Thursday, November 4, 2010

Internal Control: Concepts (Reviewer in Auditing Theory)

Internal Control: Concepts


1. The basic concept of internal control which recognizes that the cost of internal control should not exceed the benefits expected to be derived is known as

a. Management by exception. b. Management responsibility. c. Limited liability. d. Reasonable assurance.


2. Of the following control environment characteristics, identify the one that contributes most to effective internal control

a. The audit committee consists of the president, two vice- presidents, and the corporate controller.

b. The company does not have a centralized human resources function.

c. The company has an effective internal audit staff that monitors controls on a continuous basis.

d. The company routinely transacts business with related parties.


3. It would be appropriate for the payroll accounting department to be responsible for which of the following functions?

a. Approval of employee time records. b. Maintenance of records of employment, discharges, and pay increases. c. Preparation of periodic governmental reports as to employees' earnings and withholding taxes. d. Temporary retention of unclaimed employee paychecks.


4. The most effective control to prevent unbilled and unrecorded shipments of finished goods is to

a. Require all outgoing shipments to be accompanied by a prenumbered shipping order and bill of lading (signed by the carrier). Forward a copy of these documents to accounting, to be placed in an open file awaiting receipt of the customer invoice copy.

b. Forward a copy of the shipping order and bill of lading to billing.

c. Implement a policy that prevents sales invoices from being mailed to customers in the absence of a properly approved shipping order and bill of lading signed by the carrier.

d. Forward a copy a the signed bill of lading to the stores manager.


5. Apex Manufacturing Corporation mass produces eight different products. The controller, who is interested in strengthening internal controls over the accounting for materials used in production, would be most likely to implement

a. An economic order quantity (EOQ) system. b. A job order cost accounting system. c. A perpetual inventory system. d. A separation of duties among production personnel.


6. Which of the following activities represents both an appropriate human resources function and a deterrent to payroll fraud?

a. Distribution of paychecks.

b. Authorization of overtime.

c. Authorization of additions to and deletions from the


d. Collection and retention of unclaimed paychecks.


7. Alpha Company uses its sales invoices for posting perpetual inventory records. Inadequate internal control procedures over the invoicing function allow goods to be shipped that are not invoiced. The inadequate controls could cause an

a. Understatement of revenues, receivables, and inventory.

b. Overstatement of revenues and receivables, and an understatement of inventory.

c. Understatement of revenues and receivables, and an overstatement of inventory.

d. Overstatement of revenues, receivables, and inventory.


8. The human resources department receives an edit listing of payroll changes processed at every payroll cycle. If they do not verify the changes processed, this could result in:

a. Undetected errors in payroll rates for new employees.

b. Inaccurate social security deductions.

c. Labor hours charged to the wrong account in the cost reporting system.

d. Employees not being asked if they want to contribute to the company pension plan.


9. Property acquisitions that are misclassified as maintenance expense would most likely be detected by internal control procedures that provide for

a. Investigation of variances within a formal budgeting system.

b. Review and approval of the monthly depreciation entry by the plant supervisor.

c. Segregation of duties of employees in the accounts payable department.

d. Examination by the internal auditor of vendor invoices and canceled checks for property acquisitions.


10. During the review of a small business client's internal control system, the auditor discovered that the accounts receivable clerk approves credit memos and has access to cash. Which of the following controls would be most effective in offsetting this weakness?

a. The owner reviews errors in billings to customers and postings to the subsidiary ledger.

b. The controller receives the monthly bank statement directly and reconciles the checking accounts.

c. The owner reviews credit memos after they are recorded.

d. The controller reconciles the total of the detail accounts receivable accounts to the amount shown in the ledger.


11. Which of the following, if material, would be considered fraud?

a. Mistakes in the application of accounting principles.

b. Clerical mistakes in the accounting data underlying the financial statements.

c. Misappropriation of an asset or groups of assets.

d. Misinterpretations of facts that existed when the financial statements were prepared.


12. Competence of personnel is necessary to proper recording of transactions and supports financial statements that are fairly presented. In reviewing the organization for necessary competence, which of the following job types would be of least interest to the auditor?

a. Corporate controller.

b. Vice-president for marketing.

c. Manager of electronic data processing.

d. Chief accountant.


