Week 8_Acquisition and Payment Cycle.pdf
- 1. Week 8: Acquisition and Payment Cycles
- 2. Lecture 7_Summary : Acquisition and Payments Cycle • Audit of Acquisition Cycle - Test of controls - Substantive tests of transactions - Substantive analytical procedures - Tests of details of balances • Other Accounts - Property, plant and equipment - Prepaid expenses - Other liabilities (accrued liabilities) - Income and expense accounts • Accounts Payable - Understatements
- 3. Accounts in the Acquisition and Payment Cycle
- 4. Accounts and Classes of Transactions in the Acquisition and Payment Cycle • There are three classes of transactions included in the cycle: – Acquisitions of goods and services – Cash disbursements – Purchase returns and allowances and purchase discounts
- 5. Business Functions in the Cycle and Related Documents and Records • There are four business functions in the acquisition and payment cycle: – Processing purchase orders – Receiving goods and services – Recognizing the liability – Processing and recording cash disbursements
- 6. Classes of Transactions, Accounts, Business Functions, and Related Documents and Records for the Acquisition and Payment Cycle
- 7. Methodology for Designing Tests of Controls and Substantive Tests of Transactions for the Acquisition and Payment Cycle
- 8. Methodology for Designing Tests of Controls and Substantive Tests of Transactions • Substantive tests of transactions for the acquisition and payment cycle include: – Understand internal control – Assess planned control risk (note key controls covering authorization of purchases, separation of asset custody,timely recording and independent review of authorization, authorization of payment) – Determine extent of tests of controls – Design tests of controls and substantive tests of transactions for acquisitions – Design tests of controls and substantive tests of transactions for cash disbursements – Sampling for tests of controls and substantive tests of transactions (occurrence,completeness,accuracy, classification)
- 13. Methodology for Designing Tests of Details of Balances for Accounts Payable
- 14. Methodology for Designing Tests of Details of Balances for Accounts Payable • All acquisition and payment cycle transactions typically flow through accounts payable, this account is critical to any audit of the acquisition and payment cycle • Accounts payable tend to be material for most companies, and auditors almost always perform some tests of details of balances • Methodology for designing tests of details for accounts payable include: – Identify significant risks and assess the risk of material misstatement for accounts payable – Set performance materiality – assess control risk and design and perform tests of controls and substantive tests of transactions
- 15. Design and Perform Substantive Analytical Procedures • The use of analytical procedures is as important in the acquisition and payment cycle as it is in every other cycle, especially for uncovering misstatements in accounts payable • Analytical procedures for the balance sheet and income statement accounts in the acquisition and payment cycle that are useful for uncovering areas in which additional investigation is desirable
- 16. Substantive Analytical Procedures for the Acquisition and Payment Cycle Substantive Analytical Procedure Possible Misstatement Compare acquisition-related expense account balances with prior years. Misstatement of accounts payable and expenses. Review list of accounts payable for unusual, non vendor, and interest-bearing payables. Classification misstatement for nontrade liabilities. Compare individual accounts payable with previous years. Unrecorded or nonexistent accounts, or misstatements. Calculate ratios, such as purchases divided by accounts payable, and accounts payable divided by current liabilities. Unrecorded or nonexistent accounts, or misstatements.
