1 Chapter 11 Audit of Acquisition Cycle and Inventory.

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Chapter 11

Audit of Acquisition Cycle and Inventory

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Overview of Acquisition CycleThe acquisition cycle covers the purchase, receipt,

payment, and accounting for goods and servicesMajor accounts include inventory, accounts

payable, and expensesMain phases in the acquisition and payment

process: Authorized requisition Authorized purchase Receipt of goods and services Approval for payment Cash disbursement

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Discuss Risk and Business AnalysisAcquisition cycle deals with receipt of all goods and services

Misstatements may occur just because of the volume of transactions

It is also an area where fraud is likely to take place. For example, Employee theft of inventory causing inventory on the books to be

overstated Employees setting up fictitious vendors and paying themselves

for goods never received by the company Executives abusing travel and entertainment expenses for

personal use Capitalizing expenses as assets to inflate earnings Overestimating "restructuring reserves" at the time of acquisition

so expenses could be reduced in future periods

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What are the red flags of the acquisition and payment cycle?There are a number of red flags unique to the acquisition

and payment cycle. These include: Inventory growing at a rate greater than sales Expenses significantly above or below industry norms Capital assets growing faster than the business and for

which there are not strategic plans Significant reduction of "reserves" Expense accounts that have significant credit entries Travel and entertainment expense accounts that do not

have documentation Inadequate follow-up to auditor recommendations on

needed controls

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What analytical analysis can be done for misstatements?

Analytical procedures to identify potential misstatements: Calculate and analyze dollar and percentage change in

inventory, cost of goods sold, and expense accounts Compute and analyze ratios like inventory turnover and

number of day's sales in inventory Prepare common sized income statement to identify cost

of good sold or expense accounts that are out of lineAuditor compares client analytics to past client

performance, industry results, and auditor's expectations

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Overview of Control Procedures and Control Risk Assessment

Requisition goods or services Need identified Pre-numbered requisition form completed and sent to purchasingPurchase goods or services Purchase order shows quantity and price of goods ordered, quality

specifications, shipping terms Purchase orders are pre-numbered to establish completeness Purchase orders must be properly authorized Many companies have separate purchasing department:

Agents job is to find best combination of price, service, and quality Reduces fraud by separating purchasing from custody and recording Centralizes control in one location Controls set to stop purchasing agents from abusing their positions

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Overview of Control Procedures and Control Risk AssessmentReceive goods Receiving department should ensure

Only authorized goods are received The goods meet order specifications An accurate count of goods received is taken All receipts of goods are recorded

Receiving reports are pre-numbered to establish completeness

Receiving department records quantity of goods received

Goods also inspected for quality Receiving reports sent to accounting

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Overview of Control Procedures and Control Risk AssessmentApprove payment Accounting matches vendor invoice, purchase

order, and receiving reports - If quality and quantity match, account payable is recorded

Cash disbursement Supporting documentation is reviewed and

approved for payment Documents are marked "paid" to avoid duplicate

payment

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Testing Controls over Accounts Payable and Related ExpensesThe primary risk is that Accounts Payable and expenses

will be understatedTherefore, controls related to the following are usually

significant: Proper authorization Completeness of recording Timeliness of recording Correctness of valuationAttribute sampling (Chapter 9) may be used to test control

operationThe level of assessed control risk will impact the rigor of

the subsequent substantive testing of Accounts Payable and expenses

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What are some substantive tests of accounts payable? The auditor's main concern is that Accounts

Payable will be understatedTherefore, emphasis is placed on testing the

completeness assertionTypical substantive tests include:1. Reconcile vendor statements or confirm

accounts payable2. Tests of subsequent disbursements3. Analytical review of related accounts

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1. Reconciling Vendor Statements or Confirm Accounts Payable

Auditor requests vendors' monthly statements or sends confirmation to major vendors

Auditor reconciles vendor statement or confirmation with client balance in the accounts payable subsidiary ledger

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2. Testing Subsequent Disbursements Auditor samples cash disbursements after

the end of the year Determines if disbursements are for audit

year transactions by vouching back to source documents (purchase order, vendor invoice, receiving report)

If disbursement is for audit year transaction, auditor reprocesses the transaction to see if it was properly recorded as a payable

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3. Analytical Review of Related Expense Accounts Used to determine if accounting data

indicates understatement of expenses

If understatement likely, auditor expands tests of accounts payable

Analytics used on clients with low control risk

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Auditing of Expense AccountsAuditing payables and cash disbursements provides

indirect evidence about expense accountsAdditional analysis of selected expense accounts is usually

meritedThe auditor should consider management is more likely to Understate rather than overstate expenses Classify expenses as assets rather than vice versa

