Audit of the Acquisition and Payment Cycle Dr. Donald K. McConnell Jr. 11/23/2018

Auditor’s Usual Concern: Asset Overstatement and Liability Understatement Overstatement of sales or inventories: existence or occurrence assertion violations Something has to be on the books that we can audit Asset overstatement detectable through: Confirmation Vouching Physical examination Public company: Existence or occurrence assertion usually riskier for assets 11/23/2018

Auditor’s Usual Concern: Asset Overstatement and Liability Understatement Understatement of expenses and accounts payable: completeness assertion violations Requires simply omitting expenses and related payables to overstate income! Inherently harder to audit completeness than existence or occurrence assertion Public company: Completeness assertion usually riskier for liabilities 11/23/2018

However, Don’t Focus Only On Earnings Overstatement Risk! Asset reserves (e.g. allowances for bad debts) can be intentionally overstated Accrued liabilities (e.g. product liab. wty. accruals) can be intentionally overstated Why? Income smoothing (earnings management) schemes Sometimes called “rainy day,” “cookie jar reserves,” or “hidden”reserves An irony: it’s GAAP in some European countries to create such reserves! SEC increasingly concerned with such practices A personal audit experience 11/23/2018

Obtaining an Understanding of and Testing Internal Controls: an Overview 11/23/2018

Three Primary Year-end Substantive Procedures Either audit a sample of year-end vendor statement reconciliations to books, or confirmation of accounts payable [latter unusual] Search for unrecorded liabilities [Arens, et. al. calls this “out-of-pd liabilities test”] Purchase cutoff testing 11/23/2018

Why Aren’t Accounts Payable Typically Confirmed? Confirming recorded liabilities of little value for completeness concerns Our concern is with what is not on the books! What if no open transactions with a vendor have been booked? Confirmation, using trial balance of A/P, ineffective if vendor has no balance on the books! Confirmation would only be effective if: Some open vendor transactions are on the books, i.e. There is a balance in the accounts payable master files 11/23/2018

Why Aren’t Accounts Payable Typically Confirmed? (con.) We have external vendor statements to substantiate year-end accounts payable balances We have no corresponding external evidence in the sales and collection cycle! That is, customers don’t mail out monthly statements to vendors! 11/23/2018

Why Is Confirmation of Accounts Payable Not Typically Done? (con.) If you do mail confirmations of A/P, what do you get? Usually a copy of the same vendor statement in the client’s files! 11/23/2018

First Primary Test: Audit a Sample of Year-end Vendors Statement Reconciliations This is in lieu of confirmation of accounts payable An example: packet page 19-1 11/23/2018

Accounts Payable Confirmations Only used when IR and CR are high in the acquisition cycle Traditional criteria for AP confirmation selection: Small or zero balances when compared to prior years Large vendor balances 11/23/2018

Recommended Criteria Where Accounts Payable Are Confirmed Since completeness assertion is at greater risk for accounts payable, a more appropriate population to confirm from might be a list of authorized vendors Regardless of balances Rather than using a trial balance of accounts payable (Au 330.13) 11/23/2018

Second Primary Test: Search for Unrecorded Liabilities Focuses on journal of original entry for liabilities: Accrual basis: purchases journal or voucher register Cash basis: cash disbursements journal Scope of the search: usually the month following year end Vouch all entries exceeding X% of tolerable misstatement to supporting documentation Examine for evidence of December obligations recorded in January If material, requires an audit AJE 11/23/2018

Search for Unrecorded Liabilities: Other Considerations Why not just directly examine invoices paid after year end? (Bypass identifying transactions in general of original entry) Not a controlled listing! How do you know they’re all there? Last day of search: examine invoices not yet entered into the payables system Examine year-end receiving reports not matched with vendor invoices until month after year end, to insure payable was booked before year end 11/23/2018

Search for Unrecorded Liabilities: Other Considerations (con.) How might scope of the search be altered based on finding numerous unrecorded liabilities? How might scope of the search be altered based on good previous experience? How might scope be altered in the audit of a charitable hospital where: funding is based upon earnings shortfalls I.e., the worse the earnings, the greater the funding? 11/23/2018

Some Auditors Will Expand Search for Unrecorded Liabilities in Lieu of Vendor Statement Testing Month following year end: vouch all entries > 25% of TM Second month following year end: vouch all entries > 50% of TM Third month (or part thereof) following year end: vouch all entries > 75% of TM 11/23/2018

Third Primary Test: Purchases Cut off Test When does merchandise title pass? Usually F.O.B. shipping point F.O.B. destination only common in import/export transactions However, audit assumption: title passes F.O.B. destination, unless material amounts in transit at year end Primary source document is receiving report Demonstration of purchases cut off test 11/23/2018

What If Material F.O.B. Shipping Point Merchandise Is in Transit at Year End? Determined by examining receiving reports dated in early January for large shipments; ascertaining shipment dates by examining shipping document dates An audit AJE must be made Modern inventory management techniques (e.g. “Just-in-Time”) raise this probability 11/23/2018

Accounts Payable Evidence: Vendor Statements or Vendor Invoices? Auditing year-end accounts payable? Testing controls (and transaction level substantive testing) Why is the distinction important? 11/23/2018