13. An auditor would consider internal control procedures relating to a client's payroll procedures to be ineffective if the payroll department supervisor is responsible for

a. Hiring subordinate payroll department employees. b. Having custody over unclaimed paychecks. c. Updating employee earnings records. d. Applying pay rates to time tickets.


14. Which of the following is the most effective control procedure to detect vouchers that were prepared for the payment of goods that were not received?

a. Count goods upon receipt in storeroom.

b. Match purchase order, receiving report, and vendor's invoice for each voucher in accounts payable department.

c. Compare goods received with goods requisitioned in receiving department.

d. Verify vouchers for accuracy and approval in internal audit department.


15. For effective internal control purposes, which of the following individuals should be responsible for mailing signed checks?

a. Receptionist. b. Treasurer. c. Accounts payable clerk.

d. Payroll clerk.


16. Evidence of proper authorization, approval and review of transactions may appear on the face of documents supporting the transactions. Which of the following techniques does not provide evidence of proper authorization, approval or review.

a. Purchase orders are signed by the purchasing agent.

b. Receiving reports are signed by persons inspecting and counting incoming goods.

c. Vouchers are signed or initialed by the person comparing vendors' invoices, purchase orders, and receiving reports for prices, quantities, and stock description.

d. Several checks are signed in advance whenever the treasurer is scheduled to be out of town for an extended period.


17. In general, material irregularities perpetrated by which of the following are most difficult to detect?

a. Internal auditor. b. Keypunch operator. c. Cashier. d. Controller.


18. Which of the following is not an element of an entity's internal control?

a. Control risk. b. Control activities. c. The information system d. The control environment.


19. Which of the following would not be considered an internal control feature?

a. Prenumbered documents.

b. Limited access to documents. c. Competent personnel. d. A comparison-shopping staff.


20. A system of internal control, regardless of how carefully designed and implemented, contains certain inherent limitations. Which of the following errors or irregularities is not caused by an inherent limitation.

a. The president and chief executive officer, with the assistance of the corporate controller, inflated earnings by recording fictitious sales at year-end.

b. A newly-installed electronic data processing system failed to provide for a comparison of sales order amount with prior customer balance and credit limit. This resulted in numerous sales to customers who had already exceeded their credit limits.

c. Numerous recording errors occurred because persons analyzing and recording transactions did not have the necessary accounting background.

d. A computer programmer and a computer operator conspired to divert funds from the company to an account controlled by the dishonest employees.


21. A company policy should clearly indicate that defective merchandise returned by customers is to be delivered to the

a. Sales clerk. b. Receiving clerk. c. Inventory control clerk. d. Accounts receivable clerk.


22. Controls that enhance the reliability of the financial statements may be classified as prevention controls and detection controls. Which of the following is primarily a detection control?

a. Separation of duties between recording cash receipts and depositing cash.

b. Bank accounts are reconciled monthly by persons independent of cash recording and cash custody.

c. The human resources department authorizes the hiring of only those persons for accounting positions that meet the written job requirements specified by the corporate controller.

d. An accounting manual, accompanied by a detailed chart of accounts, carefully and clearly describes each type of transaction affecting the entity.


23. Internal control procedures are strengthened when the quantity of merchandise ordered is omitted from the copy of the purchase order sent to the

a. Department that initiated the requisition b. Receiving department c. Purchasing agent d. Accounts payable department


24. Which of the following observations, made during the preliminary survey of a local department store's disbursement cycle, reflects a control strength?

a. Individual department managers use pre-numbered forms to order merchandise from vendors.

b. The receiving department is given a copy of the purchase order complete with a description of goods, quantity ordered, and extended price for all

merchandise ordered.

c. The treasurer's office prepares checks for suppliers based on vouchers prepared by the accounts payable department.

d. Individual department managers are responsible for the movement of merchandise from the receiving dock to storage or sales areas as appropriate.


