CHAPTER 4

Audit of the Acquisition and Payment Cycle

Chapter Objectives
After successfully completing this chapter, you should be able to:
 Identify business functions, transactions, accounts affected, and documents & records in the
acquisition and payment cycle
 Identify potential misstatements in acquisition and payment transactions
 Assess control risk and designing tests of controls & substantive tests of transactions for acquisitions
and payments
 Design and perform tests of account balances affected by acquisition and payment cycle
ACCOUNTS AFFECTED IN THE ACQUISITION AND PAYMENT CYCLE
 Purchases  Accounts payable
 Purchase returns and allowances  Property, plant, and equipment
 Purchase discounts  Prepaid expenses
 Cash in bank  Manufacturing, administrative, selling
 Inventory expenses
CLASSES OF TRANSACTIONS IN THE ACQUISITION AND PAYMENT CYCLE
 Acquisition of goods and services
 Returns and allowance transactions
 Cash disbursements for those acquisitions

BUSINESS FUNCTIONS IN THE ACQUISITION AND PAYMENT CYCLE

 An employee recognizes a need for a purchase; completes a requisition and sends it to purchasing.
Purchasing department shops for the appropriate quality at the best price, then prepares a purchase
order (Processing purchase orders)
 When goods arrive from the vendor, the receiving dept inspects, counts, and prepares a receiving
report (Receiving goods and services)
 When the vendor’s invoice arrives, accounts payable enters the amount in the acquisitions journal and
the accounts payable master file (Recognizing the liability)
 Before the due date, a cheque is mailed to the vendor and the payment is recorded in the cash
payments journal and accounts payable master file (Processing and recording cash disbursements)
DOCUMENTS AND RECORDS IN THE ACQUISITION AND PAYMENT CYCLE
 Purchase requisition,
 Purchase order,
 Receiving reports,
 Vendor’s invoice,
 Debit memo, voucher,
 Acquisition transaction file,
 Acquisitions journal,
 As/P master file,
 As/P trial balance,
 Vendor’s statement,
 Cheque/electronic payment,
 Cash disbursement transaction file,
 Cash disbursements journal

1|Page A u d i ti n g P r i n c i p l e s & P r a c ti c e s I I - C h 4 / A A U / / N o v 2 0 2 0
 METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR ACQUISITION AND PAYMENT CYCLE

Understand Internal Controls

Assess Planned Control Risk

Determine Extent of Testing controls

Design tests of Controls &

Substantive Tests of Transactions

In assessing control risk, the auditor should consider key internal controls such as adequate segregation of
duties, proper authorization, adequate documents and records, use of prenumbered documents, internal
verification procedures etc. Besides, the auditor determines the extent of testing controls in terms of whether
substantive tests will be reduced sufficiently to justify the cost of performing tests of controls.

DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS -

ACQUISITIONS AND PAYMENTS
In designing audit tests for acquisition and payments, the auditor should consider the specific transaction-
related audit objectives (See the attachment containing the Summary of Transaction-Related Audit
Objectives, Key Controls, Tests of Controls, and Substantive Tests of Transactions for Acquisitions and for
Cash Disbursements )

Key Internal Controls

1. Authorization of purchases
 Proper authorization for acquisitions ensures that the goods and services acquired are for authorized
company purposes, and the acquisition of excessive or unnecessary items are avoided.
 Different levels of authorization for different types of acquisitions or birr/dollar amounts required.
 After the purchase requisition for an acquisition has been approved, a purchase order to acquire the
goods or services must be initiated.
 Purchasing department is responsible to ensure an adequate quality of goods and services are
acquired at a minimum price.
 The purchasing department should be separate from those who authorize the acquisition or receive
the goods.
 All purchase orders should be prenumbered to permit easier accounting for all outstanding purchases
orders and should be designed to minimize the likelihood of unintentional omissions on the form
when goods are ordered.

2. Separation of the custody of the received goods from other functions

 The receiving department initiates a receiving report as evidence of the receipt and examination of
goods.
  One copy is normally sent to the raw materials storeroom and another to the accounts payable
department for their information needs.
 The personnel in the receiving department should be independent of the storeroom personnel and the
accounting department.
 The accounting records should transfer responsibility for the goods each time they are moved, from
receiving to storage, from storage to manufacturing, etc.

