LESSON 2:

TEST OF CONTROLS
AND SUBSTANTIVE
TESTS FOR
ACCOUNTING CYCLES
Transaction Cycles

Transaction Cycles are the means through which an

accounting system processed transactions of related
activities such as sale of goods to customers, acquisition of
merchandise and payment to vendors, production of finished
products for sale, and payment to employees for services
they had rendered.
A transaction is an agreement between two entities to
exchange goods or services or any other event that can be
measured in economic terms by an organization.

2
Categories of Transaction Cycles

 Revenue and receipt

 Expenditure and disbursement
 Human resources and payroll
 Production or conversion
 Financing and investing

3
Audit by Transaction Cycles

 Auditing by transaction cycle allows the auditor to find

evidence on Related Accounts, Transactions and
Disclosures all at the same time. This makes auditing
efficient.
 The biggest audit concern for overstatement and
understatement is - company overstates revenue and
assets, and understates expenses and liabilities.
 Segregation of duties reduces the risk of overstatement.
 Auditors are required to obtain an understanding of
internal controls in relation to the transaction cycles and
4
document that understanding.
 LESSON 2.1:
TEST OF CONTROLS
AND SUBSTANTIVE
TESTS FOR REVENUE
CYCLE
Revenue and Receipt Cycle

Business Functions
 Resources are distributed to customers in exchange for
promises of future payments
 Customers pay cash for resources distributed to them
Accounts Affected
 Sales and the related sales returns, allowances and discount
 Receivable, allowances for bad debts and bad debts expense
 Cash

6
Revenue and Receipt Cycle

Departments Involve
Revenue
 Sales or customers order
 Credit
 Inventory control or warehouse
 Shipping
 Billing
 Accounting (inventory, receivable and general)
Receipt
 Receiving, mail room or receptionist
 Treasury
 Accounting (receivable and general)
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Revenue and Receipt Cycle

Form Description Initiated by: Distributed to:

Sales order (order slip, Contains the details of goods Sales  Customer
customer order) ordered (quantity, prices and Department  Credit
payment terms)  Shipping
 Billing
Shipping document (bill Describes the goods to be Shipping  Carrier
of lading or delivery shipped and serves as contract Department  Customer
receipt) between the entity and carrier  Billing
Sales invoice Describes the goods sold, amount Billing  Customers
(billing statement) due and the terms of payment. Department  Accounting

Remittance advice Intended to facilitate the Billing  Customers

accounting for cash collection Department
Daily summaries Summarizes transactions Receivable,  Receivable
recorded during the day by the Treasury, Mail
different department Room
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Revenue and Receipt Cycle -
Assertions
Assertions Audit Objectives Audit Procedures
Existence and • To determine that 1. Review the sales journal, general ledger and
occurrence recorded sales are accounts receivable master file or trial
Rights and authorized and are for balance for large or unusual items.
Obligations shipments actually 2. Trace sales journal entries to copies of sales
made to non-fictitious orders, sales invoices, and shipping
customers. documents.
• To determine that the 3. Trace shipping documents to entry of
recorded receipts shipments perpetual inventory record.
represent actual 4. Compare prices on sales invoices with
collections of cash from authorized price lists or properly executed
customers. contracts.
5. For a sample of entries in cash receipts
journal, trace to the pre-listing of cash
receipts and to remittance advice. For
sample of entries, reconcile daily deposit to
validated deposit slip.
9
Revenue and Receipt Cycle -
Assertions
Assertions Audit Objectives Audit Procedures
Completeness • To determine that 1. Trace shipping documents to sales invoices
existing sales and entry into sales journal and account
transactions are receivable master file.
recorded on a timely 2. Compare dates of recorded sales
basis. transactions with dates on shipping records
• To determine that all or perform sales cut-off tests.
receipts of cash and 3. For a sample of days, verify that all cash
checks are recoded. receipts are recorded by reconciling daily
listing(s) of cash receipts and validated
deposit slip to cash receipts journal.

