Chapter 11
Audit of
Acquisition and
Payment Cycle
and Inventory
Copyright © 2010 South-Western/Cengage Learning
Audit Opinion Formulation Process
LO 1 Acquisition and Payment Cycle
• The acquisition and payment cycle includes
identifying products or services, purchasing,
receiving, approving payments, and paying for goods
and services received
• Major accounts include inventory, cost of goods sold, accounts
payable, and expenses
• Acquisition and payment cycle consists of five distinct
activities:
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Requisition for goods or services
Purchase of goods or services according to company policies
Receipt of goods and services
Approval of items for payment
Cash disbursements
Automated Purchasing System
•
Networked software system linking to vendors
whose offerings and prices have been preapproved
by appropriate management
Automated purchasing system will perform the
following beneficial tasks:
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Apply preloaded specifications and materials lists to the
system to start the process.
Automatically flag invoices that don’t reconcile with
purchase orders.
Create change orders and variance purchase orders
LO 2 Integrated Audit of the Acquisition
and Payment Cycle
• Phases I and II of the Audit Opinion
Formulation Process
– Continually update information on business risk
– Analyze potential motivations to misstate accounts in the
acquisition and payment cycle
– Perform preliminary analytical procedures to determine if
unexpected relationships exist in the accounts
– Develop an understanding of the internal controls in the
acquisition and payment cycle that are designed to address
the risks identified in the three previous steps
Integrated Audit of the Acquisition and
Payment Cycle
• Phases III and IV of the Audit Opinion
Formulation Process
– Determine the important controls that need to be tested
– Develop a plan for testing internal controls and perform the
tests of key controls in the acquisition and payment cycle
– Analyze the results of the tests of controls
– Perform planned substantive procedures based on the
potential for misstatement and the information gathered
LO 3 Risks Related to the Acquisition
and Payment Cycle
• Acquisition cycle deals with receipt of all goods and
services
• Misstatements may occur just because of the volume of
transactions
• Frauds that have taken place include the following:
– Employee theft of inventory
– Employee schemes involving fictitious vendors as means to
transfer payments to themselves
– Executives misusing travel and entertainment accounts and
charging them as company expense
– Schemes to classify expenses as assets
– Manipulation of “restructuring reserves” to manage future
income
Risks Related to the Acquisition and
Payment Cycle
• Number of potential fraud indicators that
affect the cycle include:
– Inventory growing at a rate greater than sales
– Expenses significantly above or below industry
norms
– Capital assets growing faster than the business and
for which there are not strategic plans
– Significant reduction of "reserves"
Risks Related to the Acquisition and
Payment Cycle (continued)
– Expense accounts that have significant credit
entries
– Travel and entertainment expense accounts that do
not have documentation
– Inadequate follow-up to auditor recommendations
on needed controls
– Payments made to senior officers in the form of
loans that are subsequently forgiven.
