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

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

Accounts Associated with the Acquisition and Payment Cycle Assets: Cash Inventory Supplies Property, plant, and equipment Patents, trademarks, and copyrights Prepaid rent Prepaid taxes Prepaid insurance

Accounts Associated with the Acquisition and Payment Cycle Expenses: Cost of goods sold Rent expense Property taxes Income tax expense Insurance expense Professional fees Retirement benefits Utilities

Accounts Associated with the Acquisition and Payment Cycle Liabilities: Accounts payable Rent payable Accrued professional fees Accrued property taxes Other accrued expenses Income taxes payable

Methodology for Designing Tests of Details of Balances Identify client business risks affecting other accounts Phase I Set tolerable misstatement and assess inherent risk for accounts Phase I Assess control risk for accounts Phase I

Methodology for Designing Tests of Details of Balances Design and perform tests of controls and substantive tests of transactions for the acquisition and payment cycle Phase II

Methodology for Designing Tests of Details of Balances Design and perform analytical procedures for the acquisition and payment cycle Phase III Phase III Design tests of details of account balances to satisfy balance-related audit objectives Audit procedures Sample size Items to select Timing

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

Classifications of Property, Plant, and Equipment Accounts Land and land improvements Buildings and building improvements Manufacturing equipment Furniture and fixtures Autos and trucks Leasehold improvements Construction-in-process for property, plant, and equipment

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

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

Analytical Procedures for Manufacturing Equipment Possible misstatement Compare depreciation expense divided by gross manufacturing equipment cost with previous years Misstatement in depreciation expense and accumulated depreciation Compare accumulated depreciation divided by gross manufacturing equipment cost with previous years Misstatement in accumulated depreciation

Analytical Procedures for Manufacturing Equipment Possible misstatement Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with previous years Expensing accounts that should be capitalized Compare gross manufacturing cost divided by some measure of production with previous years Idle equipment or equipment that was disposed of but not written off

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

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.

Balance-Related Audit Objectives Existence: Current acquisitions as listed exist. 1. Examine vendors’ invoices and receiving reports 2. Physically examine assets.

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.

Balance-Related Audit Objectives Accuracy: Current year acquisitions as listed are accurate. 1. Examine vendors’ invoices.

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.

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.

Major Balance-Related Audit Objectives Rights: The client has rights to current year acquisitions. 1. Examine vendors’ invoices.

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

Verify Ending Balance of Asset Accounts 1. All recorded equipment physically exists on the balance sheet date. 2. All equipment owned is recorded.

Verify Depreciation Expense The most important objective is accuracy. Consistent depreciation policy Correct calculations

Verify Ending Balance in Accumulated Depreciation 1. Accumulated depreciation as stated in the property master file agrees with the general ledger. 2. Accumulated depreciation in the master file is accurate.

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

Audit of Prepaid Expenses Prepaid rent Organization costs Prepaid taxes Patents Prepaid insurance Trademarks Deferred charges Copyrights

Prepaid Insurance and Related Accounts Insurance Expense Beginning balance Current period insurance expense Acquisitions Ending balance

Internal Controls Acquisition and recording of insurance Insurance register Insurance expense

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

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.

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.

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.

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

Audit of Accrued Liabilities Accrued payroll Accrued payroll taxes Accrued officers’ bonuses Accrued commissions Accrued professional fees Accrued rent Accrued interest

Accrued Property Taxes and Related Accounts Property Tax Expense Payments (property taxes) Beginning balance Current period property tax expense Ending balance

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

Approach to Auditing Income and Expense Accounts Analytical procedures Tests of controls and substantive tests of transactions Tests of details of account balances

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

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

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 manufacturing expenses with previous years Misstatement of individual manufacturing expenses and related balance sheet accounts

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.

Tests of Details of Account Balances – Expense Analysis Expense account analysis: Repairs and maintenance Rent and lease Legal expense

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.

End of Chapter 19