Review Questions Solutions
Chapter 12, Auditing Acquisitions and Payments Processes:
Cash Disbursements and Related Activities in the Automotive Industry
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A1 What kinds of transactions are included in the acquisition and payment cycle?
Purchases and payments for inventory, operating expenses and long-lived productive
assets
Purchase returns and discounts
(In this book, payments for payroll, investments, repayment of long-term debt, and other
financing transactions are included in other cycles.)
A2 What is the main activity of a retail business?
The purchase and resale of finished goods
A3 Relating to inventory, once it has arrived at a retailer, what are some internal
controls that should be implemented?
Physically safeguarding the inventory that is received, preparing documents to record the
receipt and movement of the inventory
A4 What types of fixed assets are common for retailers?
Major leasehold improvements that result from building out the space they lease
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B1 What is the major business function of a manufacturing company?
Manufacturing entities manufacture, create, build, assemble, or produce inventory to be
sold to customers; they purchase raw materials inventory and add labor and overhead to
produce the finished goods.
B2 How does encumbering funds help keep a government entity’s spending within
its budget?
Encumbering funds is a process that “sets aside” the amount of money that is committed
to a purchase from what is available to be spent. The encumbrance process occurs either
before or at the time of the purchase – before the invoice is received.
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C1 Besides personal use vehicles, what are some other examples of products created
in the automotive industry?
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Commercial use vehicles, military vehicles, parts, accessories, components, services
(such as: training, field support, manual preparation, financing, test support, repair
services, parts delivery).
C2 Why are acquisition and payment activities very important to the success of
automotive industry companies (in contrast to being considered simply back-office
functions?)
These activities are tied to companies achieving their market-related goals; they have to
receive raw materials on a timely basis for their scheduled manufacturing, to meet
inventory needs to fulfill sales.
C3 Why might automotive industry companies choose to investigate suppliers before
entering into contracts with them?
Success of the purchaser is often linked to the performance of the suppliers; companies
may inspect a supplier’s quality standards and delivery performance.
C4 How is the purchasing process complicated when a manufacturer sells products
in various international markets?
Political, religious and economic impacts
Labor market conditions in other country environments
Tariffs and trade barriers
Government regulations
Income and withholding taxes in other countries
Risk of governmental expropriation
Differences in business practices
C5 How are fixed price contracts used to mitigate risk?
Fixed price contracts protect the purchases from fluctuation in the costs of raw materials;
this is good when the price of raw materials go up but bad when prices go down. Fixed
price contracts are very useful at hedging risks for fixed price sales contracts.
C6 What does it mean when a financial instrument is used to hedge the cost of items
that must be purchased for the manufacturing process?
Hedging using financial instruments means buying a financial instrument that pays a
certain return that is contingent upon something else happening – for example if the price
of steel goes up, the holder of the financial instrument receives a payment. (Theoretically,
the entity who made the hedge would be able to spend the money received on the hedge
to cover the added cost of the steel.)
C7 Why do companies in the automotive industry need extensive IT systems linked
to purchasing to manage their inventory?
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Automotive companies often use a large number of different parts, components and end
products, both purchased and sold, as well as multiple operating locations. Having ITbased information on inventory helps the purchasing function by providing specific
information about what is needed – and therefore needs to be purchased -- and when.
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D1 What objectives does management have related to purchasing, and what controls
help to accomplish these objectives?
To limit items that are ordered and purchased to those the company legitimately needs for
its use
D2 What are management’s objectives for cash disbursements, and what controls
help to accomplish them?
To ensure that all cash disbursements are for goods and services that are actually received
by the company and for correct amounts
D3 What are business objectives for recording and reporting accounting
information for acquisitions and payments?
To properly post transactions
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E1 What is important regarding the organizational authority of the person who
creates a purchase requisition?
The person should have knowledge that an item needs to be purchased and the authority
to request the purchasing department to make the purchase. The request for the purchase
should come from someone independent of the purchasing department (accomplishing
segregation of duties), with the authority to approve the need for the purchase.