LO 4 Preliminary Analytical
Procedures for Possible Misstatements
• Analytical procedures to identify potential
misstatements:
– Calculate and analyze dollar and percentage change in
inventory, cost of goods sold, and expense accounts
– Compute and analyze ratios like inventory turnover and
number of day's sales in inventory
– Prepare common sized income statement to identify cost of
good sold or expense accounts that are out of line
• Auditor compares client analytics to past client
performance, industry results, and auditor's
expectations
LO 5 Linking Internal Controls and
Financial Statement Assertions
• Requisition of goods and services
– Need identified
– Pre-numbered requisition form completed and sent
to purchasing
• Purchase goods or services
– Purchase order shows quantity and price of goods
ordered, quality specifications, shipping terms
– Purchase orders are pre-numbered to establish
completeness
Linking Internal Controls and Financial
Statement Assertions (continued)
– Purchase orders must be properly authorized
– Many companies have separate purchasing
department:
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Promotes efficiency and effectiveness
Eliminates potential favoritism
Reduces the opportunity for fraud
Centralizes control in one function
• Receipt of Goods and Services
– Receiving department should ensure
Linking Internal Controls and
Financial Statement Assertions (continued)
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Only authorized goods are received
The goods meet order specifications
An accurate count of goods received is taken
All receipts of goods are recorded
– Receiving reports are pre-numbered to establish
completeness
– Receiving department records quantity of goods
received
– Goods also inspected for quality
– Receiving reports sent to accounting
Linking Internal Controls and
Financial Statement Assertions (continued)
• Approve payment
– Accounting matches vendor invoice, purchase
order, and receiving reports - If quality and
quantity match, account payable is recorded
– The match can occur as:
• Traditional Manual Matching
• Automated Matching
• Cash disbursement
Linking Internal Controls and
Financial Statement Assertions (continued)
– Supporting documentation is reviewed and
approved for payment
– Documents are marked "paid" to avoid duplicate
payment
Design, Perform and Analyze
Results of Tests of Controls
• The primary risk is that Accounts Payable and expenses will
be understated
• Therefore, controls related to the following are usually
significant:
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Proper authorization
Completeness of recording
Timeliness of recording
Correctness of valuation
• Attribute sampling may be used to test control operation
• The level of assessed control risk will impact the rigor of the
subsequent substantive testing of Accounts Payable and
expenses
LO 6 Substantive Tests of Accounts
Payable
• The auditor's main concern is that Accounts
Payable will be understated
• Therefore, emphasis is placed on testing the
completeness assertion
• Typical substantive tests include:
– Analytical review of related accounts
– Tests of subsequent disbursements
– Reconcile vendor statements or confirm accounts
payable
Analytical Review of Related Expense
Accounts
• Used to determine if accounting data
indicates understatement of expenses
• If understatement likely, auditor expands
tests of accounts payable
• Analytics used on clients with low
control risk
Testing Subsequent Disbursements
• Auditor samples cash disbursements after the
end of the year
• Determines if disbursements are for audit year
transactions by vouching back to source
documents (purchase order, vendor invoice,
receiving report)
• If disbursement is for audit year transaction,
auditor reprocesses the transaction to see if it
was properly recorded as a payable
Reconciling Vendor Statements or
Confirmations with Payables
• Auditor requests vendors' monthly
statements or sends confirmation to major
vendors
• Auditor reconciles vendor statement or
confirmation with client balance in the
accounts payable subsidiary ledger
Substantive Tests of Expense
Accounts
• Auditing payables and cash disbursements
provides indirect evidence about expense
accounts
• Additional analysis of selected expense
accounts is usually merited
• The auditor should consider management is
more likely to
– Understate rather than overstate expenses
– Classify expenses as assets rather than vice versa
Substantive Tests of Expense
Accounts (continued)
• Substantive audit procedures include:
– Detailed tests of transactions
– Analytical review
– Review of unusual entries
LO 7 Complexities Related to Inventory
and Cost of Goods Sold
• Audit of inventory is complicated by a number of
factors including:
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Variety (diversity) of items
High volume of activity
Various (sometimes complex) valuation
Difficulty in identifying obsolete or defective inventory
Many frauds involve the inventory account
Easily transportable making it subject to double counting
May be stored at multiple locations, some may be remote
May be returned by customers
LO 8 Risks and Controls Related to
Inventory and Cost of Goods Sold
• Inventory and cost of goods sold accounts are
prone to errors.
• Inventory frauds are one of the most common
frauds used by management to manage
earnings and misrepresent the financial
position of the company.
• Exhibit 11.6 indentifies some of the possible
fraudulent schemes for manipulating inventory
and cost of goods sold.
LO 9 Internal Controls for Inventory
• A well-designed inventory control system should ensure:
– All purchases are authorized
– Accounting system ensures timely, accurate, and complete
recording
– Receipt of inventory properly accounted for
– Costs properly identified and assigned to products
– All products are systematically reviewed for obsolescence.
