WRITTEN QUESTIONS

1. Following the above conference with Rogers, Abernethy asks Andrews to produce a

memo listing the potential problems that the firm might encounter in this audit. Prepare

this memo for the lakeside engagement. Include all accounts and transactions that seem

to require special attention. Evaluate the possible severity of each of these concerns.
2. Andrews was also assigned to visit the headquarters/warehouse of lakeside to tour the

facility. What should Andrews observe, and what factors should he be especially aware

of during this visit?

3. Prepare the auditor’s report that king and company rendered at the end of the 2018

engagement. How does this qualified opinion differ from a standard auditor’s report?
Answers:
1.

Fraud Risk Factors Auditor Follow-Up

Inventory Control/Value Auditors should be concerned with the

existence, value, recording, count and legal

claim to the inventory of the Lakeside

Company.
Inventory Returns Issue – Case Auditors should evaluate the size of the

mentions up to 20% of the inventory contingent liability present in the form of

items can be returned within four months inventory returns

Distribution Operations Auditors should look into the fact that

lakesides’ sales has reportedly increased

dramatically in the past two years; they need

to ensure that the sales are being recorded

correctly.
Account Receivable – Mentioned that all Auditors should investigate the value of the
distributorship sales are made on credit accounts receivable related to distribution and

ensure that accounts that are expected to be

received are indeed not doubtful.

Loan Issues – Lakeside has mentioned Auditors should analyze each loan agreement

outstanding loans so that they can assure that Lakeside is not in

breach of any contracts.

Internal Control – Lakeside Auditors should not only understand the

management admits that internal control current internal control system in place, but

is outdated determine how reliable the evidence it

produces will be.

6 Lakeside Company Store -
th
Auditor should be concerned about any

Predecessor auditor issued a qualified departures from GAAP so that the issues that

opinion from prior statements caused the preceding opinion are either

justified or are resolved.

Related Party Issues – Mentioned of Auditors should look into these transactions

business relationship between the to verify that they are clearly disclosed so that

Lakeside Company and the Company’s no independence issue exists or arises.

president
Profit-Sharing Incentive – Lakeside Auditors should be concerned that employees

Company has recently begun a profit- will take advantage of this system and find

sharing bonus system for firm ways to cut corners, rush procedures, or

performance otherwise find ways to either increase profits

or income without upholding to the quality of

work that existed before the bonus system

was initiated.
Rental Agreements - Five of the stores Auditors should have to read the various
have been leased and, apparently, agreements to see if any of them qualify as a

Store Seven will be rented from Rogers. capital lease under the criteria established by

the Financial Accounting Standards Board.

2. When visiting the lakeside facility, Andrews would need to assess the possibility of

fraud risk. He needs to take a close look at the inventory and pay close attention to the

previous audits that have been performed prior.

3. INDEPENDENT AUDITOR'S REPORT

To the Board of Directors of Lakeside Company

Report on the Audit of the Financial Statements

Qualified Opinion

We have audited the accompanying financial statements of the Lakeside Company, which

comprise the statement of financial position as at December 31, 1990, and the statement of

comprehensive income, statement of changes in equity and statement of cash flows for the

year then ended, and notes to the financial statements, including a summary of significant

accounting policies.

In our opinion, the accompanying financial statements present fairly, in all material

respects, the financial position of the Lakeside Company as at December 31, 1990, and its

financial performance and its cash flows for the year then ended in accordance with the

Philippine Financial Reporting Standards (PFRSs).

Basis for Qualified Opinion

During 1989, the Lakeside Company made a large investment in a retail store in the sixth

store. This store has failed to reach a break-even sales point to date, and total recovery of

the Company's investment is highly uncertain. In our opinion, the chances are reasonably

possible that the asset's value has been permanently impaired and should be reduced to the

net realizable value in conformity with generally accepted accounting principles.

Management of the company has refused to recognize this impairment loss.

We conducted our audit in accordance with Philippine Standards on Auditing (PSAs). Our

responsibilities under those standards are further described in the Auditor’s

Responsibilities for the Audit of the Financial Statements section of our report. We are

independent of the Company in accordance with the Code of Ethics for Professional

Accountants in the Philippines (Code of Ethics) together with the ethical requirements that

are relevant to our audit of the financial statements in the Philippines, and we have fulfilled

our ethical responsibilities in accordance with these requirements and the Code of Ethics.

We believe that our audit provides a reasonable basis for our opinion.

