Chapter 11 - Lecture notes 11 PDF

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Solutions for end of chapter questions (Chapter 11) - Auditing the Purchasing process (Elifsen)...

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CHAPTER 11 AUDITING THE PURCHASING PROCESS Answers to Review Questions 11-1

Expenses can be classified into three categories:

1. Product costs are expenses that can be matched directly with specific transactions or events and are recognized upon recognition of the revenues. An example of a product cost would be the expensing of inventory through cost of goods sold. 2. Period costs are expenses that are recognized during the period in which cash is spent or liabilities incurred for goods and services that are used up at that time or shortly thereafter. Such expenses cannot be directly related to specific transactions and are assumed to provide no future benefit. Examples of such expenses are administrative salaries, rent expense and interest expense. 3. Allocable costs are allocated by systematic and rational procedures to the periods during which the related assets are expected to provide benefits. Depreciation of plant and equipment is an example of such an expense. 11-2   

The three types of transactions that are processed through the purchasing process are: Purchase of goods and services for cash or credit. Payment of the liabilities arising from such purchases. Return of goods to suppliers for cash or credit.

The more common accounts affected by each major type of transaction are: Purchase transaction:  Accounts payable  Inventory  Purchases or cost of goods sold  Various asset and expense accounts Cash disbursement transaction:  Cash  Accounts payable  Cash discounts  Various asset and expense accounts Purchase return transaction:  Purchase returns  Purchase allowances  Accounts payable  Various asset and expense accounts 1 © McGraw-Hill 2014 Auditing & Assurance Services 3e Eilifsen, Messier Jr, Glover & Prawitt

11-3 A purchase requisition is a request for goods and services by an authorized individual or department within the entity. A purchase order contains the description, quality, quantity and other information on the goods and services being purchased. A receiving report is used to record the receipt of goods. A vendor invoice is the bill from the vendor that includes the description and quantity of the goods shipped or services provided, the price including freight, the terms of trade including cash discounts, and the date billed. A voucher is a document that is frequently used by entities to control the payment of acquired goods and services. An entity would combine all these documents into a ‘voucher packet’ because such a packet would contain all the information on a particular purchase transaction. If there are questions about the transaction at a later time, the entity can obtain access to all the documents and information more easily. 11-4 The key segregation of duties and the errors or fraud that can occur if they are not present are: Possible Errors or Fraud Resulting from Conflicts in Duties

Segregation of Duties The purchasing function should be segregated from the requisitioning and receiving functions.

Theft of goods and possible payment for unauthorized purchases.

The invoice-processing function should be segregated from the accounts payable function.

Overpayment for goods and services or theft of cash.

The disbursement function should be segregated from the accounts payable function.

Theft of cash.

The accounts payable function should be segregated from the general ledger function.

A defalcation that would normally be detected by reconciling subsidiary records with the general ledger control account.

11-5 Two inherent risk factors that directly affect the purchasing process are (1) industryrelated factors, and (2) misstatements detected in prior audits. If the entity deals with a large number of vendors and prices tend to be relatively stable, there is less risk that the entity’s operations will be affected by raw-material shortages or that production costs will be difficult to control. However, if an entity is dependent on a single vendor to supply a critical component and the vendor is unable to provide the component, the entity may suffer production shortages and shipping delays that significantly affect financial performance. Additionally, industries that use commodities such as oil, coal and precious metals may be subject to both shortages and price instability that significantly affect their financial results. The presence of misstatements in previous audits is a good indicator that misstatements are likely to be present during the current audit. If misstatements were present in previous audits, the auditor should assess inherent risk to be high. 2 © McGraw-Hill 2014 Auditing & Assurance Services 3e Eilifsen, Messier Jr, Glover & Prawitt

11-6 The following controls and related tests are utilized to ensure that the occurrence, authorization and completeness assertions are met for purchase transactions: Assertions

Control Activities

Tests of Controls

Occurrence

Segregation of duties

Observe and evaluate proper segregation of duties.

Purchase not recorded without approved purchase order and receiving report

Test of a sample of vouchers for the presence of an authorized purchase order and receiving report; if IT application, examine application controls.

Accounting for numerical sequences of receiving reports and vouchers

Review and test entity’s procedures for accounting for numerical sequence of receiving reports and vouchers; if IT application, examine application controls. Review entity’s monetary limits authorization for acquisitions.

Authorization

Completeness

Approval of acquisitions consistent with the entity’s authorization monetary limits Approved purchase requisitions and purchase orders

Examine purchase requisitions or purchase orders for proper approval; if IT is used for automatic ordering, examination of application controls.

Competitive bidding procedures followed Accounting for numerical sequences of receiving reports and vouchers

Review entity’s competitive bidding procedures. Review and test entity’s procedures for accounting for numerical sequence of receiving reports and vouchers; if IT application, examine application controls.

