Chapter 11
Audit of Acquisition Cycle and
Inventory
Overview of Acquisition Cycle
The acquisition cycle covers the purchase,
receipt, payment, and accounting for goods
and services
Major accounts include inventory, accounts
payable, and expenses
Main phases in the acquisition and payment
process:
Authorized requisition
Authorized purchase
Receipt of goods and services
Approval for payment
Cash disbursement
Discuss Risk and Business
Analysis
Acquisition cycle deals with receipt of all goods and services
Misstatements may occur just because of the volume of
transactions
It is also an area where fraud is likely to take place. For
example,
 Employee theft of inventory causing inventory on the books
to be overstated
 Employees setting up fictitious vendors and paying
themselves for goods never received by the company
 Executives abusing travel and entertainment expenses for
personal use
 Capitalizing expenses as assets to inflate earnings
 Overestimating "restructuring reserves" at the time of
acquisition so expenses could be reduced in future periods
What are the red flags of the
acquisition and payment cycle?
There are a number of red flags unique to the
acquisition and payment cycle. These 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"
 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
What analytical analysis can be
done for 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
Overview of Control Procedures
and Control Risk Assessment
Requisition goods or 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
 Purchase orders must be properly authorized
 Many companies have separate purchasing department:
 Agents job is to find best combination of price, service, and quality
 Reduces fraud by separating purchasing from custody and
recording
 Centralizes control in one location
 Controls set to stop purchasing agents from abusing their
positions
Overview of Control Procedures
and Control Risk Assessment
Receive goods
Receiving department should ensure
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
Overview of Control Procedures
and Control Risk Assessment
Approve payment
Accounting matches vendor invoice,
purchase order, and receiving reports - If
quantity and quantity match, account
payable is recorded
Cash disbursement
Supporting documentation is reviewed and
approved for payment
 Documents are marked "paid" to avoid
duplicate payment
Testing Controls over Accounts
Payable and Related Expenses
The primary risk is that Accounts Payable and
expenses will be understated
Therefore, controls related to the following are usually
significant:
 Proper authorization
 Completeness of recording
 Timeliness of recording
 Correctness of valuation
Attribute sampling (Chapter 9) 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
What are some 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:
Reconcile vendor statements or
confirm accounts payable
Tests of subsequent disbursements
Analytical review of related accounts
Discuss Reconciling Vendor Statements
or Confirm Accounts Payable
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
Review 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
Comment on 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
Discuss Auditing 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 audit procedures include:
 Detailed tests of transactions
 Analytical review
 Review of unusual entries
Reflect upon Auditing of
Inventory & Cost of Goods Sold
Audit of inventory is complicated by a number of
factors including:
 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
What are some 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
 Inventory tested for quality when
received/manufactured
 Costs properly identified and assigned to products
 Customer returns of inventory examined for defects
 Inventory 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
Discuss Substantive Tests of
Inventory & Cost of Goods Sold
Existence: observe year-end
physical inventory
Completeness: cutoff tests
Rights: review long-term
contracts, etc.
Valuation: direct tests and
analytics
Disclosure: review GAAP
Explain Procedures for Observing a
Client's Physical Inventory
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
Explain 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
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
Explain 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 year-end
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 year-end (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)
Comment on 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
Discuss 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
Explain Inventory Valuation
Most complex assertion related to inventory because of the:
 Volume of transactions
 Diversity of products
 Variety of costing methods
 Difficulty in estimating net realizable value of products
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 may need to be written down
Comment on 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
Discuss 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