3. Timely recording and independent review of transactions

 The accounts payable department has responsibility for verifying the appropriateness of acquisitions.
 The accounts payable personnel compares the details on the purchase order, the receiving report, and
the vendor’s invoice to determine that the descriptions, prices, quantities, terms, and freight on the
vendor’s invoice are correct.
 The accounts payable department should also account for all receiving reports to assure that the
completeness objective is satisfied.
 Adequate documents and records, proper procedures for record keeping, and independent checks on
performance are also necessary controls in the accounts payable function.

4. Authorization of payments to vendors

 The most important controls over cash disbursements include:
 The signing of checks by an individual with proper authority
 Separation of responsibilities for signing checks and performing the accounts payable function
 Careful examination of supporting documents by the check signer at the time the check is
signed
 The checks should be prenumbered to make it easier to account for all checks and printed on special
paper that makes it difficult to alter the payee or amount. Companies
 Physical control over blank, voided, and signed checks is required.
 There must be a method of canceling supporting documents to prevent their reuse as support for
another check at a later time. A common method is to document the check number on the supporting
documents.

TEST OF DETAILS OF BALANCE FOR ACCOUNTS PAYABLE

In addition to testing controls and transactions for acquisitions and payments, it is necessary to audit
accounts payable balance shown in the client’s draft balance sheet. This involves performing analytical
procedures and test of details of balances. The following analytical procedures may be performed for As/P:

Analytical procedures Possible misstatement

Review list of Accounts payable for unusual, non- Classification misstatement for nontrade
vendor, & interest-bearing payables liabilities
Compare acquisition-related expense account Misstatement of As/P & expenses
balances with prior years
Compare individual As/P with previous years Unrecorded or nonexistent accounts or
misstatements
Calculate ratios (e.g. Average paying period, As/P to Unrecorded or nonexistent accounts or
current liabilities ratio misstatements

What audit procedures should be performed by the auditor to test accounts payable balance? The following
table shows the most common audit procedures for As/P balance:
Audit Objective Audit Procedures
Detail tie-in  Re-add the accounts payable list
 Trace the total to the general ledger
  Trace individual vendors’ invoice to master file for names and amounts
Existence  Trace from accounts payable list to vendors’ invoices and statements
 Confirmation with creditors
Completeness Perform out-of-period liability tests (search for unrecorded liability)
 Examine the unpaid vendors’ invoices file on the balance sheet date &
trace them to related receiving report (to test for inclusion)
 Examine subsequent cash disbursements (to test for inclusion)
 Trace Receiving Reports Issued Before Year-End to Related Vendors’
Invoices (to test for inclusion)
 Trace Vendors’ Statements That Show a Balance Due to the Accounts
Payable Trial Balance (to test for inclusion)
 Send Confirmations to Vendors with Which the Client Does Business
(also called zero balance confirmation)
Accuracy  Trace from accounts payable list to vendors’ invoices and statements
 Confirmation with creditors
 Perform out-of-period liability tests
Classification Review the list and master file for related parties, interest-bearing debts,
debit balances in accounts payable
Cutoff  Perform out-of-period liability tests
 Perform detailed tests as part of physical observation of inventory (i.e.
coordinate the cutoff test with the observation of inventory)
 Test for inventory in transits by examining vendor’s invoice (consider
shipping terms i.e. F.O.B. shipping point or F.O.B. Destination)
Obligations  Examine vendors’ statements
 Confirmation with creditors

The main thrust of the testing of accounts payable is usually to test for completeness i.e. to gain assurance
that all liabilities which should be included, are included.
One of the audit procedures to be performed for testing accounts payable is to reconcile vendors’ statements
with creditors’ ledger. Although the two must generally agree, the following are the possible reasons for the
difference:
a. Timing differences
 Invoices not yet received by the client
 Payments not received by the vendor
 Returns and credit memos not yet appearing on the vendor’s statement
b. Errors
 Supplier errors that will remain as part of the reconciliation of until the supplier corrects them
 Client errors, which the client needs to adjust
c. Administrative reasons
 Goods received accrual (invoices received but not processed-perhaps awaiting authorization
or posting)
 Goods received not invoiced (the client accrues for all goods received but does not record in
the journal and post to the creditors’ ledger until the invoice is received)
 Cheques in the drawer (delay in sending out the cheques although not a good idea to keep
signed cheques for longer time)
The auditor may use the following form to reconcile vendors’ statements with creditors’ ledger:
Balance per supplier statement XXX Balance per creditors’ ledger XXX
Less: Add:
Returns/credit memos not yet credited XXX Invoices not yet posted XXX
Payments not yet received by the XXX Goods received not invoiced XXX
supplier
Reconciled balance XXX Reconciled balance XXX

