Chapter 18: Audit of the Acquisition and Payment Cycle Auditing: The Art and Science of Assurance Engagements Chapter 18: Audit of the Acquisition and Payment Cycle Copyright © 2011 Pearson Canada Inc.

Chapter 18 Learning Objectives Describe the major business functions, documents, and records in the acquisition and payment cycle. Explain the design of controls for the acquisition and payment cycle. Design substantive tests of detail for accounts payable. Analyze the risks and audit processes for selected accounts. Copyright © 2011 Pearson Canada Inc.

Business Functions in the Acquisition and Payments Cycle Processing purchase orders Receiving goods and services Recognizing the liability for goods and services purchased Vendor master file changes Processing and recording payments 18-3 Copyright © 2011 Pearson Canada Inc.

Designing Tests of Controls for the Acquisition and Payment Cycle 18-4 Copyright © 2011 Pearson Canada Inc.

Acquisition and Payment Tests of Controls by Assertion Transaction-related audit objective Key internal control Common test of control Occurrence: Recorded acquisitions are for goods and services received, consistent with the best interests of the client. Existence of purchase requisition, purchase order, receiving report and vendor’s invoice attached to the voucher/cheque. Examine underlying documents for reasonableness and authenticity. (Continued) 18-5 Copyright © 2011 Pearson Canada Inc.

Acquisition and Payment Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Completeness: Existing acquisition transactions are recorded. Receiving reports are prenumbered and accounted for. Account for a sequence of receiving reports (a block test). (Continued) 18-6 Copyright © 2011 Pearson Canada Inc.

Acquisition and Payment Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Accuracy: Recorded acquisition transactions are accurate. Batch totals are compared with computer summary reports. Examine file of batch totals for initials of data entry clerk; compare totals to summary reports. (Continued) 18-7 Copyright © 2011 Pearson Canada Inc.

Acquisition and Payment Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Classification: Acquisition transactions are properly classified. Automatic updates and posting. Enter test transactions or observe entry, and trace to correct file. (Continued) 18-8 Copyright © 2011 Pearson Canada Inc.

Acquisition and Payment Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Timing: Acquisition transactions are recorded on the correct dates. Transaction date must be system date (today’s date) or a reasonable date. Observe data entry process. (Continued) 18-9 Copyright © 2011 Pearson Canada Inc.

Acquisition and Payment Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Posting and summarization: Acquisition transactions are properly included in the vendor and inventory master files, and are properly summarized. Comparison of accounts payable master file or trial balance totals with general ledger balance. Test clerical accuracy by footing the journals and tracing postings to general ledger and accounts payable and inventory master files. 18-10 Copyright © 2011 Pearson Canada Inc.

Attribute Sampling for Tests of Controls Attribute sampling is common in the area of tests of controls of acquisitions and payments. Because of the number of accounts affected, the auditor may choose a relatively low tolerable exception rate. It is also common to stratify so that large dollar or unusual amounts are segregated and separately tested. 18-11 Copyright © 2011 Pearson Canada Inc.

Professional Judgment Problem 18-27, p. 637 Assessment of exceptions found during the audit of cash disbursements. 18-12 Copyright © 2011 Pearson Canada Inc.

Cash Disbursements Tests of Controls by Assertion Transaction-related audit objective Key internal control Common test of control Occurrence: Recorded cash disbursements are for goods and services actually received. Approval of payment on supporting documents at the time cheques are signed. Examine indication of approval. (Continued) 18-13 Copyright © 2011 Pearson Canada Inc.

Cash Disbursements Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Completeness: Existing cash disbursement transactions are recorded. Cheques are prenumbered and accounted form. Account for a sequence of cheques (block test). (Continued) 18-14 Copyright © 2011 Pearson Canada Inc.

Cash Disbursements Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Accuracy: Recorded cash disbursement transactions are accurate. Monthly preparation of a bank reconciliation by an independent person. Examine bank reconciliations and observe their preparation. (Continued) 18-15 Copyright © 2011 Pearson Canada Inc.

Cash Disbursements Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Classification: Cash disbursement transactions are properly classified. Adequate chart of accounts. Examine procedures manual and chart of accounts. (Continued) 18-16 Copyright © 2011 Pearson Canada Inc.

Cash Disbursements Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Timing: Cash disbursement transactions are recorded on the correct dates. Transaction date must be system date. Observe data entry process. (Continued) 18-17 Copyright © 2011 Pearson Canada Inc.

Cash Disbursements Tests of Controls by Assertion (Continued) Transaction-related audit objective Key internal control Common test of control Posting and summarization: Cash disbursement transactions are properly included in the vendor master file and properly summarized. Comparison of vendor master file or trial balance totals with general ledger balance. Test clerical accuracy by footing journals and tracing postings to general ledger and vendor master file. 18-18 Copyright © 2011 Pearson Canada Inc.

