CHAPTER 15 Auditing the Expenditure Cycle Spring 2007

1. CHAPTER 15 Auditing the Expenditure CycleSpring 2007

2. Expenditure Cycle Transaction Classes and Accounts: Purchases DebitCredit Merchandise Inventory Raw Materials Inventory Purchases Prepaid Expenses Plant Assets Other Assets Various Expenses Accounts Payable

3. Expenditure Transaction Classes and Accounts: Cash Disbursement & Adjustments DebitCredit Accounts Payable Cash Purchase Discounts Purchase Returns

4. 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

5. 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

6. 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

7. 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

8. 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.

9. Assertion Completeness Existence & Occurrence Valuation Rights and Obligations Presentation and Disclosure Specific Audit Objective Completeness Cutoff / Timeliness Validity Cutoff / Timeliness Valuation at Historical Cost / GAAP Valuation at Net Realizable Value Posting and Summarization Ownership Classification Disclosure Expenditure Cycle Audit Objectives

10. Expenditure Cycle: Initial Audit Procedures Assertions Specific Audit Objectives Expected Internal Controls Enough Comfort? Yes/No What substantive testing do we plan on doing?

11. 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

12. 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

13. 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 Expenditure Cycle:Information System

14. 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.

15. 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)

16. Purchases Controls (completeness) 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.

17. 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

18. 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.

19. 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.

20. Purchases Controls (R & O) Ownership • like net realizable value, generally applies to balances, not transactions.

21. 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

22. Cash Disb Controls (completeness) 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.

23. 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.

24. 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

25. Cash Disb Controls (R & O) Ownership • Controlled by controlling voucher.

26. 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.

27. 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?

28. 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)

29. 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?

30. Accounts Payable (completeness)Substantive Tests Completeness • 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

31. 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

32. 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.

33. 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?

34. 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

35. 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