1. MODERN AUDITING 7th Edition
William C. Boynton
California Polytechnic State University at San Luis Obispo
Raymond N. Johnson
Portland State University
Walter G. Kell
University of Michigan
Developed by:
Gregory K. Lowry, MBA, CPA
Saint Paul’s College
John Wiley & Sons, Inc.

2. CHAPTER 15 AUDITING THE EXPENDITURE CYCLE
Nature of the Expenditure Cycle
Control Activities — Purchases Transactions
Control Activities — Cash Disbursements Transactions
Substantive Tests of Accounts Payable Balances
Value-Added Services

3. Nature of the Expenditure Cycle
The expenditure cycle consists of the activities related to the acquisition of and payment for goods and services. The core expenditure cycle activities are:
1. purchasing goods and services — purchase transactions, and
2. making payments — cash disbursement transactions.
Purchases and cash disbursements have a pervasive effect on the financial statements, as depicted in Figure 15-1.

4. Purchases and Cash Disbursements Figure 15-1

5. Selected Specific Audit Objectives for the Expenditure Cycle Figure 15-2

7. Nature of the Expenditure Cycle
Understanding the Client’s Business and Industry
Before designing an expenditures audit program, the auditor must consider the client’s business, the external market forces driving the business sector, and how these forces impact the entity’s expenditure cycle.

8. Nature of the Expenditure Cycle
Materiality
The expenditure cycle is a core process for many industries and given the amount and volume of transactions in this cycle the risk of material misstatement is high. Figure 15-1 illustrates the fact that the transactions in this cycle affect more financial statement accounts than other cycles.
The allocation of materiality to accounts affected by transactions in this cycle will vary according to the considerations explained in Chapter 8. The importance of the expenditure cycle varies by the type of business.

9. Nature of the Expenditure Cycle
Inherent Risk
In assessing inherent risk for expenditure cycle assertions, the auditor should consider pervasive factors that may affect assertions throughout financial statements as well as factors pertaining only to specific assertions in the expenditure cycle. Pervasive factors that might motivate management to misstate expenditure cycle assertions include:
1. Pressures to understate expenses in order to report achieving announced profitability targets or industry norms, which were not achieved in reality owing to factors such as global, national, or regional economic conditions that affect operating costs, the impact of technological developments on the entity’s productivity, or poor management.

10. Nature of the Expenditure Cycle
2. Pressures to understate payables in order to report a higher level of working capital when the entity is experiencing liquidity problems or going-concern doubts.
Both of these factors lead to a greater risk of understatement than overstatement of expenditures and payables.
The auditor should also consider the industry-related factors of the availability and price volatility of the raw materials and products needed by the entity to remain in business.

11. Nature of the Expenditure Cycle
Analytical Procedures Risk
Analytical tests are effective in identifying expenditure cycle accounts that are misstated. Analytical procedures risk is the element of detection risk that analytical procedures will fail to detect material errors. Analytical procedures are extremely cost effective.
Analytical procedures that focus only on purchases and accounts payable provide the most reliable information. If a company is growing, it is common to expect purchases, inventory, and accounts payable to grow at consistent rates.

12. Analytical Procedures Commonly Used to Audit the Expenditure Cycle Figure 15-3

13. Nature of the Expenditure Cycle
Consideration of Internal Control Components
The auditor’s understanding of internal control components is obtained by reviewing prior experience with the client, when applicable, and by inquiring of management and other entity personnel, observing activities and conditions, and inspecting documents, records, manuals, and so forth. The understanding should be documented in the form of completed questionnaires, flowcharts, or narrative memoranda.

14. Nature of the Expenditure Cycle
Control Environment
Numerous opportunities for employee fraud in processing purchase and cash disbursements transactions, and for fraudulent financial reporting by management of expenditure cycle account balances, make the control environment factor of integrity and ethical values extremely important in the expenditure cycle.
Management’s commitment to competence should be reflected in the hiring, assignment, and training of personnel involved in processing purchase and cash disbursement transactions, maintaining custody of purchased assets, and reporting on expenditure cycle activities.

15. Nature of the Expenditure Cycle
The client’s organizational structure and management’s assignment of authority and responsibility over expenditure cycle activities should be clearly communicated and provide for clear lines of authority, responsibility, and reporting relationships. When understanding how management is held accountable for resources, it is helpful to determine:
1. The reports used by management to evaluate the entity’s performance review.
2. How often and how quickly management reports are reviewed.
3. The decisions that are based on the reports.
4. The entity’s policies for following up on issues raised by key reports.

