AUDIT OF THE EXPENDITURE CYCLE: TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS – I

Nature of the Expenditure Cycle

 Expenditure cycle involved the activities associated with the acquisition and payment of goods and services, plant assets
and labor.
 For trading concern, the major classes of transaction in this cycle are:
a. Acquisitions
b. Cash disbursements
c. payroll
 For Manufacturing Firm, production cycle transactions and inventory warehousing transactions are included in the
expenditure cycle in addition to the above-mentioned major classes of transactions.
 This cycle does not include
o Acquisition of short-term or long-term securities
o Redemption of long-term debt
o Reacquisition of a company’s share capital
 Transactions in the expenditure cycle often affect more financial statement accounts than the other cycles combined.
o On the statement of financial position, the expenditure cycle impacts on all current assets, except marketable
securities and receivables, all plant and intangible assets, and many current liabilities.
 Transaction in this cycle involves major expenses reflected in the Income Statements.
 Accounts affected by the expenditure cycle
o Purchases
o Accounts and notes payable – trade
o Purchase returns and allowances
o Cash in bank (credit for cash disbursements)
o Purchase discount
o Inventories (merchandise; finished goods; raw materials; goods in process)
o Manufacturing and operating expenses requiring cash payments

Documents Used in the Expenditure Cycle

1. Purchase Requisition – a prenumbered document that originates in the inventory stockroom or an operating department
and indicates to the purchasing department that goods should be ordered.
- A requisition describes the items, specifies the quantity needed, and indicates the requester.
- It provides evidence that the purchasing department was authorized to initiate a purchase.
2. Purchase Order – a prenumbered document recording the description, quantity, and related information for goods and
services the company intends to purchase.
- It is frequently used to indicate authorization to procure goods and services.
- It contains the signature of the employee who authorized a purchase from a vendor.
3. Receiving Report – a prenumbered document prepared at the time tangible goods are received that indicates the
description of goods, the quantity received, the date received, and other relevant data.
- This is prepared within the entity and provides evidence that goods were received
4. Vendor’s Invoice – a document that indicates the description and quantity of goods and services received, price, including
freight, cash discount terms, and date of the billing.
- It is created externally and provides evidence about a purchase of goods or services.
5. Debit Memo – a prenumbered document indicating a reduction in the amount owed to a vendor because of returned goods
or an allowance granted.
6. Voucher – a prenumbered document to establish a formal means of recording and controlling acquisitions prepared by a
payables clerk for each payment.
- A vendor’s invoice, a receiving report and purchase order are attached to it.
- It provides documentation for the recording of a transaction.
7. Check – a prenumbered written authorization to a bank to transfer funds to the payee.
- Checks are used as a means of payment.
- Check that has been presented for payment is referred to as PAID or canceled check.
- A paid check provides evidence about payments that an entity has made, such as date, payee and
amount.
8. Vendor’s Statement – a statement prepared monthly by the vendor indicating the beginning balance, acquisitions, and
returns and allowances, payments to the vendor, and ending balance.
- It may be used to determine that all transactions recorded on the statements have been recorded in the
books.

Accounting Records Involved in the Expenditure Cycle

1. Purchase Journal – a journal for recording purchase transactions.
2. Cash Disbursement Transaction File/Journal – a file for recording the individual payment made by check.
- It contains the total cash paid, the debit to accounts payable at the amount the transaction was recorded
in the acquisition transaction file, discounts taken, and other debits and credits.
3. Accounts Payable master File/Subsidiary Ledger – a file for recording individual acquisitions, cash disbursements, and
acquisition returns and allowanced for each vendor.

Audit of Acquisitions and Cash Disbursements Transactions

 The transaction typically classified in the acquisition and cash disbursement cycle flow through these business activities:
1. Processing purchase orders
2. Reserving goods and services
3. Recognizing the liability
4. Processing and recording cash disbursements

