Chapter 11

1. 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