Chapter 8

1. Chapter 8 Acquisition and Expenditure Cycle “Show those numbers to the damn auditors and I'll throw you out the $%*@@ window.”----(Buddy Yates, director of WorldCom, Inc. general accounting, to an employee asking for an explanation of a large accounting discrepancy).

2. Presentation Outline • The Expenditure Cycle • Expenditure Cycle Risk, Control Procedures, and Testing • Audit Evidence in Management Reports and Data Files • Other Accounts in Cycle

3. I. The Expenditure Cycle • Requisitioning in Stores • Order Processing in Purchasing • Receiving • Delivery Acknowledgement in Stores • Invoice Verification in Purchasing • Accounts Payable Prepares the Voucher Package • Cash Disbursements • General Ledger • Internal Audit

4. Prepare Requisition Purchase Database Requisition Processing A. Requisitioning in Stores • Requests for purchases originate outside the purchasing department. • Purchase requisitions arise in stores or other departments. • Requisitions should be approved in the originating department. • Purchasing has access to the requisition thru the purchase database.

5. Prepare Order Purchase Requisition Select Vendor Purchase Database Order Processing Retrieve Purchase Requisition Purchase Order To Vendor B. Order Processing in Purchasing • Purchase requisitions may be overridden due to a lack of funds, improper authorization by the requesting department, etc. • Purchasing selects a vendor using an approved vendor list or a bidding process. • Accounts payable, the requesting department, and receiving all have access to the purchase order through the purchase database.

6. From Vendor Match to Purchase Order Delivery Purchase Order Retrieve Purchase Order Purchase Database Enter Receipt Blind Count Order Processing Delivery To Stores C. Receiving • Receiving accesses the purchase order and matches it with the vendor delivery. • Receiving only accepts deliveries for which there is an existing purchase order. • Blind counts are often used to force counters to actually count the items received. • A receiving supervisor later verifies the quantity against the purchase order. • Stores has access to this report thru the purchase database.

7. From Receiving Delivery Receiving Report Match to Delivery Retrieve Receiving Report Purchase Database Goods Receipt Processing D. Delivery Acknowledgement in Stores • The stores department acknowledges receipt of the delivery on the receiving report in the purchase database. • Purchasing and accounts payable have access to the acknowledged report thru the purchase database.

8. From Vendor Vendor Invoice Purchase Database Invoice Verification Vendor Invoice To Accounts Payable E. Invoice Verification in Purchasing • Purchasing uses the purchase database to compare the purchase order, acknowledged receiving report, and vendor invoice for any discrepancies. • Purchasing authorizes the invoice for payment once they are satisfied that the invoice is correct per the order and what was received.

9. From Purchasing Vendor Invoice Prepare Voucher Purchase Requisition Accounts Payable or Voucher Register Purchase Order Voucher Processing Receiving Report Retrieve Documents Voucher Check Voucher Journal Voucher Purchase Database To General Ledger To Cash Disbursements F. Accounts Payable Prepares the Voucher Package • The purchase requisition, purchase order, acknowledged receiving report, and approved vendor invoice provide the support for the preparation of a voucher. • The voucher serves to summarize the purchase for entry on the records as a liability.

10. Voucher Sign Checks Cancel Voucher after Signing Check From Accounts Payable Voucher Check Voucher Check Voucher Check Register Post Voucher Check Control Total Forward to Payee To General Ledger G. Cash Disbursements • Cash disbursements received the voucher package and check for signing. • Cash disbursements maintains a check register and forwards a journal entry to general ledger.

11. Control Total Journal Voucher From Cash Disbursements From Accounts Payable Compare Post General Ledger General Ledger Processing Control Total Journal Voucher H. General Ledger • General ledger receives the journal entry from accounts payable (Debit – Accounts payable and Credit – Cash) and compares it to the control total for cash disbursements. • The journal entry is then posted into the general ledger.

12. Bank Statement From Bank Cancelled Checks Check Register Bank Reconciliation Bank Reconciliation Bank Statement Cancelled Checks I. Internal Audit An independent reconciliation of the bank account is performed by internal audit.

13. II. Expenditure Cycle Risk, Control Procedures, and Testing • Inherent Risks • Cost and Expense Capers – Exhibit 8.2 • Expenditure Control Procedures • Assertions of Classes of Transactions and Events for the Period: Acquisition and Expenditure Cycle – Exhibit 8.4 • Direction of Tests – Exhibit 8.3 • The Completeness Assertion • Purchase Cutoffs

14. A. Inherent Risks • Unrecorded liabilities – may arise when invoice verification has not been completed for what should be a liability. • Noncancelable purchase agreements – drop in market prices below agree contractual price should result in loss recognition. • Capitalizing expenses – expenditures with no future value may be capitalized when they should be expensed.

15. B. Cost and Expense Capers – Exhibit 8.1 on p. 293

16. C. Expenditure Control Procedures • Information processing controls • Compare quantities against receiving report and purchase order • Compare prices against purchase order (i.e., quoted price) • Mathematically verify vendor's invoice • Determine when to pay invoice and prepare VOUCHER • Segregation of duties • AUTHORIZATION of the purchase is done by the purchasing department. • Custody of the inventory item(s) is held by the receiving department and, ultimately, the requesting department. • Transactions are recorded by general accounting (control account) and accounts payable department (subsidiary accounts) or vouchers payable • Physical controls • Prepare a receiving report upon initial receipt of inventory • Count and verify inventory quantities upon delivery to the inventory warehouse • Restrict access to inventories by keeping them in a secured location • Performance reviews • Compare purchases data to data from previous years or expected purchases data

17. D. Assertions of Classes of Transactions and Events for the Period: Acquisition and Expenditure Cycle – Exhibit 8.4 on p. 299

18. E. Direction of Tests – Exhibit 8.3 on p. 298

19. F. The Completeness Assertion • Search for Unrecorded Liabilities • Inquire of client about their procedures • Scan open purchase order file • Examine all UNMATCHED VENDOR STATEMENTS/INVOICES • Examine all UNMATCHED RECEIVING REPORTS occurring near year-end • Confirm A/P with NORMAL SUPPLIERS (even those with zero balances) • Review CASH DISBURSEMENTS occurring after year-end

20. G. Purchase Cutoffs • Verify CUT-OFFs for purchases • Examine Receiving Reports and Vendor Sales Invoices occurring around year-end to ensure inventory received is included in the appropriate period.

