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

2. 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

3. 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

4. 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

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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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 )
11/23/2018

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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