Test of Controls: Acquisitions

 Assertions
General Specific
Existence or Occurrence Recorded acquisitions are for items that were acquired
Completeness Acquisitions that occurred are recorded
Rights and Obligations Recorded acquisitions are the entity’s purchases and liabilities
Valuation or Allocation Acquisitions are recorded for the proper amounts
Presentation and disclosure Acquisitions are recorded to result in presentation and disclosure in accordance with
PAS/PFRS
 Existence or Occurrence: Recorded acquisitions are for items that were acquired
Controls Test of Controls
1. Acquisition should be approved by authorized  Auditor should examine the approval signature.
personnel. Approval of acquisition is evidenced by
signature on the purchase order.
2. A voucher should be prepared for the purchase of  The auditor observes the procedure and examines
goods. This should be supported by properly file of documents. If the entity does not prepare
executed purchase requisition, purchase order,
 receiving report, and vendor’s invoice.
3. The check signer should examine the supporting
documentation and cancel the documents, making
them “paid” or writing the date and number of the
check on the document.
 Completeness: Acquisitions that occurred are recorded
Controls
4. Prenumbered receiving reports should be used and
accounted for to determine that a liability is
recorded for all goods received.
5. Vouchers are prenumbered and accounted for as
they are entered in the voucher register.
 Rights and Obligations: Recorded acquisitions are the entity’s purchases and liabilities
Controls
6. Receiving reports should be prepared by persons
having access only to a blind copy of purchase
order details. Requiring a purchase order for the
recording of all acquisitions will preclude recording
consigned goods as well as goods ordered for
personal use of employees.
 Valuation or Allocation: Acquisitions are recorded for the proper amounts
Controls
7. Invoice amounts are verified by a clerk by reference
to the purchase orders and receiving reports.
Mathematical accuracy of the invoice is also
rechecked.
 Presentation and disclosure: Acquisitions are recorded to result in presentation and disclosure in accordance with
PAS/PFRS
Controls
8. Require employees to use a chart of accounts that
adequately describes accounts to be debited.
Account coding is assigned by one person and
checked by another.
vouchers, the auditor should review the entries in
the purchases journal and examine the documents
underlying them for authenticity and
reasonableness.
 The auditor can examine cancellations on the
documents to test this control. If an entity does not
effectively cancel supporting documents, the
auditor should be concerned that duplicate
payment may have been made and should scan the
voucher register for multiple entries of similar
amounts.
Test of Controls
 The auditor should observe the procedure and
account for the numerical sequence of the receiving
report.
 The auditor should observe procedure and account
for the numerical sequence of the voucher.
Test of Controls
 The auditor should observe that the procedure is
being performed.
Test of Controls
 The auditor should examine the voucher for
signature indicating performance.
Test of Controls
 Auditor should examine the chart of accounts. Also,
he should examine the signature of employee
performing the checking or verification.

Audit Program for Test of Controls: Acquisitions Transactions

 Audit Procedures
1. For a sample of purchases, examine the related purchase requisition and purchase order.
2. For a sample of purchases, trace the transaction to the voucher register and the perpetual inventory records
maintained in stores.
3. Check vendor invoice for mathematical accuracy
4. Trace posting from the voucher register to the general ledger.
 Possible errors that may result due to control weaknesses over acquisition transactions follow:
Internal Control Weaknesses or Factors Example of Fraud / Error Description of Possible Errors or
that Increase the Risk of the Misstatements
Misstatement
1. Documentation of purchase  A purchase order is made for  Unauthorized purchases;
transactions, incomplete and goods that have not been payments made to vendors for
inadequate; ineffective authorized or requested. goods and services not
controls for matching purchase authorized.
requisitions with purchase
orders.
2. Ineffective controls for  Goods are ordered but  Misappropriation of goods
matching invoices with delivered to an inappropriate purchased.
receiving documents before address and stolen.
disbursements are authorized.
3. Inadequate segregation of  A bookkeeper prepares a  Inaccurate recording of a
duties of record keeping and check to himself and records purchase or disbursement.
preparing cash disbarments, or it as having been issued to a
check signer does not review major supplier.
and cancel supporting
documents.
4. Ineffective controls for review  A purchase is recorded when  Duplicate recording of
and cancellation of supporting an invoice is received from a purchases.
documents by the check vendor and recorded again
signer. when a duplicate invoice is
sent by the vendor.
5. Accounting manuals not used.  Purchase of merchandise  Error in recording purchase
erroneously recorded as transactions.
purchase of equipment.
6. Creditors’ statement not  Creditor is paid twice when  Undetected errors in recording
examined for possible errors. bookkeeper fails to reconcile purchase transactions.
postings in the AP subsidiary
ledger with creditor’s
statement of account.
7. Ineffective board of directors,  Purchases journal “closed  Late (early) recording of cost of
audit committee, or internal early” with this period’s purchases – “cutoff problems”
audit function; top purchases recorded as having
management action not occurred in subsequent
conducive to ethical conduct; period.
undue pressure to meet
earnings target