E2 Some businesses extend purchasing department employees the authority to
perform a broader range of activities than do other businesses. What activities do all
purchasing departments perform? What activities might be allowed in some
businesses and not in others?
The purchasing department receives the purchase requisition and arranges with a vendor
to obtained the needed goods. If management contracts with certain vendors to purchase
specific items at an agreed upon price, the purchasing department may only have the
authority to execute purchase transactions based on management’s contracts, using
approved vendor and price lists. In other businesses, the purchasing department may shop
for the best vendor to provide the item based on criteria such as price, quality and ability
to deliver within a specific time frame.
E3 What function does a receiving department perform, and what are its activities?
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The receiving function takes possession of the goods, counts and inspects the items,
noting what was received and when as well as the condition of the delivered goods.
E4 What records does a receiving department prepare?
A receiving report.
A receiving log may also be prepared as a way to cross reference the information.
E5 How is segregation of duties among the requisitioning, ordering, and receiving
processes accomplished?
Segregation of duties is accomplished because each department makes decisions and adds
the information over which it has authority. In an automated environment, each
department only has access to the information it controls.
E6 What should happen when discrepancies exist among supporting documents for
a purchase or when the goods received are not what was ordered or arrive
damaged?
The typical process for a discrepancy is to first investigate internally. Then, if
appropriate, the purchasing company notifies the vendor or shipper of any discrepancies,
errors, or damage. The purchaser prepares a debit memo to document the amount that
payment for a purchase should be reduced. The purchaser may receive a corrected
invoice or statement. The exact process for negotiating and documenting this issues
varies from company to company.
E7 What are the different ways cash disbursements can be reviewed and authorized
before disbursement occurs?
Documents are accumulated into a payment support package which is reviewed before
the cash disbursement is authorized. Cash disbursement is by paper check, or electronic
transfer. Final approval for the payment should come from the treasury or cashier
department, prior to disbursement.
If the payment is by paper check, the check signer reviews the disbursement and
supporting documents before signing the check. If check signing is done automatically
using a signature plate, the responsible person reviews the supporting documents and
then approves the list of checks to be produced and signed. If the disbursement is by
electronic transfer, the responsible person reviews the supporting documents prior to
authorizing transfer of the money. Supporting documents are canceled or marked paid.
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F1 What functions of acquisition and payment should be segregated from each
other?
Approving the need for the purchase
Executing the purchase
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Receiving the shipment
Recording the account payable
Authorizing the cash disbursement
F2 What steps can be taken to safeguard assets?
Physical safeguarding
Keeping goods in safe locations
Storing goods in locked facilities
Documentary controls to safeguard assets
Each person who takes responsibility for the goods signs for them, accepting
responsibility
Inventory records are reconciled with receiving documents
F3 How can the improper posting of the debit side of a purchase transaction cause
income to be misstated?
For example, income goes up inappropriate, if a transaction that is supposed to be an
increase to expenses is recorded as an increase to fixed assets
F4 Why and how is cutoff important to acquisitions and payments?
Proper cutoff ensures appropriate matching of expenses against revenues, and
completeness of liabilities. Invoices received around the end of the fiscal period have to
be evaluated to determine in which period they are to be recorded. Acquisitions for which
invoices have not yet been received have to be estimated and recorded (accrued) so that
they are shown in the proper period.
F5 What is an imprest petty cash fund, and how does it work?
An imprest petty cash fund refers to a set amount of cash that is issued to a custodian via
a documented cash disbursement such as a paper check or electronic transfer. That person
is responsible for disbursing the cash for the approved types of expenditures and
collecting receipts or other documentation for the payments. At any time the amount of
cash on hand and the receipts should add up to the total amount of the fund. When the
cash on hand drops to a specified level, it is replenished by a cash distribution equal to
the amount of the receipts or documentation that are used to support authorization of the
replenishment.
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G1 How do audit procedures in one part of an integrated audit (ICFR or financial
statement audit) relate to conclusions in the other part of the audit?