Responsibilities of Management and Those Charged with Governance for the

financial statements

Management is responsible for the preparation and fair presentation of the financial

statements in accordance with PFRSs, and for such internal control as management

determines is necessary to enable the preparation of financial statements that are free from

material misstatement, whether due to fraud or error.

In preparing the financial statements, management is responsible for assessing the

company’s ability to continue as going concern, disclosing, as applicable, matters related to

going concern and using the going concern basis of accounting unless management either

intends to liquidate the company or to cease operations or has no realistic alternative but to

do so.

Those charged with Governance are responsible for overseeing the company's financial

reporting process.

Auditor's Responsibilities for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether the financial statements

as a whole are free from material misstatement, whether due to fraud or error, and to issue

an auditor's report that includes our opinion. Reasonable assurance is a high level of

assurance but is not a guarantee that an audit conducted in accordance with PSAs will

detect a material misstatement when it exists. Misstatement can arise from fraud or error

and are considered material if, individually or in the aggregate, they could reasonably be

expected to influence the economic decisions of users taken on the basis of these financial

statements.

As part of an audit in accordance with PSAs, we exercise professional judgment and

maintain professional skepticism throughout the audit. We also:

 Identify and assess the risks of material misstatement of the financial statements,

whether due to fraud or error, design and perform audit procedures responsive to

those risks, and obtain audit evidence that is sufficient and appropriate to provide a

basis for our opinion. The risk of not detecting s material misstatement resulting

from fraud may involve collusion, forgery, intentional omissions, misrepresentation

or the override of internal control.

 Obtain an understanding of internal control relevant to the audit in order to design

audit procedures that are appropriate in the circumstances, but not for the purpose

of expressing an opinion on the effectiveness of the Company's internal control.

 Evaluate the appropriateness of accounting policies used and reasonableness of

accounting estimates and related disclosures made by the management.

 Conclude on the appropriateness of management's use of going concern basis of

accounting and based on the audit evidence obtained, whether a material

uncertainty exists related to events or conditions that may cast significant doubt on

the company's ability to continue as going concern. If we conclude that a material

uncertainty exists, we are required to draw attention in our auditor's report to the

related disclosures in the financial statements or, if such disclosures are inadequate,

to modify our opinion. Our conclusion are based in the audit evidence obtained up to

the date our auditor's report. However, future events or conditions may cause the

company to cease to continue as going concern.

 Evaluate the overall presentation, structure and content of the financial statements,

including the disclosures, and whether the financial statements represent the

underlying transactions and events in a manner that achieves fair presentation.

We communicate with those charged with governance regarding, among other matters, the

planned scope and timing of the audit and significant audit findings, including any

significant deficiencies in internal control that we identify during our audit.

Report on Other Legal and Regulatory Requirements

Our audits were conducted for the purpose of forming an opinion on the basic financial

statements taken as a whole. The supplementary information for the year ended December

31, 1990 required by the Bureau of internal revenue is presented for the purpose of

additional analysis and is not required part of the basic financial statements prepared in

accordance with PFRS. Such supplementary information has been subjected to the auditing

procedures applied in the audit of the basic financial statements and, in our opinion, is

fairly stated in all material respects in relation to the basic financial statements taken as a

whole.

William King, CPA

King and Company

Makati City, Philippines

January 31, 1991

WRITTEN QUESTIONS

1. Exhibits 2-1 and 2-2 are attached. From the information that has been presented in the

first two cases, complete these forms.

2. If the firm of Abernethy and Chapman does seek and receive this audit engagement, a

review will be made of the working papers produced by the predecessor auditor.

Prepare a list of the specific contents that should be examined. Indicate each area that

should be reviewed and the purpose of studying these particular working papers.
3. Assume that Abernethy and Chapman audit’s Lakeside’s 1991 financial statements and

gathers sufficient, competent evidence to render an unqualified opinion without any

mention of the uncertainty. Assume further that lakeside opts to issue comparative

statements showing figures for 1990 and 1991. Write a single audit report that will

inform the render of both opinions, as well as the examination made by the previous

auditors.
Answers:
1. See Exhibit 2-1 and 2-2
2. The Auditor has to assess and review the audit document prepared by the predecessor

auditor through series of steps. The goal is to examine the types of information that

would be available to an auditor in an ongoing engagement. Review of audit documents

prepared by predecessor auditor. Areas to be reviewed and the purpose of review:

Area that Should be Reviewed Purpose of Review

Proposed Adjusting Entries To determine the type and materiality of the

proposed adjustments.

