Chapter 8 Acquisition and Expenditure Cycle “Show those numbers to the damn auditors and I'll throw you out the $%*@@ window.”----(Buddy Yates, director of WorldCom, Inc. general accounting, to an employee asking for an explanation of a large accounting discrepancy). McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Learning Objectives Identify significant inherent risks in the acquisition and expenditure cycle. Describe the acquisition and expenditure cycle, including typical source documents and controls. Give examples of tests of controls over purchases of inventory and services. Explain the importance of the completeness assertion for the audit of accounts payable liabilities, and list some procedures for a “search for unrecorded liabilities.” McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives (cont.) Discuss audit procedures for other accounts affected by the acquisition and expenditure cycle. Specify some ways fraud can be found in accounts payable and cash disbursements. Describe some common errors and frauds in the acquisition and expenditure cycle, and design some audit and investigation procedures for detecting them. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Acquisition and Expenditure Cycle Concerned with transactions involving: the purchase of merchandise and materials necessary for the continued operations of business and the subsequent payment for such purchases. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 8.1 Cost and Expense Capers McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Inherent Risks Unrecorded liabilities Noncancelable purchase agreements Capitalizing expenses McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Acquisition and Expenditure Cycle: Typical Activities Department requesting purchase of item(s) prepares a PURCHASE REQUISITION Purchase is approved by preparation of a PURCHASE ORDER After vendor approval, goods are received by company and evidenced by preparing a RECEIVING REPORT Vendor bills company for goods using a VENDOR'S INVOICE McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

EXHIBIT8.2 ACQUISITION AND EXPENDITURE CYCLE McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Control Procedures Information processing controls Compare quantities against receiving report and purchase order Compare prices against quoted price or catalog listing Mathematically verify vendor's invoice Determine when to pay invoice and prepare VOUCHER Segregation of duties AUTHORIZATION of the purchase is done by the purchasing department. Custody of the inventory item(s) is held by the receiving department and, ultimately, the requesting department. Transactions are recorded by general accounting (control account) and accounts payable department (subsidiary accounts) Physical controls Prepare a receiving report upon initial receipt of inventory Count and verify inventory quantities upon delivery to the inventory warehouse Restrict access to inventories by keeping them in a secured location Performance reviews Compare purchases data to data from previous years or expected purchases data McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Audit Evidence in Management Reports and Data Files Open purchase orders Unmatched receiving reports Unmatched vendor invoices Accounts payable trial balance Purchases journal Inventory reports McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. EXHIBIT 8.4 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

The Completeness Assertion Search for Unrecorded Liabilities Scan open purchase order file Examine all UNMATCHED VENDOR STATEMENTS/INVOICES Examine all UNMATCHED RECEIVING REPORTS occurring near year-end TRACE from unpaid VOUCHERS in A/P Confirm A/P with NORMAL SUPPLIERS (even those with zero balances) Review CASH DISBURSEMENTS occurring after year-end McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Purchase Cutoffs Verify CUT-OFFs for purchases Examine Receiving Reports and Vendor Sales Invoices occurring around year-end to ensure inventory received is included in the appropriate period. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Other Accounts in Cycle Accrued Expenses Prepaid Expenses Expenses Inventory Property Plant and Equipment McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Accrued Payables Major differences between ACCRUED PAYABLES and ACCOUNTS PAYABLE Examples include INTEREST, PROPERTY TAXES, WAGES, and INCOME TAXES PAYABLE These payables are not normally INVOICED or EVIDENCED by the RECEIPT OF GOODS These differences may make it more difficult to detect UNRECORDED ACCRUALS McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Auditing Accrued Payables and Prepaid Expenses Agree balances to PRIOR YEAR WORKPAPERS Verify PAYMENTS Examine UNDERLYING AGREEMENTS RECALCULATE amounts Search for UNRECORDED ACCRUALS Review CASH DISBURSEMENTS at year-end Look for expected accruals at other stages of the audit (BONDS, NOTES, employees paid on 15th, etc.) ANALYTICAL PROCEDURES McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 8.5 Account Analysis for Prepaid Expenses McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

AUDITING PROPERTY, PLANT, AND EQUIPMENT GENERAL APPROACH Use TEST OF TRANSACTION approach Small number of transactions Relatively high dollar transactions Authorization of Transactions (Board of Directors) takes on added importance. Less concern for ACCESS to ASSETS More concerned with UNRECORDED DISPOSALS McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

AUDITING PROPERTY, PLANT, AND EQUIPMENT Agree balances to prior year documentation PURCHASES OF PPE VOUCH to INVOICE or COST RECORDS Inspect TITLE VOUCH to BOARD MINUTES EXPENDITURES SUBSEQUENT TO ACQUISITION VOUCH to INVOICE and WORK DESCRIPTIONS Consider propriety of classification (EXPENSE or CAPITALIZE) McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

AUDITING PROPERTY, PLANT, AND EQUIPMENT DISPOSAL OF PPE VOUCH from PPE to BOD MINUTES (AUTHORIZATION) Vouch to cash receipts journal and validated deposit slip Recalculate gain/loss TRACE from BD MINUTES to PPE for disposals (COMPLETENESS) Look for unrecorded disposals Agree balances to PRIOR YEAR WORKPAPERS Examine insurance policies, property tax records, etc. PHYSICALLY INSPECT or CONFIRM fixed assets Both existing and newly-acquired items Confirm assets LEASED to others under capital leases McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

AUDITING PROPERTY, PLANT, AND EQUIPMENT DEPRECIATION EXPENSE Recalculate using USEFUL LIFE, SALVAGE VALUE, COST, and METHOD (VA) Evaluate REASONABLENESS of USEFUL LIFE, SALVAGE VALUE, etc. Is depreciation consistent with COMPANY POLICY (half year conventions)? LEASE AGREEMENTS Verify proper treatment (Capitalized or Operating) Ensure disclosure in footnotes is appropriate McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Exhibit 8.6 McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Auditing Expense Accounts Analytical procedures (e.g. sales commissions) Agree to related balance sheet account (depreciation) Substantive tests of transactions (e.g. payroll) Vouch detail (e.g. legal expense) McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Fraud Signs Photocopies of invoices Invoices in numerical order Round numbers Slightly below threshold P.O. Boxes No listed phone # Vendor and Employee addresses the same Multiple vendors at same location McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.