In an integrated audit, audit procedures should contribute to both audits.
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G2 How can walkthroughs provide evidence about the operating effectiveness of
ICFR in the audit of acquisitions and payments?
The auditor can review client procedures and observe client personnel as they perform
steps.
G3 Related to purchases, what are important concerns addressed by controls? What
are the control concerns that are more universal in nature, but also apply to
purchase activities?
1. Purchases are for goods and services actually needed by the company
2. Purchases are with vendors the company authorizes
3. The company actually receives the goods and services before any cash disbursements
are made
1. All transactions are posted
2. Transactions are posted at the correct amounts, to the proper accounts, and in the
correct accounting period
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H1 How are purchase returns likely tested for the financial statement audit?
Using analytical procedures
H2 How can purchase returns be tested for the ICFR audit?
The auditor:
Observes the receiving process
Tests the return process by following goods that have been flagged for return through the
system
Observe employee activities
Examine documentation of purchase returns
H3 How do auditor’s and management’s concerns differ regarding purchase
discounts?
Management is concerned that no purchase discounts that are supposed to be taken in
accordance with company policy are missed. The auditor is concerned that the amount
paid for a purchase is properly recorded, whether or not the discount was taken.
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I1 What are the different ways that cash disbursements may be authorized in the
current business environment? What important control step does the person
providing the approval carry out?
By an individual or multiple check signer using paper checks
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Electronic signatures on checks
Electronic funds transfers authorized by codes
The person providing the approval should review the documentation prior to providing
authorization that the cash be disbursed.
I2 When cash disbursements are made through electronic funds transfer, what is an
important control?
Limit authorized access and carefully safeguard authorization codes.
I3 What are important detective controls for cash disbursements?
Reconciliation and monitoring:
1. Bank statements must be reconciled on a timely basis by a person independent of
handling or recording cash receipts and disbursements
2. Vendors invoices and statements should be reconciled to accounts payable records by a
person independent of ordering and recording transactions
I4 What control purposes and management assertions are supported by bank
reconciliations?
1. To ensure that all cash disbursements that (1) occurred are recorded, and (2) are
recorded actually occurred.
(existence or occurrence, completeness, valuation or allocation)
2. To ensure that cash disbursements are recorded in the same accounting period in which
they are made.
(cutoff)
3. To ensure that cash disbursements are properly posted to the correct cash account and
correct vendor record in the accounts payable subsidiary ledger, and to the general ledger.
(existence or occurrence, completeness, valuation or allocation, presentation and
disclosure)
I5 What control purposes and management assertions are supported by reconciling
vendor invoices and statements to accounts payable subsidiary ledger records?
1. To ensure that all cash disbursements that (1) occurred are recorded, and (2) are
recorded actually occurred.
(Existence or occurrence, completeness, valuation or allocation)
2. To ensure that cash disbursements are properly posted to the correct cash account and
correct vendor record in the accounts payable subsidiary ledger, and to the general ledger.
(existence or occurrence, completeness, valuation or allocation, presentation and
disclosure)
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J1 What is the advantage of performing dual purpose tests?
Dual purpose tests provide the auditor with the opportunity to collect audit evidence
about ICFR and the account balances in the financial statement using the same evidence
items.
J2 How is underlying information (used for substantive analytical procedures)
tested, and why?
To be able to rely on the results of analytical procedures the auditor must test whether the
underlying information is complete and accurate. ICFR of the accounting system must
function for the underlying information to be relied on. Additional evidence of reliability
comes from dual purpose tests and tests of details of balances.
J3 How are analytical procedures used for acquisitions and payments?
They are used to confirm or dispute other audit evidence and to provide evidence on
expense accounts for which less direct examination is performed.
J4 Why do analytical procedures help whether they confirm or dispute other
findings?
If analytical procedures confirm other audit evidence they corroborate that the other audit
evidence is reliable. If analytical procedures results are inconsistent with the results of
other audit procedures, the auditor performs more audit work and will be able to assess
whether the other evidence is appropriate.
