Presentation on theme: "CHAPTER 15 Auditing the Expenditure Cycle Spring 2007"— Presentation transcript:
1CHAPTER 15 Auditing the Expenditure Cycle Spring 2007 Outline of what we’re going to talk about today
2Expenditure Cycle Transaction Classes and Accounts: Purchases Debit CreditMerchandise InventoryRaw Materials InventoryPurchasesPrepaid ExpensesPlant AssetsOther AssetsVarious ExpensesAccounts PayableDescribe the nature of the expenditure cycle and the transaction classes and accounts involvedNote that there is a decision made here to either capitalize or expense the expenditure
4General Audit Strategy Assess Inherent RiskUse Knowledge of Business and Industry to Perform Analytic Procedures and Assess Analytic Procedures RiskAssess Control RiskEvidence of effectiveness gained while obtaining an understanding of internal controlsEvidence of effectiveness of management controlsEvidence of effectiveness from direct tests of programmed controlsDesign Appropriate Substantive Tests of DetailsRecall that within this general strategy, the relative emphasis placed on the different types of tests can change.Low IR, emphasis on APEmphasis on CR --Emphasis on Substantive tests
5Expenditure Cycle: Initial Audit Procedures Obtain an understanding of the business and industry.Significance of purchase cycleEconomic driversIndustry trade termsConcentration of suppliers / purchase commitments
6Expenditure Cycle: Initial Audit Procedures cont. Business Aspects of the Expenditure CycleWhat does the operating cycle look like?Normal A/P turnNormal Inventory turnNormal A/R turnWhat do we know about costs?Fixed/variableVolatilityDependency on suppliersThis 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?
7Expenditure Cycle: Initial Audit Procedures cont. Consider management incentives & pressuresLiabilitiesUnderstate current liabilities to meet debt covenantsCash DisbursementsHigh volume and overall susceptible to fraudExpensesDecision to capitalize vs. expense impacts net income
8Expenditure Cycle: Initial Audit Procedures Understand how key expenditure cycle issues of economic substance are reflected in the financial statementsHow 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.
9Expenditure Cycle Audit Objectives AssertionCompletenessExistence & OccurrenceValuationRights and ObligationsPresentation and DisclosureSpecific Audit ObjectiveCompletenessCutoff / TimelinessValidityValuation at Historical Cost / GAAPValuation at Net Realizable ValuePosting and SummarizationOwnershipClassificationDisclosure
10Expenditure Cycle: Initial Audit Procedures AssertionsSpecific Audit ObjectivesExpected Internal ControlsWhere 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/NoWhat substantive testing do we plan on doing?
11Expenditure Cycle: Initial Audit Procedures Analytical ProceduresEstimate Accounts Payable with knowledge of the company’s historical operating cycle, creditor trade terms, and cost of goods sold.Ratio of CGS / APRatio of Inventory / APUse results of analytical procedures to direct attention to potentially misstated areas of f/sBasic rule: correlation of cogs or inventory with AP depends upon the business cycles involved in acquisition, selling and payment
12Expenditure Cycle: Understand (and maybe test) Internal Controls Control EnvironmentEthical ValuesHuman Resource PracticesCommitment to Competence (Hiring / Training)Background ChecksAssignment of Authority and ResponsibilityAccountabilityMgmt. Risk AssessmentCash flowSupply chainFraud riskMgmt Risk AssessmentHow 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.
13Expenditure Cycle: Information System DocumentsPurchase requisitionPurchase orderReceiving reportVendor’s invoice (external)Voucher (internal)CheckCash disbursements journalFilesApproved vendor master fileAccounts payable master file /or/ Voucher registerOpen P.O. fileReceiving fileSuspense fileUnpaid voucher filePaid voucher fileDefinitions on page 700 – See process in Figure 15-5 on page 699 – System flowchart
14Expenditure Cycle: Obtain an Understanding of Internal Controls We also need to know…Reports:Reports used in decision makingException reportsUnderstand 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.
15Assessing Control Activities - Hints Determine first if general controls are adequateEnsure you are clear on what audit objective you are assessingComputer 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)
16Purchases Controls (completeness) Establish initial pre-numbered control over PO, receiving, and voucherHave computer:Ascertain that documents are pre-numbered with no missing documents in sequenceIdentify all purchase orders without receiving reports or vouchersCutoffComputer 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
17Purchases Controls (existence) ValidityThe 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.CutoffSame as w/ completenessValidity and Cutoff relate to existence
18Purchases Controls (valuation) Valuation at Historical CostHave 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
19Purchases Controls (valuation) Valuation at N.R.V.Not applicable at transaction level.Generally not applicable for liability.Posting and SummarizationHave 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:InventoryFixed assetsIntangibles
20Purchases Controls (R & O) Ownershiplike net realizable value, generally applies to balances, not transactions.
21Purchases Controls (P & D) ClassificationHave 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 accountsDisclosureRelated party?The auditor rarely finds controls over disclosure and must test substantively
22Cash 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.CutoffIndependent Bank Reconciliation on a monthly basis.
23Cash Disb Controls (existence) ValidityComputer will automatically check for duplicate payments of specific voucher/vendor’s invoice so it is not paid twice.Controls over access to cashComputer 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.
24Cash Disb Controls (valuation) Valuation at historical costIssue: 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 NRVNot applicable to transactions.Posting and SummarizationRun to run totals on disbursement’s journal.Compare sum of A/P subsidiary ledgers with control account in the general ledger
25Cash Disb Controls (R & O) OwnershipControlled by controlling voucher.
26Cash Disb Controls (P & D) ClassificationException 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.DisclosureDo not expect control here.
27Accounts Payable: Determining Detection Risk Inherent RiskMajor concern is understatement.Analytic Procedures RiskControl RiskControl risk over purchasesControl risk over disbursementsUse audit risk model to solve for test of details risk – How much more comfort do we need?
28Accounts Payable: Standard Substantive Tests Initial substantive proceduresAgree beginning balance to prior year workpapersAgree subsidiary ledger to general ledgerComputer scan of all transactions and balances for unusual items.Rank order payables by size or agingComputer analysis of voucher register (consider fraud assessment procedures here)
29Accounts Payable: Standard Substantive Tests Analytical ProceduresLiquidity ratios look too goodSignificant change in accounts payable turn daysUnderstand the company’s ability to generate cash flow from operationsIs accounts payable growing at about the same pace as inventory growth?
30Accounts Payable (completeness) Substantive Tests Search for unrecorded liabilities (primary test)Subsequent cash disbursements (checks & wires)Unpaid invoicesCutoffObtain listing of last receipts at inventory observation and trace to recording of payableSearch for unrecorded liabilitiesThis also ties in with cash disbursements cut-off
31Accounts Payable (existence) Substantive Tests ValidityConsider confirmation based on risk of misstatement: This is a costly procedureSignificant number of purchase returns (returns to vendor?)Review vendor’s statements
32Accounts Payable (valuation) Substantive Tests Valuation at historical costSubsequent payment of Accounts PayableConfirmation of Accounts PayableReview of Vendor’s StatementsValuation at N.R.V.Not an issue with liabilityPosting and SummarizationSee initial procedure where this is tested substantively.
33Accounts Payable (R & O) Substantive Tests OwnershipOwnership 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?
34Accounts Payable (P & D) Substantive Tests PresentationReview A/P for debit balances that should be reclassifiedReview proper classification of trade payables, related party payables, etc.DisclosureReview financial statement disclosures against disclosure check list
35How this all fits together: The Audit Risk Model AR = IR x CR x AP x TDAR = IR x AP x CR x TDTop DownBottom Up