Auditing the Expenditure Cycle

CHAPTER 10

3 MAIN SECTIONS:

A. Expenditure Cycle Activities and Technologies

B. Expenditure Cycle Audit Objectives, Controls, and Tests of Controls
C. Substantive Tests of Expenditure Cycle Accounts

A. EXPENDITURE CYCLE ACTIVITIES AND TECHNOLOGIES

1. Purchases and Cash Disbursement Procedures Using Batch Processing Technology

2. Reengineering the Purchases/Cash Disbursement System
3. Overview of Payroll Procedures

Purchases and Cash Disbursement Procedures Using Batch Processing Technology

The following section describes the sequence of events as they occur in this system.

Data Processing Department: Step 1

 The purchasing process begins in the data processing department, where the inventory control function is
performed.
 When inventories are reduced by sales to customers or usage in production, the system determines if the
affected items in the inventory subsidiary file have fallen to their reorder points.
 If so, a record is created in the open requisition file. Each record in the open requisition file defines a separate
inventory item to be replenished.
 The record contains the inventory item number, a description of the item, the quantity to be ordered, the
standard unit price, and the vendor number of the primary supplier.
 The information needed to create the requisition record is selected from the inventory subsidiary record.
 The inventory subsidiary record is then flagged “On Order” to prevent the item from being ordered again before
it arrives.
 At the end of the day, the system sorts the open requisition file by vendor number and consolidates multiple
items from the same vendor in to a single requisition.
 Next, vendor mailing information is retrieved from the valid vendor file to produce purchase requisition
documents.
 Copies of these documents go to manual procedures in the purchasing and accounts payable (AP) departments.

Purchasing Department
  Upon receipt of the purchase requisition, the purchasing department prepares a five-part purchase order.
Copies go to the vendors, accounts payable, receiving, data processing, and the purchasing department’s own
file.

Data Processing Department: Step 2

 Returning to Figure 10.1, the purchase order is used to create an open purchase order record and to transfer the
corresponding record(s) in the open purchase requisition file to the closed purchase requisition file.

Receiving Department

 When the goods arrive from vendors, the receiving clerk prepares a receiving report. Copies go to purchasing,
accounts payable, and data processing.

Data Processing Department: Step 3

 The data processing department runs a batch job (Step 3) that updates the inventory subsidiary file from the
receiving reports and removes the “On Order” flag from the inventory records. The system calculates batch
totals of inventory receipts for the general ledger update procedure and then closes the corresponding records
in the open purchase order file to the closed purchase order file.

Accounts Payable.

 When the accounts payable clerk receives the supplier’s invoice, he or she reconciles it with the supporting
documents that were previously placed in the accounts payable pending file. The clerk then prepares a voucher,
files it in the open voucher file, and sends a copy of the voucher to data processing.

Data Processing Department: Step 4

 A batch program validates the voucher records against the valid vendor file, adds them to the voucher register
(or open AP subsidiary file), and prepares batch totals for posting to the AP control account in the general
ledger.

Cash Disbursement: Data Processing Department.

 Each day, the system scans the Due Date field of the voucher register for items due. Checks are printed for these
items, and each check is recorded in the check register (cash disbursements journal).
 The check number is recorded in the voucher register to close the voucher and transfer the items to the closed
AP file. The checks, along with a transaction listing, are sent to the cash disbursements department.
 Finally, batch totals of closed accounts payable and cash disbursements are prepared for the general ledger
update procedure.
 At the end of the day, batch totals of open (unpaid) and closed (paid) accounts payable, inventory increases, and
cash disbursements are posted to the accounts payable control, inventory control, and cash accounts in the
general ledger.
 The totals of closed accounts payable and cash disbursements should balance.

Cash Disbursement: Cash Disbursements Department

  The cash disbursements clerk reconciles the checks with the transaction listing and submits the negotiable
portion of the checks to management for signing.
 The checks are then mailed to the suppliers. One copy of each check goes to accounts payable, and the other
copy is filed in cash disbursements along with the transaction listing.

Cash Disbursement: Accounts Payable.

 Upon receipt of the check copies, the accounts payable clerk matches them with open vouchers and transfers
these closed items to the closed voucher file. The expenditure cycle process concludes with this step.

 Alternative Inventory Ordering Procedures

 Reengineering the Purchases/Cash Disbursement System

Data Processing
The following tasks are performed automatically:

 The inventory file is searched for items that have fallen to their reorder point.
 A record is entered in the purchase requisition file for each item to be replenished.
 Requisitions are then consolidated according to vendor number.
 Vendor mailing information is retrieved from the valid vendor file.
 Purchase orders are prepared and sent to the vendor. Alternatively, these may be transmitted using EDI
technology.
 A record of each transaction is added to the open purchase order file.
 A transaction listing of purchase orders is sent to the purchasing department for review.