10
Revenue and Receipt Cycle -
Assertions
Assertions Audit Objectives Audit Procedures
Valuation or • To determine that 1. Re-compute information on sales invoices
allocation recorded sales are for 2. Trace entries in sales journal to sales
the amount of goods invoices.
shipped and are 3. Trace details on sales invoices to shipping
correctly billed and documents, price tests and customer’s
recorded. orders.
• To determine that 4. For a sample of entries in cash receipts
debits to cash and journal, examine remittance advice and
credits to accounts verify that the discount taken was
receivable are valued appropriate. Foot accounts receivable
at amounts received. subsidiary ledger and reconcile to the
general ledger.

11
Revenue and Receipt Cycle -
Assertions
Assertions Audit Objectives Audit Procedures
Presentation and • To determine that 1. Examine documents supporting sales
Disclosure sales transactions are transactions for proper classification.
properly classified 2. Review account coding for a sample of
• To determine that cash entries in the cash receipts journal.
receipts are recorded
to result in
presentation and
disclosure in
accordance with
PAS/PFRS.

12
Test of Controls for Sales and
Receivables
Department Control Procedures Sample TOC Procedures
Order and Credit 1. Prepare prenumbered sales order  Inquire about credit procedure for
2. Perform credit investigation new customers.
3. Approve credit for returns  From a population of approved
4. Initiate write-offs to be approved sales order and returns, select a
by the treasurer sample and examine documents
5. Follow-up on old and past-due for evidence of credit check.
accounts

13
Test of Controls for Sales and
Receivables
Department Control Procedures Sample TOC Procedures
Warehouse and 1. Receive approved sales order  Observe warehouse personnel
Shipping from credit department. filling sales orders.
2. Pull inventory from warehouse  Observe physical controls over
and release to shipping. inventory
3. Perform independent check of  Observe evidence of independent
goods received from warehouse checks
and approved sales order in
shipping number
4. Prepare prenumbered delivery  Inspect a sample of prenumbered
receipt or bill of lading. shipping documents and agree to
sales order and account for
prenumbering.

14
Test of Controls for Sales and
Receivables
Department Control Procedures Sample TOC Procedures
Billing and 1. Match shipping documents and  Vouching a sample of sales
Accounts sales orders before preparing. invoices to shipping documents
Receivable and approved sales orders.
 Trace a sample of shipping
documents to sales invoice and
sales journal and A/R master file.
2. Periodically account for all  Observe procedure. Test a sample
prenumbered shipping period.
documents.
3. Perform independent check of  Reperform pricing check from a
sales order pricing. sample of sales invoices check
pricing with master price list.

15
Test of Controls for Sales and
Receivables
Department Control Procedures Sample TOC Procedures
Billing and 4. Prepare prenumbered sales  Observe procedure and
Accounts invoice. reperform.
Receivable 5. Batch and total invoices.
6. Update A/R master file. Agree
input to invoice batch totals.
7. Print sales journal.
8. Print sales summary. Agree to
invoice batch totals
9. Mail monthly customer  Observe mailing.
statements.

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Test of Controls for Sales and
Receivables
Department Control Procedures Sample TOC Procedures
Accounting 1. Receive sales summary.  Observe and reperform.
2. Perform independent check of
invoice batch totals and sales
summary.
3. Review sales account
classifications.
4. Post to GL
5. Follow-up customer exceptions.  Inspect customer exception file
and disposition.
SEGREGATION OF DUTIES
 Authorization – Sales Order and Credit, Treasure
 Record keeping – Billing, A/R, Accounting
 Custody – Warehouse and Shipping

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Test of Controls for Cash Receipts

Department Control Procedures Sample TOC Procedures

Mailroom/ 1. Separate checks and remittance  Inspect checks prior to deposit for
Receiving advices. endorsement.
2. Stamp restrictive endorsement on  Observe preparation of prelisting.
checks.
3. Prepare prelisting of checks
received.
4. Forward checks to cashier.
Forward remittance advices to
A/R. Forward prelisting to
Accounting.
Cashier 1. Receive checks and prepare  Observe preparation of cash
deposit. summary.
2. Prepare daily cash summary,
copy to A/R and Accounting.
3. Deliver checks to bank.
4. File validated deposit slip.  Inspect deposit slip and compare
18
to cash summary.
Test of Controls for Cash Receipts

