AUDITING CHAPTER 12

1. AUDITINGCHAPTER 12 Purchases & Cash Disbursements Transactions By David N. Ricchiute

2. TOPICS • Nature of expenditure/disbursement cycle • Flow of information • Auditor’s assessment of control risk • Audit of internal control for purchases, cash disbursements • Computer auditing, sampling, tests of controls • Assurance, consulting services GBW 8th ed., Ch. 12

3. NATURE EXPENDITURE/DISBURSEMENT CYCLE • Goods, services acquired from vendors, employees in exchange for obligations to pay • Obligations to vendors, employees are paid GBW 8th ed., Ch. 12

4. EXPENDITURE, DISBURSEMENT CYCLE • Flow of information • Purchase requisition received to purchase goods • Purchasing department issues purchase order to vendor for purchase of goods • Receiving department creates report that identifies information about goods received • Accounts payable receives vendor’s invoice • Accounts payable creates voucher to authorize payment GBW 8th ed., Ch. 12

5. DOCUMENTS • Purchase requisition • Request to purchase goods • Purchase order • Request issued by Purchasing dept. to vendor • Receiving report • Identifies information about goods received • Vendor’s invoice • Formal notice amount, terms of payment • Voucher package • Voucher & supporting documents GBW 8th ed., Ch. 12

6. CONTROLS OVER PURCHASING • Purchase requisition must be approved • Prenumbered purchase order describes price, quantity, terms of goods ordered • Goods received compared to purchase order in receiving department • Accounts payable matches purchase order, receiving report, invoice before authorizing payment • Accounts payable prepares voucher for recording by General Accounting GBW 8th ed., Ch. 12

7. CASH DISBURSEMENTS • Process • Voucher package sent to Treasury department (separate from accounts payable) • Treasury department reviews, reconciles, authorizes payment • Checks drawn for payment • May require 2 signatures over a limit GBW 8th ed., Ch. 12

8. INTERNAL CONTROL & RISK ControlsRisks GBW 8th ed., Ch. 12

9. ASSESSING CONTROL RISKObtain Understanding • Review Sarbanes-Oxley Section 404 documentation for sales process • Document the client’s system • Flowchart, questionnaire, narrative • Perform transaction walk-through • Identify control activities • Test controls to reduce control risk below maximum • Assess control risk GBW 8th ed., Ch. 12

10. TEST OF CONTROLSPurchasing, Disbursements • Provide a reasonable degree assurance that employees comply with management’s procedures • Purchasing • Properly authorized, executed, recorded • Disbursements • Payments remitted, recorded promptly GBW 8th ed., Ch. 12

11. CONTROL RISKPurchasing • Major risks • Unauthorized purchases • Non-competitive prices GBW 8th ed., Ch. 12

12. TESTING CONTROLSPurchasing • Select random sample paid voucher packages • Examine for cancellation, authorization, details • Obtain Purchasing Department’s copy of requisition, purchase order • Compare to voucher package • Trace to competitive bids GBW 8th ed., Ch. 12

13. CONTROL RISKReceiving • Major risks • Goods received not counted, inspected • Goods received not compared to purchase orders GBW 8th ed., Ch. 12

14. TESTING CONTROLSReceiving • Obtain Receiving Department copy of receiving report for voucher sample • Compare receiving reports • Review receiving reports for evidence of count, inspection • Trace receiving reports to receiving log GBW 8th ed., Ch. 12

15. CONTROL RISKCash Disbursements, Recording • Major risks • Cash payments made to unauthorized payee • Details recorded in voucher register are recorded for proper vendor • Totals agree to general ledger GBW 8th ed., Ch. 12

16. TESTING CONTROLSCash Disbursements, Recording • Obtain canceled checks for voucher package • Examine for signatures, endorsements • Compare detailed information about check from voucher package to canceled check • Trace voucher packages, canceled checks to postings • Review for classification, accuracy • Scan voucher register for unusual items GBW 8th ed., Ch. 12

17. ASSESSING CONTROL RISK • 2 Questions • Are controls effective? • Can controls be relied upon? • If answer is yes to both • Assess control risk below maximum • Assess detection risk above minimum • Restrict substantive tests of sales, receivables, cash GBW 8th ed., Ch. 12