Receiving Department

 When the goods arrive, the receiving clerk accesses the open purchase order file in real time by entering the
purchase order number taken from the packing slip. The receiving screen then prompts the clerk to enter the
quantities received for each item on the purchase order.

Data Processing

 Quantities of items received are matched against the open purchase order record, and a “Y” value is placed in a
logical field to indicate the receipt of inventories.
 A record is added to the receiving report file.
 The inventory subsidiary records are updated to reflect the receipt of the inventory items.
 The general ledger inventory control account is updated.
 The record is removed from the open purchase order file and added to the open AP file, and a due date for
payment is established.

Each day, the Due Date fields of the accounts payable records are checked for items due to be paid. The following
procedures are performed for the selected items:

 Checks are printed, signed, and distributed to the mailroom for mailing to vendors.
 EDI vendors receive payment electronically.
 The payments are recorded in the check register file.
 Items paid are transferred from the open accounts payable file to the closed AP file.
 The general ledger accounts payable and cash accounts are updated.
 Reports detailing these transactions are transmitted via terminal to the accounts payable and cash
disbursements departments for management review and filing.

Since the financial information about purchases is known in advance from the trading partner agreement, the
vendor’s invoice provides no critical information that cannot be derived from the receiving report.

 Automated versus Reengineered System (Advantages and Control Implications)

The Automated System

 Improved Inventory Control

 Better Cash Management
 Less Time Lag
 Better Purchasing Time Management
 Reduction of Paper Documents

The Reengineered System

Advantages

 it uses real-time procedures and direct-access files to shorten the lag time in recordkeeping;
 it eliminates routine manual procedures through automation; and
 it achieves a significant reduction in paper documents by using electronic communications between
departments and by storing records on direct-access media.

Control Implications
 Segregation of Duties
 Accounting Records and Access Controls

Overview of Payroll Procedures

Drawbacks when payroll checks are processed through the regular accounts payable and cash
disbursements system:

 General expenditure procedures that apply to all vendors will not apply to employees
 Writing checks to employees requires special controls
 General expenditure procedures are designed to accommodate a relatively smooth flow of transactions

Reengineering the Payroll System

Human Resource Management (HRM) System - captures and processes a wide range of personnel-related data,
including employee benefits, labor resource planning, employee relations, employee skills, personnel actions (pay rates,
deductions, and so on), as well as payroll.

This system differs from the simple automated system described previously in the following ways:

(1) operations departments transmit transactions to data processing via terminals,

(2) direct access files are used for data storage, and

(3) many processes are now performed in real time. We discuss the key operating features of this system as follows:

 Personnel.
 Cost Accounting.
 Timekeeping.
 Data Processing:
1) Labor costs are distributed to various work-in-process, overhead, and expense accounts.
2) An online labor distribution summary file is created. Copies of the file go to the cost accounting and general
ledger departments.
3) An online payroll register is created from the attendance file and the employee file. Copies of the files go to the
accounts payable and cash disbursements departments.
4) The employee records file is updated.
5) Payroll checks are prepared and signed. They are sent to the treasurer for review and reconciliation with the
payroll register. The paychecks are then distributed to the employees.
6) The disbursement voucher file is updated and a check is prepared for the funds transfer to the payroll imprest
account. The check and a hard copy of the disbursement voucher go to cash disbursements. One copy of the
voucher goes to the general ledger department, and the final copy goes to accounts payable.
7) At the end of processing, the system retrieves the labor distribution summary file and the disbursements
voucher file and updates the general ledger file.

B. EXPENDITURE CYCLE AUDIT OBJECTIVES, CONTROLS, AND TESTS OF CONTROLS

1. Input Controls
2. Process Controls
3. Output Controls
Input Controls

 Input controls are designed to ensure that transactions are valid, accurate, and complete.

The following input controls relate to expenditure cycle operations.

a) Data Validation Controls - Input validation controls are intended to detect transcription errors in transaction
data before they are processed. Tests of validation controls provide evidence about the accuracy assertion.
General types of validation tests are:
 Missing data checks are used to examine the contents of a field for the presence of blank spaces.
 Numeric-alphabetic data checks determine whether the correct form of data is in a field.
 Limit checks determine if the value in the field exceeds an authorized limit.
 Range checks assign upper and lower limits to acceptable data values.
 Validity checks compare actual values in a field against known acceptable values.
 Check digit controls identify keystroke errors in key fields by testing their internal validity.

b) Batch Controls - Batch controls are used to manage high volumes of transaction data through a system.
Tests of batch controls provide the auditor with evidence relating to the assertions of completeness and
accuracy. Periodic reconciliation provides assurance of the following:
 All invoices that were entered into the system were processed.
 No invoices were processed and paid more than once.
 All invoices entered into the system are accounted for as either successfully processed or rejected
because of errors.

c) Purchases Authorization Controls - Purchases authorization actually occurs in the revenue cycle when goods
are sold to customers. At that time, the system compares the quantity-on-hand with the reorder point to
determine if the inventory needs to be reordered. Tests of purchases authorization controls provide
evidence pertaining to the accuracy and valuation assertions.

d) Employee Authorization - The authorization of employees should be done to help prevent fraud like creating
checks for “ghost” employees. Tests of employee authorization provide evidence pertaining to the
existence, accuracy, valuation, and rights and obligation assertions.