Department Control Procedures Sample TOC Procedures

Accounts 1. Match remittance advices and  Observe procedure.
Receivable check deposit summary.
2. Update A/R master file.
3. Print CR journal/Updated A/R
Master file.
4. Print CR summary, copy to
Accounting.
Accounting 1. Compare cash summary from  Inspect evidence of independent
cashier, the prelisting of checks check.
from mailroom and the CR  Reperform independent check for
summary from A/R. selected date.
2. Post GL  Inspect bank reconciliation.
3. Prepare bank reconciliation
SEGREGATION OF DUTIES:
 Record keeping – Accounting and A/R
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 Custody – Mailroom and Cashier (Treasurer)
 LESSON 2.2:
TEST OF CONTROLS
AND SUBSTANTIVE
TESTS FOR
EXPENDITURE CYCLE
Expenditure and Disbursement Cycle

Business Functions
 Resources are acquired from vendors in exchange for
obligations to pay
 Entity pays cash to vendors and employees
Accounts Affected
 Purchases, purchases returns, allowances and discount
 Payables
 Cash
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Expenditure and Disbursement Cycle

Departments Involve
Expenditure
 User (any department within the entity)
 Purchasing
 Receiving
 Accounts payable
 Accounting (Inventory and General)
Disbursement
 Treasury
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 Accounting (payable and general)
Expenditure and Disbursement Cycle

Form Description Initiated by: Distributed to:

Requisition slip Contains the details of User  Purchasing
(purchase requisition) the user department’s request. Department
Purchase order Described the goods to be Purchasing  Vendor
acquired (quantity and Department  User
description)  Receiving
 Accounts
payable
Receiving report Describe the goods received Receiving  Purchasing
(quantity description and Department  Accounts
condition) payable

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Expenditure and Disbursement Cycle

Form Description Initiated by: Distributed to:

Shipping Describe the goods to be shipped Vendor ( thru  Receiving
document and serves as contract between the carrier) Department
the entity and carrier.
Vendors Invoice Describes the goods sold, amount Vendor  Accounts
due and the terms of payment. payable
Daily summaries Summarizes transactions Accounts  General
recorded during the day by the payable (for Accounting
different department. purchases)
Treasury (for
payment)

25
Expenditure and Disbursement Cycle
- Assertions
Assertions Audit Objectives Audit Procedures
Existence and • To determine that 1. Examine underlying documents for
occurrence recorded purchases authenticity and reasonableness.
are for items that were 2. Scan voucher register for large or unusual
acquired. items.
• To determine that 3. Inspect acquired property, plant and
recorded cash equipment.
disbursements 4. Trace inventory purchased to perpetual
occurred. records.
5. Scan voucher register for duplicate
payments
6. Examine paid checks for appropriate
endorsements
7. Examine document underlying payment.

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Expenditure and Disbursement Cycle
- Assertions
Assertions Audit Objectives Audit Procedures
Completeness • To determine that 1. Trace a sequence of receiving reports to
purchases that entries in the voucher register.
occurred are recorded. 2. Test cut-off.
• To determine that all 3. Account for a sequence of entries in the
cash disbursements voucher register.
made are recorded 4. Reconcile cash disbursements per books
with cash disbursements per bank.
5. Prepare or test bank reconciliation.
Rights and • To determine that 1. Trace from invoices to perpetual inventory
Obligations purchases are the records.
entity’s acquisitions and 2. Examine vendor’s invoices to determine that
liabilities. goods were purchased.
• To determine that all 3. Examine underlying documents.
cash disbursements
made were the entity’s
obligations.
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Expenditure and Disbursement Cycle
- Assertions
Assertions Audit Objectives Audit Procedures
Valuation and • To determine that 1. Recompute the invoices and compare
Allocation purchases are invoice price to purchase order.
recorded for the proper 2. Recalculate invoices paid.
amounts.
• To determine that
debits to various
accounts and credits to
cash are valued at
proper amounts
Presentation and To determine that Check accuracy of accounts on invoices by
Disclosure purchases and cash reference to chart of accounts.
disbursements are
recorded to result in
presentation and
disclosure in accordance
with PAS/PFRS
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Test of Controls for Expenditure and
Payables
Department Control Procedures Sample TOC Procedures
Requisitioner 1. Prepare prenumbered requisition.  Inspect requisition for proper
2. Obtain approvals. approval.
3. Send original copy to purchasing.  Observe procedures to account
4. Inspect goods when received for prenumbering.
from receiving department. Sign
receiving report upon receipt of
goods.
Purchasing 1. Received approved requisition.  Inspect purchase orders for
2. Contact approved vendors approved requisition.
3. Issued prenumbered purchase  Observe procedures to account
order: for prenumbering.
• Original to vendor
• Blind copy to receiving
• Copy to A/P
• File Copy