Opening Balances in Accounts To ensure that the opening balances were

audited and that enough evidence was

 collected

Look Through Work Papers Regarding To evaluate if internal controls have any

Internal Controls weaknesses or if there are any areas that do

not have controls in place, as well as strong

controls that are in place

Understand accounting principles that To understand how Lakeside has consistently

Lakeside previously used recorded their accounts/ To ascertain the

specific accounting principles applied in the

previous fiscal year

Audit Results Understand what previous auditors found and

be wary of that information while moving

forward with the client. For example, the

“impairment of value” from the case

Documentation of Audit Planning To decide if the predecessor’s planning steps of

the audit were efficient or not, and then

compare their planning steps to those of

Abernethy and Chapman. This could save time

in the future while going through the audit and

make the audit more thorough

Contingencies To understand what King Company’s thoughts

and concerns of Lakeside’s contingency plan

were and use them for further insight when

Abernethy and Chapman look into the

 contingency plan / To review the analysis of

contingencies

Significant and Unusual Transactions Determine if Lakeside Company has any

unique transactions that could

3. INDEPENDENT AUDITOR'S REPORT

To the Board of Directors of Lakeside Company

Report on the Audit of the Financial Statements

Qualified Opinion

We have audited the accompanying financial statements of the Lakeside Company, which

comprise the statement of financial position as at December 31, 1990, and the statement of

comprehensive income, statement of changes in equity and statement of cash flows for the

year then ended, and notes to the financial statements, including a summary of significant

accounting policies.

In our opinion, the accompanying financial statements present fairly, in all material

respects, the financial position of the Lakeside Company as at December 31, 1990, and its

financial performance and its cash flows for the year then ended in accordance with the

Philippine Financial Reporting Standards (PFRSs).

Basis for Qualified Opinion

During 1989, the Lakeside Company made a large investment in a retail store in the sixth

store. This store has failed to reach a break-even sales point to date, and total recovery of

the Company's investment is highly uncertain. In our opinion, the chances are reasonably

possible that the asset's value has been permanently impaired and should be reduced to the

net realizable value in conformity with generally accepted accounting principles.

Management of the company has refused to recognize this impairment loss.

We conducted our audit in accordance with Philippine Standards on Auditing (PSAs). Our

responsibilities under those standards are further described in the Auditor’s

Responsibilities for the Audit of the Financial Statements section of our report. We are

independent of the Company in accordance with the Code of Ethics for Professional

Accountants in the Philippines (Code of Ethics) together with the ethical requirements that

are relevant to our audit of the financial statements in the Philippines, and we have fulfilled

our ethical responsibilities in accordance with these requirements and the Code of Ethics.

We believe that our audit provides a reasonable basis for our opinion.

Responsibilities of Management and Those Charged with Governance for the

financial statements

Management is responsible for the preparation and fair presentation of the financial

statements in accordance with PFRSs, and for such internal control as management

determines is necessary to enable the preparation of financial statements that are free from

material misstatement, whether due to fraud or error.

In preparing the financial statements, management is responsible for assessing the

company’s ability to continue as going concern, disclosing, as applicable, matters related to

going concern and using the going concern basis of accounting unless management either

intends to liquidate the company or to cease operations or has no realistic alternative but to

do so.

Those charged with Governance are responsible for overseeing the company's financial

reporting process.

Auditor's Responsibilities for the Audit of the Financial Statements

Our objectives are to obtain reasonable assurance about whether the financial statements

as a whole are free from material misstatement, whether due to fraud or error, and to issue

an auditor's report that includes our opinion. Reasonable assurance is a high level of

assurance but is not a guarantee that an audit conducted in accordance with PSAs will

detect a material misstatement when it exists. Misstatement can arise from fraud or error

and are considered material if, individually or in the aggregate, they could reasonably be

expected to influence the economic decisions of users taken on the basis of these financial

statements.

As part of an audit in accordance with PSAs, we exercise professional judgment and

maintain professional skepticism throughout the audit. We also:

 Identify and assess the risks of material misstatement of the financial statements,

whether due to fraud or error, design and perform audit procedures responsive to

those risks, and obtain audit evidence that is sufficient and appropriate to provide a

basis for our opinion. The risk of not detecting s material misstatement resulting

from fraud may involve collusion, forgery, intentional omissions, misrepresentation

or the override of internal control.

