Chapter PHASE II - RISK RESPONSE: AUDIT OF THE EXPENDITURE CYCLE ae Expected Learning Outcomes After studying this chapter, you should be able to: 4. Enumerate and describe the steps involved in auditing the expenditure cycle 2. Describe the nature and the major classes of transactions in the expenditure cycle. 3. Explain the process analyzing and recording transactions in the expenditure cycle, i.e., purchase, purchase adjustments and cash disbursements transactions as well as the corresponding accounts, documents and records used. 4. Apply the risk assessment and risk response phases of the audit process, i.e., test of controls and substantive tests of transactions in the expenditure cycle. WUBZ Searoed th canscannetCHAPTER 7 AUDIT OF THE EXPENDITURE CYCLE INTRODUCTION This chapter covers the explanation of the expenditure (or acquisitions: and disbursements) cycle and the internal control environment and objectives Pertaining thereto. ‘Then, consideration is given to internal controls over the expenditure transactions and to the study and evaluation of controls over these two classes of transactions. The following activities should be undertaken by the auditor in relation to the audit of the expenditure cycle: | expenditure cycle, the 1. Diagram the flow of transaction is a typi specific accounts affected and the elements of control within the cycle. ssertions embodied in the financial 2. Relate the effect of controls on the statement. 3. Determine the essential features of internal control over the transactions in the expenditure cycle. 4. Prepare an audit program to gather evidence regarding compliance with control procedures that reduce control risk. lantive tests of 5. Evaluate effectiveness of controls and perform the subs transactions to gather evidence to determine whether financial statement assertions are materially correct on accounts affected by the expenditure cycle, 6. Design tests of details of account balances and analytical procedures to satisfy balance-related audit objectives. Steps 1 to 5 are discussed in this chapter while Step no. 6 is covered in Chapters 11 and 13. Ae ail ‘Seanad wthCamS:anerAudit of the Exp a a“ spe OF HE EXPENDITURE CYCLE yal a expenditure cere inyolaes the activities associated with the acquisition and rent of 200 ae ein plant assets and labor. For a trading m classes of transactions in this cycle are: - “Acquisition of goods and services Cash disbursements purchase returns and allowances and purchase discounts ern, the najof rs manufacturing firm, production cycle transactions and inventory ing transactions are included in the expenditure cycle in addition to the warehous! 5 7 Intioned major classes of transactions. above-me! this chapter does not include the acquisition of all plant and intangible assets. short-term OF long-term securities, the issuance and redemption of long-term debt nd the issuance OF reacquisition of a company “s share capital. These transactions are considered to be part of the investing and financing cycles, the audit of which a ckled in Chapters 9 and 10. Transactions in the expenditure cycle often affect more financial statement accounts than the other cycles combined. On the statement of financial position, the expenditure cycle impacts on all current assets. except marketable securities and receivables, all plant and intangible assets, and many current liabil Transactions in this cycle involve major expenses reflected in the Income Statements such as salaries and wages, taxes, utilities, advertising, repairs and other expenses manufacturing costs (if applicable). Typical accounts included in the acquisition and payment cycle are shown by T- accounts in Figure 7-1. Note the large number of accounts affected by this cycle. To keep the illustration manageable, only the control accounts are shown for the three major categories of expenses used by most companies. For each control account, examples of the subsidiary expense accounts are also given, Because of the large number of accounts in the cycle, it is not surprising that it often takes more time to audit the acquisition and payment cycle than any other. Figure 7-1 shows that every transaction is either debited or eredited to dosent Payable. Because many companies make acquisitions directly by check or through petty cash, the figure is an ‘versimplification, We assume that eash disbursement transactions are processed in the same manner ‘as all others. ‘Seanad wth Comsat200 Chapter 7 Figure 7-1: Accounts in the Acquisition and Payment Cycle Cash in Sala Raw material Merchandise purchases inventory Accounts payable Ze. Purchase return: Cash Acquisitions of roperty, plant and pa preci disbursements | goods & services <——> Purchase returns & Purchase discounts _-——~ allowances Purchase Manufacturing expense control account Subsidiary accounts _ Repair & maintenance Taxes Supplies Freight in Utilities =p —_. Prepaid expenses ‘Subsidiary accounts Commissions Travel expense Delivery expense Repairs Advertising Administrative lexpense control account Subsidiary accounts Supplies Officers’ travel Legal fees Auditing fees taxesrpenditure Cycle 204 PROCESSING EXPENDITURE TRANSACTIONS Summary of Business Functions in the Expenditure Cycle and Related Documents and Records The acquisition and payment cycle involves the decisions and proce» necessary for obtaining the goods and services for operating a business. The cycle typically begins with the initiation of a purchase requisition by an authorized employee who needs the goods or services and ends with payment for the benefits received. Although the discussion that follows deals with a smail manufacturing company that makes tangible products for sale to third part the same principles apply to a service company, a government unit, or any other typ of organization. There are four business functions shown in the third column of Figure 7-2. These functions occur in every business in the recording of the three of transactions in the acquisition and payment cycle. Observe that the first three business functions are for recording the acquisition of goods and services on account and the last process if for recording the cash disbursements for payments to vendors. Processing purchase returns and allowances and purchase are also business functions in the cycle, but these are not separately sh Figure 7-2 because the amounts are not significant for most companies. This section explains the four business functions in Figure 7-2 and de: typical documents and records for each function, These documents and records are shown in the fourth column of Figure 7-2. It is essential to understand the business functions and documents and records in a company befo control risk and designing test of controls and substantive tests of transactions Typically, the accounts affected by the expenditure cycle are: Purchases Accounts and notes payable ~ trade Purchase returns and allowances Cash in bank ( credit for cash disbursements) Purchase discount Inventories (merchandise; finished goods: raw materials, process) 7. Manufacturing and operating expenses (selling and administrative) requiring cash payments. Queene ‘Seanad wih CamS:aner202 Chapter 7 ~ Figure 7-2: Classes of Transactions, Accounts, Business Functions, ang Related Documents and Records for the Acquisiti ion and