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Test of Controls for Expenditure and
Payables
Department Control Procedures Sample TOC Procedures
Receiving 1. Receive goods from vendor  Inspect receiving report and
2. Inspect goods. All shipments matching PO.
received must have a PO.
3. Prepare receiving report.
4. Match details of order received  Observe performance by
with blind copy of PO and receiving clerk.
indicate quantity received.
5. Send goods to requisitioning  Inspect receiving report for signed
department. Obtain signature on receipts.
receiving report that requisitioner
received goods.
6. Distribute receiving report:  Trace a sample of receiving
 Original to A/P reports to PO, requisition, invoice
 Copy to Purchasing and entry in the purchase journal
 File Copy. and A/P master file.

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Test of Controls for Expenditure and
Payables
Department Control Procedures Sample TOC Procedures
Accounts Payable 1. Receive vendor’s invoice.  Inspect vouchers for supporting
2. Match the documents: vendor’s documents and evidence of
invoice, receiving report, PO, independent checks.
requisition.  Observe procedure, reperform.
3. Check the mathematical  Vouch a sample of vouchers to all
accuracy, approvals, GL account required supporting documents.
coding.  Observe evidence of independent
4. Prepare prenumbered voucher. check, reperform.
5. Account for the numerical
sequence of vouchers.
6. Data entry:
 Prepare purchase journal
 Update A/P master file
 Daily purchase summary
7. Reconcile daily purchase
summary totals and daily entries
31 to purchase journal.
Test of Controls for Expenditure and
Payables
Department Control Procedures Sample TOC Procedures
Accounting 1. Receive purchase summary.  Observe evidence of independent
2. Post to GL check; reperform.
3. Reconcile GL and A/P file.
4. Reconcile vendor’s monthly
statements and A/P master file.
SEGREGATION OF DUTIES:
Authorization – Purchasing and Requisitioning Dept.
Record keeping – A/P and Accounting
Custody - Receiving

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Test of Controls for Disbursements

Department Control Procedures Sample TOC Procedures

Accounts Payable 1. Pull voucher at due date and  Compare debits to accounts
send to Treasurer for payment. payable to property cancelled
2. Received cancelled voucher and voucher packages.
supporting documents from  Trace from cancelled voucher
Treasurer. packages to cash disbursement
3. Receive check summary from journal entries.
Treasurer for data entry.  Vouch cash disbursement journal
4. Date Entry: entries back to cancelled
 Update A/P Masterfile. vouchers packages.
 Print Cash disbursements
journal

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Test of Controls for Disbursements

Department Control Procedures Sample TOC Procedures

Treasurer 1. Receive voucher for payment.  Observe performance of
2. Review document for independent checks.
completeness and approvals.  Observe accounting for sequence.
3. Prepare prenumbered checks.  Inquire about procedure, observe.
4. Prepare check summary.  Select checks for testing and
5. Sign checks by authorized inspect signatures.
signatory and cancel voucher and  Observe cancellation of checks by
supporting documents. check signer.
6. Mail check to vendor.  Inquire about procedure. Observe
7. Forward cancelled voucher, performance.
supporting documents to
Accounts Payable.
8. Send copy of check summary:
 Accounts Payable
 Accounting