16. Nature of the Expenditure Cycle
Management Risk Assessment
Management risk assessments related to expenditure cycle activities include consideration of such matters as:
1. The entity’s ability to meet cash flow requirements for purchase transactions.
2. Loss contingencies associated with purchase commitments.
3. The continued availability of important supplies and the stability of important suppliers.
4. The effect of cost increases on the entity.
5. Attention to the risk of duplicate payments by the entity.
6. Attention to the risk of employee fraud by the entity.

17. Nature of the Expenditure Cycle
Information and Communication (Accounting System)
An understanding of the accounting system requires knowledge of the methods of data processing and key documents and records used in processing expenditure cycle transactions. It is important to understand the flow of transactions through the accounting system from initiating the transaction to its recording in the general ledger and eventual summarization in the financial statements.

18. Nature of the Expenditure Cycle
Key information the auditor should understand includes:
1. How purchases, payments, and returns are initiated.
2. How purchase transactions are accounted for as goods and services are received or goods are returned.
3. What accounting records, documents, accounts, and computer files are involved in accounting for the various stages of each purchase cycle transaction?
4. The process by which an entity initiates payment for goods and services.

19. Nature of the Expenditure Cycle
Monitoring
Several types of ongoing and periodic monitoring activities in this component may provide management with information concerning the effectiveness of the other internal control components in reducing the risk of misstatements related to expenditure cycle transactions and balances.

20. Nature of the Expenditure Cycle
Monitoring activities about which the auditor should obtain knowledge, when applicable, include:
1. ongoing feedback from the entity’s suppliers concerning any payment problems or future delivery problems,
2. communications from external auditors regarding reportable conditions or material weakness in relevant internal controls found in prior audits, and
3. periodic assessments by internal auditors of control policies and procedures related to the expenditure cycle.

21. Nature of the Expenditure Cycle
Initial Assessments of Control Risk
The auditor’s procedures to obtain an understanding of the 4 internal control components just discussed extend to the design of policies and procedures and whether they have been placed in operation, but not to determining the effectiveness of such controls. Thus, based on the information from the understanding only, the auditor’s initial assessment of control risk must be at the maximum.
The auditor may perform some tests of controls concurrently with the procedures to obtain the required understanding. In such cases, limited assurance may be obtained about the effectiveness of those controls.

22. Control Activities — Purchase Transactions
Virtually every company that requires an audit has a computerized accounting system. There are 2 types of computer controls:
1. General controls, which relate to the computer environment and have a pervasive effect on computer applications.
2. Application controls, which relate to the individual computerized accounting applications, such as the expenditure cycle.

23. Control Activities — Purchase Transactions
Common Documents and Records
The following documents and records are found in most accounting systems:
1. Purchase requisition. Written request for goods or services by an authorized individual or department to the purchasing department.
2. Purchase order. Written offer from the purchasing department to a vendor or supplier to purchase goods or services specified in the order.
3. Receiving report. Report prepared on the receipt of goods showing the kinds and quantities of goods received from vendors.

24. Control Activities — Purchase Transactions
4. Vendor invoice. The bill from the vendor stating the items shipped or services rendered, the amount due, the payment terms, and the date billed.
5. Voucher. An internal form indicating the vendor, the amount due, and payment date for purchases received. It is used to authorize recording and paying a liability. Many purchase systems require a complete voucher packet before approving payment. The voucher packet usually contains a copy of the appropriate purchase requisition, purchase order, receiving report, vendor invoice, and voucher — all the documentation supporting the purchase transaction.

25. Control Activities — Purchase Transactions
6. Exception reports. Reports with information about transactions identified for further investigation by computer application controls.
7. Voucher summary. Report of total vouchers processed in a batch or during a day.
8. Voucher register. Formal accounting record of recorded liabilities approved for payment.
9. Approved vendor master file. Computer file containing pertinent information on vendors and suppliers that have been approved to purchase services from and make payments to.
10. Open purchase order file. Computer file of purchase orders submitted to vendors for which the goods or services have not been received.

26. Control Activities — Purchase Transactions
11. Receiving file. Computer file with receiving information on quantities of inventory received from vendors.
12. Purchase transactions file. Computer file containing data for approved vouchers for purchases that have been received. Used to print the voucher register and update the accounts payable, inventory, and general ledger files.

27. Control Activities — Purchase Transactions
13. Accounts payable master file. Computer file containing data on approved unpaid vouchers. The file may be organized by vendor. It should sum to the balance in the accounts payable control account.
14. Suspense files. Computer file that hold transactions that have not been processed because they have been rejected by computer application controls.

