Chapter 12

Rittenberg/Schwieger/JohnstoneAuditing: A Business Risk Approach

Sixth Edition

Chapter 12

Audit of Acquisition Cycle and Inventory

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Overview of Acquisition Cycle

The acquisition cycle covers the purchase, receipt, payment, and accounting for goods and services

Major accounts include inventory, accounts payable, and expenses

Main phases in the acquisition and payment process:Authorized requisitionAuthorized purchaseReceipt of goods and services Approval for paymentCash disbursement

Risk and Business Analysis

Acquisition cycle deals with receipt of all goods and servicesMisstatements may occur just because of the volume of

transactionsIt 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

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

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 accountsCompute and analyze ratios like inventory turnover and

number of day's sales in inventoryPrepare common sized income statement to identify

cost of good sold or expense accounts that are out of line

Auditor compares client analytics to past client performance, industry results, and auditor's expectations

Overview of Control Procedures and Control Risk Assessment

Requisition goods or services Need identified Pre-numbered requisition form completed and sent to

purchasing

Purchase 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 qualityReduces fraud by separating purchasing from custody and

recordingCentralizes control in one locationControls set to stop purchasing agents from abusing their positions

Overview of Control Procedures and Control Risk Assessment

(continued)

Receive goods Receiving department should ensure

Only authorized goods are receivedThe goods meet order specificationsAn accurate count of goods received is takenAll receipts of goods are recorded

Receiving reports are pre-numbered to establish completeness

Receiving department records quantity of goods received

Goods also inspected for qualityReceiving reports sent to accounting

Overview of Control Procedures and Control Risk Assessment

(continued)

Approve payment Accounting matches vendor invoice, purchase order,

and receiving reports - If quantity 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

Testing Controls over Accounts Payable and Related Expenses

The primary risk is that Accounts Payable and expenses will be understated

Therefore, controls related to the following are usually significant: Proper authorizationCompleteness of recordingTimeliness of recordingCorrectness of valuation

Attribute sampling (Chapter 9) may be used to test control operation

The level of assessed control risk will impact the rigor of the subsequent substantive testing of Accounts Payable and expenses

What are some substantive tests of accounts payable?

The auditor's main concern is that Accounts Payable will be understated

Therefore, emphasis is placed on testing the completeness assertion

Typical substantive tests include:Reconcile vendor statements or confirm

accounts payableTests of subsequent disbursementsAnalytical review of related accounts

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

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

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

Auditing of Expense Accounts

Auditing payables and cash disbursements provides indirect evidence about expense accounts

Additional analysis of selected expense accounts is usually merited

The auditor should consider management is more likely toUnderstate rather than overstate expensesClassify expenses as assets rather than vice versa

Substantive audit procedures include:Detailed tests of transactionsAnalytical reviewReview of unusual entries

Auditing of Inventory and Cost of Goods Sold

Audit of inventory is complicated by a number of factors including:Variety (diversity) of itemsHigh volume of activityVarious (sometimes complex) valuationDifficulty in identifying obsolete or defective inventoryMany frauds involve the inventory accountEasily transportable making it subject to double

countingMay be stored at multiple locations, some may be

remoteMay be returned by customers

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

Substantive Tests of Inventory and Cost of Goods Sold

Existence: observe year-end physical inventory

Completeness: cutoff testsRights: review long-term contracts,

etc.Valuation: direct tests and analyticsDisclosure: review GAAP

Explain Procedures for Observing a Client's Physical Inventory

Meet with client to discuss their plan to count inventoryReview client's plans for counting and tagging

inventoryReview inventory counting procedures with audit

personnelDetermine whether specialists are needed to identify

inventory itemsUpon arriving at each site:

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

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

obtain document numbers for last receipt and shipment for cutoff tests

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 itemsMake selected test countsItems that appear obsolete or defectiveHigh-dollar value items in inventoryMovement of inventory during counting process

Document conclusion as to quality of the inventory counting process

Procedures for Observing a Client's Physical Inventory

What does the auditor do after the inventory count?

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 recordsTrace the obsolete or damaged inventory

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

Counting Inventory Before or After Year-end

On occasion, it may not be feasible to count inventory at year-end

Acceptable to count inventory before or after year-end if:Controls are strongThe opportunity and motivation to misstate inventory

is lowAuditor 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

Completeness

Inventory cutoff tests:Obtain information on last items shipped and received

at year-endCompare this information to transactions recorded in

the sales and purchases journalDetermine 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)

Allowance for Returns

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

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

Inventory Valuation

Most complex assertion related to inventory because of the:Volume of transactionsDiversity of productsVariety of costing methodsDifficulty in estimating net realizable value of

products

Inventory Valuation (continued)

Auditor 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

Appropriate Disclosure

Auditor reviews client disclosure for compliance with GAAP

Disclosure should include:Costing method(s) usedFrequency of accountingInventory pledged as collateralAny other unusual circumstance

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