Payment Cycle Classes of Business Documents and Transactions Accounts Functions Records, Acquisitions Inventory (1) Processing Purchase requisition Property, plant & equip. purchase Purchase order Prepaid expenses orders Leasehold improvements Accounts payable Manufacturing expenses Selling expenses Administrative expenses (2) Receiving Receiving report goods and services (3) Recognizing the liability Acquisition journal Summary acquisitions report Vendor's invoice Debit memo Voucher Accounts payable master file Accounts payable trial balance Vendor's statement Cash disbursements cash disbursements) Accounts payable Purchase discounts Cash in bank (from | (4) Processing and recording cash disbursements Check Cash disbursements journal ‘Seanad wthCamS:anergse requisition purchase Ted document that originates in the ony 5 ox an operating department #27 os to the purchasing deparment that 2 oud be ordered. A requisiton describes fies the quantity needed, and requester gitar, foes purcnase order mbered document recording the A poten, cual. and related information for geod and Services the company intends to oronase. THiS document is frequently used to pucras?. crization 10 procute goods and receiving report Ber enuoered covument prepared at the time A Poe goods are received thal indoales the on of goods, the quantity received, the date desc received, and otner relevant data vendor's invoice Wefoment hat indicates the description and cuanty of goods and. services received, price, ahdng eight, cash discount terms, and date of the billing. Debit memo A prenumbered document incicaling 2 reduction in tre amount owed to 2 vendor because of returned goods or an allowance granted. Voucher A prenumbered document to establish a formal means of recording and controling acquisitions prepared by @ payables clerk for each payment. A vendors invoice, a receiving report, and a purchase crder are attached to it Check ; 4 prenumbered writen authorization fo & bank to transfer funds to the payee. Checks are used as means of payments. ___ Audit of the Expe Cycle and their Audit ignificance Audit Significance A purchase requisition provides evidence that the purchasing department was authonzed to initiate a purchase ‘A purchase order contains the signature of the employee who authorized a purchase from a vendor This report is prepared within the entity and provides evidence that goods were received. This document is created externally and provides evidence about @ purchase of goods or services. 'A voucher provides documentation or the recording of a ransaction. ‘A check that has been presented for payment is felerred to as paid or canceled check. A paid check provides evidence about payments than an entity has made, such as date, payee, and amount. ‘Scan wth CamS:aner5 statements may be used to II transactions recorded on nn recorded in the Vendor's statement oe Vendor A statement prepared monthly by the vendor ; indicating the beginning balance, acquisitions, determine a Te bee! retums and allowances, payments {0 the vendor, the slater and ending balance. tools Accounting Records Involved in the Expenditure Cycle Purchase journal A journal for recording purchase transactions; Cash disbursement transaction file /journal A file for recording the individual payments made by check. It contains the total at the amount the transaction was cash paid, the debit to accounts payable QF recorded in the acquisition transaction file, discount taken, and other debits and credits. Accounts payable master file / subsidiary ledger A file for recording individual acquisitions, cash disbursements, and acquisition returns and allowances for each vendor. Cost Accounting Records These records in a manufacturing company are used to summarize transactions affecting Raw Materials, Goods in Process, Finished Goods, Labor Costs and Manufacturing Overhead. ‘Seanad wthCamS:anerAudit of the Expenditure Cycle 208 ups OF THE EXPENDITURE CYCLE pHASE I= RISK ASSESSMENT |, PERFORMING RISK ASSESSMENT RICQUISITION AND PAYMENT CYCLE PROCEDURES IN THE AS part of performing risk assessment procedures. the auditor obtains information that is useful in assessing the risk of material misstatement. This includes information about inherent risks at the financial statement level (for example, the client's business and operational risks, financial reporting risks) and at the account and assertion levels, fraud risks including feedback from audit team brainstorming sessions, strengths and weaknesses in internal control, and results from preliminary analytical procedur?s. Once the risks of material misstatement have been identified, the auditor then determines how best to respond to them as part of the audit opinion formulation process. Identifying Inherent Risks Inventory is usually material, complex, and subject fo manipulation. Given the large number of inventory-related fraud that have been perpetrated, auditors should exercise particularly high levels of prefessional skepticism in audits of inventory and cost of goods sold accounts. ° A great variety (diversity) of items exists in inventory. e Inventory accounts typically experience a high volume of activity. * Inventory accounts may be valued according to various accounting valuation methods. Identifying obsolete principle to determin © Inventory is easily transportable. e Because inventory often includes a variety of types of products, the auditor must possess and apply significant knowledge about the business in order to address obsolescence and valuation questions. © Individuals involved with the purchase of inventory may have incentives to exploit weaknesses in the control system to their economic advantage. inventory and applying the lower of cost or market e valuation are difficult tasks. ‘Seanad wthCamS:anerIdentifying Fraud Risk Factors Because of the volume of transactions, as well as the ability to physical mov, inventory, the acquisition and payment cycle is often the subject of fraug Most of the frauds in this eycle involve overstatement of inventory oF assers and understanding of expenses. Many disbursements frauds involve fictitious purchases or, in some cases, kickbacks 0 the purchasing agent. Examples of fraud in the acquisition and payment cycle include: © Theft of inventory by the employee © Inventory shrinkage, which is @ red due to physical loss or theft © Employee schemes involving fictitiou payments to themselves © Executives recording fictitious vendors as meal themselves © Executives recording fictitious inventory or inappropriately recording higher values for existing inventory by creating false records for items that do not exist (for example, inflated inventory count sheets and bogus receiving reports or purchase orders) e Large manual adjustments to inventory accounts Schemes to classify expenses as assets (for example, inappropriately capitalizing items that are truly current-period expenses) Executives misusing travel and entertainment accounts and charging them as company expenses uction in inventory presumed to be s vendors as means to transfer ns to transfer payments to ‘Seanad wthCamS:anerAudit of the Expenditure Cycle 207 Figure 7-3 identifies some of . ss th a inanipulating inventory arid cost of g e possible fraudulent schemes for Figure 7-3: Approaches for Manipulating Inventory and Cost