34
Test of Controls for Disbursements

Department Control Procedures Sample TOC Procedures

Accounting 1. Received check summary.  Observe procedure and
2. Post to GL reperform.
3. Perform independent check of  Inspect bank reconciliation.
totals per check summary and
amounts journalized and posted
by A/P.
4. Perform periodic independent
bank reconciliation.
SEGREGATION OF DUTIES:
Authorization – A/P
Record keeping – Accounting
Custody – Treasurer

35
 LESSON 2.3:
TEST OF CONTROLS
AND SUBSTANTIVE
TESTS FOR HUMAN
RESOURCE AND
PAYROLL CYCLE
Human Resource and Payroll Cycle

Business Functions
 Services are received from employees in exchange for
obligations to pay
 Entity pays cash to employees
Accounts Affected
 Salaries and wages expense and payable
 Premiums expense and payable
 Withholding taxes payable
 Cash
37
Human Resource and Payroll Cycle

Departments Involve
Expenditure
 User (any department within the entity)
 Human resources (HR) or personnel
 Payroll
 Accounting (Inventory and General)
Disbursement
 Treasury
 Accounting (payable and general)
38
Human Resource and Payroll Cycle

Form Description Initiated by: Distributed to:

HR records It contains all information related Human  Payroll (limited
(Personnel records or to entity’s employees from time Resources to payroll
201 file) they are hired up to their eventual Department related
termination. It documents all information
actions taken by the employees or only)
management on behalf of an
employee. Commonly, it also
documents salary rates
deductions, and other payroll
related information.
Daily Time Describes the number of hours User  Payroll
Record (DTR) worked by an employee during a Department
particular day covered by a pay
period.

39
Human Resource and Payroll Cycle

Form Description Initiated by: Distributed to:

Payroll register Shows all related payroll Payroll  Treasury
information (gross payroll  General
deduction, and net pay) for each Accounting
pay period
Labor cost Shows payroll information which Payroll  General
summary is capitalize or can be attributed to Accounting
a particular job or customer order
Employee Show the cumulative, year- Payroll  Accounts
Earnings Record to-date summary of earnings and Payable
deductions of every employees
Daily summaries Summarizes transactions Payroll  General
recorded during the day by day Accounting
different department.

40
Summary of Functions of
User Department
Activities Possible Controls
Monitor and approves daily time records Common controls adopted by different entities
Note: However, due to introduction of in this department include:
computerized human resources system records • Appropriate review activities shall be made
are commonly tracked through biometrics and to ensure the validity of daily time records
access devices. prepared by employees.
• In case of computerized systems, approval
of any exceptions shall be made by the user
department head.

41
Summary of Functions of
HR Department
Activities Possible Controls
1. Initiates, updates and maintains Common controls adopted by different entities
2. HR records. in this department include:
3. Forward payroll related information to • Access including initiating changes to HR
payroll department (e.g. salary and wage records shall be limited only to the HR
rates, bonuses, department.
4. overtime pays, and payroll deductions) • Information not relevant to payroll calculation
5. Determines terms and settlement (lump sum shall not be shared to other departments.
or installment) or in case of termination of
employee/s.
6. Immediately notify payroll department of
terminated employee to avoid inclusions of
these employees in the subsequent payroll
calculations.

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Summary of Functions of
Payroll Department
Activities Possible Controls
1. Receives and reviews relevant payroll Common controls adopted by different entities
related information from HR and user in this department include:
department. • Appropriate level of management (preferably
2. Consider any update on employees pay a member who is not involved in payroll
rates and preparation)
3. deduction. • To assure adequacy of segregation of duties,
4. Prepares payroll register. payroll department should be segregated
5. Updates cumulative employee earning from HR Treasury and some user
record. department.
6. Identifies and submits to inventory
accounting capitalizable payroll in case of
servicing and manufacturing companies with
inventoriable labor cost.

