Dego Kids, Inc. (60 points)

You are auditing Dego Kids, Inc. (Dego) for the year ended December 31, 2019. Dego manufacturers plastic building blocks for children and sells to retailers across the Philippines. It has been operating since the 1980s.

Dego's facilities include a head office building, a large manufacturing factory, and four large warehouses. Once production of the toys is finished, the toys are warehoused in one of the warehouses until they are delivered to customers. Dego has no internal audit department.

Each retailer-customer is designated a unique account number, which is used to enter sales order received in writing from the customers. An order clerk enters the orders. The system then automatically checks that the goods are available and that the order will not be over the customer's credit limit. However, for first time customers, the sales manager processes the credit application, which is checked through a credit agency. The credit controller then enters the credit limit of such first-time customers into the system. Dego has a list of prices, which is updated every six (6) months. Large customers may avail of a discount. This discount scheme shall be conformed by the sales director and shall be set up in the customer master file.

After the order is entered, Dego then confirms acceptance of the goods ordered via mail/e-mail automatically sent to the customer with an information on the most likely delivery date. Dego then sorts the order according to the address of the customer and the warehouse closest to the customer receiveds the order. A delivery list and sequentially pre-numbered goods delivery notes are generated. One warehouse employee packs the goods from the delivery list and, before the goods are delivered, a second employee double checks the delivery list to the sequentially pre-numbered goods delivery note, which shall accompany the goods to be delivered.

Once delivered, a copy of the goods delivery note is sent to the accounts receivable department in the head office and a sequentially pre-numbered sales invoice is raised and checked to the goods delivery note. A computer sequence check is done regularly to check for missing sales invoice numbers.

In 2019, Dego uncovered a material fraud. The fraud involved the scheme of cash/check receipts from customers being channeled into personal accounts of employees. To cover up the fraudulent scheme, perpetrators recorded receipts from subsequent unrelated customers against the earlier outstanding receivable balances.

The fraud was made possible because of the collusion between related employees. One employee was in charge of the cash receipts and prepared the bank reconciliation weekly and the other employee recorded the receipts in the sales ledger. Monthly customer statements of account were supposed to be sent out by a sales ledger clerk, however, this was not done. There was also no review of the bank reconciliations, which showed a small unreconciled amount each. The fraud was only uncovered when both perpetrators took a vacation leaves at the same time and it was discovered that cash/checks receipts from customers were being applied to older receivables to hide the earlier sums embezzled.

Requirements:

1. As the auditor, what test of controls would you normally carry out on the sales system of Dego? Explain the objective of each test. (20 points)

2. As the auditor, what substantive procedures would you perform to confirm Dego's year-end receivables? (10 points)

3. As the auditor, what substantive procedures would you perform to confirm Dego's revenue? (10 points)

4. What controls should Dego implement to reduce the risk of fraud from happening again? Describe how each control would mitigate risk. (20 points)