of Goods Sold Event Affe ali 1. Purchase inventory Tren eas ea | payable Record purchases in a later | period \ 5 Not record purchases 2. Return inventory Accounts payable, Oversiate retums | to supplier inventory Record retums in an earlier | = period 3. Inventory is sold Cost of goods sold, Record at too low an amount inventory } not record cost of goods sold | | nor reduce inventory | 4. Inventory becomes Loss on write-down Not write off or wnte down | obsolete ofinventory, inventory | obsolete inventory | 5, Periodic count Inventory shrinkage, Qvercount inventory (double | of inventory quantities | _ inventory counting, etc.) \ Identifying Control Risks Once the auditor has obtained an understanding of the inherent and fraud risks of material misstatement in the acquisition and payment cycle accounts, the auditor needs to understand the controls that the client has designed and implemented to address those risks. Remember, the auditor is required to gain an overall understanding of internal controls for both integrated audits and financial statement only ‘audits, Such understanding is normally gained by means of a walkthrough of the process, inquiry, observation, and review of the client’s documentations. The auditor considers both entity-wide controls and transaction controls at the account and assertion levels. This understanding provides the auditor with a basis for making an initial contrel risk assessment. ‘Seanad wthCamS:aner208 Chapter > Overview of Common Controls in the! Inventory Purchases: Manufacturing Organization fi iets by the produ © Written requisitions are made for specific products by the Production manager or stockroom manage’. a os Computer-generated requisitions aT generated based on Current inventory levels and production plans. Inventory Purchases: Retail Orgamization © Overall authorization to purchase product Jines is delegated to individual buyers by the marketing manager, The authorization 1s built into the computer as a control. The limit for individual goods can be exceeded only on specific approval by the marketing manager. . Store managers may be granted a uthority to purchase @ limited number of goods. The store manage = ability to issue a purchase order may be subject to overall corporate limits, usually specified in dollars. The supplier may have access to the retailer's inventory database and, by contract, ship replacement merchandise bases on sales activity and reorder points. Inventory Purchases: Just-in-Time Manufacturing Process @ Anagreement is signed with the supplier whereby the supplier agrees to ship merchandise Gustin time) according to the production schedule set by manufacturer. A long-term supply contact is negotiated specifying price, quality of products, estimated quantities, penalties for product hortages or quality problems, and so forth. Specific purchase orders are not issued; rather, the production plan is communicated to the supplier wvith the specified delivery dates. The production plan serves as the requisition Supplies Purchases Requisitions are issued by individual departments and sent to the appropriate department manager for approval. Each department may be given a budget for supplies and may have the ability to issue purchase orders directly for the needed items or may able to purchase a limited number of items without a purchase order. ‘Seanad wthCamS:anerwas Audit of the Expenditure Cycle _ 209 Performing Preliminary Analytical Procedures When planning the audit, the auditor is required to perform preliminary analytical procedures. These procedures can help auditors identify areas of potential misstatements. The following are examples of possible expected relationships in the acquisition and payment cycle: «Assume that the company’s production and pricing strategies have remained the same during the past year. Gross margin is expected to be stable and consistent with the industry average. Assume that the company has introduced a new product with a low price point and significant customer demand. Inventory turnover is expected fo increase, and days’ sales in inventory are expected to decrease. © Assume that the company has invested in a new manufacturing process that results in significantly less waste and overall increases in efficiency during the production process. Cost of goods sold is expected to decline, and gross margin is expected to increase. The following relationships might suggest a heightened risk of fraud in the acquisition or payment cycl © Unexpected increases in gross margin © Inventory that is growing at a rate greater than sales + Expenses that are either significantly above or below industry norms © Unexpected increases in the number of suppliers * Capital assets that seem to be growing faster than the business and for which there are no strategic plans * Expense accounts that have significant credit entries * Travel and entertainment expense approval of expenditures accounts, but no documentation or * Inadequate follow-up to the auditor's recommendations on needed controls ‘Seanad wthCamS:aner ie210 Chapter 7 PHASE I~ RISK RESPONSE “ALASE I — RISK RESPONSE, Responiling to Identified Risks of Material Misstatement Once the auditor has developed an understanding of the risks of material misstatement, the auditor can determine the appropriate audit Procedures to Perform. Audit procedures should be proportional to the assessed risks, with areas of higher risk receiving more audit attention and effort. Responding to identified risks typically involves developing an audit approach that contains substantive procedures (for example, tests of details and, when appropriate, substantive analytical procedures) and tests of controls, when applicable. The appropriateness and sufficiency of selected procedures vary to achieve the desired level of assurance for each relevant assertion. While audit firms may have a standardized audit program for auditing the acquisition and payment cycle, the auditor should customize the audit program based on the assessment of risk of material misstatement. The auditor may develop an audit Program that consists of first performing limited tests of operating effectiveness of controls, then performing limited to moderate substantive analytical Procedures, and finally Performing, contrast, consider a client where the auditor h: misstatement related to the existenci of inventory as low, and believes that the client has implemented effective controls in this area. For this client, the auditor will likely perform tests of controls, gain a high level of assurance from substantive analytical procedures such aya Feasonableness test, and then complete the substantive Procedures by Performing tests of details at a limited level ‘as assessed the risk of material ‘Seanad wthCamS:aner> Audit of the Expenditure Cycle 211 AUDITING ACQUISITION TRANSACTIONS This section covers the following areas: 1, Evaluation and Obtaining Evidence About Internal Control Operating Effectiveness in the Acquisition Cycle IJ, Tests of Controls over Acquisition Transactions II]. Illustrative Audit Program for Acquisition Transactions IV. Substantive Tests of Acquisition Transactions Typically, the acquisition transactions involve the following business activities. a. Processing purchase orders b. Receiving goods and services c. Recognizing