Chapter 13
In testing the cutoff of accounts payable at the balance sheet date, explain why it is important that auditors coordinate their tests with the physical observation of inventory. What can the auditor do during the physical inventory observation to enhance the likelihood of an accurate cutoff?
It is important that the cutoff of accounts payable be coordinated with that of the physical inventory observation to determine that they are established at the same point in time. If these cutoffs are not consistent, goods may be counted in the physical inventory for which no liability in accounts payable has been recorded, or vice versa. Such a situation would result in an understatement of accounts payable and cost of goods sold or an overstatement of these two accounts respectively. During the physical inventory observation, the auditor should gather cutoff information (e.g., the last several receiving reports, shipping documents, transfer documents) to assist in the determination that an accurate cutoff was established
Explain the relationship between tests of controls for the acquisition and payment cycle and tests of details of balances for the verification of property, plant, and equipment. Which aspects of property, plant, and equipment are directly affected by the tests of controls, and which are not?
Since the source of the debits in the asset account is the purchase journal (or similar record), the current period acquisitions of capital assets have already been partially verified as part of the acquisition and payment cycle. The disposal of assets, amortization, and accumulated amortization are not tested as a part of the acquisition and payment cycle.
Which of the following analytical procedures might suggest that certain repairs and maintenance expenses have been inappropriately capitalized? (1) The ratio of additions to equipment divided by the beginning balance in the equipment account is significantly lower than the same ratio from the prior three years. (2) The balance in the repairs and maintenance expense account is noticeably lower than amounts recorded in the past several years. (3) The balance in the gross equipment account has decreased this year compared to the prior year. (4) The ratio of amortization expense divided by gross equipment is higher in the current year compared to prior years.
(2) The balance in the repairs and maintenance expense account is noticeably lower than amounts recorded in the past several years.
Budd, the purchasing agent of Lake Hardware Wholesalers, has a relative who owns a retail hardware store. Budd arranged for hardware to be delivered by manufacturers to the relative's retail store on a COD basis, thereby enabling his relative to buy at Lake's wholesale prices. Budd was probably able to accomplish this because of Lake's poor internal control over (1) purchase requisitions. (2) purchase orders. (3) cash receipts. (4) perpetual inventory records.
(2) purchase orders.
In auditing accounts payable, an auditor's procedures will most likely focus primarily on management's assertion of (1) existence. (2) realizable value. (3) completeness. (4) valuation and allocation.
(3) completeness.
For effective internal control, the accounts payable department generally should (1) stamp, perforate, or otherwise cancel supporting documentation after payment is mailed. (2) ascertain that each requisition is approved as to price, quantity, and quality by an authorized employee. (3) omit information about the quantity ordered on the copy of the purchase order forwarded to the receiving department prior to receipt of goods. (4) establish the agreement of the vendor's invoice with the receiving report and purchase order.
(4) establish the agreement of the vendor's invoice with the receiving report and purchase order.
Equipment acquisitions that are misclassified as maintenance expenses most likely would be detected by an internal control that provides for (1) segregation of duties of employees in the accounts payable department. (2) authorization by the board of directors of significant equipment acquisitions. (3) investigations of variances within a formal budgeting system. (4) independent verification of invoices for disbursements recorded as equipment acquisitions.
(4) independent verification of invoices for disbursements recorded as equipment acquisitions.
Distinguish between a vendor's invoice and a vendor's statement. Which document is more reliable evidence for performing tests of details of acquisition transactions and for directly verifying accounts payable balances? Why?
A vendor's invoice is sent with or at the same time as the order and states the amount of goods shipped, the price, and other details. This is the vendor's bill for the goods shipped. Vendor statements contain the individual open items and the ending balance due in the account. A vendor's statement is not as meaningful as an invoice to verify individual transactions because a statement includes only the total amount of the transactions and not the details making up the shipment, such as unit price and freight. The vendor's statement should be used to verify the correct balance in accounts payable account for an individual vendor. The statement contains the ending balance and the detailed transactions required to reconcile the accounts payable listings and determine the propriety of the balance shown for individual vendors
1. What is the assertion that auditors are primarily concerned with for accounts payable? Why? Why is this more difficult for the auditor?
