1. CHAPTER 15 Auditing the Expenditure Cycle Spring 2007
Outline of what we’re going to talk about today

2. Expenditure Cycle Transaction Classes and Accounts: Purchases
Debit Credit
Merchandise Inventory
Raw Materials Inventory
Purchases
Prepaid Expenses
Plant Assets
Other Assets
Various Expenses
Accounts Payable
Describe the nature of the expenditure cycle and the transaction classes and accounts involved
Note that there is a decision made here to either capitalize or expense the expenditure

3. Expenditure Transaction Classes and Accounts: Cash Disbursement & Adjustments
Debit Credit
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
Recall that within this general strategy, the relative emphasis placed on the different types of tests can change.
Low IR, emphasis on AP
Emphasis on CR --
Emphasis on Substantive tests

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
This 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?

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

10. Expenditure Cycle: Initial Audit Procedures
Assertions
Specific Audit Objectives
Expected Internal Controls
Where 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/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
Basic rule: correlation of cogs or inventory with AP depends upon the business cycles involved in acquisition, selling and payment

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
Mgmt Risk Assessment
How 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.

13. Expenditure Cycle: Information System
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
Definitions on page 700 – See process in Figure 15-5 on page 699 – System flowchart

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)
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.
Relates to f/s assertion of completeness

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
Validity and Cutoff relate to existence

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.
Valuation at Historical cost, NRV and posting and summarization

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.
Valuation at NRV Discuss later in context of various assets:
Inventory
Fixed assets
Intangibles

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)
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
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