the liability d. Cash disbursements Figure 7-4 shows a flowchart of the manual system for executing acquisition and purchases transactions. While Figure 7-5 shows the flowchart of purchase returns. ‘Seanad wthCamS:aner212 Chapter 7 ee __ _ Figure 7-4: Purchases Flowchart Purchasing Stores Accounts Payable General Ledgery- ee ge Audit of the Expenditure Cycle_213 igure 7-5: Purchase Returns Operation Depar Recelving or Inventory meet c Controller's Office shipping “Fecounts Payable Dept Unacceptable goods Prepare sentto urbered shipping department tall of lading at? ‘tach to voucher pao | lading Open To vendor wit voucher shipment Exhbt ‘Seanad wth CamS:aner214 Chapter 7 I. Evaluation and Obtaining Evidence About Internal Control Operating Effectiveness in the Acquisition Cycle For integrated audits, the auditor will test the operating effectiveness of important controls as of the client’s year end. If the auditor wants to rely on controls for the financial statement audit, the auditor will test the operating effectiveness of those controls throughout the year. Figure 7-6 illustrates an intemal control questionnaire for acquisition of goods and services that may be used in obtaining evidence on the operating effectiveness in the acquisition cycle. Figure 7-6: Internal Control Questionnaire for Acquisitions Cycle: Expenditure Class of Transactions: Acquisitions Yes No NA Remarks Executing 1. Is there separation between authonty, recording, and custody of merchandise / supplies purchases? 2. Are steps taken to ensure the best price for merchandise? 3. Is immediate control established over merchandise received from vendors? 4, _ Are receiving reports made out after an independent count? 5, Is a signed receipt obtained from storeroom on delivery of goods by receiving? 6. Are purchase orders, receiving reports, and vendors’ invoices matched in preparing vouchers? 7. Are vouchers internally verified for accuracy? Are vouchers approved by authorized - — personnel? 9.__Are daily voucher summaries prepared and agreed to vouchers issued? | ‘Seanad wthComS:aner| Audit of the Expenditure ©) (Recordi i 7, Are all issued vouchers accounted for in journalizing? Are voucher register entries | 2 reviewed for reasonableness? 1-7 Are unpaid voucher file and perpetual inventory records independently maintained? T Are there periodic independent reconciliations of control accounts and subsidiary records? Custod) 1. Are goods stored in locked areas with restricted access? 7, Are there periodic independent comparisons of inventory records with goods on hand? For integrated results, important controls as the c! controls for the financial statement audit, the at . Test of Controls over Acquisition Transactions the auditor will test the operating effectiveness of lient’s year end. If the auditor wants to rely on uditor will test the operating effectiveness of those controls throughout the year. The following assertions relate to acquisitions transactions. General Specific 1. Existence or occurrence Recorded acquisitions are for items that were acquired. 2. Completeness 7, Acquisition that occurred are recorded. 3. Rights and obligations 3, Recorded acquisitions are the entity's purchases and liabilities. 4. Valuation or allocation 7, Acquisitions are recorded for the proper amounts. 5. Presentation and disclosure 5, Acquisitions are recorded to result in presentation and disclosure in accordance with PAS | PFRS. In many instances, more than one control is 3 assertion. Because specific controls may \ Ontrols discussed in this section should be view required to ensure the validity of vary with the client, the tests of fed as illustrative.only. ‘Seanad wth CamS:aner216 Chapter 7 The following sections present the controls an the propriety of each assertion determine the effectiveness of the controls or Discussion: A. Existence or Occurrence: Recorded ac acquired. Controls and the tests u f my 1 acquisitions transactions, entity should have t0 ensure an auditor might perform to quisitions are for items that Were Tests of Controls Tf Acquisitions should be approved by authorized personnel. Approval of acquisition is evidenced by Signature on the purchase order. ‘Auditor should examine the] approval signature. the supporting documentation and cancel the documents, making them “paid’ or writing the date and number of the check on the document. 2. A voucher should be prepared for| 2. To lest this control, the auditor the purchase of goods. This should observes the procedure ang be supported by properly executed examines file of documents. If the Purchase requisition, purchase entity does not prepare vouchers, order, receiving report, and vendor's the auditor should review the invoice. entries in the purchases journal and examine the documents underlying them for authenticity and reasonableness. 3. The check signer should examine | 3. The auditor can — examine cancellations on the documents to test this control. If an entity does not effectively cancel supporting documents, the auditor should be concerned that duplicate payment may have been made and should scan the voucher register for multiple entries of similar amounts. accounted for as they are entered in the voucher register. Completeness: Acquisitions that occurred are recorded, 4. Prenumbered receiving reports | 4. To test this control the auditor should be used and accounted for should observe the procedure and to determine that liability is account for the — numerical recorded for all goods received. Sequence of the receiving report. 5. Vouchers are prenumbered and | 5. The auditor should observe Procedure and account for the Numerical sequence of the voucher. 5 ‘Seanad wthCamS:aner9 m Audit of the Ex ights and Obligations: c. Rig ligations: Recorded acquisitions are the entity's purchases and liabilities. See EES EEE 6. Receiving reports should be prepared by persons having access only to a blind copy of purchase order details. Requiring a purchase order for the recording of all acquisitions will preclude recording consigned goods as well as goods ordered for personal use of employees. poeeeeeeeeeeeee 6. To test this control, the auditor = | \ | | | should observe that the procedure is being performed. Acquisitions are recorded in the proper = Valuation or Allocation: amounts. 7 Invoice amounts are verified by a[/7. The auditor Should examine the | clerk by reference to the purchase voucher for signature indicating orders and receiving reports. performance. Mathematical accuracy of the invoice is also rechecked. Presentation and Disclosure: Acquisitions are recorded to results in presentation and disclosure in accord: ance with PAS/PFRS. . Require employees to use a chart | 8. ‘Auditor should examine the chart of accounts that adequately of accounts. Also, he of she describes accounts to be debited. should examine the signature of ‘Account coding is assigned” by employee performing the one person and checked by checking or verification. another. ‘Seanad wth ComS:anerIL Mlustrative Audit Program For Tests Of Controls: Acquisition Transactions ee - -. e audi that audi The following audit program summarizes the audit procedures ditors MAY Use to test controls on acquisitions transactions Happy Sounds Corporation Test of Controls: Acquisitions December 31, 20X7 we Done Audit Procedures Ref_| By | Date For a sample of purchases, examine the related purchase requisition and purchase order. For a sample of purchases, trace the transaction to the voucher register and the perpetual inventory Fecords maintained in stores. 