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Chapter 11 Answer
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Chapter 11 - Audit of Acquisition Cycle and Inventory
--------------------------------------------------------------------------1. Acquisition and payment cycle overview
2. Identifying risks
3. Substantive tests of acquisition and payment cycle accounts
--------------------------------------------------------------------------The acquisition and payment cycle includes the processes for purchasing, receiving,
and paying for goods and services. The major accounts in this cycle include Inventory,
Accounts Payable, Cost of Goods Sold, and related expense accounts. Source documents
and processes:

Requisition: need for goods and services identified, pre-numbered requisition form
filled out and forwarded to purchasing department

Purchase: Purchasing department (or automated purchase program) fills out prenumbered purchase order showing quantity and price of goods ordered, quality
specifications, shipping terms. Copies sent to vendor and Accounts Payable; blind
copy to Receiving.

Receipt: Receiving department inspects goods for damages/quality and prepares prenumbered receiving report listing quantity and type of goods received. Copy sent to
Accounts Payable and Inventory Warehouse.

Approval: AP clerk matches prices and quantities on vendor invoice to purchase order
and receiving report. If quantities and prices match, payment is approved.

Cash disbursements: check cut and mailed to vendor, documents marked "paid"
In order to perform an integrated audit of this cycle, the auditor must understand the
processes and documents in this cycle as well as the potential risks associated with the
procurement and ownership of goods.
Identify and Assess Risks
To identify and assess risks related to the acquisition and payment cycle, the auditor will
gather information about business and operational risks, inherent risks, fraud risks, and
internal control weaknesses. Typical audit procedures include inquiry, brainstorming
sessions, preliminary analytical procedures, and the examination of internal controls.
Of the management assertions 1, existence and valuation assertions are typically the
most relevant for inventory. Why? The cost of acquiring inventory is allocated between
ending inventory and cost of goods sold. If the ending inventory is overstated, cost of
goods sold will be understated.
1
Five management assertions underlie the financial: existence/occurrence, completeness,
rights & obligations, valuation/allocation, and presentation and disclosure
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Completeness and valuation are typically the most relevant for accounts payable and
purchases. Why? Managers may not want to record the liability and related expense.
Fraud Risks
Financial statement fraud schemes in the acquisition cycle include:





Overstate ending inventory to understate cost of goods sold
Understate net purchases to understate accounts payable and the cost of good sold
Defer the write-down/off of obsolete inventory
Miss-classify expenses as assets (hang the debit)
Defer recording of liabilities
Asset misappropriation frauds in the acquisition cycle include: 2



Theft of inventory
Purchases from fictitious vendors or vendors overcharging the client (billing
schemes); inventory and payables recorded at overstated amounts
Expense reimbursement schemes
Preliminary analytical procedures to identify possible misstatements: 3

Calculate and analyze dollar and percentage change in inventory, cost of goods sold,
accounts payable, expense accounts (horizontal analysis)

Compute and analyze ratios like inventory turnover and number of day's sales in
inventory (valuation)

Prepare common sized income statement to identify cost of good sold or expense
accounts that appear out of line (vertical analysis)
Results are compared to client’s prior results, industry averages, and auditor
expectations to identify anomalies. These include:



Inventory increasing at a rate faster than sales (especially with JIT)
Expenses significantly above/below industry or company norms (above may conceal
theft of assets; below may be sign of fraudulent statements)
Capital assets growing faster than the business and/or for which there are no
strategic plans
2
Asset misappropriate frauds can lead to materially misstatement financials if the fraud
is not discovered and accounted for
3
Exhibit 11.6 lists several ratios for acquisition cycle accounts
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



Significant reduction in contra asset reserve accounts and expenses
Expense accounts that have significant credit entries
Lack of documentation for travel and entertainment expense accounts (popular area
for fraudulent disbursements)
Inadequate follow-up to auditor recommendations (control environment)
Inherent, Business and Operational Risks
Factors that complicate the audit of inventory include:
 Variety of items in inventory and the high volume of transactions
 Complex valuation methods
 Difficulty in identifying obsolete or defective inventory
 Inventory may be easily transportable and/or stored at multiple locations making it
susceptible to double counting
 Client may have generous return policies which affect inventory (sales)
Control Risks
Because of these risks and the volume of transactions in the acquisition cycle, internal
controls are critical. Of particular importance are the segregation of duties and control
procedures related to authorization and reconciliations. Basic controls in the acquisition
and payment cycle:

Requisition: acquisitions are driven by needs (often production or sales budgets).
These controls relate primarily to appropriate authorization procedures.

