1. Audit of Acquisition Cycle and Inventory
Chapter 11
Audit of Acquisition Cycle and Inventory

2. Overview of Acquisition Cycle
The acquisition cycle covers the purchase, receipt, payment, and accounting for goods and services
Major accounts include inventory, accounts payable, and expenses
Main phases in the acquisition and payment process:
Authorized requisition
Authorized purchase
Receipt of goods and services
Approval for payment
Cash disbursement

3. Discuss Risk and Business Analysis
Acquisition cycle deals with receipt of all goods and services
Misstatements may occur just because of the volume of transactions
It is also an area where fraud is likely to take place. For example,
Employee theft of inventory causing inventory on the books to be overstated
Employees setting up fictitious vendors and paying themselves for goods never received by the company
Executives abusing travel and entertainment expenses for personal use
Capitalizing expenses as assets to inflate earnings
Overestimating "restructuring reserves" at the time of acquisition so expenses could be reduced in future periods

4. What are the red flags of the acquisition and payment cycle?
There are a number of red flags unique to the acquisition and payment cycle. These include:
Inventory growing at a rate greater than sales
Expenses significantly above or below industry norms
Capital assets growing faster than the business and for which there are not strategic plans
Significant reduction of "reserves"
Expense accounts that have significant credit entries
Travel and entertainment expense accounts that do not have documentation
Inadequate follow-up to auditor recommendations on needed controls

5. What analytical analysis can be done for misstatements?
Analytical procedures to identify potential misstatements:
Calculate and analyze dollar and percentage change in inventory, cost of goods sold, and expense accounts
Compute and analyze ratios like inventory turnover and number of day's sales in inventory
Prepare common sized income statement to identify cost of good sold or expense accounts that are out of line
Auditor compares client analytics to past client performance, industry results, and auditor's expectations

6. Overview of Control Procedures and Control Risk Assessment
Requisition goods or services
Need identified
Pre-numbered requisition form completed and sent to purchasing
Purchase goods or services
Purchase order shows quantity and price of goods ordered, quality specifications, shipping terms
Purchase orders are pre-numbered to establish completeness
Purchase orders must be properly authorized
Many companies have separate purchasing department:
Agents job is to find best combination of price, service, and quality
Reduces fraud by separating purchasing from custody and recording
Centralizes control in one location
Controls set to stop purchasing agents from abusing their positions

7. Overview of Control Procedures and Control Risk Assessment
Receive goods
Receiving department should ensure
Only authorized goods are received
The goods meet order specifications
An accurate count of goods received is taken
All receipts of goods are recorded
Receiving reports are pre-numbered to establish completeness
Receiving department records quantity of goods received
Goods also inspected for quality
Receiving reports sent to accounting

8. Overview of Control Procedures and Control Risk Assessment
Approve payment
Accounting matches vendor invoice, purchase order, and receiving reports - If quality and quantity match, account payable is recorded
Cash disbursement
Supporting documentation is reviewed and approved for payment
Documents are marked "paid" to avoid duplicate payment

9. Testing Controls over Accounts Payable and Related Expenses
The primary risk is that Accounts Payable and expenses will be understated
Therefore, controls related to the following are usually significant:
Proper authorization
Completeness of recording
Timeliness of recording
Correctness of valuation
Attribute sampling (Chapter 9) may be used to test control operation
The level of assessed control risk will impact the rigor of the subsequent substantive testing of Accounts Payable and expenses

10. What are some substantive tests of accounts payable?
The auditor's main concern is that Accounts Payable will be understated
Therefore, emphasis is placed on testing the completeness assertion
Typical substantive tests include:
Reconcile vendor statements or confirm accounts payable
Tests of subsequent disbursements
Analytical review of related accounts

11. 1. Reconciling Vendor Statements or Confirm Accounts Payable
Auditor requests vendors' monthly statements or sends confirmation to major vendors
Auditor reconciles vendor statement or confirmation with client balance in the accounts payable subsidiary ledger

12. 2. Testing Subsequent Disbursements
Auditor samples cash disbursements after the end of the year
Determines if disbursements are for audit year transactions by vouching back to source documents (purchase order, vendor invoice, receiving report)
If disbursement is for audit year transaction, auditor reprocesses the transaction to see if it was properly recorded as a payable

13. 3. Analytical Review of Related Expense Accounts
Used to determine if accounting data indicates understatement of expenses
If understatement likely, auditor expands tests of accounts payable
Analytics used on clients with low control risk

14. Auditing of Expense Accounts
Auditing payables and cash disbursements provides indirect evidence about expense accounts
Additional analysis of selected expense accounts is usually merited
The auditor should consider management is more likely to
Understate rather than overstate expenses
Classify expenses as assets rather than vice versa
Substantive audit procedures include:
Detailed tests of transactions
Analytical review
Review of unusual entries