25. In a properly designed set of internal control procedures, the same employee should not be permitted to

a. Sign checks and cancel supporting documents.

b. Receive merchandise and prepare a receiving report.

c. Prepare disbursement vouchers and sign checks.

d. Initiate a request to order merchandise and approve merchandise received.


26. A means of ensuring that payroll checks are drawn for properly authorized amounts is to:

a. Conduct periodic floor verification of employees on the payroll.

b. Require that undelivered checks be returned to the cashier.

c. Require supervisory approval of employee time cards.

d. Witness the distribution of payroll checks.


27. Effective internal control requires organizational

independence of departments. Organizational independence would be impaired in which of the following situations?

a. The internal auditors report to the audit committee of the board of directors.

b. The controller reports to the vice president of production.

c. The payroll accounting department reports to the chief accountant. d. The cashier reports to the treasurer.


28. External forces can serve to either strengthen or weaken an entity's internal control. Which of the following conditions supports strong internal control?

a. Threat of an Internal Revenue Service audit.

b. The existence of related parties and related party transactions.

c. Pressure by the financial community to improve earnings performance.

d. An economic downturn.


29. Proper segregation of functional responsibilities calls for the separation of the

a. Authorization, recording, and custodial functions. b. Authorization, execution, and payment functions. c. Receiving, shipping, and custodial functions. d. Authorization, approval, and execution functions.


30. A set of control procedures referred to as "periodic inventories and comparisons," provides effective monitoring of accountability. Although the term "inventories" is broadly defined for this purpose, which of the following does not fit the definition of periodic inventories and comparisons?

a. Bank accounts are reconciled monthly by persons independent of cash custody and cash recording.

b. Cash receipts are deposited intact daily and the receipted deposit ticket is obtained directly from the bank and compared with the recorded cash receipts by a person independent of cash custody and cash recording.

c. Perpetual inventory records are maintained for major classes of materials and finished goods and monthly counts and comparisons are made on a test basis.

d. The treasurer reviews all documentation before signing disbursement checks. The checks are then mailed directly to the vendors and the documents are effectively canceled.


31. When considering the effectiveness of internal control, the

auditor should recognize that inherent limitations do exist. Which of the following is an example of an inherent

limitation in a client's internal control?

a. The effectiveness of procedures depends on the segregation of employee duties.

b. Procedures are designed to assure the execution and

recording of transactions in accordance with

management's authorization.

c. In the performance of most control procedures, there

are possibilities of errors arising from mistakes in


d. Procedures for handling large numbers of transactions are processed by electronic data processing equipment.


32. The most effective control for ensuring that customers are billed only for goods shipped is to

a. Require that carriers sign properly completed bills of lading.

b. Implement a policy that prevents the mailing of sales invoices to customers in the absence of a properly approved shipping order and a bill of lading signed by the carrier.

c. Require that all shipments be approved by accounting.

d. Prohibit goods from leaving the warehouse without being accompanied by a signed bill of lading and a properly approved shipping order.


33. In a properly designed accounts payable system, a voucher is prepared after the invoice, purchase order, requisition, and receiving report are verified. The next step in the system is to

a. Cancel the supporting documents. b. Enter the check amount in the check register. c. Approve the voucher for payment. d. Post the voucher amount to the expense ledger.


34. In general, a material internal control weakness may be

defined as a condition in which material errors or

fraud would ordinarily not be detected within a timely

period by

a. An auditor during the normal study and evaluation of the system of internal control.

b. A controller when reconciling accounts in the general ledger.

c. Employees in the normal course of performing their assigned functions.

d. The chief financial officer when reviewing interim financial statements.


35. The most effective control for insuring that incoming materials are received by stores is to

a. Establish a separate receiving function independent of purchasing and stores.

b. Require that a prenumbered copy of the receiving report, that accompanies the materials to stores, be signed by the stores manager, as evidence of receipt, and forwarded to accounting.

c. Compare the receiving report with the vendor's invoice before approving payment.

d. Provide for a review and comparison of all documents accompanying an approved voucher before signing disbursement checks.