Purchase: many companies have centralized purchasing functions that look for the
best combination of product performance and price. These departments may reduce
fraud by segregating the purchase function from custody and recording functions.
However, controls are necessary to prevent purchasing agents from abusing their
positions. These controls include requiring competitive bids for large purchases,
rotating purchase agents, and supervisor review and stratified authorization of
purchases above a pre-set dollar amount.
In addition, pre-numbered purchase order should be used to establish the
completeness of the purchases. A (blind) copy of the PO is often used by
the receiving department to determine whether to accept an order. Copies
of the PO and receiving reports are sent to Accounts Payable.

4
Receipt: Receiving department checks that only authorized goods are accepted,
received goods meet order specs and are accurately counted, and that all receipts
are documented. Pre-numbered receiving reports or scanning are typically used.
Copies of receiving reports are forwarded to Accounts Payable. 4
Exhibit 11.4 lists controls in both traditional and automated receiving systems
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
Approval of Payment: employees in Accounts Payable typically match the
quantities and prices on the purchase order, receiving report, and vendor invoice to
ensure that the items ordered were received and that the vendor is not overcharging.
Controls are designed to ensure all items are timely recorded as accounts payable,
that the authorization process includes a review of documents. Discrepancies and
disputes with vendors should be handled by supervisors

Cash Disbursements: documentation should be marked as paid/canceled in order
to avoid duplicate payments
In addition, accounting for inventory is enhanced when client controls are designed to
achieve the following. Auditor procedures to test include:

Purchases properly authorized: auditor vouches sample of purchase journal
transactions back to purchase orders to see if authorized

Receipt of inventory recorded timely: auditor vouches sample of purchase
journal entries to purchase order and receiving reports to see if date of recording
matches date of title transfer. May also reprocess sample of purchase
orders/receiving reports to recording in purchases journal

Inventory tested for defects when received/manufactured: defective items
adversely impact valuation. If defective items are not identified, inventory and
accounts payable may be overstated (and over paid)

Product costs properly assigned to units produced: auditor reviews client
product costing system including allocation of overhead costs

Products introduced only after market studies and quality control tests
performed: unmarketable or defective products create significant inventory writeoffs and high sales returns (valuation issues)

Customer returns examined: if returned items are damaged or defective, they
should be scrapped and written off. Failure to examine creates overstated inventory

Periodic evaluation of inventory for damage and obsolescence and timely
write-off when inventory is found to be impaired

Active management of inventory; JIT inventory management, policies of
discounting inventory after a period of time
The specific controls implemented by the client will depend on the type of its inventory
and business operations.
Responding to the Risks of Misstatement
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Once the auditor has developed an understanding of the risks of material misstatement,
s/he can decide which procedures to perform.
Where internal controls are not adequately designed (or testing may not be efficient), an
auditor may decide to use substantive approach for testing specific assertions. This is
more common with small clients.
However, in most cases, a combined approach is used – this requires evaluation and
tests of internal controls (in order to rely on them) and substantive procedures. These
combinations are reflected in Exhibit 11.7
1. Auditors develop an understanding of internal controls in the acquisition and payment
cycle through inquiry, observation, review of client documents, and review of prior year
work papers; document
2. The preliminary assessment of control risk is based on an understanding of the
client system’s design and whether the control procedures are sufficient to ensure the
control objectives are met.
3. If control risk is assessed below maximum and reliance is cost-effective, the auditor
must document the controls that support this assessment and test the relevant controls
to see if they are operating as designed. In the acquisition cycle, the controls designed
to ensure that purchases and payments are properly authorized and transactions
recorded in the proper period (existence, completeness) at proper amount (valuation)
are particularly relevant.
4. Based on the results of the testing procedures, the auditor will determine whether the
preliminary control risk assessment should be revised. If testing indicates the controls
are not operating effectively, auditor will increase the assessed level of control risk
(and lower the related detection risk and increase the rigor of the substantive testing). If
controls are working effectively, control risk assessment is unchanged.
Substantive Tests of Inventory and Cost of Goods Sold
When substantively testing Inventory and Cost of Goods Sold, the primary management
assertions for Inventory are existence and valuation.
To that end, substantive audit procedures include observation of the count of the
physical units in the year-end inventory, tracing unit costs from the inventory subsidiary
ledger to the vendor invoices, and recomputation of cost of inventory.
1. Observe the count of year-end inventory
Prior to the count, auditor will meet with the client/inventory counting service to
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discuss the plan to count inventory including how to control movement of inventory and
count sheets. The auditor will also need to determine whether specialists are needed to
evaluate inventory items
On arriving at each inventory site, the auditor will
 Obtain a map of, and a time schedule for, each inventory count area
 Obtain list of tag numbers for each area
 Observe whether client has shut down receipt or shipment of goods
 Obtain the document numbers for the last receiving reports and shipping documents
for the year – to perform subsequent cut-off tests.
During observation of the counting of inventory, the auditor should
 Note the first and last tag numbers in each section; account for all tag numbers to
prevent later insertion of additional inventory items
 Make selected test counts to determine the accuracy of the count. If auditor and
client counts differ, auditor must resolve the difference. The test counts should focus
on big dollar and difficult to count items. Why?