Accounts payable and accrued liabilities, auditors are especially concerned with completeness and cut-off assertions because of the potential for understatements in the account balance.
What are accrued liabilities? Can you provide an example of a few? What are the most important audit objectives (key risks)? What audit procedures will the auditor use to ensure that all have been appropriately recorded?
Accrued liabilities are estimated unpaid obligations for services or benefits that have been received prior to the balance sheet date Examples: accrued expenses, accrued payroll, and accrued rent. The key risks for these accounts are completeness (that they are all included), accuracy (that they are calculated correctly), and allocation or cut-off Audit procedures: i. inquire of management to determine which accruals exist, ii. determine the policy for establishing the accrual, iii. inspect the related documentation (such as subsequent payroll journals for accrued wages, payroll taxes, and bonuses), iv. recalculate the accrual, and v. assess the reasonableness of assumptions (if applicable).
Explain why asset impairments are difficult to identify and audit. How might a client or auditor use a valuation specialist in determining the fair value of property and equipment?
Asset impairments are difficult to audit because there is significant judgment involved in identifying assets that may be impaired, and in estimating the fair value of the asset and amount of the impairment loss. Auditors need a good understanding of the industry and the client's operations in order to identify assets that may be impaired. For example, an auditor may be able to identify that a particular piece of machinery or equipment is outdated based on current manufacturing techniques. Once an asset has been identified as impaired, the fair value of the asset must be determined using a market method or an income method, and both require significant judgment. In addition, management may have incentives to overstate or understate the impairment loss, and the auditor needs to consider these incentives when auditing management's estimate. An auditor may use a valuation specialist to develop an independent estimate of the fair value of the asset. This will help the auditor identify possible management bias in their estimate of fair value
Evaluate the following statement by an auditor concerning tests of acquisitions and cash disbursements: "In selecting the acquisitions and cash disbursements sample for testing, the best approach is to select a random month and test every transaction for the period. This approach enables me to thoroughly understand internal control because I have examined everything that happened during the period. As a part of the monthly test, I also test the beginning and ending bank reconciliations and prepare proof of cash for the month. At the completion of these tests, I feel I can evaluate the effectiveness of internal control."
Auditing standards require that the tests of controls and related tests of details of transactions cover the entire accounting period in order to determine that the system was operating in a consistent manner throughout the period. In selecting the number of items for testing, the auditor must determine the sample size, statistically or non-statistically, such that it is likely to be representative of the actual conditions of the population of all transactions during the entire period. Therefore, the auditor's approach is not valid since it only allows him/her to conclude on whether the control was operating in the period tested (the entire period being audited). In testing items that are periodic procedures rather than individual transactions (such as monthly bank reconciliations), the auditor must determine the appropriate timing to determine that those procedures are operating properly.
What types of analysis can be performed on equipment and related accounts (amortization, gain and /or loss on sale of equipment, repairs, and maintenance)? What possible misstatements could the analysis indicate?
Compare amortization expense divided by gross manufacturing equipment cost with that of previous years. - Misstatement in amortization expense and accumulated amortization. Compare accumulated amortization divided by gross manufacturing equipment cost with that of previous years. - Misstatement in accumulated amortization. Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with those of previous years. - Expensing amounts that should be capital items. Compare gross manufacturing cost divided by some measure of production with those of previous years. - Idle equipment or equipment that has been disposed of but not written off.
What procedures are included in Cut-off tests? Why should the cut-off information for purchases be obtained during the physical inventory observation?
Cut-off tests for accounts payable are intended to determine whether transactions recorded a few days before and after the balance sheet date are included in the correct period. In determining that the accounts payable cut-off is correct, it is essential that the cut-off tests be coordinated with the physical observation of inventory. When inspecting accounts payable vendor invoices, the auditor needs to check for the method of shipping.