Discussion Question 18-22, p. 635 Accounts payable and cash disbursements audit issues in the face of a client cash shortage What are risks and audit procedures? 18-19 Copyright © 2011 Pearson Canada Inc.

System Conversions System conversions arise when an organization has undertaken a major change in its systems by implementing a new computer system or has made major changes to a particular system. For example, a batch processing system could be replaced with an online processing system. 18-20 Copyright © 2011 Pearson Canada Inc.

Impact of System Conversion When an organization changes an entire system or a set of systems, there are three issues that the auditor needs to address: A new system of internal controls will need to be documented and evaluated The auditor will need to audit the actual data conversion process The auditor will need to determine whether accounting policies have been changed The following example looks at an accounts payable conversion (from batch to online) by assertion. 18-21 Copyright © 2011 Pearson Canada Inc.

Conversion Tests of Controls and Tests of Detail by Assertion: Existence Key internal control Common test of control Common test of details Agree vendor file details for each vendor from the new (online) system to the old (batch) system. Review vendor file listings for evidence of agreement. On a test basis, agree vendor file details for vendors from the new (online) system to the old (batch) system. 18-22 Copyright © 2011 Pearson Canada Inc.

Conversion Tests of Controls and Tests of Detail by Assertion: Completeness and Accuracy Key internal control Common test of control Common test of details Agree aged accounts payable trial balance details from the old (batch) system to the new (online) system for each vendor and in total. Review aged accounts payable trial balance listings for evidence of comparison. On a test basis, agree aged A/P trial balance details from the old (batch) system to the new (online) system for vendors and in total. 18-23 Copyright © 2011 Pearson Canada Inc.

Conversion Tests of Controls and Tests of Detail by Assertion: Cutoff Key internal control Common test of control Common test of details Procedures exist to ensure appropriate cutoff of transactions. Conduct cutoff tests, for receiving reports and vendor invoices. Same as for tests of controls. 18-24 Copyright © 2011 Pearson Canada Inc.

Accounts Payable Accounts payable is the ending balance sheet obligation. Acquisition and payments are the transactions that occur throughout the year. Both the ending liability and the transactions often involve highly material amounts. 18-25 Copyright © 2011 Pearson Canada Inc.

Designing Tests of Details of Balances of Accounts Payable 18-26 Copyright © 2011 Pearson Canada Inc.

Tests of Details of Balances for Accounts Payable 18-27 Copyright © 2011 Pearson Canada Inc.

Analytical Procedures Possible misstatement Compare acquisition-related expense account balances with prior years. Misstatement of accounts payable and expenses. Review list of accounts payable for unusual, nonvendor, and interest bearing payables. Classification misstatement for nontrade liabilities. (Continued) 18-28 Copyright © 2011 Pearson Canada Inc.

Analytical Procedures (Continued) Possible misstatement Compare individual accounts payable with previous years. Unrecorded or nonexistent accounts, or misstatements. Calculate ratios such as purchase divided by accounts payable, and accounts payable divided by current liabilities. 18-29 Copyright © 2011 Pearson Canada Inc.

Review Question 18-8, p. 633 Learn how accounts payable confirmations differ from accounts receivable confirmations. 18-30 Copyright © 2011 Pearson Canada Inc.

The Nature of Manufacturing Assets Manufacturing assets are capital assets that normally have expected lives of more than one year, are used in the business, and are not acquired for resale. The assets are used as a part of the operation of the client’s business. Operational use and normal life of greater than one year distinguishes these assets from inventory, prepaid expenses, or investments. 18-31 Copyright © 2011 Pearson Canada Inc.

Tracking Manufacturing Assets Large organizations will normally have a capital asset master file, where each asset is described and tracked. This master file is also the source of information for calculating and recording amortization. Small organizations may have a manual listing of such assets, or may simply track a balance forward from year to year. 18-32 Copyright © 2011 Pearson Canada Inc.

Differences Between Manufacturing Assets and Current Asset Accounts There are usually fewer current period acquisitions. The amount of any given acquisition may be material. The equipment is likely to be kept and maintained in the accounting records for several years. 18-33 Copyright © 2011 Pearson Canada Inc.

Audit Emphasis for Manufacturing Asset Additions Emphasis is on auditing current period acquisitions. These are also traced to the capital cost allowance section of the tax working papers. Amortization and accumulated amortization accounts are also verified. Other accounts that are verified in a similar manner include: patents, copyrights, catalogue costs. 18-34 Copyright © 2011 Pearson Canada Inc.

Categories of Audit Tests for Manufacturing Equipment and Related Accounts Analytical procedures Verification of: Current-year acquisitions Current-year disposals The ending balance in the asset account Amortization expense The ending balance in accumulated amortization 18-35 Copyright © 2011 Pearson Canada Inc.

