control does not exceed the expected benefits to be derived.

Human Error of unusual nature:- These controls are potential for human error, such as, due to carelessness, distraction, mistakes of judgment and misunderstanding of instructions.

Collusion among employees:-The possibility collusion among employees or with parties outside the entity can't be denied.

Abuse of responsibility:- The possibility that a person responsible for exercising an internal control could abuse that responsibility, for example, a member of management overriding an internal control.

Judgment and integrity of Management:- Manipulations by management with respect to transactions or estimates and judgments required in the preparation of financial statements.

b.) Strategy for appropriate audit:-

Though there might be an inherent limitation, since as per test of control, internal controls are operating effectively, we should perform substantiate audit procedures related to a transaction with related parties and do one or more following audit techniques.

- Analytical tools

- Inspection

- re-computation

- re-performance

- Observations

- Risk assessment procedures etc.