36. Internal control is a function of management, and effective control is based upon the concept of charge and discharge of responsibility and duty. Which of the following is an important feature of effective internal control?

a. Responsibility for accounting and financial duties should be assigned to one responsible officer.

b. Responsibility for the performance of each duty must be fixed.

c. Responsibility for the accounting duties must be borne by the auditing committee of the company.

d. Responsibility for accounting activities and duties must be assigned only to employees who are bonded.


37. The director of internal auditing of a manufacturing company is updating the long-range audit schedule. There are several possible audit assignments that can fill a given time spot. Information on potential dollar exposure and key internal controls have been gathered. Based on perceived audit risk, select the assignment of greatest merit.

a. Precious metals inventory - book value, $1,000,000; separately stored, but access not restricted.

b. Branch office petty cash - ledger amount, $50,000; ten branch offices, equal amounts; replenishment of accounts requires three separate approvals.

c. Sales force travel expenses - budget, $1,000,000; 50 sales people; all expenditures over $25 must be receipted.

d. Expendable tools inventory - book value, $500,000; issued by tool crib attendant upon receipt of authorization form.


38. Which of the following is an effective internal accounting control over cash payments?

a. Signed checks should be mailed under the supervision of the check signer.

b. Spoiled checks which have been voided should be

disposed of immediately. c. Checks should be prepared only by persons responsible for cash receipts and cash disbursements. d. A check signing machine with two signatures should be utilized.


39. Proper segregation of functional responsibilities in an effective system of internal control calls for separation of the functions of

a. Authorization, execution, and payment.

b. Authorization, recording, and custody.

c. Custody, execution, and reporting. d. Authorization, payment, and recording.


40. For good internal control, which of the following functions should not be the responsibility of the treasurer's department?

a. Data processing. b. Handling of cash. c. Custody of securities. d. Establishing credit policies.


41. For effective internal control, the accounts payable department should compare the information on each vendor's invoice with the

a. Receiving report and the purchase order. b. Receiving report and the voucher. c. Vendor's packing slip and the purchase order. d. Vendor's packing slip and the voucher.


42. Of the following statements about internal control, which one is not valid?

a. No one person should be responsible for the custodial responsibility and the recording responsibility for an asset.

b. Transactions must be properly authorized before such transactions are processed.

c. Because of the cost/benefit relationship, a client may apply control procedures on a test basis.

d. Control procedures reasonably insure that collusion among employees cannot occur.


43. The purpose of segregating the duties of hiring personnel and distributing payroll checks is to separate the

a. Administrative controls from the internal accounting controls.

b. Human resources function from the controllership function.

c. Operational responsibility from the record keeping responsibility.

d. Authorization of transactions from the custody of dated assets.


44. Which of the following is an internal control procedure that would prevent a paid disbursement voucher from being presented for payment a second time?

a. Vouchers should be prepared by individuals who are responsible for signing disbursement checks.

b. Disbursement vouchers should be approved by at least two responsible management officials.

c. The date on a disbursement voucher should be within a few days of the date the voucher is presented for payment.

d. The official signing the check should cancel the paid voucher after examining the documentation supporting the disbursement.


45. Which of the following control procedures would most likely be used to maintain accurate perpetual inventory records?

a. Independent storeroom count of goods received.

b. Periodic independent reconciliation of control and subsidiary records.

c. Periodic independent comparison of records with goods on hand.

d. Independent matching of purchase orders, receiving reports, and vendors' invoices.


46. Which of the following control procedures may prevent the failure to bill customers for some shipments?

a. Each shipment should be supported by a pre-numbered sales invoice that is accounted for.

b. Each sales order should be approved by authorized personnel.

c. Sales journal entries should be reconciled to daily sales summaries.

d. Each sales invoice should be supported by a shipping document.


47. For maximum effectiveness, the organizational status of the internal audit department:

a. Should be sufficient to permit the accomplishment of

its audit responsibilities.

b. Is best when the reporting relationship is direct to the board of directors.

c. Requires the board's annual approval of the audit department’s, plans, and budgets.

d. Is guaranteed when the charter specifically defines its independence.