– New products introduced only after market studies and quality
control tests have been made
– Management actively manages inventory
– Long term contracts are closely monitored
LO 10 Substantive Tests of Inventory
and Cost of Goods Sold
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Existence: observe year-end physical inventory
Completeness: cutoff tests
Rights: review long-term contracts, etc.
Valuation: direct tests and analytics
Disclosure: review GAAP
Procedures for Observing a Client's
Physical Inventory
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Meet with client to discuss their plan to count inventory
Review client's plans for counting and tagging inventory
Review inventory counting procedures with audit personnel
Determine whether specialists are needed to identify inventory
items
• Upon arriving at each site:
– Meet with client, and obtain map and schedule of inventory
count area
– Obtain list of sequential tag numbers for each area
– Observe procedures to shut down receipt or shipment of goods;
obtain document numbers for last receipt and shipment for cutoff
tests
Procedures for Observing a Client's
Physical Inventory
• Observe the counting of inventory and note the
following:
– The first and last tag numbers in each section
– Account for all tag numbers to prevent later insertion
of additional inventory items
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Make selected test counts
Items that appear obsolete or defective
High-dollar value items in inventory
Movement of inventory during counting process
• Document conclusion as to quality of the inventory
counting process
What does the auditor do after the
inventory count?
After the inventory count, the auditor should:
• Trace the test counts to the client's inventory
records
• Trace the number of high-dollar items to the
client's inventory records
• Trace the obsolete or damaged inventory to the
client's inventory records to see if the items
have been written down
Counting Inventory Before or After
Year-end
• On occasion, it may not be feasible to count inventory
at year-end
• Acceptable to count inventory before or after yearend if:
– Controls are strong
– The opportunity and motivation to misstate inventory is
low
– Auditor can test the year-end balance using analytics and
tests of transactions between the physical count and yearend (called the roll-forward or rollback period)
– Auditor reviews intervening transactions for unusual
activity
Completeness
• Inventory cutoff tests:
– Obtain information on last items shipped and received at
year-end
– Compare this information to transactions recorded in the
sales and purchases journal
– Determine if transaction is recorded in correct accounting
period
• Auditor should also inquire about any inventory out
on consignment or stored in a public warehouse
• Tracing test counts and number of high-dollar items
to the client's inventory records tests completeness (as
well as existence)
Allowance for Returns
• In most situations, expected returns of
inventory are not material
• However, some companies provide return
guarantees and expect significant returns
• Management can use previous experience,
updated for current economic conditions, to
develop estimates of returns
Rights
• Most of the work regarding ownership of
inventory is performed during the auditor's
testing of purchases
• Auditor should also review long-term contracts
to determine obligations
• Inquiry should be made about inventory on
consignment
Inventory Valuation
• Most complex assertion related to inventory
because of the:
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Volume of transactions
Diversity of products
Variety of costing methods
Difficulty in estimating net realizable value of
products
Inventory Valuation (continued)
• Auditor uses direct tests and analytics to assess
inventory valuation:
– Direct tests include verifying cost by reviewing vendor
invoices
– Auditor usually examines current market data and other
conditions that might indicate inventory obsolescence
– Management inquiry and review of industry publications
can help the auditor identify obsolete units
– Analytics, like inventory turnover or day's sales in
inventory, may identify slow-moving inventory which may
need to be written down
– Auditor looks for obsolete units during the counting of
inventory; these units need to be written down
Appropriate Disclosure
• Auditor reviews client disclosure for
compliance with GAAP
– Disclosure should include:
• Costing method(s) used
• Frequency of accounting
• Inventory pledged as collateral
• Any other unusual circumstance
Cost of Goods Sold
• Audit of cost of goods sold can be direct tied
to the audit of inventory
• If beginning and ending inventories have been
verified and acquisitions have been tested, cost
of goods sold can be direct calculated
• Auditor should also apply analytics to cost of
goods sold to see if there are any significant
variations - either overall or by product line