Identify some of the procedures you would perform when doing a search for unrecorded liabilities (out of liability tests).
Inspect underlying documentation for subsequent cash disbursements. Inspect underlying documentation for bills not paid several weeks after the year end. Trace receiving reports issued before year end to related vendors' invoices. Trace vendors' statements that show a balance due to the accounts payable trial balance. Send confirmations to client's vendors. Review purchase agreements for commitments
What is the relationship between the audit of property, plant, and equipment accounts and the audit of repair and maintenance accounts? Explain how the auditor organizes the audit to take this relationship into consideration.
Many clients may accidentally or intentionally put purchases of assets into the repair and maintenance expense account. This misstatement is caused by a lack of understanding of accepted accounting principles and some clients' desire to avoid income taxes. Alternatively, some clients may be biased to overstate assets (in situations where users focus on this, such as real estate companies or if there is a bank covenant related to asset values). Repair and maintenance accounts are verified primarily to uncover unrecorded capital asset purchases. The auditor may verify the larger amounts debited to those expense accounts at the same time that capital asset accounts are being audited.
What information must be disclosed in the financial statements when there are related party transactions?
Must be properly disclosed for the financial statements to be in conformity with GAAS: i. The nature of any related party relationship ii. The nature and extent of transactions, and amounts due to and from the related parties, including contractual obligations and contingencies
Describe the typical source documents, accounting records and types of transactions in the acquisition and payment cycle. (See Table 13-1)
Processing Purchase Orders Receiving Goods and Services Recognizing the Liability Processing and Recording Cash Disbursements The cycle consists of two halves: recording purchases and recording cash payments
For acquisitions, describe the key controls for each transaction-related audit assertion. Provide a test of control for each key control identified. (See Table 13-5)
Recorded acquisitions are for goods and services received, consistent with the best interests of the client (occurrence) - vouch entries from purchase journal and ensure that all support documents were produced (purchase invoice, receiving reports, purchase orders) and ensure appropriate approvals. Existing acquisitions are recorded (completeness) - trace from order through to the purchase journal and ensure all documents produced; do sequence tests on receiving reports and other source documents. Acquisitions are accurately recorded (accuracy) - recalculate vendor invoice details with reference to purchase order prices and receiving report quantities. Acquisitions are correctly classified (classification). - ensure the date per receiving report is the same as the date per the purchase journal (system is recording to the correct period).
What is the most important assertion when testing amortization expense? Remember, this account is on the income statement. What are some of the tests auditors perform to ensure this assertion is met?
Recorded amounts are internal allocations rather than exchange transactions with outside parties Primary audit objectives involve determining whether the client is: i. Following a consistent and reasonable amortization policy from period to period (valuation) ii. Checking the accuracy of amortization calculation by recomputing for selected assets Audit procedure: i. Reconcile opening to closing balance. Opening balance plus additions minus disposals should agree to the ending balance. ii. Agree subsidiary totals to closing balance. Add the property, plant, and equipment master file and agree the total to the ending balance.
Describe audit procedures (test of details of account balances) you would perform on equipment acquisitions and equipment disposals and the audit assertion(s) addressed.
The audit steps conducted for current year acquisitions are: i. Inspect supporting documentation for asset costs. ii. Inspect large repair and maintenance documentation. iii. Search for trade ins. iv. Physically inspect the asset or repair. v. Reassess risks based upon findings. The audit steps conducted for current year disposals are: i. Inquire about the nature of the disposals. ii. Inspect documentation of the disposal. iii. Recalculate gains and losses. iv. Trace postings to the correct accounts. v. Physically inspect the plant location. vi. Inspect related accounts for potential unrecorded disposals. vii. While inspecting asset acquisition, search for trade ins.
Why does the auditor examine transaction details for subsidiaries, affiliates, officers, and directors?