AUDIT OF PROPERTY, PLANT AND EQUIPMENT (PPE)

1. Characteristics of Property, Plant, and Equipment
 Have expected lives of more than one year
 Used in the business
 Not acquired for resale
2. Classification of Property, Plant, and Equipment
  Land and land improvements  Autos and trucks
 Buildings and buildings improvements  Leasehold improvements
 Equipment  Construction-in- progress
 Furniture and fixtures
3. Property, Plant, and Equipment Accounts
 PPE account  Gain/loss on disposal
 Accumulated depreciation  Repair and maintenance account
 Depreciation expense
4. Property, Plant, and Equipment Transactions
 Acquisitions  Disposals
 Periodic Depreciation
5. Property, Plant, and Equipment records

Fixed asset master file is the primary accounting record for Property, Plant, and Equipment. It shows
detailed records for each asset containing such information as:
 Description of the asset  Current year depreciation
 Date of acquisition  Accumulated depreciation
 Original cost  Disposals etc
 The total for all records in the master file equals the general ledger balances for the related accounts i.e.
PPE account, depreciation, and accumulated depreciation.

6. Audit Tests for Property, Plant, and Equipment

a. Perform analytical procedures

Most of the typical analytical procedures assess the likelihood of material misstatements in
depreciation expense and accumulated depreciation as shown below:

Analytical procedure Possible misstatement

Compare depreciation expense divided by Misstatement in depreciation expense and
gross fixed asset cost with previous years accumulated depreciation
Compare accumulated depreciation divided by Misstatement in accumulated depreciation
gross fixed asset cost with previous years
Compare monthly or annual repairs and Expensing amounts that should be capitalized
maintenance, supplies expense, small tools
expense, or similar accounts with previous
years
Compare gross manufacturing cost divided by Idle equipment or equipment that was disposed
some measure of production with previous of but not written off
years
b. Verify current period acquisitions
Current year acquisitions must be recorded correctly because failure to capitalize them or recording at
incorrect amounts affects the balance sheet as well as the income statement until the asset is disposed
of or fully depreciated (see the attachment)
c. Verify current period disposals
The most important internal control over disposals is the existence of a formal method to inform
management and record the results of sale, trade-in, abandonment or theft. The most important audit
procedures are those for searching for unrecorded disposals such as:
 Review whether newly acquired assets replace existing assets
 Analyze gains and losses on disposals
 Review plant modifications and changes in product line
 Review insurance coverage for indications of deletion of fixed assets
 Make inquiries of management for possible disposals
d. Verify the ending balance in the asset account
 Test for agreement between property (fixed assets) master file and general ledger
 Conduct physical inventory of fixed assets
 Test for presentation and disclosures (e.g. separately presenting each fixed asset; fixed assets
collaterized for loans)
e. Verify depreciation expense

Recorded amounts of depreciation are internal allocations rather than exchange transactions with
outside parties. Primary audit objectives involve determining whether the client is:
 Following a consistent depreciation policy from period to period and whether
 Making calculations accurately
f. Verify the ending balance in accumulated depreciation
 Debits to accumulated depreciation account are normally tested as a part of the audit of the disposals
of assets. Credits are verified as part of the audit of depreciation expense.
AUDIT TESTS FOR ACCRUALS
 Review relevant invoices when received after the balance sheet date. If none are received,
compare with previous periods.
 Obtain the list of accruals from the client, recalculate it to confirm arithmetical accuracy.
 Agree the figure per schedule to the general ledger and financial statements
 Agree the calculation of the accruals by reference to supporting documentation e.g. previous
period invoice

