CHAPTER 15 Auditing the Expenditure Cycle Spring 2007 Outline of what we’re going to talk about today

Expenditure Cycle Transaction Classes and Accounts: Purchases Debit Credit Merchandise Inventory Raw Materials Inventory Purchases Prepaid Expenses Plant Assets Other Assets Various Expenses Accounts Payable Describe the nature of the expenditure cycle and the transaction classes and accounts involved Note that there is a decision made here to either capitalize or expense the expenditure

Expenditure Transaction Classes and Accounts: Cash Disbursement & Adjustments Debit Credit Accounts Payable Cash Purchase Discounts Purchase 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 Recall that within this general strategy, the relative emphasis placed on the different types of tests can change. Low IR, emphasis on AP Emphasis on CR -- Emphasis on Substantive tests

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 This is part of BOTH assessing inherent risk and control risk!!!! Who are key suppliers? How competitive is the supply channel? What is supply / distribution channel?

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 Valuation at Historical Cost / GAAP Valuation at Net Realizable Value Posting and Summarization Ownership Classification Disclosure

Expenditure Cycle: Initial Audit Procedures Assertions Specific Audit Objectives Expected Internal Controls Where there are specific management assertions, we expect that management places controls over those assertions, and those are the controls we hope to test. Enough Comfort? Yes/No 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 Basic rule: correlation of cogs or inventory with AP depends upon the business cycles involved in acquisition, selling and payment

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 Mgmt Risk Assessment How management monitors ability to meet cash flow requirements. Entity’s potential loss contingencies from purchase commitments. Continued availability of supply. Impact of cost increases on entity.

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 Definitions on page 700 – 701. See process in Figure 15-5 on page 699 – System flowchart

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) 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. Relates to f/s assertion of completeness

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 Validity and Cutoff relate to existence

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. Valuation at Historical cost, NRV and posting and summarization

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. Valuation at NRV Discuss later in context of various assets: Inventory Fixed assets Intangibles

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) 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 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 Top Down Bottom Up