CHAPTER 15 Auditing the Expenditure Cycle Spring 2007

CHAPTER 15 CHAPTER 15 Auditing the Expenditure Auditing the Expenditure

CycleCycleSpring 2007Spring 2007

Expenditure Cycle Transaction Classes and Accounts: Purchases

Debit CreditMerchandise Inventory

Raw Materials InventoryPurchases Prepaid ExpensesPlant AssetsOther Assets

Various Expenses

Accounts Payable

Expenditure Transaction Classes and Accounts: Cash Disbursement & Adjustments

Debit CreditAccounts Payable Cash

Purchase DiscountsPurchase Returns

General Audit Strategy Assess Inherent Risk

Use Knowledge of Business and Industry to Perform Analytic Procedures and Assess Analytic Procedures Risk

Assess Control Risk Evidence of effectiveness gained while obtaining an

understanding of internal controls Evidence of effectiveness of management controls Evidence of effectiveness from direct tests of

programmed controls Design Appropriate Substantive Tests of

Details

Expenditure Cycle: Initial Audit Procedures

Obtain an understanding of the business and industry. Significance of purchase cycle Economic drivers Industry trade terms Concentration of suppliers / purchase

commitments

Expenditure Cycle: Initial Audit Procedures cont.

Business Aspects of the Expenditure Cycle What does the operating cycle look like?

Normal A/P turn Normal Inventory turn Normal A/R turn

What do we know about costs? Fixed/variable Volatility Dependency on suppliers

Expenditure Cycle: Initial Audit Procedures cont.

Consider management incentives & pressures

Liabilities Understate current liabilities to meet debt

covenants Cash Disbursements

High volume and overall susceptible to fraud Expenses

Decision to capitalize vs. expense impacts net income

Expenditure Cycle: Initial Audit Procedures

Understand how key expenditure cycle issues of economic substance are reflected in the financial statements How is the transaction initiated (initiate)? How does receipt of good or service take place?

(movement) How is the transaction recorded (recording)? What is the standards business practice for

settling liability? (consideration) See flowchart 15-5 on page 698 noting

where transactions involve outside entities.

Expenditure Cycle Audit Objectives

Assertion Completeness

Existence & Occurrence

Valuation

Rights and Obligations

Presentation and Disclosure

Specific Audit Objective Completeness Cutoff / Timeliness

Validity Cutoff / Timeliness

Valuation at Historical Cost / GAAP

Valuation at Net Realizable Value Posting and Summarization

Ownership

Classification Disclosure

Expenditure Cycle: Initial Audit Procedures

Assertions

Expected Internal Controls

Enough Comfort? Yes/No

Specific Audit Objectives

What substantive testing do we plan on doing?

Expenditure Cycle: Initial Audit Procedures

Analytical Procedures Estimate Accounts Payable with knowledge of

the company’s historical operating cycle, creditor trade terms, and cost of goods sold.

Ratio of CGS / AP Ratio of Inventory / AP

Use results of analytical procedures to direct attention to potentially misstated areas of f/s

Expenditure Cycle: Understand (and maybe test) Internal Controls

Control Environment Ethical Values Human Resource Practices

Commitment to Competence (Hiring / Training) Background Checks

Assignment of Authority and Responsibility Accountability

Mgmt. Risk Assessment Cash flow Supply chain Fraud risk

Expenditure Cycle:Information System

Documents Purchase requisition Purchase order Receiving report Vendor’s invoice

(external) Voucher (internal) Check Cash disbursements

journal

Files Approved vendor

master file Accounts payable

master file /or/ Voucher register

Open P.O. file Receiving file Suspense file Unpaid voucher file Paid voucher file

Expenditure Cycle: Obtain an Understanding of Internal Controls

We also need to know… Reports:

Reports used in decision making Exception reports

Understand how reports are used to manage and control the entity. Timeliness of review of reports. Business decisions made with reports. Follow-up on issues raised in reports.

Assessing Control Activities - Hints

Determine first if general controls are adequate

Ensure you are clear on what audit objective you are assessing

Computer Controls: Think about the fields and data that the computer

is comparing. Think about what information appears on an

exception report. Once you have assessed which controls you

want to place reliance on, then they can be tested (often using sampling)

Purchases Controls (completeness)

Completeness Establish initial pre-numbered control over PO,

receiving, and voucher Have computer:

Ascertain that documents are pre-numbered with no missing documents in sequence

Identify all purchase orders without receiving reports or vouchers

Cutoff Computer should compare receiving date with the

date the invoice is recorded. They should be in the same accounting period.

Purchases Controls (existence)

Validity The computer should compare:

Vendor number on purchase order and voucher with vendor on a master vendor file (encourage use of check digits in vendor numbers).

Compare quantities on voucher (and vendor’s invoice) with quantities on receiving report.

