1. Completing the Tests in the Acquisition and Payment Cycle: Verification of Selected Accounts
Chapter 19

2. Learning Objective 1
Recognize the many accounts in the acquisition and payment cycle.

3. Accounts Associated with the Acquisition and Payment Cycle
Assets:
Key accounts in this cycle are discussed as follows:
Property, plant and equipment
Prepaid expenses
Other liabilities
Income and expense accounts

4. Learning Objective 2
Design and perform audit tests of property, plant, and equipment and related accounts.

5. Classifications of Property, Plant and Equipment
The primary account record for equipment and other property, plant, and equipment accounts is generally a fixed asset master file. It includes a detailed record for each piece of equipment and other types of property owned.
The totals for all records in the master file equal the general ledger balances for the related accounts: equipment, depreciation expense, and accumulated depreciation.

6. Equipment and Related Accounts
Manufacturing
Equipment
Accumulated
Depreciated
Beginning
balance
Disposals
Disposals
Beginning
balance
Acquisitions
Current period
depreciation
Ending
balance
Ending balance
Gain or Loss
on Disposals
Depreciation
Expense

7. Auditing Manufacturing Equipment and Related Accounts
Perform analytical procedures
Plus verify:
Current year acquisitions
Current year disposals
Ending balance in the asset account
Depreciation expense
Ending balance in accumulated depreciation
Auditors verify equipment differently from current asset accounts for three reasons:
There are usually fewer current period acquisitions of equipment, especially large equipment used in manufacturing
The amount of any given acquisition is often material
The equipment is likely to be kept and maintained in the accounting records for several years.

8. Analytical Procedures for Manufacturing Equipment

9. Verify Current Year Acquisitions
Current year additions have a long-term effect
on the financial statements.
Seven of the eight balance-related
audit objectives are used as a frame of reference.
The correct recording of current year additions is important because of the long-term effect
the assets have on the financial statements.

10. Balance-related Audit Objectives
Detail tie-in:
Current acquisitions agree
with the master file.
1. Foot the acquisition schedule.
2. Trace the individual acquisitions
to the master file.
3. Trace the total to the general ledger.
Footing the acquisitions schedule and tracing individual acquisitions should be limited unless controls are deficient.
The totals in the master file equal the general ledger balances for the related accounts: equipment, depreciation expense, and accumulated depreciation.

11. Balance-related Audit Objectives
Existence:
Current acquisitions as listed exist.
1. Examine vendors’ invoices and
receiving reports
2. Physically examine assets.
The most common audit test is to verify additions to examine vendor invoices. It is normal for auditors to verify large and unusual transactions for the entire year as well as a representative sample of typical additions.

12. Balance-related Audit Objectives
Completeness:
Existing acquisitions are recorded.
1. Examine vendors’ invoices of closely
related accounts to uncover items that
should be manufacturing equipment.
2. Review lease and rental agreements.
This objective is one of the most important for equipment.

13. Balance-related Audit Objectives
Accuracy:
Current year acquisitions as listed
are accurate.
1. Examine vendors’ invoices.
Extent of work depends on inherent risk and effectiveness of internal controls.

14. Balance-related Audit Objectives
Classification:
Current year acquisitions as listed
are correctly classified.
1. Examine vendors’ invoices in
manufacturing equipment account.
2. Examine vendors’ invoices of closely
related accounts.
3. Examine rent and lease expense
for capitalizable leases.
The objective is closely related to tests for completeness. It is done in conjunction with that objective and the tests for accuracy.

15. Balance-related Audit Objectives
Cutoff:
Current year acquisitions are recorded
in the correct period.
1. Review transactions near the balance
sheet date for correct period.
Usually done as part of accounts payable cutoff tests.

16. Major Balance-related Audit Objectives
Rights:
The client has rights to current year
acquisitions.
1. Examine vendors’ invoices.
Ordinarily, the main concern is whether equipment is owned or leased. Purchase or lease contracts are examined for equipment and property deeds, abstracts, and tax bills are examined for land or major buildings.

17. Verify Current Year Disposals
Review whether newly acquired assets
replace existing assets
Analyze gains and losses on disposal
Review documents for indications of
deletion of equipment
Make inquiries about the possibility of
the disposal of assets
Transactions involving the disposal of equipment are often misstated when company internal controls lack a formal method to inform management of the sale, trade-in, abandonment or theft of recorded machinery and equipment.

18. Verify Ending Balance of Asset Accounts
All recorded equipment physically
exists on the balance sheet date
All equipment owned is recorded
Two of the auditor’s objectives when auditing the ending balance in the equipment accounts include determining the aforementioned points.

19. Verify Depreciation Expense
The most important objective is accuracy.
Consistent depreciation policy
Correct calculations
Depreciation expense is one of the few expense accounts not verified as part of tests of controls and substantive tests of transactions. The recorded amounts are determined by internal allocations rather than by exchange transactions with outside parties.
A useful method of auditing depreciation is an analytical procedures test of reasonableness made by multiplying undepreciated fixed assets by the depreciation rate for the year.

20. Verify Ending Balance in Accumulated Depreciation
Accumulated depreciation as stated
in the property master file agrees
with the general ledger.
Accumulated depreciation in the
master file is accurate.
The two objectives usually emphasized in the audit of the ending balance in accumulated depreciation are shown above.

21. Learning Objective 3
Design and perform audit tests of prepaid expenses.

22. Audit of Prepaid Expenses
Prepaid rent
Organization costs
Prepaid taxes
Patents
Prepaid insurance
Trademarks
Deferred charges
Copyrights
Analytical procedures are often sufficient for prepaid expenses, deferred charges and intangibles.