Substantive Tests of Transactions: Acquisitions

Assertions Audit Objectives Audit Procedures
 1. Existence or Occurrence A. To determine that recorded  Examine underlying
purchases are for items that documents for authenticity
was acquired. and reasonableness. Scan
voucher register for large or
unusual items. Inspect
acquired PPE. Trace inventory
purchase to perpetual records.
Scan voucher register for
duplicate payments.
2. Completeness B. To determine that purchases  Trace a sequence of receiving
that occurred are recorded. reports to entries in the
voucher register. Test cutoff.
Account for a sequence of
entries in the voucher register.
3. Rights and Obligations C. To determine that purchases  Trace from invoices to
are the entity’s acquisitions perpetual inventory records.
and liabilities. Examine vendor’s invoices to
determine that goods were
purchased
4. Valuation of allocation D. To determine that purchases  Recompute invoices and
are recorded for the proper compare invoice prices to
amounts purchase order.
5. Presentation & Disclosure E. To determine that purchases  Check accuracy of accounts on
are recorded to result in invoices by reference to chart
presentation and disclosure of accounts
in accordance with PAS/PFRS
 Examine underlying documents for authenticity and reasonableness. Scan voucher register for large or
unusual items. Inspect acquired PPE. Trace inventory purchase to perpetual records. Scan voucher register for
duplicate payments.
- To test existence of acquisitions transactions in the voucher register, an auditor should examine
for selected transactions, the underlying documents, the voucher, purchase order, receiving report and
vendor’s invoice.
- The auditor should also physically inspect additions to fixed assets to substantiate their existence and
trace inventory purchases to perpetual records.
- The auditor can scan the voucher register as well as files of check copies to them for possible duplicate
payments of invoices.
 Trace a sequence of receiving reports to entries in the voucher register. Test cutoff. Account for a sequence of
entries in the voucher register.
- The auditor may select a sequence of receiving reports and vouchers to determine that entries have been
made for them in the voucher register or purchases journal.
- He can perform a cutoff test at year-end to ascertain that all acquisitions occurring during the year have
been recorded,
 Trace from invoices to perpetual inventory records. Examine vendor’s invoices to determine that goods were
purchased
- The auditor should examine supporting documents to ascertain that goods were not received on
consignment, that the goods were not delivered to another location, simply that the ordered goods were
received.
- These supporting document include the voucher, vendor’s invoice, receiving report, purchase order, and
purchase requisition.
 Recompute invoices and compare invoice prices to purchase order.
- To ensure that acquisitions are recorded for proper amounts, auditor may select a sample of transactions
and examine the purchase requisition, trace the price to the purchase order, compare the quantity on the
invoice with the quantity on the receiving report and recalculate the invoice total.
- The auditor might also choose to perform the substantive testing of prices paid by tracing prices in
published catalogs at the time of the purchase.
 Check accuracy of accounts on invoices by reference to chart of accounts
- Auditors can review documents underlying entries in the voucher register to determine whether the
invoice was correctly coded and will be properly presented and disclosed in the financial statements.
- This procedure can be performed simultaneously with substantive tests of valuation.

Audit of Cash Disbursements

Test of Controls: Cash Disbursements Transactions

 Assertions
General Specific
Existence or Occurrence Recorded cash disbursements occurred
Completeness All cash disbursements made are recorded
Rights and Obligations All cash disbursements made are for obligations of the entity
Valuation or Allocation Debits to various accounts and credits to cash are valued at proper amounts
Presentation and disclosure Cash disbursements are recorded to result in presentation and disclosure in accordance
with PAS/PFRS
 Existence or Occurrence: Recorded cash disbursements occurred
Controls Test of Controls
1. Authorized individual signs and mails promptly the  The auditor may inquire of the check signer and
checks after reviewing documentation. employees who work with him about whether this
procedure is followed.
 The auditor may also observe if the procedure is
being followed.
2. A review should be made by a person not  The auditor may inquire about whether this
responsible for handling disbursements to procedure is being followed or may examine the
determine that checks are processed on a timely outstanding checks list to determine that checks
basis. are being processed promptly.
 Completeness: All cash disbursements made are recorded
Controls Test of Controls
3. Checks should be prenumbered and accounted for  The auditor should observe whether the employee
to ensure that all checks that were written are who prepares the check register accounts for the
entered in the check register. sequence of the checks.
4. An employee who does not handle disbursements  The auditor observed that the employee who
and cash receipts prepares the bank reconciliation prepares the reconciliation does not handle cash
receipts or disbursements. In addition, the auditor
 inspects the reconciliation.
 Rights and Obligations: All cash disbursements made are for obligations of the entity
Controls Test of Controls
5. Checks signer who is independent of voucher  The auditor inquiries about the segregation of
preparation should examine the supporting duties and observing whether separation really
documentation before signing checks to determine exists.
that the payment is for an obligation of the entity.  He can also inquire about the check signer’s
procedures for reviewing documents in support of
cash disbursement and may observe the check
signer performing these procedures.
 Valuation or Allocation: Debits to various accounts and credits to cash are valued at proper amounts
Controls Test of Controls
6. Checks signer who is independent of voucher  The auditor inquiries about the segregation of
preparation should examine the supporting duties and observing whether separation really
documentation before signing checks to determine exists.
that the payment is for an obligation of the entity.  He can also inquire about the check signer’s
procedures for reviewing documents in support of
cash disbursement and may observe the check
signer performing these procedures.
 Presentation and disclosure: Cash disbursements are recorded to result in presentation and disclosure in accordance
with PAS/PFRS
Controls Test of Controls
7. Chart of accounts adequately described accounts to  The auditor observes the procedure. He can also
be used, and account coding is assigned by one examine the signatures of the employees
person and checked by another. performing the review account coding.