Have managers review items charged to their budgets to determine that items are valid.

Cutoff Same as w/ completeness

Purchases Controls (valuation)

Valuation at Historical Cost Have the computer:

Multiply quantity x price and add for each item on vendor’s invoice. Compare quantity with receiving report. Compare price with P.O.

Batch totals if invoices are processed in batches. Limit tests where limits vary based on account

numbers. Have managers review items charged to their

budgets to determine that amounts are reasonable.

Purchases Controls (valuation)

Valuation at N.R.V. Not applicable at transaction level. Generally not applicable for liability.

Posting and Summarization Have the computer compare:

Run to run totals: Running balance in voucher register + transactions = new balance.

Sum of accounts payable subsidiary ledger with general ledger control account.

Purchases Controls (R & O)

Ownership like net realizable value, generally applies to

balances, not transactions.

Purchases Controls (P & D)

Classification Have the computer:

Compare account numbers on purchase order with account numbers on voucher.

Have managers review items charged to their budgets to determine that items are properly charged to their accounts

Disclosure Related party? The auditor rarely finds controls over disclosure

and must test substantively

Cash Disb Controls (completeness)

Completeness The AP master file is the report of all unpaid

vouchers. Have the computer generate an exception report

of all items past their due date and not paid. Account for pre-numbered checks. Print

exception report with any missing sequences.

Cutoff Independent Bank Reconciliation on a monthly

basis.

Cash Disb Controls (existence)

Validity Computer will automatically check for duplicate

payments of specific voucher/vendor’s invoice so it is not paid twice.

Controls over access to cash Computer will not process payment without recording

of the voucher. Key control is over validity of voucher. Pay only vendor’s on authorized vendor list. Control

ability to put vendor on list. Segregation of duties between making changes

in approved vendor list, recording payable and disbursing cash.

Cash Disb Controls (valuation)Valuation at historical cost Issue: The check is written in the proper amount. Computer compares check amount, plus purchase discount, to

voucher amount. Requires additional authorization for paying different amount.

Authorization procedures for signing checks of certain sizes.

Valuation at NRV Not applicable to transactions.

Posting and Summarization Run to run totals on disbursement’s journal. Compare sum of A/P subsidiary ledgers with control

account in the general ledger

Cash Disb Controls (R & O)

Ownership Controlled by controlling voucher.

Cash Disb Controls (P & D)

Classification Exception report where controller reviews all

transactions not charged to accounts payable and cash.

Have managers review items charged to their budgets to determine that items are properly charged to their accounts.

Disclosure Do not expect control here.

Accounts Payable: Determining Detection Risk Inherent Risk

Major concern is understatement. Analytic Procedures Risk Control Risk

Control risk over purchases Control risk over disbursements

Use audit risk model to solve for test of details risk – How much more comfort do we need?

Accounts Payable: Standard Substantive Tests

Initial substantive procedures Agree beginning balance to prior year

workpapers Agree subsidiary ledger to general ledger Computer scan of all transactions and

balances for unusual items. Rank order payables by size or aging Computer analysis of voucher register

(consider fraud assessment procedures here)

Accounts Payable: Standard Substantive Tests

Analytical Procedures Liquidity ratios look too good Significant change in accounts

payable turn days Understand the company’s ability to

generate cash flow from operations Is accounts payable growing at about

the same pace as inventory growth?

Accounts Payable (completeness)Substantive Tests

Completeness Search for unrecorded liabilities (primary test)

Subsequent cash disbursements (checks & wires) Unpaid invoices

Cutoff Obtain listing of last receipts at inventory

observation and trace to recording of payable Search for unrecorded liabilities This also ties in with cash disbursements cut-off

Accounts Payable (existence)Substantive Tests

Validity Consider confirmation based on risk of

misstatement: This is a costly procedure Significant number of purchase returns (returns to

vendor?) Review vendor’s statements

Accounts Payable (valuation)Substantive Tests

Valuation at historical cost Subsequent payment of Accounts Payable Confirmation of Accounts Payable Review of Vendor’s Statements

Valuation at N.R.V. Not an issue with liability

Posting and Summarization See initial procedure where this is tested

substantively.

Accounts Payable (R & O)Substantive Tests

Ownership Ownership tests are risk based. Key is internal

controls that ensure that only the transactions of the entity are recorded in books.

Ties with cut-off procedures. Do they have title of purchases they have not recorded as liabilities?

Accounts Payable (P & D)Substantive Tests

Presentation Review A/P for debit balances that should be

reclassified Review proper classification of trade payables,

related party payables, etc.

Disclosure Review financial statement disclosures against

disclosure check list

How this all fits together: The Audit Risk Model

AR = IR x CR x AP x TD

AR = IR x AP x CR x TD

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