Note movement of inventory during the count. Incoming inventory is not a problem,
auditor has client hold incoming goods on receiving dock. Sales are more difficult.
After count, auditor examines sales made during the count and adjusts count so
items are not double counted as inventory and CGS. This is not exact, but we are
looking for immaterial.


Ask about any goods in transit or goods on consignment
Note items that appear obsolete or in poor/damaged condition

IMPORTANT: auditor must have copies of ALL completed inventory count sheets
before s/he leaves the client. Why?

At completion of count, document conclusion as to the quality of the counting
process
After the observation of the inventory count, the auditor will:
 Trace test counts to client's inventory subsidiary ledger to determine if physical
inventory count matches recorded unit quantity

Trace non-test count items (especially high-dollar items) to the client's inventory
subsidiary ledger. Why non-test count items?

Trace obsolete or damaged inventory to the client's inventory subsidiary ledger to
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see if the items have been properly written down

Inventory cutoff tests: reprocess source documents for last items shipped and
received just before and after year-end to the sales and purchases journal to see if
transactions are recorded in the proper accounting period
When it is not feasible to count inventory at year-end, auditors can count inventory just
before or after year-end if control risk and the motivation to misstate inventory is low. In
these cases, the auditor will test the year-end balance using analytics and tests of
transactions between the physical count and year-end (called roll-forward or rollback
period), and by reviewing transactions for unusual activity

Roll forward: count taken before YE + units purchased – units sold

Roll back: count taken after YE – units purchased + units sold
The preceding procedures provide strong evidence about the existence of the
physical inventory and evidence about valuation. The auditor will perform additional
procedures to gather evidence about the other assertions:
Completeness
 Testing the completeness of the recording of Accounts Payable provides evidence
about the completeness of the purchases of inventory

Tracing inventory counts to the client's inventory subsidiary ledger tests
completeness by uncovering under-recorded inventory

Inventory cutoff tests look for unrecorded purchases and sales

Inquiries about inventory out on consignment or stored in a public warehouse and in
transit (and not included in inventory count)
Valuation: given the volume of transactions, variety of products and costing methods,
and difficulty in identifying obsolete items, auditing the valuation assertion can be
difficult. Auditors typically use recomputation, analytics, and observation to assess the
valuation of inventory:

Unit purchase prices are verified by tracing to purchase orders and vendor invoices.
With unit cost, physical unit flow, and the inventory method used by the client,
auditors can recompute inventory costs

Analytics, like inventory turnover or day's sales in inventory, may identify slowmoving inventory which may need to be written down

Auditor observation of discarded/obsolete units during the inventory count also
address valuation. Management inquiry and review of industry publications help the
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auditor identify obsolete units
Presentation and disclosure: review client disclosure for compliance with GAAP
including cost methods used and other items (such as inventory pledged as collateral)
Cost of Goods Sold: when auditors substantively test Inventory, they are also
indirectly testing the Cost of Goods Sold. When beginning inventory, purchases, and
ending inventory have been audited, the remaining item is in the inventory cost flow
model is Cost of Goods Sold.
If the auditor is able to establish a stable relation between Sales and Cost of Goods Sold,
s/he auditor may use analytics to estimate an amount for Cost of Goods Sold.
If the recorded Cost of Goods Sold is close to this estimate, the auditor may conclude it
is not materially misstated without additional procedures. If there is a significant
difference between estimated and recorded figures, then additional substantive tests
will need to be performed.
Substantive Tests of Accounts Payable
The primary risk for auditors is that the Accounts Payable are understated. A client may
defer recording, omit recording, or record the payable at a lesser amount. In
addition, if a payable is understated, then an expense or Inventory is also understated.
How does this affect the financial statements?
Audit procedures to test the completeness of recorded payables:
1. Deferred recording: the auditor will sample entries in the Purchases Journal for a
few weeks after year-end and then vouch those entries back to the source
documents (purchase order, vendor invoice, receiving report). The date of recording
(after year-end) is reconciled with the dates on the source documents. Payables
recorded after year-end but with documents showing a purchase prior to year-end are
have been deferred (cut-off test).
2. The above procedure works if the client only defers the recording of a payable. But,
what if the client omits recording the payable and does not record the transaction
until the invoice is paid. To find these omissions, the auditor will sample entries in the
Cash Disbursements Journal for a few weeks after year-end. This is a two step
procedure:
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
Vouch the disbursement back to the source documents. If the documents show
goods/services were received before year-end, we can only say that a purchase made
before year end was paid after year end.