15. Auditing of Inventory & Cost of Goods Sold
Audit of inventory is complicated by a number of factors including:
Variety (diversity) of items
High volume of activity
Various (sometimes complex) valuation
Difficulty in identifying obsolete or defective inventory
Many frauds involve the inventory account
Easily transportable making it subject to double counting
May be stored at multiple locations, some may be remote
May be returned by customers

16. What are some internal controls for inventory?
A well-designed inventory control system should ensure:
All purchases are authorized
Accounting system ensures timely, accurate, and complete recording
Receipt of inventory properly accounted for
Inventory tested for quality when received/manufactured
Costs properly identified and assigned to products
Customer returns of inventory examined for defects
Inventory reviewed for obsolescence
New products introduced only after market studies and quality control tests have been made
Management actively manages inventory
Long term contracts are closely monitored

17. Substantive Tests of Inventory & Cost of Goods Sold
Existence: observe year-end physical inventory
Completeness: cutoff tests
Rights: review long-term contracts, etc.
Valuation: direct tests and analytics
Disclosure: review GAAP

18. Procedures for Observing a Client's Physical Inventory - Existence
Meet with client to discuss their plan to count inventory
Review client's plans for counting and tagging inventory
Review inventory counting procedures with audit personnel
Determine whether specialists are needed to identify inventory items
Upon arriving at each site:
Meet with client, and obtain map and schedule of inventory count area
Obtain list of sequential tag numbers for each area
Observe procedures to shut down receipt or shipment of goods; obtain document numbers for last receipt and shipment for cutoff tests

19. Procedures for Observing a Client's Physical Inventory - Existence
Observe the counting of inventory and note the following:
The first and last tag numbers in each section
Account for all tag numbers to prevent later insertion of additional inventory items
Make selected test counts
Items that appear obsolete or defective
High-dollar value items in inventory
Movement of inventory during counting process
Document conclusion as to quality of the inventory counting process

20. What does the auditor do after the inventory count? - Existence
After the inventory count, the auditor should:
Trace the test counts to the client's inventory records
Trace the number of high-dollar items to the client's inventory records
Trace the obsolete or damaged inventory to the client's inventory records to see if the items have been written down

21. Counting Inventory Before or After Year-end - Existence
On occasion, it may not be feasible to count inventory at year-end
Acceptable to count inventory before or after year-end if:
Controls are strong
The opportunity and motivation to misstate inventory is low
Auditor can test the year-end balance using analytics and tests of transactions between the physical count and year-end (called the roll-forward or rollback period)
Auditor reviews intervening transactions for unusual activity

22. Cut Off - Completeness Inventory cutoff tests:
Obtain information on last items shipped and received at year-end
Compare this information to transactions recorded in the sales and purchases journal
Determine if transaction is recorded in correct accounting period
Auditor should also inquire about any inventory out on consignment or stored in a public warehouse
Tracing test counts and number of high-dollar items to the client's inventory records tests completeness (as well as existence)

23. Comment on Allowance for Returns - Valuation
In most situations, expected returns of inventory are not material
However, some companies provide return guarantees and expect significant returns
Management can use previous experience, updated for current economic conditions, to develop estimates of returns

24. Rights
Most of the work regarding ownership of inventory is performed during the auditor's testing of purchases
Auditor should also review long-term contracts to determine obligations
Inquiry should be made about inventory on consignment

25. Inventory Valuation - Valuation
Most complex assertion related to inventory because of the:
Volume of transactions
Diversity of products
Variety of costing methods
Difficulty in estimating net realizable value of products
Auditor uses direct tests and analytics to assess inventory valuation:
Direct tests include verifying cost by reviewing vendor invoices
Auditor usually examines current market data and other conditions that might indicate inventory obsolescence
Management inquiry and review of industry publications can help the auditor identify obsolete units
Analytics, like inventory turnover or day's sales in inventory, may identify slow-moving inventory which may need to be written down
Auditor looks for obsolete units during the counting of inventory; these units may need to be written down

26. Disclosure Auditor reviews client disclosure for compliance with GAAP
Disclosure should include:
Costing method(s) used
Frequency of accounting
Inventory pledged as collateral
Any other unusual circumstance

27. Cost of Goods Sold
Audit of cost of goods sold can be direct tied to the audit of inventory
If beginning and ending inventories have been verified and acquisitions have been tested, cost of goods sold can be direct calculated
Auditor should also apply analytics to cost of goods sold to see if there are any significant variations - either overall or by product line