43
Summary of Functions of
Treasury Department
Activities Possible Controls
1. Reviews payroll register received. Common controls adopted by different entities
2. Prepares check and have it signed by in this department include:
authorized signatories. • Separate bank account should be
3. Distributes checks to employees. maintained exclusively for payroll
4. Prepares daily summary which is to be disbursement.
forwarded to general accounting. • On a surprise basis, an employee’s
Note: Most companies disburse payroll though independent from payroll and user
bank fund transfer from company’s payroll department may distributes paychecks. The
account. purpose of this is to identify whether or not
In this case, the treasury department should be fictitious employees exist.
the one authorizing the bank transfer. • Unclaimed payroll checks shall be re-
deposited to the bank.

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Summary of Functions of
Accounting Department

Inventory: Records inventoriable labor costs to appropriate

jobs or customers account and forward a daily summary to
general accounting.
General: Reviews daily summaries and documents received
from Payroll, Treasury, and Inventory departments. It records
the recognition of payroll related expenses and liabilities in
the general journal.

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 LESSON 2.4:
TEST OF CONTROLS
AND SUBSTANTIVE
TESTS FOR
PRODUCTION AND
CONVERSION CYCLE
Production and Conversion Cycle

 Production or conversion cycle covers the production of

entity’s product for sale. It is where materials, labor and
overhead are converted into finished goods.
 The primary objective of this cycle is the proper valuation
of inventories and cost of goods sold.

47
Production and Conversion Cycle
Segregation of Duties
Person/s assigned to perform the
Procedures performed by auditor.
function
Custody
1. Physical custody of materials and labor • Auditor observes physical count and
documents is normally held by the reconciles the result of such count to entity’s
production department. records.
2. Since most of the assets here are highly • If held by other parties, auditor may send
susceptible to theft and misappropriation, confirmation requests to the custodian. (e.g.
adequate physical controls must be consignees, agents or branches.)
implemented.

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Production and Conversion Cycle
Segregation of Duties
Person/s assigned to perform the
Procedures performed by auditor.
function
Authorization
1. The production department is authorized to • Auditor reviews production orders and
make normal production runs. related documents supporting production
2. However, in case of special runs (to meet a runs made by the department to determine
special order), authorization must come whether it bears the necessary authorization.
from the board of directors or its authorized
representative.
Record
1. Transactions are recorded by the cost • Auditor normally reviews the
accounting. Daily summaries are then o Competency of the individuals making
prepared and forwarded to general journal entries.
accounting for recording and posting in the o Reconciliation of the general ledger.
general journal and ledger, respectively.

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 LESSON 2.5:
TEST OF CONTROLS
AND SUBSTANTIVE
TESTS FOR
FINANCING AND
INVESTING CYCLE
Financing Cycle

Existence or Occurrence and Rights and Obligations

 Issuance of long-term notes, bonds, and share capitals are made in
accordance with BOD’s authorizations and legal requirements and
proceeds are promptly deposited intact.
 Payments of bond interest and cash dividends are made to proper
payees in accordance with BODs or management authorizations.
 Redemption and reacquisition of bonds and share capital
transactions are executed in accordance with BODs authorization.
 Cancellation of notes when they are paid to avoid double payment.
 Recorded balances are periodically verified with bondholders and
51 shareholders.
Financing Cycle

Completeness, Valuation or Allocation and Presentation and

Disclosures
 Transactions and events are correctly recorded as to amount,
classification and accounting Period.
 Transactions are promptly and correctly posted to individual
accounts.

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Investing Cycle

Existence or Occurrence and Rights and Obligations

 Sales and purchases of PPE, securities and intangibles are made in
accordance with management’s authorization.
 Dividend and interest checks from investment are promptly
deposited.
 Access to PPE, securities and intangibles are restricted to
authorized personnel.
 Recorded balances are compared with the existing assets at
reasonable intervals.

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Investing Cycle

Completeness, Valuation or Allocation and Presentation and

Disclosures
 Transactions and events are correctly recorded as to amount,
classification and accounting Period.
 Transactions are promptly and correctly posted to individual
accounts.

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THANK YOU!

© Practical Auditing Textbook and IFRS-Based Exercises

Patricia M. Empleo, 2021 Edition
© Auditing Assurance Concepts and Application
Ma. Elenita Balatbat-Cabrera, Gilbert Anthony B. Cabrera and
Bernadette Ann B. Cabrera (2022 Edition)
All rights reserved.