Analytical Procedures for Manufacturing Equipment Potential misstatement detected Compare amortization expense divided by gross manufacturing equipment cost with previous years Misstatement in amortization expense and accumulated amortization Compare accumulated amortization divided by gross manufacturing equipment cost with previous years Misstatement in accumulated amortization (Continued) 18-36 Copyright © 2011 Pearson Canada Inc.

Analytical Procedures for Manufacturing Equipment (Continued) Potential misstatement detected Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with previous years Expensing amounts that should be capital items Compare gross manufacturing cost divided by some measure of production with previous years Idle equipment or equipment that has been disposed of but not written off 18-37 Copyright © 2011 Pearson Canada Inc.

Verification of Current Year Acquisitions Important because of the long-term effect that assets have on financial statements. Starting point is normally a continuity schedule prepared by the client (showing additions, disposals and amortization). An important technique is examination of supporting documentation. 18-38 Copyright © 2011 Pearson Canada Inc.

Verification of Current Year 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. 18-39 Copyright © 2011 Pearson Canada Inc.

Verification of Asset Balances The nature of the internal controls over existing assets determines whether it is necessary to verify manufacturing equipment acquired in prior years. Relevant controls include a periodic count and a formal method of informing the accounting department of disposals. 18-40 Copyright © 2011 Pearson Canada Inc.

Verification of Amortization Expense Recorded amounts are internal allocations rather than exchange transactions with outside parties. Primary audit objectives involve determining whether the client is: Following a consistent amortization policy from period to period and whether Making calculations accurately 18-41 Copyright © 2011 Pearson Canada Inc.

Verification of Accumulated Amortization Debits are normally tested as a part of the audit or disposals of assets. Credits are verified as part of the audit of amortization expense. 18-42 Copyright © 2011 Pearson Canada Inc.

Discussion Question 18-24, p. 636 Discuss your responsibilities for auditing opening and closing asset balances Prepare an audit program for the audit of asset balances 18-43 Copyright © 2011 Pearson Canada Inc.

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. 18-44 Copyright © 2011 Pearson Canada Inc.

Audit of Prepaid 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. 18-45 Copyright © 2011 Pearson Canada Inc.

Prepaid Insurance Expense: Audit tests 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). 18-46 Copyright © 2011 Pearson Canada Inc.

Auditing Intangible Assets Intangible assets include goodwill, copyrights, trademarks, deferred expenses, capitalized charges for brand names, and others. 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. 18-47 Copyright © 2011 Pearson Canada Inc.

Typical Accrued Liabilities Payroll-related accruals (bonuses, commissions, income taxes, interest, payroll, payroll taxes and pension costs) Professional fees Rent Warranty costs 18-48 Copyright © 2011 Pearson Canada Inc.

Auditing Accrued Property Taxes Payments of property taxes have been partially tested by means of the tests of the acquisition and payment cycle. Emphasis in the tests is normally on the ending property tax liability and payments. 18-49 Copyright © 2011 Pearson Canada Inc.

Audit of 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. 18-50 Copyright © 2011 Pearson Canada Inc.

Approach to Auditing Operations 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, and is often conducted using audit software or spreadsheet software. 18-51 Copyright © 2011 Pearson Canada Inc.

Typical Analytical Procedures for Operations Possible misstatement Compare individual expenses with previous years Overstatement or understatement of a balance in an expense account Compare individual asset and liability balances with previous years Overstatement or understatement of a balance sheet account that would also affect an income statement account (Continued) 18-52 Copyright © 2011 Pearson Canada Inc.

Typical Analytical Procedures for Operations (Continued) Possible misstatement Compare individual expenses with budgets Misstatement of expenses and related balance sheet accounts Compare gross margin percentage with previous years Misstatement of cost of goods sold and inventory (Continued) 18-53 Copyright © 2011 Pearson Canada Inc.

Typical Analytical Procedures for Operations (Continued) Possible misstatement Compare inventory turnover ratio with previous years Misstatement of cost of goods sold and inventory Compare prepaid insurance and insurance expense with previous years Misstatement of insurance expense and prepaid insurance (Continued) 18-54 Copyright © 2011 Pearson Canada Inc.

Typical Analytical Procedures for Operations (Continued) Possible misstatement Compare commission expense divided by sales with previous years Misstatement of commission expense and accrued commissions Compare individual manufacturing expenses divided by total manufacturing expenses with previous years Misstatement of individual manufacturing expenses and related balance sheet accounts 18-55 Copyright © 2011 Pearson Canada Inc.

Case 18-29, p. 637 Review the results of analytical review. Are the explanations reasonable? 18-56 Copyright © 2011 Pearson Canada Inc.