J5 What is involved in most common analytical procedures? What is compared?
Compare a current year account balance with the account balance in prior years, a budget
or an industry benchmark
Calculate a ratio or statistic and compare the outcome to other relevant information
Analytical procedures consider the relationships of company information, in light of
changes within the company and external influences. The goal is to determine whether
the observed relationships make sense in light of the business activities and economic
environment.
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K1 What other audit evidence besides confirmations are used to support the
auditor’s conclusions about accounts payable?
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In addition to confirmations, the auditor uses examination of documents and the search
for unrecorded liabilities.
K2 What is the important management assertion for accounts payable about which
confirmation can provide audit evidence?
Completeness; unrecorded or under-recorded liabilities (understatement)
K3 What is the purpose of sending confirmations to vendors with small or zero
balances?
The amount by which a liability can be understated is “infinite” – in other words, if a
liability is simply not recorded, the balance is shown as zero, but the actually liability
could be any amount. If the auditor only selected large accounts payable balances to
confirm the process would miss the liabilities that are actually large but are shown as
being small or zero amounts in the company’s records.
K4 What is a “blank” confirmation? Why is this format often used for accounts
payable?
A blank confirmation is one in which the amounts are not filled in and are to be added by
the recipient of the confirmation. Blank confirmations are used when the auditor wants to
reduce the risk that the recipient will just “sign off” on the amount, without actually
checking it.
K5 What are common sources of discrepancies between responses on blank
accounts payable confirmations and the audit client’s accounts payable subsidiary
ledger?
The most common cause of discrepancies is timing differences. The auditor is looking for
evidence that supports the balance at the fiscal year end. Transactions may have occurred
after the fiscal year end – both purchases and payments – and before the confirmation
information is provided. If the creditor confirms that balance at the date of the
confirmation, rather than at the date of the fiscal year end, then the auditor must reconcile
the difference.
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L1 What audit procedures fall under the label Search for Unrecorded Liabilities?
What management assertion do these audit procedures address?
1. Ask the client about the procedures it established and followed to be sure that all
liabilities are recorded.
2. Review cash disbursements and related supporting documents in the subsequent
accounting period. All cash disbursements should be for transactions of the current
period, or items shown as payables at the prior fiscal year end.
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3. Review invoices and statements and relating supporting documents for liabilities not
paid at the time the audit work at the client’s location is completed. Trace the unpaid bills
to either a liability of the period being audited or a payable that has been recorded in the
subsequent accounting period.
4. Understand the client’s cutoff policies for inventory. Identify the last receiving report
used at fiscal year end. Examine this and others shortly before and after fiscal year end.
Trace the transactions to the records for inclusion in the proper accounting period.
5. Perform analytical procedures for reasonableness of the accounts payable balance.
6. Read contracts for purchase commitments.
L2 What audit steps are typical for prepaid assets and accrued liabilities?
1. Determine what is included in the account balance.
2. Examine documentation related to the underlying item.
3. Perform analytical procedures.
4. If appropriate, account analysis.
L3 What are the steps to account analysis for a prepaid or accrual account?
1. Start with the beginning balance, which was audited in the prior year.
2. Examine documents supporting additions to the account.
3. Examine documents supporting decreases from the account.
4. Determine an audit conclusion about the fairness of the final balance.
L4 What does SAB 108 say regarding the financial statements for which materiality
must be considered?
Materiality must be considered from the perspectives of both the income statement and
the balance sheet. An adjustment needs to booked if the misstatement without it is
material for either the balance sheet or the income statement. (The reason for SAB 108
was that, in the past, the entry might not have been booked if it was not material to the
income statement. And, a problem developed because eventually, over time, the amount
of the misstatement on the balance sheet became material.)
L5 What prepaid or accrued items might require additional auditor attention
beyond the customary evaluation for appropriate financial reporting?
Insurance, for sufficiency of coverage
L6 Which expense accounts is an auditor likely to specifically analyze and why?