3. Check vendor invoice for mathematical accuracy. 4. Trace posting from the voucher register to the _general ledger. Possible errors that may result due to control weaknesses over acquisitions transactions follow: Internal Control Weaknesses or Factors That Increase the Risk of | Examples of Fraud / Error | Description of Possible the Misstatement Etrors or Misstatement 1. Documentation of \\ Apurchase orderis|7. — Unauthorict purchase transactions, ‘made for goods that Purchases; Payments incomplete and have not been made to vendors for inadequate; ineffective authorized or 00ds and services not controls for matching requested s oe purchase requisitions authorized. with purchase orders, j 2. Ineffective controls for [2 Goods a 7 a matching invoices with deivered 4 but | 2.” Misappropriation of 5 receiving documents inappropriate address 900ds purchases. before disbursements and stolen, are authorized, a ‘Seanad wthCamS:aneraa Audit of the Expenditure 3, Inadequate segregation of duties of record keeping and preparing cash disbursements, or check signer does not review and cancel supporting documents. 2| A bookkeeper prepared a check to himself and records it as having been issued toa major supplier. 3 inaccurate recording of a purchase or disbursement 4, Ineffective controls for review and cancellation of supporting documents by the check signer | A purchase is recorded when an invoice is received from a vendor and recorded again when a duplicate invoice is sent by the vendor. Duplicate recording or purchases 3, Accounting manuals not used. a Purchase of merchandise erroneously recorded as purchase of equipment. Error in recording purchase transactions. 6. Creditors’ statements not examined for possible errors. Creditor is paid twice when bookkeeper fails to reconcile postings in the AP subsidiary ledger with creditor's stalement of account. Undetected errors in recording purchases transactions. 7. Ineffective board of | Purchases journal Late (early) recording of directors, audit “closed early” with this cost purchases - “cutoff committee, or internal period's purchases problems”. audit function; top recorded as having management action not occurred in conducive to ethical ‘subsequent period. conduct; undue pressure to meet earnings target. ‘Seanad wthCamS:aner220 Chapter 7 TV. Substantive Tests Of Acquisition Transactions Assertions Audit Objectives Audit Procedures 1 Existence or ‘A. Todetermine that 7, Examine underlying Occurrence recorded purchases documents for are for items that were authenticity and acquired. reasonableness. Scan voucher register for large or unusual items, Inspect acquired property, plant and equipment. Trace inventory purchased to perpetual records. scan voucher register for duplicate payments. ll. Completeness B. To determine that 2. Trace a sequence of purchases that receiving reports to occurred are recorded entries in the voucher register. Test cutoff. Account for a sequence of entries in the voucher register. Ill. Rights and obligations |C. To determine that 3. Trace from invoices to purchases are the perpetual inventory entity's acquisitions Tecords. examine and liabilities. vendor's invoices to determine that goods were purchased. 1. Valuation or Allocation [D. To determine that 4. Recomputed invoices purchases are and compare invoice recorded for the proper Price to purchase amounts. order. V. Presentation and E. To determine that 5. Check accuracy of Disclosure purchases are accounts on invoices fecorded to result in by reference to chart of Presentation and accounts. disclosure in accordance with PASIPERS, ‘Seanad wthCamS:anerDise I Audit of the Expenditure Cycle 224 ussion of Audit Procedures Examine underlying documents for authenticity and reasonableness. Sean voucher register for large or unusual items, Inspect acquired property, plant and equipment. Trace inventory purchased to perpetual records. Scan voucher register for duplicate payments. To test the existence of acquisitions transactions in the voucher register, an auditor should examine for selected transactions, the underlying documents — the voucher, purchase order, receiving report, and vendor's invoice. The auditor should also physically inspect additions to fixed assets to substantiate their existence and trace inventory purchases to perpetual records. The auditor can scan the voucher register as well as files of check copies to them for possible duplicate payments of invoices. Trace a sequence of receiving reports to entries in the voucher register. Test cutoff. Account for sequence of entries in the voucher register. ‘The auditor may select a sequence of receiving reports and vouchers to determine that entries have been made for them in the voucher register or purchases journal. He / She can perform a cut-off test at year-end to Recertain that all acquisitions occurring during the year have been recorded. Trace from invoices to perpetual inventory records. Examine vendor's invoices to determine that goods were purchased. The auditor should examine supporting documents to ascertain that goods were not received on consignment, that the goods were not ‘elivered to another location, simply that the ordered goods were received. These supporting documents include the voucher, vendor's invoice, receiving report, purchase order, and purchase requisition. purchase order. Recomputed invoices and compare invoice price to To ensure that acquisitions are recorded for proper amounts, auditor may select a sample of transactions and examine the purchase requisition, trace the price to the purchase order, compare the quantity on the invoice with the quantity in the receiving report and recalculate the invoice total. The auditor might also choose to perform the substantive testing of prices paid by tracing prices in published catalogs at the time of the Purchase. ‘Seanad wthComS:aner222 Chapter 7 5. Check accuracy of accounts on invoices by reference to chart of accounts, Auditors can review documents underlying entries in the voucher register to determine whether the invoice was correctly coded and will be Properly presented and disclosed in the financial statements. This Procedure can be performed simultaneously with substantive tests of valuation. AUDIT OF CASH DISBURSEMENTS This section covers the following areas: I. Evaluation and Obtaining Evidence About Internal Control over Cash Disbursements Transactions IL. Tests of Controls over Cash Disbursements Transactions III. Mlustrative Audit Program for Cash Disbursements Transactions IV. Substantive Tests of Cash Disbursements Transactions Typically, the cash disbursement transactions involve the following business activities. a. Recording of transactions in a voucher register with appropriate supporting documents such as purchase order and receiving report. b. Submission of approved vouchers and supporting papers and unsigned check to the Finance Department. c. Release of checks signed by authorized signatories, d. Recording of checks issued. Figure 7-7 shows a flowchart for processing cash disbursements. ‘Seanad wthCamS:aner- Fi ‘Accounts Payable Voueters ed bye de Audit of the Expenditure Cycle _ 223 gure 7-7: Cash Disbursement Processing Treasurer General Ledger ‘Seanad wth Comsat224 Chapter 7 Evaluation and Obtaining Evidence about Internal Control over Cash Disbursements Transactions Figure 7-8: Internal Control Questionnaire for Cash Disbursements Transactions | Cycle: Expenditure Class of Transactions: Cash Disbursements Yes _| No | NA | Remarks Executing 1. Are all disbursements (except for petty cash) Made by checks? 