Trace a sample of receiving reports to their respective vendor invoices and vouchers. Trace a sample of vouchers to the purchases journal. 11-7 CAATs can be used to test numerous controls in the purchasing process. For example, a generalized audit software package can be used to account for the numerical sequence of purchase orders, receiving reports and vouchers. Another example involves the use of a CAAT Receiving report matched to vendor invoices and entered in purchases journal

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to test programmed controls over approval of purchase orders when IT is used for automatic ordering (e.g. electronic data interchange). 11-8 The analytical procedures that can be used to test accounts payable and accrued expenses and the possible misstatements that can be detected by each analytical procedure are: Substantive Analytical Procedure

Possible Misstatement Detected

Compare payable turnover and days outstanding in accounts payable with previous years’ and industry data.

Under- or overstatement of liabilities and expenses

Compare current-year balances in accounts payable and accruals with prior years’ balances.

Under- or overstatement of liabilities and expenses

Compare amounts owed to individual vendors in the current year’s accounts payable listing to amounts owed in prior years.

Under- or overstatement of liabilities and expenses

Compare purchase returns and allowances as a percentage of revenue or cost of sales to prior years’ and industry data.

Under- or overstatement of purchase returns

11-9 The following audit procedures may be used as part of the search for unrecorded liabilities:  Inquiry of management about control activities used to identify unrecorded liabilities and accruals at the end of an accounting period.  Obtain copies of vendors’ monthly statements and reconcile the amount to entity’s accounts payable records.  Confirm vendor accounts, including accounts with small or zero balances.  Vouch large monetary items from the purchases journal and cash disbursements journal for a limited time after year-end; examine the dates on each receiving report or vendor’s invoice to determine if the liability relates to the current audit period.  Examine the files of unmatched purchase orders, receiving reports and vendor invoices for any unrecorded liabilities. 11-10 The following are examples of disclosures for the purchasing process and related accounts:  Payables by type (trade, officers, employee, affiliate, etc.).  Short- and long-term payables.  Long-term purchase contracts, including any unusual or adverse purchase commitments.  Purchases from and payables to related parties.  Dependence on a single vendor or small number of vendors. 4 © McGraw-Hill 2014 Auditing & Assurance Services 3e Eilifsen, Messier Jr, Glover & Prawitt



Costs by reportable segment of the business.

11-11 Accounts payable confirmations are generally used less frequently by auditors than accounts receivable confirmations because the auditor can test accounts payable by examining vendor invoices and monthly vendor statements. Since these documents originate from sources external to the entity, this evidence is viewed as reliable. Accounts payable confirmations primarily provide evidence on the completeness assertion, while accounts receivable confirmations primarily provide information on the validity (occurrence/existence) assertion. When confirming accounts payable, auditors generally use a form of positive confirmation referred to as a ‘blank or zero-balance’ confirmation. This type of positive confirmation does not state the balance owed. Instead, the confirmation requests that the recipient fill in the amount or furnish other information. Both positive and negative confirmations are used for accounts receivable. Lastly, accounts payable confirmations are generally mailed at year end rather than at an interim date because of the auditor's concerns about unrecorded liabilities. Accounts receivable confirmations are sent at both dates. 11-12 Some of the typical procedures that might be applied to the audit of the income tax expenses by the auditors and/or tax expert include:  

    



Compare the size and trend in the tax expense and related balance sheet accounts over time. Perform walk-throughs and test the design and operating effectiveness of internal controls over the tax expense. Identify issues that should be given particular attention in substantive testing and evaluate the entity’s documentation. Test the mathematical accuracy of the computations supporting the tax expense and related balance sheet accounts and vouch underlying data to supporting documentation. Identify and test significant temporary differences in the tax expense calculation. Review and evaluate management’s position on significant uncertain tax positions for appropriate disclosure and accounting. Consider the realizability of net deferred tax assets. Test the reconciliation of current income tax liability and deferred income tax assets/liabilities to supporting documentation, including the general ledger, financial statements and related note disclosure. Ensure proper documentation in the audit working papers to allow for reperformance of the audit procedures applied to the tax accounts.

Solutions to Problems 11-13 This is a relatively straightforward analytical procedures problem. Here are some of the concerns the auditor might have about potential misstatements in both accounts:  Both inventory and accounts payable have increased significantly in absolute euro terms from 2012 to 2013.  The inventory increase is 69 per cent while the accounts payable increase is 28 per cent. 5 © McGraw-Hill 2014 Auditing & Assurance Services 3e Eilifsen, Messier Jr, Glover & Prawitt

 

An auditor would have expected the increase in inventory to be approximately the same as the increase in accounts payable. Based on the auditor’s expectations and the entity’s data, the auditor might suspect that there are at least two possible misstatements: (1) inventory is overstated because obsolete and/or slow-moving products have not been written down to fair market value and (2) there are unrecorded accounts payable. Other misstatements are possible.

11-14 The internal control activities that most likely would provide reasonable assurance that specific control objectives for the financial statement assertions regarding purchases and accounts payable will be achieved are: 

The purchasing, receiving and accounts payable functions are segregated.