 Obtain an understanding of internal control relevant to the audit in order to design

audit procedures that are appropriate in the circumstances, but not for the purpose

of expressing an opinion on the effectiveness of the Company's internal control.

 Evaluate the appropriateness of accounting policies used and reasonableness of

accounting estimates and related disclosures made by the management.

 Conclude on the appropriateness of management's use of going concern basis of

accounting and based on the audit evidence obtained, whether a material

uncertainty exists related to events or conditions that may cast significant doubt on

the company's ability to continue as going concern. If we conclude that a material

uncertainty exists, we are required to draw attention in our auditor's report to the

related disclosures in the financial statements or, if such disclosures are inadequate,

to modify our opinion. Our conclusion are based in the audit evidence obtained up to

the date our auditor's report. However, future events or conditions may cause the

company to cease to continue as going concern.

 Evaluate the overall presentation, structure and content of the financial statements,

including the disclosures, and whether the financial statements represent the

underlying transactions and events in a manner that achieves fair presentation.

We communicate with those charged with governance regarding, among other matters, the

planned scope and timing of the audit and significant audit findings, including any

significant deficiencies in internal control that we identify during our audit.

Report on Other Legal and Regulatory Requirements

Our audits were conducted for the purpose of forming an opinion on the basic financial

statements taken as a whole. The supplementary information for the year ended December

31, 1990 required by the Bureau of internal revenue is presented for the purpose of

additional analysis and is not required part of the basic financial statements prepared in

accordance with PFRS. Such supplementary information has been subjected to the auditing

procedures applied in the audit of the basic financial statements and, in our opinion, is

fairly stated in all material respects in relation to the basic financial statements taken as a

whole.

Richard Abernethy, CPA

Abernethy and Chapman

Quezon City, Philippines

January 31, 1991

 Exhibit 2-1
Abernethy and Chapman

ANALYSIS OF POTENTIAL LEGAL LIABILITY

Potential Client: Lakeside Company

Type of Engagement: External Audit
Form Completed by: Dan Cline Date: June 15, 1991

1. Is the potential client privately-held or publicly held?

The potential client is privately held.
2. Evaluate the possible liability to the client that Abernethy and Chapman might incur if
the engagement is accepted.
The basic liability to the client is for losses occurring as a result of any firm negligence.
If Abernethy and Chapman perform the engagement as an average, no problem exists.
If not, the client may sue for return of its audit fee as well as any other resulting losses.
Moreover, the client company has a weak internal control therefore; fraud or
embezzlement can be increased. Proving this company innocent is difficult.
3. List the third parties that presently have a financial association with the potential client
and could be expected to see the financial association with the potential client and could
be expected to see the financial statements.
 Current Stockholders
 Cypress Products
 Two banks financing the inventory
 National Insurance Company of Virginia
4. Discuss the possibility that other third parties will be brought into a position where
they would be expected to see the financial statements of the potential client.
The financial statements could be presented to a potential stockholders or lender
because the Mr. Roger has expressed considerable interest in expansion.
5. Evaluate the possible liability to third parties, both present and potential, that
Abernethy and Chapman might incur if the engagement is accepted.
If the engagement is accepted, the CPA firm should have no liability to third parties
because it is privately held the business this audit firm does not fall under federal
security laws. In the Lakeside audit, the CPA firm should have no liability to third
parties unless the audit is performed in a grossly negligent manner or the firm is
negligently responsible for careless financial misrepresentations. In a few jurisdictions,
they may be held liable to foreseen or foreseeable beneficiaries for ordinary
negligence.
 Exhibit 2-2
Abernethy and Chapman

INFORMATION FROM PREDECESSOR AUDITOR

Potential Client: Lakeside Company

Form Completed By: Dan Cline
Predecessor Auditor: William King (King and Company)
Date of Interview: June 15, 1991

