chapter 15 auditing the expenditure cycle spring 2007 l.
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CHAPTER 15 Auditing the Expenditure Cycle Spring 2007. 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.

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expenditure cycle transaction classes and accounts purchases
Expenditure Cycle Transaction Classes and Accounts: Purchases


Merchandise Inventory

Raw Materials Inventory


Prepaid Expenses

Plant Assets

Other Assets

Various Expenses

Accounts Payable

expenditure transaction classes and accounts cash disbursement adjustments
Expenditure Transaction Classes and Accounts: Cash Disbursement & Adjustments


Accounts Payable


Purchase Discounts

Purchase Returns

general audit strategy
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
expenditure cycle initial audit procedures
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
expenditure cycle initial audit procedures cont
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
expenditure cycle initial audit procedures cont7
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
expenditure cycle initial audit procedures8
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.
expenditure cycle audit objectives


Existence & Occurrence


Rights and Obligations

Presentation and Disclosure

Specific Audit Objective


Cutoff / Timeliness


Cutoff / Timeliness

Valuation at Historical Cost / GAAP

Valuation at Net Realizable Value

Posting and Summarization




Expenditure Cycle Audit Objectives
expenditure cycle initial audit procedures10
Expenditure Cycle: Initial Audit Procedures


Specific Audit Objectives

Expected Internal Controls

Enough Comfort? Yes/No

What substantive testing do we plan on doing?

expenditure cycle initial audit procedures11
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

expenditure cycle understand and maybe test internal controls
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
expenditure cycle information system

Purchase requisition

Purchase order

Receiving report

Vendor’s invoice (external)

Voucher (internal)


Cash disbursements journal


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

Expenditure Cycle:Information System
expenditure cycle obtain an understanding of internal controls
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.
assessing control activities hints
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)
purchases controls completeness
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


  • Computer should compare receiving date with the date the invoice is recorded. They should be in the same accounting period.
purchases controls existence
Purchases Controls (existence)


  • 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.


  • Same as w/ completeness
purchases controls valuation
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.
purchases controls valuation19
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.
purchases controls r o
Purchases Controls (R & O)


  • like net realizable value, generally applies to balances, not transactions.
purchases controls p d
Purchases Controls (P & D)


  • 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


  • Related party?
  • The auditor rarely finds controls over disclosure and must test substantively
cash disb controls completeness
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.


  • Independent Bank Reconciliation on a monthly basis.
cash disb controls existence
Cash Disb Controls (existence)


  • 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.
cash disb controls valuation
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
cash disb controls r o
Cash Disb Controls (R & O)


  • Controlled by controlling voucher.
cash disb controls p d
Cash Disb Controls (P & D)


  • 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.


  • Do not expect control here.
accounts payable determining detection risk
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?
accounts payable standard substantive tests
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)
accounts payable standard substantive tests29
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?
accounts payable completeness substantive tests
Accounts Payable (completeness)Substantive Tests


  • Search for unrecorded liabilities (primary test)
    • Subsequent cash disbursements (checks & wires)
    • Unpaid invoices


  • 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
accounts payable existence substantive tests
Accounts Payable (existence)Substantive Tests


  • Consider confirmation based on risk of misstatement: This is a costly procedure
  • Significant number of purchase returns (returns to vendor?)
  • Review vendor’s statements
accounts payable valuation substantive tests
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.
accounts payable r o substantive tests
Accounts Payable (R & O)Substantive Tests


  • 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?
accounts payable p d substantive tests
Accounts Payable (P & D)Substantive Tests


  • Review A/P for debit balances that should be reclassified
  • Review proper classification of trade payables, related party payables, etc.


  • Review financial statement disclosures against disclosure check list
how this all fits together the audit risk model
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