2. Are imprinted and prenumbered checks used? 3 \s a check-protection device used in printing the check amount? 4. Is each check ‘Supported by an approved voucher? 5. Is ‘Supporting documentation mutilated after Payment? 6.__Are two signatures fequired on each check? 7. Does last check signer mail the check and remittance advice? 8. Are there prohibitions against issuing checks to cash or bearer? 9._ Is the signing of blank checks prohibited? 10. Is daily summary of checks prepared and agreed to checks issued? Recording 1. Are accounting personnel Prohibited from signing checks? 2. Are daily summaries of checks Compared with check register totals? 3._Are checks recorded in numerical Sequence? Custod: 1. Are there periodic indey pendent Feconciliations of bank accounts? ‘Seanad wthCamS:aneryi. Tes Audit of the Expenditure Cycle _ 225 st of Controls over Cash Disbursements Transactions Auditors are interested in the effect of controls in the financial statements assertions embodies in the cash disbursements. Auditors address the following assertions when testing cash disbursements: General Specific 7, Existence oroccurrence _|1. Recorded cash disbursements occurred. 2. Completeness 2._ Allcash disbursements made are recorded. 3, Rights and obligations 3. All cash disbursements made are for obligations of the entity. 4, Valuation or allocation J. Debits to various accounts and credits to cash are valued at proper amounts. 5, Presentation and |5. Cash disbursements are recorded to result in disclosure presentation and disclosure in accordance with PAS / PERS. The following sections present the c the propriety of each assertion and the tests an auditor might p determine the effectiveness of the controls on cash transactions. Discussion: a. Existence or Occurrence controls an entity should have to ensure erform to disbursement e: Recorded cash disbursements occurred. Controls Tests of Controls teviewing documentation. T. Authorized individual signs and mails promptly the checks after The auditor may inquire of the check signer and employees who work with him or her about whether this procedure is followed. The auditor may also observe if the procedure is being followed. A review should be made person not handling disbursements determine that checks processed on a timely basis. responsible The auditor may inquire about by a| 2. for whether this procedure is being to followed or may examine the are outstanding checks list to determine that checks are being processed promplly. ‘Seanad wth CamS:anerChapter 7 b. Completeness: All cash disbursements made are recorded. 3. k r renumbered | 3. To test this control, the auditor oy Samed ie te ensure that should observe whether the all checks that were written are employee who prepares the check entered in the check register. register accounts for the sequence of the checks. 4. An employee who does not handle | 4. The auditor observes that the Cash disbursements end cash receipts employee who prepares the teconciliation does not handle cash receipts or disbursements. In addition, the auditor inspects the feconciliation. Rights and Obligations: All cash dis the entity. sbursements made for obligations of 5. Check signer who is independent of voucher preparation should examine the ‘supporting documentation before signing checks to determine that the Payment is for an obligation of the entity. The auditor tests this control by inquiring about the segregation of duties and observing whether separation really exists. He / She can also inquire about the check signer’s procedures for reviewing documents in support of cash disbursement and may observe the check signer performing these procedures, Valuation and Allocation: Debits to are valued at proper amounts. Various accounts and credits to cash 6. Amounts (including discounts | 6. To test this Control, the auditor taken) and calculations on Should observe the procedure. He vendors’ invoices are independently verified. Employee signs the voucher after verification is done. ! She can examine signatures on Paid invoices. ‘Seanad wthCamS:anerAudit of the Expenditure Cycle _227 . Presentation and Disclosure: Cash disbursements are recorded to result in presentation and disclosure in accordance with PAS / PFRS. 7 Chat of accounts adequately [7. The autor can test this contol | describes accounts to be used, b ae , y observing the procedure. he and ees is assigned by can also examine the signatures | pee pe and checked by of the employees performing the | another. review account coding._ rt Iilustrative Audit Program For Tests of Controls: Cash Disbursements Transactions In summary, typical audit procedures employed by the auditor in testing disbursement for the period under consideration include the following: Happy Sounds Corporation Test of Controls: Cash Disbursements December 31, 20X7 WP. Done Audit Procedures Ref By Date 4, Prove the arithmetical accuracy of the cash disbursements record and trace postings to the general ledger. 2. Compare paid bank checks with the cash disbursement records. 3, Account for all checks. 4, Reconcile recorded disbursements with the bank statement. 5. Examine supporting documents. 6. Review cash disbursements records for unusual items. ‘Seanad wthCamS:anerPosi eee may result due to control weaknesses ever payments jy Vendors follows: Internal Controls. [SOS — Weaknesses or Factors 7 | That Increase the Risk of | Examples of Fraud/ Error | Description of Possible | —__the Misstatemont _Errors or Misstatement 1. Inadequate} "7. A bookkeoper prepares | 1. Inaccurale recording of Segregation of duties a chock to himself and a purchase or of records keeping records it as having disbursement and preparing cash been issued fo a major disbursement, or supplier. check signer does not review and cancel supporting documents. 7 _ 2. Ineffective controls for | 2. A disbursement is 2. Inaccurate recording of ‘matching invoices made to pay an invoice a purchase or with receiving for goods that have not disbursement documents before been received disbursements are authorized. Ss 3. Ineffective accounting |3. Disbursement is for 3. Inaccurate recording of coding procedures travel and a purchase or may result from enlerlainment are disbursement. incompetent improperly included accounting personnel, with merchandise inadequate chart of purchases. accounts, or no controls over the _ posting process. _ 4. Ineffective controls for | 4. Apurchaseis recorded | 4. Duplicate recording and review cancellation of when an invoice is payment of purchases. supporting documents received from a vendor by the check signer. and recorded again when a duplicate invoice is sent by the 7 _ vendor. 