1. Discuss the predecessor auditor's evaluation of the integrity of the management of the
potential client.
Rogers and all of the members of his organization appear to be people of integrity
according to the King and Company.
2. Did the predecessor auditor reveal any disagreement with management as to
accounting principles, auditing procedures, or other similarity significant matters? If so,
fully describe these disagreements.
Rogers didn’t want his shareholders or the banks to know about the impairment of
value problem. He didn’t want to write down the reported value of the 6th store.
According to him, no real impairment existed even if it did the potential loss is not
material.
3. What was the predecessor auditor's understanding as to the reasons for the change in
auditors?
King and Company indicated that their qualified opinion in the audit report was the
reason that Lakeside Company wanted to seek a new independent auditor. Also, he
mentioned that Rogers always complained about the audit fees.
4. Did the predecessor auditor give any indication of other significant audit problems
associated with the potential client?
King and Company mentioned the Lakeside’s internal control system is outdated. An
ineffective internal control system will result in less reliable information and even
create opportunity for fraud with the failure of detection by an auditor. In addition,
King talked that Rogers do not understand an auditor’s work and is unwilling to spend
money. Without sufficient fees, A&C might face problem in their future auditing work
especially in Lakesides’ expansion.
5. Did the predecessor auditor indicate any problem in allowing Abernethy and Chapman
to review prior years working for the potential client? If yes explain.
King and Company stated that the audit documents could be reviewed.
6. Was the predecessor auditor's response limited in any way?
King and Company stated that no limitation was indicated.
WRITTEN QUESTIONS

1. 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 a memo and a

flowcharting format. By using both, staff members are able to achieve a better and a

quicker understanding of the design of each system.

Bases on Exhibit 3-4, Prepare a flowchart to provide a graphic display of this system.

Use the flowchart symbols that appear in Exhibit 3-3

Next analyze Exhibit 3-5, a flowchart representation of the cash receipts procedures,

and prepare a written memorandum to accompany and explain this particular system.
2. 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 nay particularly strong features that would reduce control risk. To

assist the auditor in evaluating a system, Abernethy and Chapman utilizes the form

presented in Exhibit 3-6. Complete this document based on the flowchart in Exhibit 3-5

representing the Cash Receipts section of the Revenue and Cash Receipts cycle. Be

especially careful to note any internal control weaknesses or strengths that may be

indicated.
3. Rogers has stated that he wants the auditing firm to help improve Lakeside’s accounting

systems. Exhibit 3-4 identifies the revenue recognition procedures currently used in

connection with distributorship sales. List improvements that could be made in this

system.

Exhibit 3-4
CLIENT COMPANY: Lakeside Company

SYSTEM: Revenue and Cash Receipts Cycle – Distributorship

MEMO PREPARATION: Horace Clarke – 12/02/88

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. The sales invoice is prepared in five copies with the last
three being retained 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 compares the sales invoice to the list of stores and their credit
limits. He also 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.

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 t1he 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. 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,
b.
the gross amount payable, the discount terms, and the due date.
CLIENT COMPANY: Lakeside Company

SYSTEM: Revenue and Cash Receipts Cycle – Distributorship

MEMO PREPARATION: Horace Clarke – 12/02/88

SYSTEM REVIEW AND UPDATE:

Part A - Revenue Recognition – Distributorship

Checks and invoice slip from customer are received by treasurer’s office where each check
is stamped “For Deposit Only”. Bank deposit slip in duplicate and four-part cash remittance
list indicating customer name, amount paid, and invoice number are prepared.

The checks and the bank deposit slips are taken to the bank. The checks and the bank
deposit slips are taken to the bank. The second deposit slip is validated and is returned to
the treasurer’s office to be placed along with the fourth cash remittance list in a permanent
file by date. The first validated bank deposit slip is returned by the bank to the Assistant to
president where it is placed in a temporary file by date.

The invoice slips and the first three copies of remittance list from the treasurer’s office are
sent to the sale’s division. Sales invoice 2 and the fourth copy of Bill of Lading were
originally filed by the sales division as the goods were shipped. The individual sales invoice
slips are matched with sales invoice and Bill of Lading. Appropriate discount calculated are
recorded on each copy of cash remittance list. Each invoice slips that are matched with the
appropriate sales invoice and Bill of Lading are placed in a permanent file by invoice
number. The third copy of the cash remittance list is placed in a permanent file by date.

The second cash remittance list is sent to the controller’s office where upon refuting of cash
receipts and sales discounts, journal entry is recorded in cash receipts journal. Ensuring,
the cash remittance list number two is placed in the permanent file by date.

The sales division sends the first copy of cash remittance list to the Assistant to the
President where its total is compared to the first validated bank deposit slip, individual
items are randomly reconciled and accounts receivable subsidiary ledger is updated before
being placed in a temporary file by date. After receiving the monthly bank statement, bank
reconciliation is prepared. The bank reconciliation, bank statement, validated deposit slip
and remittance slip are placed in a permanent file by date.