18. PRELIMINARY OPINION ON INTERNAL CONTROL • Required by Sarbanes-Oxley • Auditor must form opinion on management’s assessment of internal control over financial reporting based on • Reports of internal auditors • Auditor’s tests of controls • Substantive audit tests GBW 8th ed., Ch. 12

19. TESTS OF CONTROLSPromotion Accrual • Review reconciliation promotion payments • Test calculation • Review accrual • Search for post period-end payments for evidence of unrecorded promotions GBW 8th ed., Ch. 12

20. COMPUTER AUDITING & SAMPLING • Understand the system • Tests of controls • Input controls • Code verification • Data entry controls • Processing controls • Control totals • Limit tests • Assess control risk GBW 8th ed., Ch. 12

21. POTENTIAL ERRORS, FRAUDS • Cash disbursed to unauthorized parties • Duplicate payments made • Account balances inaccurate GBW 8th ed., Ch. 12

22. ASSURANCE, CONSULTING SERVICES • Especially for government procurement contracts • Competitive bids • Compliance with local laws GBW 8th ed., Ch. 12

23. AUDITINGCHAPTER 13 Accounts Payable, Prepaids, & Accrued Liabilities By David N. Ricchiute

24. TOPICS • Relationship assertions & audit procedures • Relationship audit risk, nonfinancial measures, substantive tests • Substantives tests for A/P • Substantive tests for prepaid expenses, accrued liabilities • Expense recognition & earnings manipulation24 • Audit sampling & A/P • Computer-assisted audit techniques for A/P GBW 8th ed., Ch. 12

25. ASSERTIONS & OBJECTIVES Management assertions: Recorded Purchases & A/P • Exist • Include all transactions (completeness) • Represent rights, obligations of entity • Are valued appropriately • Are presented & disclosed properly GBW 8th ed., Ch. 12

26. AUDIT RISKS • Payment problems • Insufficient cash • Overstated purchases • Understated payables GBW 8th ed., Ch. 12

27. OBJECTIVES & PROCEDURES:Existence/Occurrence Objective: determine whether all payables exist & all purchases occurred • Exist • Confirm with creditors • Transactions occurred • Cutoff testing for proper period GBW 8th ed., Ch. 12

28. OBJECTIVES & PROCEDURES:Completeness Objective: determine whether all purchases, payables are actually presented • Complete • Test for unrecorded liabilities • Analytical procedures • Test cutoff • FOB shipping point • FOB destination GBW 8th ed., Ch. 12

29. OBJECTIVES & PROCEDURES:Rights & Obligations Objective: determine whether payables & other recorded liabilities are bona fide obligations • Rights & obligations • Confirm with creditors • Test for unrecorded liabilities GBW 8th ed., Ch. 12

30. OBJECTIVES & PROCEDURES:Valuation, Allocation Objective: determine whether payables are reported at appropriate dollar amounts • Valuation, allocation • Verify A/P trial balance • Confirm with creditors • Test for unrecorded liabilities GBW 8th ed., Ch. 12

31. OBJECTIVES & PROCEDURES:Presentation, Disclosure Objective: determine whether payables are properly classified, described, disclosed • Presentation, disclosure • Compare statement presentation, disclosure with GAAP requirements GBW 8th ed., Ch. 12

32. NONFINANCIAL MEASURES OF RISK • Examples for payables: • Failure to get low price provider • Unfavorable price variances • Significant lag in product development GBW 8th ed., Ch. 12

33. AUDIT RISK MODEL AR = CR x IR x DR • Detection risk (DR): likelihood that error could occur & not be detected • Based on • Control risk (CR) • Likelihood of material error • Inherent risk (IR) • Strategies & threats GBW 8th ed., Ch. 12

34. DETECTION RISK DR = ____AR___ IR x CR • Nature, extent, timing substantive tests • Nature: more/less persuasive tests • Extent: larger/smaller samples • Timing: balance sheet date or interim GBW 8th ed., Ch. 12

35. ASSERTIONS & PROCEDURESPurchases & Payables-1 Valuation • Verify mathematical accuracy A/P • Foot, cross-foot aged trial balance • Compare trial balance total to GL • Trace sample vendor accounts to voucher packages • Examine supporting documents GBW 8th ed., Ch. 12