5. Ineffective control 5. In conjunction with 5. Unrecorded over record keeping unrecorded (but disbursements. for and access to deposited) cash cash receipls, an employee wiles and cashes an unrecorded check for identical amount ‘Scand wthComSsaner| _ = substantive Tests Of Transactions: Cash Disbursements Vv. _—{ccERTIONS.—« ar 9 ASSERTIONS [AUDIT OBJECTIVES — 1. Existence or A. To determine that 4. Examine paid checks | canna recorded ash faeppronale disbursements endorsements | occurred Examine documents underlying payments. \1, Completeness B. Todetermine that all | 2. Reconcile cash cash disbursements disbursements per made are recorded. books with cash disbursements per the bank. Prepare or test bank reconciliation. iil. Rights and C. Todetermine that all | 3. Examine underlying Obligations cash disbursements documents. made were the entity's obligations. IV, Valuation or D. To determine that 4. Recalculate invoices Allocation debits to various paid. accounts and credits to ash are valued at proper amounts. V. Presentation and E. To determine that 5. Check accuracy of Disclosure cash disbursements accounts on invoices transactions are by reference to chart recorded to result in of accounts. presentation and disclosure in accordance with PAS __[ PERS. ‘Scand wth Comsat230 Chapter 7 _ . pte DISCUSSION OF AUDIT PROCEDURES Examining Documents Underlying Cash Disbursements examine the documents underlying cash disbuisemen’s such ay Ng reports, purchase order, purcl requisitions, an h disbur: ae for consistency with each other and with the entry 1" the ona a sements Journal. Approvals on these documents provide evidence that the transaction Occurred and that the payment was the entity's debt C hecks with appropriate been paid by the bank provide evidence about the tions. The auditor likewise recomputes the discount Audito endorsements which | existence of the tran: ns. Acc taken to verify proper valuation of cash disbursement transactions. Accuracy Of accounts charged may also be verified by the auditor by reference to the chart of accounts, Reconciling Cash Disbursements per Books to Cash Disbursements per Bank The auditors may prepare a proof of cash which reconciles cash disbursements as recorded on the bank with cash disbursement recorded by the bank. Preparing or Testing Reconciliation The auditors can prepare a bank reconciliation or test a bank reconciliation prepared by the client for an interim period. When preparing the bank reconciliation, the auditor should receive the bank sentence directly from the bank. If the bank statement has been opened by the client's employees, the auditor generally compares the individual entries on it with the documents returned by the bank and looks for erasures, changes or other irregularities on the statement : ‘Scand wth CamS:anerAudit of the Expenditure Cycle _ 231 REVIEW QUESTIONS AND PROBLEMS questions 1. 2 Describe the processing of transactions in the expenditure cycle. Identify major risks of misstatements in the expenditure cycle. Identify the financial statement assertions for acquisitions transactions. When an entity’s controls are ineffective for payments, what potential misstatements could arise in the financial statements? Compare a vendor’s statement to a vendor's invoice and describe how an auditor might use each. ash is likely to be more extensive than Give two reasons audit work on ¢: ¢ relative amount of the balance sheet might appear to be justified by th figure for cash. partments of J-R Company are a purchasing department, tment, accounting department, and finance department. If cher system to be installed by the Among the de receiving depai re preparing a flowchart of a vo you wel Zompany, in which department would you show a. The assembling of the purchase order, receiving report, and vendor's invoice to determine that these documents are in agreement? b. The preparation of a check? c. The signing ofa check? 4. The mailing of a check to the payee? e. The cancellation of the voucher and supporting documents? 2 firm, you find numerous he treasurer and charged to yy action by the a small manufacturin| ts drawn payable to t unt. Does this require an; During your audit of checks for large amount the Miscellaneous Expense acco auditor? Explain. an audit, you find that a n outstanding for more action by the auditor? bank of accounts in 1 amounts have beer n call for any During your reconciliation number of checks for sma than a year. Does this situatio Explain. ‘Seana wth CamS:aner10. Explain the objectives of each of the following audit procedures for cag, ent to the balance sheet dary a. Obtain a cutoff bank statement subsequi fist of b. Compare paid checks returned with the bank statement to outstanding checks in the previous reconciliation ¢. Trace all bank transfers during the last week of the first week of the following year d. Investigate any checks representing related parties. udit year and the ge or unusual payments tg Muttiple Choice Questions we An auditor usually examines receiving reports to support entries in the Voucher register and sales returns journal. Sales journal and sales returns journal. Voucher register and sales journal Check register and sales journal aooe An internal control questionnaire indicates that an approved receiving report is required to accompany every check request for payment of merchandise. Which of the following procedures provides the greatest assurance that this control is operating effectively? a. Select and examine canceled checks, and ascertain that the related receiving reports are dated no earlier than the checks. b. Select and examine canceled checks, and ascertain that the related receiving reports are dated no later than the checks. Select and examine receiving reports, and ascertain that the related canceled checks are dated no carlier than the receiving reports. d. Select and examine receiving reports, and ascertain that the related canceled checks are dated no later than the receiving reports. The accounts payable department receives the purchase order to accomplish all the following except a. Comparing the invoice price to the purchase order price. b. Ensuring that the purchase had been properly authorized. Ensuring that the goods had been received by the party requesting them. d. Comparing the quantity ordered to the quantity purchased. c. ‘Seanad wth ComsatAudit of the Expen te 4, For effective internal control, which of the following individuals should be responsible for mailing signed checks? ~ Receptionist Treasurer Accounts payable clerk Payroll clerk aoge If internal control is properly designed, the same employee should not be permitted to ‘a. Sign checks and cancel supporting documents. p._ Receive merchandise and prepare a receiving report. c._ Prepare disbursement vouchers and sign checks: d. Initiate a request to order merchandise and approve merchandise ordered. 