The auditor needs to examine related party transactions, to test for disclosure inconformity with an acceptable financial reporting framework, and for proper valuation. The auditor also examines such transactions for propriety and reasonableness, requiring more extensive auditing procedures than third-party transactions
What are the similarities and differences in the objectives of the following two procedures? a. Select a random sample of receiving reports and trace them to related vendors' invoices and acquisitions journal entries, comparing the vendor's name, type of material and quantity acquired, and total amount of the acquisition. b. Select a random sample of acquisitions journal entries, and trace them to related vendors' invoices and receiving reports, comparing the vendor's name, type of material and quantity acquired, and total amount of the acquisition.
The difference in the purpose of the steps is that Procedure 1 determines whether all existing acquisitions are recorded properly (completeness and accuracy), whereas Procedure 2 is designed to determine whether recorded acquisitions are proper (occurrence and accuracy). The two procedures are similar in that each is designed to determine that the vendor's name, type of material and quantity purchased, and total amount of the acquisition agree with the receiving report, vendor's invoice, and purchase journal entries
Explain why most auditors consider the receipt of goods and services the most important point in the acquisition and payment cycle
The point at which goods and services are received is ordinarily when title to the goods and services passes and a legal liability is established. This is the point where most companies first recognize the acquisition and related liability in their records.
Explain why the emphasis in auditing property, plant, and equipment is on the current-period acquisitions and disposals rather than on the balances in the account carried forward from the preceding year. Under what circumstances would the emphasis be on the balances carried forward?
The reason for the emphasis in auditing capital assets in the current period is that there is an expectation that permanent assets will be kept and maintained on the records for several years. The assets carried over from the preceding years can be assumed to have been verified in the prior years' audits. If it cannot be shown through a test of controls that all disposals have been recorded, additional testing of the prior balance could be required. A first-year audit also requires tests of the beginning balance.
Explain why it is common for auditors to send confirmation requests to vendors with "zero balances" on the client's accounts payable listing but uncommon to follow the same approach in verifying accounts receivable.
Unless evidence is discovered that indicates that a different approach should be followed, auditors traditionally follow a conservative approach in selecting vendors for accounts payable confirmations and customers for accounts receivable confirmations. The auditor assumes that the client is more likely to understate accounts payable, and therefore concentrates on the vendors with whom the client deals actively, especially if that vendor's balance appears to be lower than normal on the client's accounts payable listing at the confirmation date. In verifying accounts receivable, the auditor assumes that the client is more likely to overstate account balances; and for that reason he concentrates more on the higher balances and is not particularly concerned with "zero balances" as in the case of accounts payable.
1. What are some examples of major risks of error or fraud in the acquisition and payment cycle (Table 13-4)? What controls should be in place to reduce these risks?
a. The client has complex arrangements with vendors (such as chargebacks and allowances b. The client has integrated supply chain management. c. The client has numerous routines and non routine related party transactions. d. The client has significant accruals and provisions that require considerable judgement. e. Postponement or absence of recording transactions (completeness assertion). f. Fictitious vendors (occurrence assertion); g. Incorrect or fictitious vendor allowances / discounts (completeness assertion); or h. Theft of the assets / items purchased (existence assertion for the asset, occurrence for the expense). . These frauds can usually be prevented by: i. Allowing payments to be made only to approved vendors ii. Having authorized personnel carefully scrutinize documentation supporting the acquisitions before payments are made.
The auditor examines all unrecorded invoices on hand as of February 28, 2021, the last day of the audit of the December 31, 2020, year-end. Which of the following misstatements is most likely to be uncovered by this procedure? Explain. a. Accounts payable are overstated at December 31, 2020. b. Accounts payable are understated at December 31, 2020. c. Operating expenses are overstated for the 12 months ended December 31, 2020. d. Operating expenses are overstated for the two months ended February 28, 2021.
b. Accounts payable are understated at December 31, 2020. The search for unrecorded invoices is designed to detect an understatement of accounts payable.