23. Prepaid Insurance and Related Accounts
Insurance Expense
Beginning
balance
Current period
insurance
expense
Acquisitions
Ending
balance
Prepaid insurance is found in most audits
Problems commonly encountered in the audit of prepaid insurance are typical of this class of accounts.
The auditor’s responsibility for the review of insurance coverage is an additional consideration not found in the other accounts in this category.

24. Internal Controls Acquisition and recording of insurance
Insurance register
Insurance expense
Internal controls for prepaid insurance and insurance expense can be conveniently divided in to three categories.

25. Audit Tests Compare total prepaid insurance and
insurance expense with previous years
Compute the ratio of prepaid insurance
to insurance expense and compare
it with previous years
Compare the individual insurance policy
coverage on the schedule of insurance
obtained with the preceding year’s schedule
In the audit of prepaid insurance, the auditor obtains a schedule from the client that lists for each policy in force:
policy information
beginning prepaid balance
payment of policy premiums
amount charged to insurance expense
ending prepaid insurance balance.

26. Audit Tests Compare the computed prepaid insurance
balance for the current year on a policy-by-
policy basis with that of the preceding year.
Review the insurance coverage listed on
the prepaid insurance schedule with an
appropriate client official or insurance broker.

27. Balance-related Audit Objectives
Existence and completeness:
Insurance policies in the prepaid insurance
schedule exist and existing policies are listed.
Rights:
The client has rights to all insurance policies
in the prepaid insurance schedule.
Tests for existence and omissions of insurance policies in force can be performed on the client’s prepaid insurance schedule in one of two ways:
Examine a sample of insurance invoices and policies in force and compare to the schedule.
Obtain a confirmation of insurance information from the company’s insurance agent.

28. Balance-related Audit Objectives
Accuracy and detail tie-in:
Prepaid amounts are accurate and the total
is correctly added and agrees with the
general ledger.
Classification:
Insurance expense is properly classified.
Cutoff:
Insurance transactions are recorded in the
proper period.
Audit tests to verify the accuracy of prepaid insurance involve verifying the amount of the insurance premium the length of the policy period and the allocation of the premium to unexpired insurance.
The correct classification of debits to different insurance expense accounts should be reviewed as a test of the income statement.
Cutoff for acquisitions of insurance is normally not a significant problem because of the small number of policies and the immateriality of the amount.

29. Learning Objective 4
Design and perform audit tests of accrued liabilities.

30. Audit of Accrued Liabilities
Accrued payroll
Accrued payroll taxes
Accrued officers’ bonuses
Accrued commissions
Accrued professional fees
Accrued rent
Accrued interest
The verification of accrued expenses varies depending on the nature of the accrual and the circumstances of the client. Some accounts such as accrued income taxes, warranty costs and pension costs are often material and require considerable audit effort.

31. Accrued Property Taxes and Related Accounts
Property Tax Expense
Payments
(property taxes)
Beginning
balance
Current period
property tax
expense
The emphasis on testing is with the ending property tax liability and payments.
Two audit objectives are significant:
Existing properties for which accrual of taxes is appropriate are on the accrual schedule.
Accrued property taxes are accurately recorded.
Ending
balance

32. Learning Objective 5
Design and perform audit tests of income and expense accounts.

33. Approach to Auditing Income and Expense Accounts
Analytical procedures
Tests of controls and substantive
tests of transactions
Tests of details of account balances
The audit of income and expense accounts is directly related to the balance sheet and is not a separate part of the audit process. A misstatement of an income statement account almost always equally affects a balance sheet account and vice versa.
While we discuss these tests in the context of the acquisition and payment cycle, the same concepts apply to the income statement accounts in all other cycles.

34. Analytical Procedures for Income and Expense Accounts
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
will also affect an income
statement account

35. Analytical Procedures for Income and Expense Accounts
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
Compare inventory turnover
ratio with previous years
Misstatement of cost of
goods sold and inventory

36. Analytical Procedures for Income and Expense Accounts
Possible misstatement
Compare prepaid insurance
expense with previous years
Misstatement of
insurance expense and
prepaid insurance
Compare commission
expense divided by sales
with previous years
Misstatement of
commission expense and
accrued commissions
Compare individual
manufacturing expenses
divided by total mfg.
expenses with previous years
Misstatement of
individual manufacturing
expenses and related
balance sheet accounts

37. Tests of Controls and Substantive Test of Transactions
Both tests of controls and substantive
tests of transactions have the effect of
simultaneously verifying balance sheet
and income statement accounts.
Inadequate controls and misstatements discovered through tests of controls and substantive tests of transactions indicate the likelihood of misstatements in both the income statement and balance sheet.

38. Analysis of Legal Expense
Expense account analysis:
Repairs and maintenance
Rent and lease
Legal expense
Expense account analysis involved auditor examination of underlying documentation of individual transactions and amounts making up the detail of the total of an expense account.

39. Analysis of Legal Expense
Expense account analysis:
Repairs and maintenance
Rent and lease
Legal expense

40. Tests of Details of Account Balances – Allocation
Several expense accounts result from the allocation
of accounting data rather than discrete transactions.
These include depreciation, depletion, and the
amortization of copyrights and catalog cost.
The allocation of manufacturing overhead between
inventory and cost of goods sold is an example of
a different type of allocation that affects expenses.

41. End of Chapter 19