So, we must then reprocess the documents to the Purchases Journal and A/P
subsidiary ledger. If the transaction was recorded before year-end, there is no
misstatement. However, if the transaction was not recorded before year-end, we
have an unrecorded liability.5
3. Auditors frequently confirm year-end balances with vendors. 6 For these confirmations,
the auditor can use open form confirmations.
The auditor must be sure that s/he has a complete list of client vendors (risk is client
omits vendors whose payables have been understated or omitted). Procedures to find
omitted vendors include scanning the Purchase and Cash Disbursement Journals to
identify vendors with significant activity and then trace those vendors to the clientsupplied vendor list.
Chapter 11 - Audit of Acquisition Cycle and Inventory
page 9
--------------------------------------------------------------------------Given the risk is understatement, the auditor should confirm payables from major
vendors with zero or low balances. This would require use of a unit-based sampling
approach instead of a dollar-based approach. Could you use MUS sampling to select a
sample of major vendors for confirmation?
4. Auditing accounts payable provides evidence about expenses. Auditors also use tests
of transactions and analytics to examine certain expenses:

Tests of transactions: certain expenses are higher risk. For example, employees
often overstate Travel and Entertainment expenses to get over-reimbursed. These
fraudulent disbursement schemes not only a misappropriation of assets but also
overstate expenses. On the other hand, companies capitalize costs that should be
expensed as Repairs and Maintenance. For these accounts, auditors may vouch
samples of recorded expenses with source documents to determine if the expense
has been properly accounted for. For capitalized repairs, auditors examine audit
period additions to existing assets in the Plant, Property and Equipment accounts.
Auditors also scan expense accounts for unusual entries (credits).
5
This procedure assumes the client pays its bills on a timely basis; not a bad assumption
since suppliers cut off non-paying customers
6
If internal controls are strong, an auditor may forgo confirmations and reconcile vendor
statements to the accounts payable subsidiary ledger
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
Analytics: many expenses are related to an activity or another account balance (like
a linked account). If the auditor can establish a stable relation between the expense
and some activity or other account, analytics (such as vertical and horizontal
analysis) may be used to evaluate the reasonableness of expense. Good internal
controls are critical when using client numbers.
Homework
11-33:
The five primary activities involved in the acquisition and payment cycle are follows:
 Requisition for goods and services
 Purchase of goods and services
 Receipt of, and accounting for, goods and services
 Approval of items for payment
 Cash disbursements
11-35:
(1) C- Rights and Obligations
(2) A- Existence/Occurrence
(3) E – Presentation and Disclosure
(4) B – Completeness
(5) D – Valuation or Allocation
11-36:
(1) D – Valuation or Allocation
(2) B – Completeness
(3) C- Rights and Obligations
(4) E – Presentation and Disclosure
(5) A- Existence/Occurrence
11-37:
Five reasons that inventory is a complex accounting and auditing area are as follows:
 A great variety of items exists in inventory.
 Inventory accounts typically experience high volume of activity.
 Inventory is easily transported.
 Inventory accounts may be valued according to various alternative accounting
valuation methods.
 Inventory often exists at multiple locations, with some locations being remote
from the company’s headquarters.
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11-39:
Five common fraud schemes in the acquisition and payment cycle are as follows:
 Theft of inventory by employee
 Inventory shrinkage – the reduction in inventory presumed to be due to physical
loss or theft.
 Employees schemes involving fictitious vendors as means to transfer payments to
themselves.
 Large manual adjustments to inventory accounts
 Schemes to classify expenses as assets
11-41:
a) The auditor is responsible for identifying fraud in nature of theft by employees of
material amounts. A common scheme of fraud is used by the employees is theft of
company assets, therefore auditors should perform tests to identify such frauds.
b) The following were the deficiencies in the internal control:
1. Reasons for long outstanding checks were not recorded
2. Year end balance confirmation is not taken by the company which would help identify
such differences.
3. Checks are prepared and signed by the head bookkeeper solely. Cautious practice
requires joint signatories for checks.
c) The following substantive audit procedures would have revealed the fraud:
1. Balance confirmation from large vendors and list of pending items in accounts.
2. Review of cash disbursements during the year.
