Audit of the Acquisition and Payment Cycle

1. Audit of the Acquisition and Payment Cycle Dr. Donald K. McConnell Jr.

2. Auditor’s Usual Concern: Asset Overstatement and Liability Understatement • Overstatement of sales or inventories: existence or occurrence assertion violations • Something has to be on the books that we can audit • Asset overstatement detectable through: • Confirmation • Vouching • Physical examination • Public company: Existence or occurrence assertion usually riskier for assets

3. Auditor’s Usual Concern: Asset Overstatement and Liability Understatement • Understatement of expenses and accounts payable: completeness assertion violations • Requires simply omitting expenses and related payables to overstate income! • Inherently harder to audit completeness than existence or occurrence assertion • Public company: Completeness assertion usually riskier for liabilities

4. However, Don’t Focus Only On Earnings Overstatement Risk! • Asset reserves (e.g. allowances for bad debts) can be intentionally overstated • Accrued liabilities (e.g. product liab. wty. accruals) can be intentionally overstated • Why? Income smoothing (earnings management) schemes • Sometimes called “rainy day,” “cookie jar reserves,” or “hidden”reserves • An irony: it’s GAAP in some European countries to create such reserves! • SEC increasingly concerned with such practices • A personal audit experience

5. Obtaining an Understanding of and Testing Internal Controls: an Overview

6. Three Primary Year-end Substantive Procedures • Either audit a sample of year-end vendor statement reconciliations to books, or confirmation of accounts payable [latter unusual] • Search for unrecorded liabilities [Arens, et. al. calls this “out-of-pd liabilities test”] • Purchase cutoff testing

7. Why Aren’t Accounts Payable Typically Confirmed? • Confirming recorded liabilities of little value for completeness concerns • Our concern is with what is not on the books! • What if no open transactions with a vendor have been booked? • Confirmation, using trial balance of A/P, ineffective if vendor has no balance on the books! • Confirmation would only be effective if: • Some open vendor transactions are on the books, i.e. • There is a balance in the accounts payable master files

8. Why Aren’t Accounts Payable Typically Confirmed? (con.) • We have external vendor statements to substantiate year-end accounts payable balances • We have no corresponding external evidence in the sales and collection cycle! • That is, customers don’t mail out monthly statements to vendors!

9. Why Is Confirmation of Accounts Payable Not Typically Done? (con.) • If you do mail confirmations of A/P, what do you get? • Usually a copy of the same vendor statement in the client’s files!

10. First Primary Test: Audit a Sample of Year-end Vendors Statement Reconciliations • This is in lieu of confirmation of accounts payable • An example: packet page 19-1

11. Accounts Payable Confirmations • Only used when IR and CR are high in the acquisition cycle • Traditional criteria for AP confirmation selection: • Small or zero balances when compared to prior years • Large vendor balances

12. Recommended Criteria Where Accounts Payable Are Confirmed • Since completeness assertion is at greater risk for accounts payable, a more appropriate population to confirm from might be a list of authorized vendors • Regardless of balances • Rather than using a trial balance of accounts payable (Au 330.13)

13. Second Primary Test: Search for Unrecorded Liabilities • Focuses on journal of original entry for liabilities: • Accrual basis: purchases journal or voucher register • Cash basis: cash disbursements journal • Scope of the search: • usually the month following year end • Vouch all entries exceeding X% of tolerable misstatement to supporting documentation • Examine for evidence of December obligations recorded in January • If material, requires an audit AJE

14. Search for Unrecorded Liabilities: Other Considerations • Why not just directly examine invoices paid after year end? (Bypass identifying transactions in general of original entry) • Not a controlled listing! • How do you know they’re all there? • Last day of search: examine invoices not yet entered into the payables system • Examine year-end receiving reports not matched with vendor invoices until month after year end, to insure payable was booked before year end

15. Search for Unrecorded Liabilities: Other Considerations (con.) • How might scope of the search be altered based on finding numerous unrecorded liabilities? • How might scope of the search be altered based on good previous experience? • How might scope be altered in the audit of a charitable hospital where: • funding is based upon earnings shortfalls • I.e., the worse the earnings, the greater the funding?

16. Some Auditors Will Expand Search for Unrecorded Liabilities in Lieu of Vendor Statement Testing • Month following year end: vouch all entries > 25% of TM • Second month following year end: vouch all entries > 50% of TM • Third month (or part thereof) following year end: vouch all entries > 75% of TM

17. Third Primary Test: Purchases Cut off Test • When does merchandise title pass? • Usually F.O.B. shipping point • F.O.B. destination only common in import/export transactions • However, audit assumption: title passes F.O.B. destination, unless material amounts in transit at year end • Primary source document is receiving report • Demonstration of purchases cut off test

18. What If Material F.O.B. Shipping Point Merchandise Is in Transit at Year End? • Determined by examining receiving reports dated in early January for large shipments; ascertaining shipment dates by examining shipping document dates • An audit AJE must be made • Modern inventory management techniques (e.g. “Just-in-Time”) raise this probability

19. Accounts Payable Evidence: Vendor Statements or Vendor Invoices? • Auditing year-end accounts payable? • Testing controls (and transaction level substantive testing) • Why is the distinction important?