- 17. Key tests of control for A/P Key existing controls Test of controls All purchasing documents are internally verified Examine indication of internal verification Acquisitions are approved at the proper level Examine indication of approval There is adequate segregation of duties between accounts payable and custody of signed cheques or authority to disburse funds Inquire with personnel and observe activities Supporting documents are examined by an authorised person before signing of cheques or electronic disbursement Inquire with personnel and observe activities Approval of payment is given before disbursement is made Examine indication of approval
- 18. What are the key substantive tests for payment? Transaction related audit objective Substantive test of transactions Occurrence Review the journal, general ledger and Recorded cash accounts payable master file for large or disbursements are for goods unusual amounts and services received Trace cancelled cheques or electronic disbursement to journal and examine for payee and amount Examine cancelled cheques or electronic disbursement for authorisation Examine underlying documents
- 19. Design and Perform Tests of Details of Accounts Payable Balance (1 of 3) • The overall objective in the audit of accounts payable is to determine whether the accounts payable balance is fairly stated and properly disclosed • There is an important difference in emphasis in the audit of assets and liabilities: – In auditing assets, auditors are concerned about overstatements – For liabilities, auditors are concerned about understatements
- 20. Design and Perform Tests of Details of Accounts Payable Balance (2 of 3) • Because of the emphasis on understatements in liability accounts, search for unrecorded accounts payable (out-of-period liability) tests are important • The following are typical audit procedures : – Examine underlying documentation for subsequent cash disbursements – Examine underlying documentation for invoices not paid several weeks after the year-end
- 21. Design and Perform Tests of Details of Accounts Payable Balance (3 of 3) • The following are typical audit procedures: – Trace receiving reports issued before year- end to related vendors’ invoices – Send confirmations to vendors with which the client does business – Cutoff tests – Relationship of cutoff to physical observation of inventory – Audit inventory in transit
- 22. Closing Stocks • Physical stock-take at period end determines closing stock: INCOME STATEMENT RM Opening Inventory XXX Add Purchases XXX Less Closing Inventory XXX Physical Count (CR) STATEMENT OF FINANCIAL POSITION RM INVENTORY Raw materials XXX Physical Count (DR) WIP XXX Physical Count (DR) Finished Goods XXX Physical Count (DR)
- 23. Reliability of Evidence (1 of 2) • Auditors need to understand the relative reliability of the three primary types of evidence ordinarily used for verifying accounts payable: – Vendors’ invoices – Vendors’ statements – Confirmations • Auditors should distinguish: – Between vendors’ invoices and vendors’ statements in verifying the amount due to a vendor – Between a vendor’s statement and a confirmation of accounts payable in verifying account balances. The primary difference is the source of the information.
- 24. • The auditor must also consider sample sizes in the audit of accounts payable • Sample sizes for accounts payable tests vary considerably, depending on such factors as: – The materiality of accounts payable – The number of accounts outstanding – Assessed control risk – The results of the prior year Reliability of Evidence (2 of 2)
- 26. Types of Other Accounts in the Acquisition and Payment Cycle • There are many accounts associated with the acquisition and payment cycle which include: – Property, plant, and equipment – Prepaid expenses – Other liabilities – Income and expense accounts
- 27. Equipment and Related Accounts
- 28. Audit of Property, Plant, and Equipment (1 of 2) • The primary accounting record for property, plant, and equipment accounts is generally a fixed asset master file • Auditors verify them differently from current asset accounts for three reasons: – There are usually fewer current period acquisitions – The amount of any given acquisition is often material – They are likely to be kept and maintained in the accounting records for several years
- 29. Audit of Property, Plant, and Equipment (2 of 2) • In the audit of equipment and related accounts, it is helpful to separate the tests into the following categories: – Perform substantive analytical procedures – Verify current year acquisitions – Verify current year disposals – Verify the ending balance in the asset account – Verify depreciation expense (appropriate rate) – Verify the ending balance in accumulated depreciation – Verify the ending balance is properly classified and disclosures are adequate
- 31. Substantive Analytical Procedures for Equipment Substantive Analytical Procedure Possible Misstatement Compare depreciation expense divided by gross equipment cost with previous years. Misstatement in depreciation expense and accumulated depreciation Compare accumulated depreciation divided by gross equipment cost with previous years. Misstatement in accumulated depreciation. Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with previous years. Expensing amounts that should be capitalized. Compare gross manufacturing cost divided by some measure of production with previous years. Idle equipment or equipment that was disposed of but not written off.
- 32. Audit of Prepaid Expenses • Prepaid expenses, deferred charges, and intangibles are assets that vary in life from several months to several years which include: – Prepaid rent Prepaid taxes – Patents Prepaid insurance – Trademarks Deferred charges – Copyrights Goodwill • Internal controls for prepaid insurance include: – Controls over the acquisition and recording of insurance – Controls over the insurance register – Controls over the charge-off of insurance expense
- 33. Audit of Prepaid Expenses • In the audit of prepaid insurance, the auditor obtains a schedule from the client that lists for each policy in force: – Policy information, including policy number, amount of coverage, and annual premium – Beginning prepaid insurance balance – Payment of policy premiums – Amount charged to insurance expense – Ending prepaid insurance balance – Vouch any new prepayments to supporting documentation
- 34. Prepaid Insurance and Related Accounts
- 35. Substantive test of balances for prepaid insurance 1. Insurance policies in the prepaid insurance schedule exist and existing policies are listed (Existence and Completeness). 2. The client had rights to all insurance policies in the prepaid insurance schedule (Rights). 3. Prepaid amounts on the schedule are accurate and the total is correctly added and agrees with the general ledger (Accuracy and Detail Tie-In). 4. The insurance expense related to prepaid insurance is correctly classified (Classification & Presentation). 5. Insurance transactions are recorded in the correct period (Cutoff).