48. Effective internal control over the payroll function should include which of the following?

a. Total time recorded on time clock cards should be

reconciled to job reports by employees responsible for those specific jobs.

b. Payroll department employees should be supervised by the management of the human resources department. c. Payroll department employees should be responsible for maintaining employee personnel records.

d. Total time spent on jobs should be compared with total time indicated on time clock cards.


49. Corporate directors, management, external auditors and internal auditors all play important roles in creating a proper control environment. Top management is primarily responsible for:

a. Establishing a proper environment and specifying an overall internal control structure.

b. Designing and operating a control system that provides reasonable assurance that established objectives will be met.

c. Ensuring that external and internal auditors adequately monitor the control environment.

d. Implementing and monitoring controls designed by the board of directors.


50. Which of the following is an internal control weakness

related to factory equipment?

a. A policy exists requiring all purchases of factory equipment to be made by the department in need of the equipment.

b. Checks issued in payment of purchases of equipment are not signed by the controller.

c. Factory equipment replacements are generally made when estimated useful lives, as indicated in depreciation schedules, have expired.

d. Proceeds from sales of fully depreciated equipment are credited to other income.


51. Which of the following controls would be the most appropriate means to ensure that terminated employees had been removed from the payroll?

a. Mailing checks to employees' residences.

b. Establishing direct-deposit procedures with employees' banks.

c. Reconciling payroll and time-keeping records. d. Establishing computerized limit checks on payroll rates.


52. Which of the following departments should have the responsibility for authorizing payroll rate changes?

a. Human Resources. b. Payroll.

c. Treasurer. d. Timekeeping.


53. The director of internal auditing for a large retail organization reports to the controller and is responsible for designing and installing computer applications relating to inventory control. Which of the following is the major limitation of this arrangement?

a. It prevents the audit organization from devoting full time to auditing.

b. Auditors generally do not have the required expertise to design and implement such systems.

c. It potentially affects the director's independence and thereby lessens the value of audit services.

d. Such arrangements are unlawful because the director participates in incompatible functions.


54. An internal auditor is examining inventory control in a merchandising division with annual sales of $3,000,000 and a 40 percent gross profit rate. Tests show that 2 percent of the dollar amount of purchases do not get into inventory due to breakage and employee theft. Adding certain controls costing $35,000 annually could reduce these losses to .5 percent of purchases. Should the control be recommended?

a. Yes, because the projected savings exceed the cost of the added controls.

b. No, because the cost of the added controls exceeds the projected savings.

c. Yes, because the ideal system of internal control is the most extensive one.

d. Yes, regardless of cost-benefit considerations, because

the situation involves employee theft.



55. An overriding factor contributing to internal control effectiveness is toward internal control.


56. A chart of accounts, accounting manuals, and standard journal entries promote proper of transactions.


57. Evidence of proper approval, review, and recording of transactions is provided by a well-documented .


58. Limited access controls and accountability controls are subsets of .


59. The independent auditor is interested only in those aspects of control that affect the .


60. An effective system of budgeting, standard costs, and performance reporting should highlight significant variances caused by failure to record transactions. This set of controls, therefore, assists in detecting material errors of



61. To the extent the assertion of is met, errors of omission are minimized.


61. To assure proper control in a small business, the necessary approval and review procedures should be performed by the




63. Indicate by letter the internal control that best describes each of the listed control procedures.

a. Accuracy control--prevention

b. Accuracy control--detection

c. Safeguard control--prevention

d. Safeguard control--detection

____1. All incoming checks are restrictively endorsed

immediately upon receipt

____2. Accounting manuals are used to determine debit and credit

accounts for nonrecurring transactions

____3. Bank accounts are reconciled monthly by persons not

having access to either financial assets or accounting


____4. Newly-hired accounting personnel undergo rigorous training before assuming responsibility for transaction


____5. Members of the internal audit staff perform a monthly

review of all non routine journal entries

____6. All cash receipts are prelisted and deposited intact daily

____7. A member of the controller’s staff compares the receipted bank deposit ticket with the cash prelisting

____8. A set of standard journal entries is used to record such

monthly journal entries as depreciation, amortization,

accrued payroll, accrued interest, and bad debts expense

____9. All revenue and expense budget variances in excess of

predetermined levels are investigated for cause on a

monthly basis

____10. Before signing checks, the treasurer reviews all



1. c

2. a

3. d

4. a

5. b

6. c

7. d

8. a

9. b

10. b


64. An important component of internal control monitoring is the periodic examination of substance and comparison with its recorded accountability. Give three examples of this form of monitoring and, for each example, identify the account and the underlying substance.