Requisitioning Department:  Proper authorization of requisitions by department head is required before purchase orders are prepared.  The requisitioning department head independently verifies the quantity and quality of the goods received. Purchasing Department:  The purchasing department ensures that requisitions are within budget limits before purchase orders are prepared.  The adequacy of each vendor’s past record as a supplier is verified. Receiving Department:  Secure facilities limit access to the goods during the receiving activity.  The receiving department makes a blind count of the goods received, independently of any other department. Accounts Payable Department:  Requisitions, purchase orders and receiving reports are matched with vendor invoices as to quantity and price.  The accounts payable department recomputes the mathematical accuracy of each invoice.  The voucher register is independently reconciled to the control accounts monthly.  All supporting documentation is required for payments and is made available to the treasurer. 11-15 a The flowchart for Kida Company is shown on the following page:

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Kida Company - Special Ordering System Receiving Department Accts. Payable Department

Purchasing Department From Department Head

Purchase Requisition

Purchase3 order

See Note A

Purchase order

1

Purchase 2 order

To vendor

To Dept. Head

Purchase 3 order Purchase 4 order Note A: Buyers verify that the purchaser is a department Purchase 5 head. The buyer searches order vendor catalogues and calls vendor for a quote. Vendor is given a verbal order. A prenumbered purchase order is processed. Note B: When the buyer is orally informed by the Receiving Department that the item has been received, the purchase order is transferred from the unfilled file to the filled file. Note C: Once a month the buyer reviews the unfilled file to follow up on and expedite open orders.

A Purchase order

Cheques

4

See Note D

Treasurer

See Note G

Unpaid file

Purchase3 order

See Note E

To Requisitioning Dept.

By due date

Vendor invoice

To vendors

A See Note F

Cheques

Daily Cheques

Unfilled See Note C Purchase 4 order

See Note B

Filled

Note D: When equipment is received, purchase order is stamped and any differences noted. Equipment sent to Requisitioning Department.

Paid file

Vendor invoice

Note G: Cheques sorted into two groups. Cheques under €10,000 are machine signed. Cheques over €10,000 are signed by the treasurer or controller.

Note E: Matches vendor invoice with purchase order and sets up a payable. Note F: Cheques are prepared on due date.

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b Kida Company’s major internal control deficiencies are: Purchasing:  The buyer does not verify that the department head’s request is within budget limitations.  No procedures have been established to ensure that the best price is obtained. Largeeuro requisitions should be ordered after receiving quotes and/or sealed bids.  Prior to placing an order, the buyer does not determine the adequacy of the vendor’s past record as a supplier to Kida. Receiving:  Receiving clerk does not make blind counts for all special equipment or at least for largeeuro items.  Written notice of equipment received is not sent to the purchasing department.  Written notice of equipment received is not sent to accounts payable department. Accounts Payable:  The mathematical accuracy of the invoice is not recomputed.  Invoice quantity is not compared with a report of quantity received.  Notification of the acceptability of the equipment from the requisitioning department is not obtained before the payable is recorded.  No alphabetic file of vendors from which purchases are made is maintained. Treasurer:  Documentation supporting the cheques is not sent by the accounts payable Department to the cashier in order for the cashier or treasurer to be assured that the cheque is for properly authorized and received equipment.  Cheques for large-euro purchases are not signed by two officers of Kida Company to ensure that material expenditures are proper.  All documentation to support a cheque is not cancelled by the cheque signer and returned to the accounts payable department.  The cashier alone has custody of the key, the signature plate, and record of usage.  The controller is authorized to sign cheques. 11-16 1 2 3 4 5 6

Test of details of transactions (substantive test of transactions). Tests of details of transactions (cut-off test). Tests of details of account balances. Substantive analytical procedure. Tests of details of account balances. Substantive analytical procedure.

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11-17 The substantive audit procedures Coltrane should apply to Jang’s trade accounts payable balances include the following:  Foot the schedule of the trade accounts payable.  Agree the total of the schedule to the general ledger trial balance.  Compare a sample of individual account balances from the schedule with the accounts payable subsidiary ledger.  Compare a sample of individual account balances from the accounts payable subsidiary ledger with the schedule.  Investigate and discuss with management any old or disputed payables.  Investigate debit balances and, if significant, consider requesting positive confirmations and propose reclassification of the amounts.  Review the minutes of the board of directors’ meetings and any written agreements and inquire of key employees as to whether any assets are pledged to collateralize payables.  Perform cut-off tests.  Perform analytical procedures. Confirm or verify recorded accounts payable balances by:  Reviewing the voucher register or subsidiary accounts payable ledger and consider confirming payables for a sample of vendors.  Requesting a sample of vendors to provide statements of account balances as of the date selected.  Investigating and reconciling differences discovered during the confirmation procedures.  Testing a sample of unconfirmed balances by examining the related vouchers, invoices, purchase orders and receiving reports. Perform a search for unrecorded liabilities by:  Examining files of receiving reports unmatched with vendors’ invoices and searching for items received before the balance sheet date but not yet billed or on the schedule.  Inspecting fil...