- 36. Amortization • Amortization in accounting is defined as the expensing of the acquisition cost, less residual value, of intangible assets over their estimated useful life. – Typically on a straight line basis – Applies to goodwill, patents (new inventions, processes or scientific inventions), trademarks ( brands, logos, slogans) and copyright (original works relating to authors of books, etc)
- 37. Audit of Accrued Liabilities (1 of 2) • Accrued liabilities are the estimated unpaid obligations for services or benefits that have been received before the balance sheet date which include: – Accrued payroll : Accrued payroll taxes – Accrued officers’ bonuses: Accrued commissions – Accrued professional fees: Accrued rent – Accrued interest • A second type of accrual involves estimates where the amount of the obligation due is uncertain • Accrued warranty costs and accrued pension costs are similar accruals • The verification of accrued expenses varies depending on the nature of the accrual and the circumstances of the client
- 38. Audit of Accrued Liabilities (2 of 2) • When verifying accrued property taxes, the two most significant balance-related audit objectives are: – Existing properties for which accrual of taxes is appropriate are on the accrual schedule (completeness) – Accrued property taxes are accurately recorded and the treatment is consistent from year to year (accuracy)
- 39. Accrued Property Taxes and Related Accounts
- 40. Audit of Income and Expense Accounts (1 of 2) • The following two concepts in the audit of income and expense accounts are essential when considering the purposes of the income statement: – The matching of periodic expense to income is necessary for a correct determination of operating results – The consistent application of accounting principles for different periods is necessary for comparability
- 41. Audit of Income and Expense Accounts (2 of 2) • Approach to auditing income and expense accounts include: – Substantive analytical procedures – Tests of controls and substantive tests of transactions – Tests of details of account balances
- 42. Substantive Analytical Procedures for Income and Expense Accounts (1 of 2) Substantive Analytical Procedure Possible Misstatement Compare individual expenses with previous years. Overstatement or understatement of a balance in an expense account. Compare individual asset and liability balances with previous years. Overstatement or understatement of a balance sheet account that will also affect an income statement account (for example, a misstatement of inventory affects cost of goods sold). Compare individual expenses with budgets. Misstatement of expenses and related balance sheet accounts. Compare gross margin percentage with previous years. Misstatement of cost of goods sold and inventory.
- 43. Substantive Analytical Procedures for Income and Expense Accounts (2 of 2) Substantive Analytical Procedure Possible Misstatement Compare inventory turnover ratio with previous years. Misstatement of cost of goods sold and inventory. Compare prepaid insurance expense with previous years. Misstatement of insurance expense and prepaid insurance. Compare commission expense divided by sales with previous years. Misstatement of commission expense and accrued commissions. Compare individual manufacturing expenses divided by total manufacturing expenses with previous years. Misstatement of individual manufacturing expenses and related balance sheet accounts.
- 44. Tesco PLC • British multinational grocery and general merchandise retailer headquartered in Hertfordshire, UK • Originally started as grocery retailer but expanded into books, clothing, electronics, furniture, toys, petrol, software, financial services, telecoms and internet services • Stores in 12 countries across Asia and Europe and is the grocery market leader in the UK (where it has a market share of around 30%), the Republic of Ireland, Hungary, Malaysia and Thailand
- 45. Accounting Fraud ▪ Accelerated recognition of promotional income from advertising and store placements from suppliers ▪ Delayed accruals of costs ▪ Profit inflated by £ 263 mil Audit Issues • Inadequate professional scepticism – Audit Committee chairman was former PWC partner • Close relationship – auditors since inception • Weak business risk assessment • Weak control risk assessment – management incentives linked to share price • Weak analytical review • Poor understanding of revenue recognition