Substantive audit procedures include: Detailed tests of transactions Analytical review Review of unusual entries

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Auditing of Inventory & Cost of Goods SoldAudit of inventory is complicated by a number of factors

including: Variety (diversity) of items High volume of activity Various (sometimes complex) valuation Difficulty in identifying obsolete or defective inventory Many frauds involve the inventory account Easily transportable making it subject to double counting May be stored at multiple locations, some may be

remote May be returned by customers

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What are some internal controls for inventory?A well-designed inventory control system should ensure: All purchases are authorized Accounting system ensures timely, accurate, and

complete recording Receipt of inventory properly accounted for Inventory tested for quality when received/manufactured Costs properly identified and assigned to products Customer returns of inventory examined for defects Inventory reviewed for obsolescence New products introduced only after market studies and

quality control tests have been made Management actively manages inventory Long term contracts are closely monitored

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Substantive Tests of Inventory & Cost of Goods Sold Existence: observe year-end physical

inventory Completeness: cutoff tests Rights: review long-term contracts,

etc. Valuation: direct tests and analytics Disclosure: review GAAP

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Procedures for Observing a Client's Physical Inventory - Existence

Meet with client to discuss their plan to count inventory Review client's plans for counting and tagging inventory Review inventory counting procedures with audit

personnel Determine whether specialists are needed to identify

inventory items Upon arriving at each site:

Meet with client, and obtain map and schedule of inventory count area

Obtain list of sequential tag numbers for each area Observe procedures to shut down receipt or shipment of goods;

obtain document numbers for last receipt and shipment for cutoff tests

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Observe the counting of inventory and note the following:

The first and last tag numbers in each section Account for all tag numbers to prevent later

insertion of additional inventory items Make selected test counts Items that appear obsolete or defective High-dollar value items in inventory Movement of inventory during counting process

Document conclusion as to quality of the inventory counting process

Procedures for Observing a Client's Physical Inventory - Existence

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What does the auditor do after the inventory count? - Existence

After the inventory count, the auditor should: Trace the test counts to the client's

inventory records Trace the number of high-dollar items to

the client's inventory records Trace the obsolete or damaged inventory

to the client's inventory records to see if the items have been written down

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Counting Inventory Before or After Year-end - ExistenceOn occasion, it may not be feasible to count inventory at

year-endAcceptable to count inventory before or after year-end if: Controls are strong The opportunity and motivation to misstate inventory is

low Auditor can test the year-end balance using analytics

and tests of transactions between the physical count and year-end (called the roll-forward or rollback period)

Auditor reviews intervening transactions for unusual activity

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Cut Off - Completeness Inventory cutoff tests: Obtain information on last items shipped and received at

year-end Compare this information to transactions recorded in the

sales and purchases journal Determine if transaction is recorded in correct

accounting period

Auditor should also inquire about any inventory out on consignment or stored in a public warehouse

Tracing test counts and number of high-dollar items to the client's inventory records tests completeness (as well as existence)

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Comment on Allowance for Returns - Valuation In most situations, expected returns of

inventory are not material However, some companies provide return

guarantees and expect significant returns Management can use previous

experience, updated for current economic conditions, to develop estimates of returns

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Rights

Most of the work regarding ownership of inventory is performed during the auditor's testing of purchases

Auditor should also review long-term contracts to determine obligations

Inquiry should be made about inventory on consignment

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Inventory Valuation - ValuationMost complex assertion related to inventory because of the: Volume of transactions Diversity of products Variety of costing methods Difficulty in estimating net realizable value of productsAuditor uses direct tests and analytics to assess inventory valuation: Direct tests include verifying cost by reviewing vendor invoices Auditor usually examines current market data and other conditions

that might indicate inventory obsolescence Management inquiry and review of industry publications can help

the auditor identify obsolete units Analytics, like inventory turnover or day's sales in inventory, may

identify slow-moving inventory which may need to be written down Auditor looks for obsolete units during the counting of inventory;

these units may need to be written down

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DisclosureAuditor reviews client disclosure for

compliance with GAAP

Disclosure should include: Costing method(s) used Frequency of accounting Inventory pledged as collateral Any other unusual circumstance

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Cost of Goods Sold Audit of cost of goods sold can be direct

tied to the audit of inventory If beginning and ending inventories have

been verified and acquisitions have been tested, cost of goods sold can be direct calculated

Auditor should also apply analytics to cost of goods sold to see if there are any significant variations - either overall or by product line