Legal expenses
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M1 How does authorization for the purchase of property, plant and equipment
differ from authorization for other purchases?
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Because the dollar amounts are typically large, they may be approved based on a capital
budgeting process, internal rate of return, other performance thresholds; they may be
approved at the department or division level, by top management, or by the Board of
Directors.
M2 What difficult analyses and calculations may be required in determining (and
therefore auditing) the proper amounts to record for additions to fixed asset?
Components of self constructed assets
Capitalized interest
Value of donated fixed assets
Costs to make a fixed asset operational like freight-in, set up and testing
M3 Why is the impact of poor ICFR related to the disposal of fixed assets not
usually important to the financial statement?
Poor ICFR may mean that assets disposed of (for example, junked, used for parts, sold
for scrap) may not be removed from the company’s records. This is not important to the
amounts on the financial statements if the items are fully depreciated so that there is no
net impact on the balance sheet.
M4 Why is the auditor concerned about the impact of possible impairment of value
on the fixed assets of audit clients? Summarize the accounting guidance regarding
impairment. What are the related auditing procedures?
Long lived assets must be written down if the value is impaired; if the carrying value of
the asset (cost less accumulated depreciation) may not be recovered. The standard states
that impairment has occurred and the assets must be written down if the carrying value is
greater than the aggregate of the asset’s undiscounted estimated future cash flows. The
amount of the write down is calculated based on the difference between the asset’s fair
value and carrying value.
The auditor investigates how the company addresses impairment through inquiry
walkthrough. If impairment may have occurred the auditor reviews the client’s
assumptions and analyzes the client’s calculations and conclusions regarding write-down
of the asset.
M5 What is the main type of transaction that triggers an intangible asset being
recorded?
Purchase of the asset or purchase of a business that owns the asset
M6 What are identifiable intangible assets? Give examples. What audit procedures
will the auditor likely apply to intangible assets?
Identifiable intangible assets are those intangible assets that are not goodwill.
Patents, franchise rights, customer lists, trademarks, copyrights
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If the identifiable intangible asset is purchased separately the auditor can examine the
purchase documents the same as for any other purchase. For intangible assets obtained
through a merger and acquisition, the auditor performs procedures to understand the
entire transaction, and is able to examine the cost of the identifiable intangible assets.
Intangible assets with set expected economic lives are amortized and the auditor
examines amortization similar to what is done for depreciation. Intangible assets with
indefinite useful economic lives are analyzed for impairment.
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N1 For what items are cash disbursements most frequent in the automotive
industry?
Inventory and period costs
N2 What characteristics of the purchasing, receiving, and payment activities in the
automotive industry make ICFR very important? What ICFR are important, and
what does the auditor do to test them?
High volume of inventory purchases for many different items from multiple vendors.
1. Segregation of duties; the following should be segregated: requisition, ordering,
receiving, cash disbursement
2. Automated controls; CAATs can be used to test for authorization, initiation of
transactions, application program controls
3. Controls over the receiving function; important and the auditors focus on problems that
can result from multiple operating locations; auditors look at links off receiving to the
inventory process
4. Controls over payments; focus on determining whether only invoices for authorized
and received goods are paid
5. Physical safekeeping and documentary tracking of goods; focus of overall physical
control and movement from receiving to the warehouse
N3 Why is the audit of warranties challenging?
Warranty expense and liabilities must be estimated. The expense is usually calculated
based on past experiences, but current circumstances can change that. The client and
auditor consider the impacts of: roll out of new products, inconsistent or different
reliability of production inputs, new regulations.
N4 Why are fixed assets likely to be important to the financial statements of a
company in the automotive industry?
They may be large dollar amounts.
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N5 how does the auditor come to an audit conclusion regarding presentation and
disclosure for acquisition and payment activities and related accounts?
The auditor has to understand how transactions are supposed to be captured, calculated,
and posted, and the disclosures required by GAAP and regulatory agencies. The auditor
has to be aware that transactions may be with related parties and consider appropriate
disclosures for related parties and intercompany transactions.
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