28. Control Activities — Purchase Transactions
Functions
The processing of purchase transactions involves the following purchasing functions:
1. Initiating purchases. The request by an entity for a transaction with another entity, including:
a. Placing vendors on an authorized vendor list.
b. Requisitioning goods and services.
c. Preparing purchase orders.

29. Control Activities — Purchase Transactions
2. Receipt of goods and services. The physical receipt or shipment of a product or service, including:
a. Receiving the goods.
b. Storing goods received for inventory.
c. Returning goods to a vendor.
3. Recording liabilities. The formal recognition by an entity of a legal obligation, including:
a. Preparing the payment voucher and recording the liability.
b. Accountability for recorded transactions.

30. Control Activities — Purchase Transactions
Obtaining an Understanding and Assessing Control Risk
The auditor should obtain an understanding of the purchase cycle that is sufficient to plan the audit. If the auditor plans to assess control risk as low for an assertion, it is particularly important that he or she obtain an understanding of control procedures for that assertion.
Tests of controls provide the means for determining the effectiveness of such controls. The extent of the auditor’s consideration of factors related to assessing control risk for any given assertion depends on audit strategy.

31. Control Activities — Purchase Transactions
Inherent risk for purchase transactions is often considered to be at the maximum or high, because:
1. the purchase cycle has a pervasive effect on the financial statements and
2. the susceptibility of assets to misappropriation.
The auditor should also consider the results of analytical procedures to determine the planned assessed levels of control risk and tests of details risk.

32. Control Activities — Purchase Transactions
If the auditor plans to assess control risk as low, he or she will usually have to:
1. test the effectiveness of general controls,
2. use computer-assisted audit techniques (CAATs) to evaluate the effectiveness of programmed controls, and
3. test the effectiveness of procedures to follow up on exceptions identified by programmed controls.

33. Control Activities — Cash Disbursement Transactions
Common Documents and Records
Important documents and records used in processing cash disbursement transactions include the following:
1. Check. Formal order to a bank to pay the payee the amount indicated on demand.
2. Check summary. Report of total checks issued in a batch or during a day.
3. Cash disbursement transaction file. Information on payments by check to vendors and others. Used for posting to the accounts payable and general ledger master files.
4. Cash disbursement journal or check register. Formal accounting record of checks issued to vendors and others.

34. Control Activities — Cash Disbursement Transactions
Functions
The cash disbursement function is the process by which a company provides consideration for the receipt of goods and services. The cash disbursement function normally involves simultaneously paying the liability and recording the cash disbursement. Example control procedures are summarized in Figure 15-7.

35. Control Risk Components — Cash Disbursement Transactions Figure 15-7

38. Control Activities — Cash Disbursement Transactions
Obtaining an Understanding and Assessing Control Risk
The auditor should obtain an understanding of internal controls that is sufficient to plan the audit. If the auditor plans to a low assessed level of control risk for an assertion, he or she will probably need to understand specific control procedures related to that assertion.
Tests of controls provide the means for assessing the effectiveness of internal controls. The nature and extent of tests of controls will vary inversely with the auditor’s planned assessed level of control risk.

39. Substantive Tests of Accounts Payable Balances
Determining Detection Risk for Tests of Details
Accounts payable are affected by both purchase transactions that increase the balance and by cash disbursement transactions that decrease the balance. Thus, tests of details risk for accounts payable assertions is affected by inherent risk, analytical procedures risk, and control risk factors related to both of these transaction classes.

40. Correlation of Risk Components — Accounts Payable Assertions Figure 15-9

41. Substantive Tests of Accounts Payable Balances
Designing Substantive Tests
The general framework for developing audit programs for substantive tests that was explained in Chapter 11 and illustrated in Chapter 14 for accounts receivable can also be used in designing substantive tests for accounts payable. Multiple tests are keyed to each account balance audit objective.

42. Substantive Tests of Accounts Payable Balances
Accounts Payable Confirmations
Unlike the confirmation of accounts receivable, there is no presumption made about the confirmation of accounts payable. This procedure is optional because:
1. confirmation offers no assurance that unrecorded payables will be discovered and
2. external evidence in the form of invoices and monthly vendor statements should be available to substantiate the balances.

43. Value-Added Services
Generally accepted auditing standards do not require that the auditor perform value-added services. Nevertheless, when auditors complete an audit they are usually very knowledgeable about the client’s business and business practices, the results of its operations and cash flows, as well as the entity’s internal controls. Management and the board of directors normally want to take full advantage of the auditor’s knowledge.

44. CHAPTER 15 AUDITING THE EXPENDITURE CYCLE

45. Copyright
Copyright 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make backup copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.