3. Checking of checks appearing uncleared in the bank reconciliation statement of the
previous year and tracing its clearance in the current year.
4. Checking of expense accounts to identify any unusual amounts or expenses of
unusual nature.
11-42:
Controls
A
B
C
D
E
F
G
H
I
J
K
L
M
Activities in the Cycle
3) Receipt of, and accounting for, goods
1)Requisition for goods and services
2)Purchase of goods and services
5) Cash disbursements
2)Purchase of goods and services
5) Cash disbursements
2)Purchase of goods and services
1)Requisition for goods and services
2)Purchase of goods and services
3) Receipt of, and accounting for, goods
3) Receipt of, and accounting for, goods
3) Receipt of, and accounting for, goods
4)Approval of items for payments
and services
and services
and services
and services
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N
O
P
Q
R
2)Purchase of goods and services
5)Cash disbursements
2)Purchase of goods and services
5)Cash disbursements
1)Requisition for goods and services
11-43:
(a) The inefficiencies and deficiencies are as follows:
• Everyone has the authorization to file and issue the purchase orders, but there is
no such responsibility.
• The filing of vendor packing slip is done without any comparison with the received
goods.
• All the goods are placed in the storage by receiving the department personnel
without the notification of the warehouse personnel.
• The invoice of the shipper is accepted automatically by anyone in the receiving
function and is forwarded to the controlling for the purpose of recording and
consequent payment by the department of treasury.
(b) The improvement of the process can be done in the following ways:
• The head of the department should specify the responsibility for purchase orders
filing and the ones that are identified should be held answerable for the
dependability of the files.
• The invoice of the shipper should be directed straight to the personnel responsible
for filing who should match the invoice of the shipper with the order of purchase. If
it matches the invoice of the shipper, then should be directed to the controller.
• The vendor packing slip can then be sent to the personnel responsible for filing
and the associate order of purchase. The goods then should be counted by the
dock personnel who is responsible for preparing the pre numbered receiving
report.
• Separation between the quality control inspection, receiving, and warehousing
should be maintained.
(c) Incompatible function need to be segregated to minimize the possibility and error of
an employee stealing the asset and covering it up by also doing the record keeping and
authorization. If someone could authorize the inventory purchase, obtain the physical
custody and process the payment, they could ten have their company pay for the items
they use or sell them personally.
When these functions are automated, then the orders of purchase are generated
automatically by the inventory control system on the basis of certain parameters. Those
constraints should only be changed or set by the person who is independent of the
payment and receiving function using the suitable access restrictions––ID and password.
The personnel in the receiving department should access information of purchase order
in the computer in read-only mode. They should scan the barcodes or enter physically
the receiving information in the computer. The invoice of the vendor might be received
electronically or entered into the system by the personnel of accounts payable form a
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paper invoice.
(d) Control risk should be set the highest because the receiving personnel have the
access to the purchase order, the vendor’s invoice, the goods ordered. The controller
receives the invoice of the vendor signed by the receiving personnel who can take the
goods and make the company pay for it.
The auditor will then need to rely on the substantive tests of the related accounts––the
cost of goods sold, inventory, and accounts payable.
11-48:
The sequence in which the activities are to be performed is:
5.
1.
3.
7.
4.
6.
2.
11-49:
The following are the tasks and related assertions tested by the auditor while observing
the physical inventory:
Task
Assertion
a. The auditor makes test counts of selected items and records the test 1. Existence and
count for subsequent tracing into client’s inventory compilation
Occurrence
b. The auditor takes notation of all items that appear to be obsolete or
that are in questionable condition; the auditor would follow up on
2. Valuation and
these items with inquiries of client personnel and retains the data to
Allocation
determine how they are accounted for in inventory compilation.
c. The auditor observes handling of scrap and other material.
3. Presentation
and Disclosure
d. The auditor observes whether any physical movement of goods
occur during the counting of inventory
4. Completeness
e. The auditor records all high-dollar-value items for subsequent
tracing into client’s records.
5. Rights and
Obligations
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