Exhibit 3-6
Abernethy and Chapman

INTERNAL CONTROL - PRELIMINARY ANALYSIS

CLIENT: Lakeside Company

SYSTEM: Revenue and Cash Receipts Cycle – Distributorship Cash Receipts
DATE: September 10, 1988
PREPARED BY: Dan Cline

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

 Invoice Slips (one copy per payment) - prepared internally but returned directly by
outside party. It is bottom portion of the number 4 copy of the sales invoice.
 Validated Bank Deposit Slips (two copies per day) – prepared internally but validated
by outside bank and mailed directly to the Assistant to the President.
 Cash Remittance List (four copies per day) - prepared internally.
 Sales Invoice (second copy) – prepared internally.
 Bill of Lading (only fourth copy is a part of this system) - prepared internally, two
copies sent to customer
 Bank Statement (one copy per month) – prepared externally.
 Bank Reconciliation (one copy per month) - prepared internally.

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 Each document within the system is
this system pre-numbered? numbered in order for better accessibility of
x
the report prepared.

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?
5. Is the record-keeping
function independent of
the custody function at all
points throughout the
All processes made by the team are based on
x standards and so authority and complete.
A number of the documents are reviewed
prior to the beginning of this system such as
x
the sales invoice and bill of lading.
In order for better performance and analysis
of the document. We used procedures to help
x
us complete the review of the documents.
x Records such as receipts and invoices are
provided with lots of copies for better keeping
of documents throughout the system.
 system?
6. Are all mathematical
computations
independently verified?
7. Does record-keeping begin
at the origin of the
transaction?
All computations are independently verified
except for the cash discount. The flowchart is
x unclear as to the procedures to be applied
when the sales division calculation does not
agree with the customer payment.
As stated in revenue and cash receipts cycle
presented by Lakeside Company, we can say
x that record-keeping began in the origin of the
transaction.

8. Are all transactions All transactions pass through different

authorized? departments and then assessed by the higher
x
management for authorization.

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

 Checks received are immediately stamped “For Deposit Only” right upon receipt
 Spot checking of cash remittance list totals and dates against blank statement

10. In the space below, indicate any other specific internal control weaknesses that appear
to be present in this system.
There might be a difficulty when it comes to locating invoices because these, along
with other related documents are permanently filed by invoice number in the sales division
rather than by customer name.

3. The improvements that could be made in Lakeside’s accounting systems are as follows:

 A signed receipt should be received as a proof of transfer when goods are shipped.
  Establish a separate accounts receivable department to monitor all changes in each

customer’s individual account and a separate credit department to investigate new

clients and set credit limits.

 A separate billing department should also be established to prepare the sales

invoices in ascertain their accuracy.

 In order to provide better control over the inventory being removed from the

company, Lakeside most have a separate shipping department.

 Rogers must be prohibited or other company personnel from giving credit except

under specified conditions.

 Lakeside Company should use a sales order form different from that of Sales Invoice.

Written Questions

1. Prepare a worksheet to indicate the analytical procedures that Mitchell should perform.

Use the information presented in Exhibits 4-1 through 4-5. Create this worksheet using
 three columns. In the first, indicate the procedure that is being applied. In the second,

note the results. In the final column, indicate the significance (if any) of the findings.
Answers:

Procedure Findings Significance

Scan the trial balance A debit balance appears in the Bad accounts may be increasing

Allowance for Doubtful or a debit entry may have been

Accounts misposted.
Determine age of Age as of 12/31/89 – 93.0 Increase in age may indicate that

inventory days. Age as of 12/31/90 – company is holding obsolete or

(inventory/cost of 100.5 days. unsalable inventory, or that the

goods sold/365) year-end cut-off was incorrect.

Scan the income The company's stores The serious effect of the losses

statement continue to report an overall will make the possibility that the

loss which is increasing in store will eventually

amount. discontinued.
Scan the balance sheet Nothing unusual
Scan the cash flow Cash flow from operations The cash flow problems,

statement declined significantly in combined with the solvency

problems may indicate a problem

with the company's ability to

continue as a going concern.

Scan the trial balance Something appears to be These fluctuations could indicate

wrong with the information recording errors or an employee

generated by Store Three. The attempting to inflate the earnings

sales for that store have being reported for Store Three.

increased by approximately This problem is more relevant

94% since the previous year. than might be encountered

 At the same time, the cost of normally because of the profit

the goods sold has dropped sharing bonus system that

from 58.5% of sales (which is rewards employees for reporting

consistent with the other high income figures.

stores) to only 50.3% of sales.