AUDITING INTANGIBLE ASSETS

Intangible assets include goodwill, copyrights, trademarks, deferred expenses, capitalized charges for brand
names, and others. It may be extremely difficult to value as they do not have a ready value, and can rapidly
drop in value. Audit expertise in the area is required, or the auditor may need to engage an independent
expert to value material intangible assets.
AUDIT OF PREPAID EXPENSES
Prepaid expenses arise from the concept of matching expenses with revenues. These types of accounts are
found in almost every audit. Prepaid insurance is used as an example because it is a common expense and the
auditor is responsible for reviewing the adequacy of insurance coverage. Regarding audit of insurance
expense, the auditor considers internal controls in the following categories: Controls over the acquisition and
recording of insurance, insurance coverage, and charge-off of insurance expense. The organization may have
an insurance register or spreadsheet, or it may simply have a file of insurance policies in force. Audit tests
for insurance expense include:
 Analytical procedures
 Verification that charges to the insurance expense arose from credits to prepaid insurance (based
upon a schedule of insurance charges and prepaid expenses prepared by the client)

AUDIT OF INCOME AND EXPENSES (OPERATIONS)

The purpose of audit of operations is to determine whether the income and expense accounts are fairly
presented. The auditor needs to be aware of the importance of the income statement to users. Matching and
consistent application of accounting principles are evaluated. This part of the audit is closely linked to the
audit of all of the other transaction cycles. All tests conducted during the audit need to be considered to
evaluate their impact upon the audit of operations. Analytical review is an important audit step for the audit
of operations. The most common analytical procedures are presented in the below table:
Analytical procedure Possible misstatement
Compare individual expenses with previous years Overstatement or understatement of a balance in an
expense account
Compare individual asset and liability balances Overstatement or understatement of a balance sheet
with previous years account that would also affect an income statement
account
Compare individual expenses with budgets Misstatement of expenses and related balance sheet
accounts
Compare gross margin percentage with previous Misstatement of cost of goods sold and inventory
years
Compare inventory turnover ratio with previous Misstatement of cost of goods sold and inventory
years
Compare prepaid insurance and insurance expense Misstatement of insurance expense and prepaid insurance
with previous years
Compare commission expense divided by sales Misstatement of commission expense and accrued
with previous years commissions
Compare individual manufacturing expenses Misstatement of individual manufacturing expenses and
divided by total manufacturing expenses with related balance sheet accounts
previous years

Review Questions

1. What four basic business operations are executed in the acquisition and payment cycle?
2. Mention the two main classes of transactions in the acquisition and payment cycle.
3. Identify the appropriate records and documents in relation to the following functions:
a. Purchasing c. Recognizing the liability
b. Receiving
d. Processing and recording cash disbursements
4. List one possible internal control for each of the six transaction-related audit objectives for cash
disbursements. For each control, list a test of control to test its effectiveness.
5. List one possible control for each of the six transaction-related audit objectives for acquisitions. For each
control, list a test of control to test its effectiveness.
6. What are the similarities and differences in the objectives of the following two procedures? (1) Select a
random sample of receiving reports and trace them to related vendors’ invoices and acquisitions journal
entries, comparing the vendor’s name, type of material and quantity acquired, and total amount of the
acquisition. (2) Select a random sample of acquisitions journal entries and trace them to related vendors’
invoices and receiving reports, comparing the vendor’s name, type of material and quantity acquired,
and total amount of the acquisition.
7. What is meant by a voucher? Explain how its use can improve an organization’s internal controls.
8. How would you verify that all unpresented cheques (cheques not cleared the bank) are included on a
client’s bank reconciliation?
9. What is the relationship between the audit of property, plant, and equipment accounts and the audit
of repair and maintenance accounts? Explain how the auditor organizes the audit to take this relationship
into consideration.
10. In auditing depreciation expense, what major considerations should the auditor keep in mind? Explain
how each can be verified.
11. Explain the conditions under which the external auditors rely on the work of others such as valuers,
surveyors, internal auditors etc.
12. Assume that you are auditing the accounts payable of A Company and have found that the balance
according to A Company’s creditors’ ledger does not agree to the statement from its supplier B
Company. You extracted the following data in your attempt to search for the difference (all figures are in
Birr):

Balance per A Company …………………………............................. 700

Balance per B Company………………………….............................. 3,000
Invoices in file of creditors’ ledger clerk’s desk awaiting posting …. 300

Goods returned by A Company to B Company in last week of the year, not yet reflected on B Company
……………. ................................................................. 400
Value of goods from B Company received by A Company’s receiving department and invoiced by B
Company on the very last day of the year (invoices are sent by mail)
…………………........................................................................... 100
Payment by cheque sent by mail by A Company to B Company on the very last day of the year
……………………........................................................................ 1,500
Required: What is the correct figure for the balance between A Company and B Company that should
form part of A company’s payable figure in its financial statements?