21. III. Audit Evidence in Management Reports and Data Files • Open Purchase Orders • Unmatched Receiving Reports • Unmatched Vendor Invoices • Accounts (Vouchers) Payable Trial Balance • Purchases Journal • Fixed Asset Reports

22. A. Open Purchase Orders • Purchase orders are open from the time they are issued until goods are received. • Auditors can find evidence of losses on purchase commitments in this file (i.e., market prices are below price in purchase order).

23. B. Unmatched Receiving Reports Auditors can inspect unmatched receiving report file to determine whether the company has material unrecorded liabilities on the financial statement date.

24. C. Unmatched Vendor Invoices Auditors can inspect unmatched vendor invoice file and compare it to the unmatched receiving report file to determine whether the company has material unrecorded liabilities on the financial statement date.

25. D. Accounts (Vouchers) Payable Trial Balance • The trial balance is a list of payable amounts by vendor, and the sum should agree with the accounts payable control account. • Some organizations have a trial balance of individual unpaid vouchers rather than vendor names. • Search for unrecorded liabilities should emphasize small and zero balances, especially for regular vendors.

26. E. Purchases Journal Purchases can be scanned for purchasing patterns indicating error or fraud: • Purchase with unapproved vendors • Purchases to multiple companies at the same address • Duplicate payments • Vendors whose address matches an employee

27. F. Fixed Asset Reports Information for depreciation calculation (cost, useful life, method salvage) can be used for the audit of depreciation on a sample basis or by computer applications to recompute all depreciation.

28. IV. Other Accounts in Cycle • Accrued Liabilities v. Accounts Payable • Auditing Accrued Liabilities and Prepaid Expenses • Account Analysis for Prepaid Expenses – Exhibit 8.5 • Auditing Property Plant and Equipment • Sample PP&E and Depreciation Document – Exhibit 8.6

29. A. Accrued Liabilities v. Accounts Payable • Major differences between ACCRUED Liabilities and ACCOUNTS PAYABLE • Examples include INTEREST, PROPERTY TAXES, WAGES, and INCOME TAXES PAYABLE • These payables are not normally INVOICED or EVIDENCED by the RECEIPT OF GOODS • These differences may make it more difficult to detect UNRECORDED ACCRUALS

30. B. Auditing Accrued Liabilities and Prepaid Expenses • Agree balances to PRIOR YEAR WORKPAPERS • Verify PAYMENTS • Examine UNDERLYING AGREEMENTS • RECALCULATE amounts • Agree EXPENSE ACCOUNTS to trial balance • Search for UNRECORDED ACCRUALS • Review CASH DISBURSEMENTS at year-end • Look for expected accruals at other stages of the audit (BONDS, NOTES, employees paid on 15th, etc.) • ANALYTICAL PROCEDURES

31. C. Account Analysis for Prepaid Expenses – Exhibit 8.5

32. D. AUDITING PROPERTY, PLANT, AND EQUIPMENT • GENERAL APPROACH • Small number of transactions • Relatively high dollar transactions • Authorization of Transactions (Board of Directors) takes on added importance. • Less concern for ACCESS to ASSETS • More concerned with UNRECORDED DISPOSALS

33. D. AUDITING PROPERTY, PLANT, AND EQUIPMENT (Continued) • Agree balances to prior year documentation • PURCHASES OF PPE • VOUCH to INVOICE or COST RECORDS • Inspect TITLE • VOUCH to BOARD MINUTES • EXPENDITURES SUBSEQUENT TO ACQUISITION • VOUCH to INVOICE and WORK DESCRIPTIONS • Consider propriety of classification (EXPENSE or CAPITALIZE)

34. D. AUDITING PROPERTY, PLANT, AND EQUIPMENT (Continued) • DISPOSAL OF PPE • VOUCH from PPE to BOD MINUTES (AUTHORIZATION) • Vouch to cash receipts journal and validated deposit slip • Recalculate gain/loss • TRACE from BD MINUTES to PPE for disposals (COMPLETENESS) • Look for unrecorded disposals • Agree balances to PRIOR YEAR WORKPAPERS • Examine insurance policies, property tax records, etc. • PHYSICALLY INSPECT or CONFIRM fixed assets • Both existing and newly-acquired items • Confirm assets LEASED to others under capital leases

35. D. AUDITING PROPERTY, PLANT, AND EQUIPMENT (Continued) • DEPRECIATION EXPENSE • Recalculate using USEFUL LIFE, SALVAGE VALUE, COST, and METHOD (VA) • Evaluate REASONABLENESS of USEFUL LIFE, SALVAGE VALUE, etc. • Is depreciation consistent with COMPANY POLICY (half year conventions)? • LEASE AGREEMENTS • Verify proper treatment (Capitalized or Operating) • Ensure disclosure in footnotes is appropriate

36. E. Sample PP&E and Depreciation Documentation – Exhibit 8.6 on p. 304

37. Summary • Segregation of Duties in Expenditure Cycle • Risk and Testing in Expenditure Cycle • Searching for Unrecorded Liabilities • Audit of Property, Plant & Equipment