1. Compare inventories (substance) with perpetual inventory

records (account)

2. Reconcile bank accounts

Substance: bank statements

Account: general ledger cash account

3. Agree accounts receivable subsidiary ledger with control, mail statements to customers, and clear all

exceptions reported by customers

Substance: customer responses to statements

Account: accounts receivable subsidiary ledger and

control account

4. Count cash in cash register (substance) and compare with

locked-in tape (account)

5. Compare brokers’ monthly statement (substance) with

investment ledger (account)

6. Compare vendors’ statements (substance) with accounts

payable ledger (account)

7. Compare receipted bank deposit slip (substance) with cash receipts entry and prelisting (account)

8. Inspect plant assets (substance) and compare with plant

assets ledger (account)

65. Asset safeguard controls may be classified as access controls and accountability controls. Give two examples of each.


Access controls:

1. Secure areas for merchandise, small tools, supplies, securities, etc.

2. Cash registers with locked-in tapes

3. Limited access to unused documents

4. Daily intact deposits of cash receipts

5. System of passwords to limit access to computer data bases

6. Dual access to negotiable securities

Accountability controls:

1. Fixing responsibility over prenumbered documents

2. Periodic accounting for numeric sequence of used


3. Establishing imprest funds for petty cash and fixing

responsibility for custodianship

4. Bonding of employees in positions of trust

66. For each of the cases described below, identify the principal control activities that would have prevented or detected the misstatement.

1. The shipping clerk of Duvinski Enterprises was able to remove goods from the company’s warehouse by fabricating shipping orders and bills of lading. An accomplice with a trucking company was able to pick up the goods during normal business hours and transport them to warehouse space rented by the duo. The fraud was detected when the one of the trucking company dispatchers discovered that the truck was being used for unscheduled runs. Further investigation by the firm revealed the delivery destination, whereupon the driver confessed to the thefts.

2. In conducting the annual audit for Bevis Rod and Reel, Inc., the auditors noted that several monthly and year-end adjustments had not been recorded by the company. Among the omissions were depreciation, interest accruals, and employer payroll taxes.

3. Although the auditors, by drafting the necessary audit adjustments, provide reasonable assurance as to the fairness of the annual financial statements, Comptronix Exploration and Development Company’s monthly statements frequently contained material errors due to improper recording of unique and often complex transactions.

4. Unrecorded customer remittances were misappropriated by an accounts receivable clerk. The affected accounts were reduced by a combination of fictitious sales returns, inflated sales discounts, and write-off of the overstated balances to the allowance for doubtful accounts.


1. Use of prenumbered documents, restricted access to unused documents, fixing of responsibility over document custody, and periodic accounting for, and cancellation of, used documents would have prevented the clerk from gaining access to the documents and using them to effect the fraudulent transfer. Also, as part of the accounting for used documents, shipping orders and bills of lading should be matched with sales invoices to determine that all shipments have been billed to customers. In the present case, the shipments were never billed.

2. A set of standard journal entries for all recurring adjustments would have ensured proper recording of monthly depreciation, interest, and payroll taxes. Monthly review of the general ledger trial balance by responsible accounting personnel provides further assurance that both recurring and nonrecurring adjustments are not overlooked.

3. A detailed chart of accounts and accounting manuals describing the various accounts and related transactions, together with adequate hiring and training policies for accounting personnel, should provide reasonable assurance of correct recording of non routine transactions.

4. Proper separation of duties should have prevented the accounts receivable clerk from having access to customer remittances. Customer accounts should be posted from cash prelistings and remittance advices--not from the checks themselves. Also, effective internal control should require proper approval of all accounts receivable write-offs. Finally, sales returns should be supported by proper documentation, including receiving reports evidencing receipt of the returned goods.

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