4 voucher is prepared mt have 6. Ina properly designed accounts payable syste after the invoice, purchase order, requisition, and receiving repo! been verified. The next step in the system is to a. Cancel the supporting documents. b. Enter the check amount in the check register. c. Approve the voucher for payment. d. Post the voucher amount to the expense ledger. Exercises Exercise 1 Henry Martin is responsible for preparing checks, recording cash disbursements, and preparing bank reconciliations for Star Corporation. While reconciling the October bank statement, Martin noticed that several checks totaling P9.370 had been outstanding for more than one year. Concluding that these checks would never be presented for payments, Martin prepared a check for P9,370 payable to himself, forged the treasurer's signature, and cashed the check. Martin made no entry in the accounts for this disbursement and attempted to conceal the theft by destroying the forged check and omitting the long-outstanding checks from subsequent bank reconciliations. Required: 1. Identify the weaknesses in Ste 2. Explain several audit proce disbursement. ‘ar Corporation’s internal control. dures that might disclose the fraudulent a ‘Seana wth CamS:anerExercise 2 Circle Corporation. In the au You are the auditor in change of the audit of Circle Co poration tn the wt of investments, you have just been given the follov by Circle Corporation at December 31, 20X3. $$ So CIRCLE CORPORATION Schedule of Marketable Securities | December 31, 20X3 { Market Value December 1~ 10,000 shares of Diamond Comp ee a 6,000 shares of Square Corp Ty re 8,000 shares of Rectangle Corporation {pot pubic cay 400 Line Corporation 7.5%» Convertible Bonds 8,000 Required: 1. Identify the potential audit problems that may be indicated by the schedule. 2. To value the shares of Rectangle Corporation, management has employed a securities valuation firm. Explain the audit considerations involved in auditing the value developed by the valuation firm. Exercise 3 Items a through / represent possible errors and fraud that you suspect may be Present at Rex Company. The accompanying List of Auditing Procedures represents procedures that the auditor would consider performing to gather evidence concerning possible errors and fraud. For each item, select one or two procedures, as indicated, that the auditor most likely would perform to gather evidence in support of that item. The procedures on the list may be selected once, more than once, or not at all. LIST OF AUDITING PROCEDURES A. Compare the details ofthe cash receip's | L. Examine the ents sNppia joural entries with the details of the | documents to verify that | the corresponding daily deposit slips. merchandise that produced the B. Scan the debits to the fixed asset} receivable was actually sent to the accounts and vouch selected amounts | customer {0 vendors’ invoices and management's | M. Inspect the entity's correspondence files authorization {or indications of customer disputes for evidence thal certain shipments were on consignment. ‘Seanad wthCamS:anerpavlorm aalytial procndes tat Fompare documented authorized pay fips tothe entiy’s budget and forecast ptain the cutoff bank statement and fompare the cleared checks to the year- fend bank reconciliation prepare bank transfer schedule Inspect the enlily’s deeds 10 its real estate. Make inquiries of the entily’s attorney concerning the delails of real eslale transactions. Confirm the terms ‘of borrowing arrangements with the lender Examine selected equipment repair ‘orders and supporting documentation to determine the propriely of the charges 4, Send requests (0 confirm the entily’s Secounts receivable on a surprise basis at an interim date. Send a second request for confimation of the receivable (0 the customer and make inquiries of a reputable credit agency concerning the customer's creditworthiness. mm ° Audit of the Expendiure Cyele 28 238 Perform edit checks of dato on ' payroll transaction tapes. Inspect payroll check endorsement similar handwriting. | Observe paytoll check distributian on @ | surprise basi. \ Vouch data in the payroll register »| documented authorized pay rates in the human resources department's files Reconcile the payfoll checking account \ and determine if there were unusual time lags between the issuance and | or | payment of payroll checks. Inspect the fle of prenurmbered vouchers for consecutive numbering and proper approval by an appropriate employee Determine that the details of selected prenumbered vouchers match the telated vendors’ invoices. Examine the supporting purchase orders and receiving reports for selected paid vouchers. Possible Misstatements Due to Errors and Fraud leading an unusua b. An auditor suspects tha the cash disbursements jus until after the first wee! procedure.) c. The entity borrowed transaction was prope! created a lien on the entity’s financial statements. (Select onl: The auditor suspects that a kitting schet department employee who can issue lly luxurious lifestyle. (Select only 1 procedure.) t the controller wrote several checks and recorded t before year-end but did not mail the checks k of the subsequent year. (Select only 1 me exists because an accounting ‘and record checks seems to be funds from financial institution. Although the rly recorded, the auditor suspects that the loan real estate that is not disclosed in its ly 1 procedure.) ‘Seanad wth CamS:anerThe auditor discovered an unusually large receivable from one of the uspects that the receivable may pe entity's new customers. The auditor s fictitious because the auditor has never heard of the customer ang because the auditor's initial attempt to confirm the receivable has been ignored by the customer. (Select only 2 procedures.) The auditor suspects that fictitious employees have been placed on the Payroll by the entity’s payroll supervisor, who has access to payroy} Tecords and to the paychecks. (Select only I procedure.) The auditor suspects that selected employees of the entity receive unauthorized raises from the entity's payroll supervisor. who has access £0 payroll records. (Select only I procedure.) The entity's cash receipts of the first few days of the subsequent year Were properly deposited in its general operating account after the year. end. However, the auditor suspects that the entity recorded the cash Feceipts in its books during the last week of the year under audit. (Select only 1 procedure.) The auditor suspects that vouchers were prepared and processed by an accounting department employee for merchandise that was either ordered Nor received by the entity. (Select only 1 procedure.) The details of invoices for equipment repairs were not clearly identified or explained to the accounting department employees. The auditor Suspects that the bookkeeper incorrectly recorded the repairs as fixed assets. (Select only 1 procedure.) The auditor suspects that a lapping scheme exists because an accounting department employee who has access to cash receipts also maintains the accounts receivable ledger and refuses to take any vacation or sick days. (Select only 2 procedures.) The auditor suspects that the entity is inappropriately increasing the cash reported in its balance sheet by drawing a check on one account and not recording it as an outstanding check on that account and simultaneously recording it as a deposit in a second account. (Select only 1 procedure.) The auditor suspects that the entity’s controller has overstated sales and accounts receivable by recording fictitious sales to regular customers in the entity ’s books. (Select only 2 procedures.) Note: The Substantive Tests of Details of Balances of the Principal Accounts affected by the Expenditure Cycle are covered in... Chapter 11 - Audit of Cash Balances Chapter 13 - Audit of Inventories, Cost of Sales and Trade Payables ‘Scan wthComS:aner