36. ASSERTIONS & PROCEDURESPurchases & Payables-2 Existence, Obligations, Valuation • Consider confirming year-end payables with creditors Existence, Occurrence, Completeness • Test cut-off for recording in proper period GBW 8th ed., Ch. 12

37. ASSERTIONS & PROCEDURESPurchases & Payables-3 Completeness, Valuation, Obligations • Test for unrecorded liabilities Existence, Occurrence, Completeness, Valuation • Perform analytical procedures GBW 8th ed., Ch. 12

38. ASSERTIONS & PROCEDURESPurchases & Payables-4 Presentation & Disclosure • Review statements to determine • Payables, other liabilities properly classified, described • Disclosures adequate GBW 8th ed., Ch. 12

39. SUBSTANTIVE TESTS:Payables Confirmation • Not commonly confirmed unless • Controls inadequate • Concern with liabilities overstatement • Main concern for payables: understatement • Confirmation not effective for detecting unrecorded liabilities • Not listed on trial balance • Not in sample GBW 8th ed., Ch. 12

40. TESTING UNRECORDED LIABILITIES • Four sources • Year-end A/P trial balance • Cash disbursements journal • Canceled voucher packages • File unmatched receiving reports GBW 8th ed., Ch. 12

41. CAPITALIZED COSTS:AOL In fiscal 1995, 1996, AOL capitalized advertising costs in an account called “Deferred Membership Acquisition Costs,” & amortized costs over a 24 month period $77 million, 19% assets $314 million, 33% assets Is this the proper accounting treatment? What was the effect on the financial statements? GBW 8th ed., Ch. 12

42. ASSERTIONS & PROCEDURES: Prepaid Expenses • Examples: Prepaid insurance, rent, advertising, & supplies • Existence, rights, obligations • Examine insurance policies • Completeness: • Insurance coverage exceeds replacement cost • Cutoff testing from A/P • Valuation • Recalculate unexpired premiums GBW 8th ed., Ch. 12

43. ASSERTIONS & PROCEDURES : Accrued Liabilities • Examples: accrued taxes, warranty costs, rent, interest • Occurrence, obligations, valuation • Examine property tax bills • Compare provisions to prior year: reasonableness • Additions/disposals assets • Completeness • Unusual fluctuations GBW 8th ed., Ch. 12

44. EXCESS RESERVES:W. R. Grace From 1991 – 95, Grace recorded $20 million in excess reserves on statements of a health-care subsidiary that produced a large portion of Grace’s consolidated net income. “Extra earnings could be used when they wanted to goose up the numbers.” Specifically, how would they “goose up the numbers?” GBW 8th ed., Ch. 12

45. EARNINGS MANIPULATIONEnvironmental Liabilities Columbia Transmission in recent years recorded projected compliance costs related to low levels of contamination by PCB-based lubricating oils. . . resulted in additional pre-tax charges of $65 million GBW 8th ed., Ch. 12

46. MANAGEMENT, AUDITOR INCENTIVES • Management • Incentive to understate cleanup costs • Examples • Arco, Exxon, Phillips’ stock prices declined due to environmental disasters • Auditor • Incentive for reasonable assurance that material environmental liabilities are disclosed • Shareholders may sue if unreported GBW 8th ed., Ch. 12

47. NONSTATISTICAL SAMPLING: Accounts Payable • Assess control risk • Select sampling plan • Determine • Population, sampling unit, sample size • Evaluate results • Decision rule: if likely error < tolerable error then payables not likely materially misstated GBW 8th ed., Ch. 12

48. COMPUTER-ASSISTED TESTS:A/P Accuracy • Verify footings, cross-footings, extensions of aged trial balance or subsidiary records • Compare details of trial balance with subsidiary records • Compare details subsidiary records with source documents GBW 8th ed., Ch. 12

49. COMPUTER-ASSISTED TESTS: Summarizing Data • Age A/P according to due dates • List debit balances for reclassification to A/R GBW 8th ed., Ch. 12

50. COMPUTER-ASSISTED TESTS: Sample Selection, Comparison • Use random number generator to select sample from aged A/P trial balance • Compare charges/credits from subsidiary records with purchases/cash disbursements GBW 8th ed., Ch. 12