Also, the inventory held by

this store has risen by over

50%.
Scan the trial balance Sales Commissions for District Although not necessarily a

D in 1991 appear to be slightly material figure, the potential

out of line. All of the other error should be investigated so

commissions are that Lakeside can make the

approximately 5.7% of sales, appropriate corrections if

while this account is nearly needed.

6.7% of the applicable sales

figure.
Scan the trial balance Rent expense on vehicles and Such a decrease often serves to

equipment has decreased in indicate that the company has

1991. acquired new property.

Scan the trial balance The Repairs and Maintenance This significant increment may

account has increased by over indicate a posting error that will

156% since 1990. require correction. Conversely,

actual repairs may have been

made by Lakeside. In that

situation, the auditor needs to

 verify that all capitalized costs

have been segregated and

properly accounted for within the

company records.
Scan the trial balance The "Gain on Disposition of Often a company will fail to

Fixed Asset" balance of 14,000 remove the appropriate cost and

warrants investigation. related accumulated depreciation

when a plant asset is sold. The

auditor should also ascertain that

the current year depreciation

expense has been properly

recognized. Finally, the sale of an

asset can lead to the acquisition

of a new asset as a replacement.

The independent auditor should

follow up on this possibility to

assure that any replacement is

appropriately capitalized.
Scan the trial balance The Allowance for Doubtful The auditor should determine if

Accounts balance shows a the client has written off an

debit balance on September especially large group of

30, 1991, compared to a credit accounts. Perhaps bad debt

balance one year earlier. experience is changing and a

larger allowance is required.

Scan the trial balance The company's two bank The auditor should verify that no
 credit lines now have a total loan covenants have been broken.

balance that exceeds the In addition, because of disclosure

750,000 maximum that was requirements as well as the

indicated in an earlier case. effects on the interest expense

account, the auditors will need to

review any new borrowing

agreement.
Scan the trial balance The long-term notes payable The auditor should determine the

have increased by 50,000. The application of those funds as well

auditor would certainly be as the loan agreement signed by

interested in the application of the company.

those funds as well as the loan

agreement signed by the

company.
Scan the trial balance Sales returns have increased The auditors need to ascertain

significantly for both the the reasons for such an increase.

company stores and the Any change in the trend for sales

distributorship. returns would lead the auditors

to revaluate year-end accruals.

Scan the trial balance The equipment account shows If the company has acquired

an increase from the previous additional equipment during the

year. year, the auditor needs to verify

that capitalization and

depreciation were given proper

treatment.
Scan the trial balance The estimated bonus expense That increase is probably due to
 has increased. the profit-sharing plan having

been in effect for all nine months

of 1991, but the increase should

be investigated.

Written Questions

1. Exhibit 5-1 contains the questions that Mitchell is to answer concerning accounts

receivable control procedures. Using this case, as well as Exhibits 3-4 and 3-5,

complete this questionnaire.

2. Exhibit 5-2 is a portion of the audit program that Mitchell designed to test the

operating efficiency of controls in the revenue and cash receipts cycle. For each

individual test, indicate the anticipated results if the system is working properly.

Also, list the potential problems if the control is not functioning as designed.
 Exhibit 5-2
Abernethy and Chapman
TESTING OF TRANSACTIONS DETAILS AND CONTROLS
LAKESIDE COMPANY AUDIT EXAMINATION
REVENUE AND CASH RECEIPTS CYCLE

(1) From the invoice file in the Sales Division, select five invoices at random.*

(A) Compare the sales invoice with the sales invoice slip.
(B) Compare the sales invoice with the bill of lading.
(C) Trace the amount of the remittance to the cash remittance list filed in the
Controller’s Office.
(D)Recompute the appropriate discount and compare the discount taken according to
the cash remittance list.
(E) Verify the pricing of the invoice against an approved pricing list.
(F) Extend and foot each invoice.
(G) Trace the amount of the remittance to the validated bank deposit slip filed in the
office of the Assistant to the President.
(H)Trace the amount of the remittance to the Account Receivable Subsidiary Ledger.
(I) Verify that each has been initialed by an appropriate official to indicate credit
approval

(2) From the Accounts Receivable Subsidiary Ledger, select three accounts at random. For
each of these accounts, choose one debit entry and one credit entry.