Process Controls

- Process controls include computerized procedures for updating files and restricting access to data.
 a) File Update Controls - Run-to-run controls use batch control data discussed in the previous section to
monitor the batch as it moves from one programmed procedure (run) to another. These controls ensure
that each run in the system processes the batch correctly and completely. Tests of file update controls
provide the auditor with evidence relating to the management assertions of existence, completeness,
rights and obligations, and accuracy.
 Sequence Check Control. - A sequence check control needs to be in place to compare the sequence of
each record in the batch with the previous record to ensure that proper sorting took place.
 Liability Validation Control. - An important control in purchases/accounts payable systems is the
validation of the liability prior to making payment.
 Valid Vendor File.- The valid vendor file is similar to the authorized employee file. This file consists of
a list of vendors with whom the organization normally does business.

b) Access Controls - Access controls prevent and detect unauthorized and illegal access to the firm’s assets.
Evidence gathered about the effectiveness of access controls tests the management assertions of
existence, completeness, accuracy, valuation and allocation, rights and obligations, and presentation
and disclosure.
The following are examples of risks specific to the expenditure cycle:
 An individual with access to the AP subsidiary ledger (and supporting documents) could add his
or her account (or someone else’s) to the file. Once recognized by the system as a legitimate
liability, the account will be paid even though no purchase transaction transpired.
 Access to employee attendance cards may enable an unauthorized individual to trigger an
unauthorized paycheck.
 An individual with access to both cash and accounts payable records could remove cash from
the firm and record the act as a legitimate disbursement.
 An individual with access to physical inventory and inventory records can steal products and
adjust the records to cover the theft.

c) Physical Controls - Physical controls include manual activities and human actions to initiate computer
procedures to safeguard the assets of the organization. Evidence gathered by reviewing the segregation
of duties can be used to test all of the management assertions.
The relevant physical controls for the purchases and payroll systems are the following:
 Purchases System Controls
a. Segregation of inventory control from the warehouse
b. Segregation of the general ledger and accounts payable from cash disbursements
c. Supervision of receiving department. (Inspection of assets & Theft of assets).
d. Reconciliation of supporting documents (The purchase order, The receiving report & The
supplier’s invoice)
 Payroll System Controls
a. Verification of timecards
b. Supervision
c. Paymaster
d. Payroll imprest account

Output Controls
 - Output controls are designed to ensure that information is not lost, misdirected, or corrupted and that system
processes function as intended. Evidence gathered through tests of output controls relates to the completeness and
accuracy assertions.

The following are examples of audit trail output controls:

a) Accounts Payable Change Report - This document is a summary report that shows the overall change to
accounts payable.
b) Transaction Logs - Every transaction successfully processed by the system should be recorded on a
transaction log, which serves as a journal.
c) Transaction Listing - the system should produce a (hard copy) transaction listing of all successful
transactions.
d) Log of Automatic Transactions - To maintain an audit trail of these activities, all internally generated
transactions must be placed in a transaction log, and a listing of these transactions should be sent to the
appropriate manager for review.
e) Unique Transaction Identifiers - Each transaction processed by the system must be uniquely identified
with a transaction number.
f) Error Listing - A listing of all error records should go to the appropriate user to support error correction
and resubmission.

C. SUBSTANTIVE TESTS OF EXPENDITURE CYCLE ACCOUNTS

Understanding Data

 Inventory File

The Inventory file contains quantity, price, supplier, and warehouse location data for each item of
product inventory.

 Purchase Order File

This file contains records of purchases placed with suppliers.
 Purchase Order Line Item File
The Line Item file contains a record of every item ordered.
 Receiving Report File

When the ordered items arrive from the supplier, they are counted and inspected, and receiving
documents are prepared.

 Disbursement Voucher File.

Based on the supplier’s terms of trade and the company’s payment policy, the payment due date is
determined and placed in the disbursement voucher record.

Testing the Accuracy and Completeness Assertions

  Review Disbursement Vouchers for Unusual Trends and Exceptions
a) ACL’s Stratify and Classify
o The stratify function groups financial data into specific strata.
o The classify function forms strata based on nonfinancial (and nonnumeric) data.

 Reviewing for Accurate Invoice Prices

o ACL allows the auditor to compare the prices charged on every invoice in the file for the period
under review.

Testing the Completeness, Existence, and Rights and Obligations Assertions

 Searching for Unrecorded Liabilities

 Searching for Unauthorized Disbursement Vouchers
 Review for Multiple Checks to Vendors
 Auditing Payroll and Related Accounts