Audit Program for Tests of Controls: Cash Disbursements Transactions

 Audit Procedures
1. Prove the arithmetical accuracy of the cash disbursements record and trace postings to the general ledger.
2. Compare paid bank checks with the cash disbursement records.
3. Account for all checks.
4. Reconcile recorded disbursements with the bank statement.
5. Examine supporting documents.
6. Review cash disbursement records for unusual items.
 Possible errors that may result due to control weaknesses over payment to vendors follow:
Internal Control Weaknesses or Factors Example of Fraud / Error Description of Possible Errors or
that Increase the Risk of the Misstatements
Misstatement
1. Inadequate segregation of  A bookkeeper prepares a  Inaccurate recording of a
duties of record keeping and check to himself and records it purchase or disbursements.
preparing cash disbursements, as having been issued to a
or check signer does not major supplier.
review and cancel supporting
documents.
2. Ineffective controls for  A disbursement is made to pay  Inaccurate recording of a
matching invoices with an invoice for goods that have purchase or disbursement.
receiving documents before not been received.
disbursements are authorized.
3. Ineffective accounting coding  Disbursements for travel and  Inaccurate recording of a
procedures may result from entertainment are improperly purchase or disbursement
incompetent accounting included with merchandise
personnel, inadequate chart of purchases.
accounts, or no controls over
the posting process.
4. Ineffective controls for review  A purchase is recorded when  Duplicate recording and
and cancellation of supporting an invoice is received from a payment of purchases.
documents by the check vendor and recorded again
signer. when a duplicate invoice is
sent by the vendor.
5. Ineffective control over record  In conjunction with unrecorded  Unrecorded disbursements.
keeping for and access to cash (but deposited) cash receipts,
an employee writes and
cashes an unrecorded check
for the identical amount.

Substantive Tests of Transactions: Cash Disbursements

Assertions Audit Objectives Audit Procedures
1. Existence or Occurrence A. To determine that recorded  Examine paid checks for
cash disbursements occurred appropriate endorsements.
Examine documents
underlying payments.
2. Completeness B. To determine that all cash  Reconcile cash disbursements
disbursements made are per books with cash
recorded. disbursements per the bank.
Prepare or test bank
reconciliation.
3. Rights and Obligations C. To determine that all cash  Examine underlying
disbursements made were documents
the entity’s obligations
4. Valuation of allocation D. To determine that debits to  Recalculate invoices paid.
various accounts and credits
to cash are valued at proper
amounts.
5. Presentation & Disclosure E. To determine that cash  Check accuracy of accounts on
disbursements are recorded to invoices by reference to chart
result in presentation and of accounts
disclosure in accordance with
PAS/PFRS

 Examining Documents underlying Cash Disbursements.

 - Auditors examine the documents underling cash disbursements such as receiving reports, purchase order,
purchase requisitions, and vendor’s invoice for consistency with each other and with the entry in the cash
disbursements journal.
 Approvals on these documents provide evidence that the transaction occurred and that the
payments was the entity’s debt.
- Checks with appropriate endorsements and which have been paid by the bank provide evidence about the
existence of the transactions.
- The auditor likewise recomputes the discount taken to verify proper valuation of cash disbursement
transactions.
- Accuracy of accounts charged may also be verified by the auditor by reference to the char of accounts.
 Reconciling Cash Disbursements per Books to Cash Disbursements per Bank
- The auditors may prepare a proof of cash which reconciles cash disbursements as recorded on the bank
with cash disbursement recorded by the bank.
 Preparing or Testing Reconciliation
- The auditor can prepare bank reconciliation or test a bank reconciliation prepared by the client for an
interim period.
 When preparing the bank reconciliation, the auditor should receive the bank statement directly
from the bank.
- If the banks statement has been opened by the client’s employee, the auditor generally compares the
individual entries on in with the documents returned by the bank and looks for erasures, changes or other
irregularities on the statement.