For each debit entry:

(A) Trace the amount to the sales invoice filed in the Sales Division and compare the
amounts.
 For each credit entry:
(A) Trace the amount to the cash remittance list filed in the Controller’s Office.
(B) Trace the amount to the validated bank deposit slip filed in the Treasurer’s Office.

(3) Select 10 customers on the approved customer list and verify that a credit report is on
file and properly completed.

(4) Select two cash remittance lists at random. Foot the list and compare the total to the
posting in the Cash Receipts Journal.

Note: Sample sizes in practice would normally be larger than indicated here. Sample sizes have been kept small so
they will be more manageable.
Abernethy and Chapman
TESTING OF TRANSACTIONS DETAILS AND CONTROLS
LAKESIDE COMPANY AUDIT EXAMINATION
REVENUE AND CASH RECEIPTS CYCLE

Step Anticipated Results Potential Problem(s)

1-A Total sales invoice together with sales There are misstated in recording the sales,
invoice slip should have the same this happen when the invoices do not
amount. It should be indicate that they agree. Employees do not comply with the
made comparisons. systems requirements.

1-B Sales invoice and bill of landing should
have the same amount. The employees
must leave there initials as it serve to
be the proof of the test and there
should be prior comparison.
When the sales and bill of landing are
having different balances it notifies the
auditor that there are inventory have been
shipped or there are records that have
incorrect amounts or incorrect inventory.

1-C There must be consistency in invoices Anyone in the company may have been
of the cash remittance list and the cash engaged in lapping or commit theft
that receive. In addition, for the
purpose of control procedures,
company should encourage its
customer to contain in the invoice slip
the amount of payment.
1-D Calculated cash discounts should be
identical with the amounts recorded by
the client company. In most cases, this
calculated discount figure will be equal
to the difference between the sales
invoice total and the cash remittance.
Discounts may be incorrectly recorded to
hide cash shortages or as a step in stealing
cash funds from the company. Also, the
company may be allowing customers to
take discounts that have not actually been
earned. Allowing these reductions would
indicate lack of efficiency in internal
control.

1-E The approved price list should be
follow in pricing the customers and it
should be the base of the entire price in
the invoice.
Sales income is overstated because of the
improper pricing and the customers may
pay wrong amounts. Because the invoice
price don’t less the discounts. Employees
may receive kickbacks because the invoice
price is too high.

1-F The extensions and footings on the Wrong amounts may be paid by customers.
invoice should be correct. Improper footings or extensions, either
intentionally or unintentionally, also leads
to incorrect sales and receivables figures
on the financial statements.

1-G The bank deposited slip and the Test that has been done notifies the
amount received should have the same auditor of the chance that there is lapping
amount and the date of payment and because of the difference on cash receipts
deposit should be the same. it can point out the theft.

1-H All cash remittances should be Since the subsidiary ledger is not well
recorded promptly as credits to the controlled in the Lakeside organization,
specific subsidiary ledger accounts. this procedure may be used to determine
the possibility of errors within the ledger.
This test also may indicate lapping as well
as other manipulations of the accounts so
as to conceal cash shortages.
1-I Each invoice should be initialed by Because the credit system is not well
either Rogers or Miller to indicate documented, the auditor will be searching
credit approval. for evidence that sales can be made
without credit approval. Such evidence
would have an effect on the auditor's
judgment as to the amount of evidence
needed in examining the allowance
account and bad debt expense.

2-A There should be a proper sales invoice The company prepare all sales invoice with
in accordance with each debit entry. other documents internally, the employees
can made up the sales. This test can notify
the auditor to any misinterpretation of the
sales.

2-B Cash remittance list and each credit Employees may commit lapping; tracing
should be the same as to amount can refer to errors in postings within the
depending on the method of posting system.
and probability time of payment.

2-C Bank deposit slips and each specific This test can possibly uncover the
account that is credited should be the employee’s attempts to cover shortage of
same. cash or lapping.

3 Company’s file should contain entire Auditory can find additional evidences
and updated credit reports on the concerning the collectability and validity
individual customers. company’s receivable if the reports they
have are incomplete. Credit reports are
very important in putting a proper credit-
granting system because it shows that the
company’s control is efficiently operating.

4 The total amount and the date must be Two cash remittance are the cash thefts
the same in the balance that is and cash shortages this two are often have
recorded in the cash receipts journal mistake in footing the listing of cash
and it should be correct. transactions.