NOTES ON AUDIT OF THE EXPENDITURE AND DISBURSEMENT CYCLE/CORRECTION OF ERRORS

THE EXPENDITURE AND DISBURSEMENTS CYCLE

Disbursement Cycle
The processes for identifying products or services to be acquired, purchasing goods and services, receiving
the goods, approving payments, and paying for goods and services received.

The major accounts in the acquisition and payment cycle are INVENTORY, COST OF GOODS SOLD,
ACCOUNTS PAYABLE, and other expense accounts.

INVENTORY

IAS 2.6 Inventories are assets:

(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or in the
rendering of services.

IAS 2.7 Net realisable value refers to the net amount that an entity expects to realise from the sale of
inventory in the ordinary course of business. Fair value reflects the price at which an orderly transaction
to sell the same inventory in the principal (or most advantageous) market for that inventory would take
place between market participants at the measurement date. The former is an entity‑specific value; the
latter is not. Net realisable value for inventories may not equal fair value less costs to sell.

Inventory measurement – LCNRV

1. Initially recorded at cost
2. IAS 2.9 – Measured at lower of cost of net realisable value (LCNRV)
Net realisable value (NRV) - is the estimated selling price in the ordinary course of
business less the estimated costs of completion and the estimated costs necessary to
make the sale. Not the same as fair value, which is the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date.
3. Recorded as an expense when sold, in the same period as when the revenue is recognised.

Cost of inventories

IAS 2.10 Cost of inventories

The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred
in bringing the inventories to their present location and condition.

IAS 2.11 Costs of purchase

The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other
than those subsequently recoverable by the entity from the taxing authorities), and transport, handling
and other costs directly attributable to the acquisition of finished goods, materials and services. Trade
discounts, rebates and other similar items are deducted in determining the costs of purchase.

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IAS 2.12 Costs of conversion
The costs of conversion of inventories include costs directly related to the units of production, such as
direct labour. They also include a systematic allocation of fixed and variable production overheads that
are incurred in converting materials into finished goods. Fixed production overheads are those indirect
costs of production that remain relatively constant regardless of the volume of production, such as
depreciation and maintenance of factory buildings, equipment and right‑of‑use assets used in the
production process, and the cost of factory management and administration. Variable production
overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of
production, such as indirect materials and indirect labour.

IAS 2.15-18 Other costs

Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the
inventories to their present location and condition. For example, it may be appropriate to include
non‑production overheads or the costs of designing products for specific customers in the cost of
inventories.

Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which
they are incurred are:
(a) abnormal amounts of wasted materials, labour or other production costs;
(b) storage costs, unless those costs are necessary in the production process before a further
production stage;
(c) administrative overheads that do not contribute to bringing inventories to their present
location and condition; and
(d) selling costs.

An entity may purchase inventories on deferred settlement terms. When the arrangement effectively
contains a financing element, that element, for example a difference between the purchase price for
normal credit terms and the amount paid, is recognised as interest expense over the period of the
financing.

Inventory composition

1. Manufacturing companies – raw materials, work-in-progress, finished goods

2. Merchandising companies – merchandise for sale (finished goods)
3. Costs incurred in bringing the inventories to their present location and condition
a. Taxes and import duties
b. Freight costs (including freight to transport consigned goods to consignee)
c. Factory or manufacturing supplies necessary in manufacturing and bring the product
ready for same (Valix examples: Gasoline and oil for testing finished goods, machine
lubricants)
4. Consigned goods – Goods in the hands of consignee are part of consignor’s inventory, but exclude
consigned goods in the possession of the company (as consigned)
5. FOB shipping point – Goods in transit and purchased FOB shipping point are the inventory of the
buyer, while goods in transit and sold FOB shipping point are excluded from the seller’s inventory
6. FOB destination – Goods in transit and purchased FOB destination are the inventory of the seller
and should be excluded from the buyer’s inventory
7. Goods in the display room, branch, with salesmen or agents – included in seller’s inventory

BA 123 – 2nd Semester, S.Y. 2022-2023 Quick Notes on Expenditure and Disbursements Aratea/Magana/Placido
 8. Goods on approval or trial – Title does not pass to the buyer yet, unless accepted. If not yet
accepted, should still be part of seller’s inventory

Exclusion to legal test:

1. Goods sold on installment – Included in buyer’s inventory and excluded from seller’s inventory

ACCOUNTS PAYABLE

Payables –amounts due to individuals and companies.

Types of Payables
• Accounts Payable – amounts owed to suppliers for purchase of goods/services
• Notes Payable – written promise for amounts to be paid
• Unearned Revenue – cash received and recorded as liabilities before revenue is earned
• Accrued Expenses – expenses incurred but not yet paid in cash or recorded (e.g., Interest Payable,
Salaries Payable, Rent Payable, etc.)
• Others

Audit Assertions on Inventory and Accounts Payable (Auditing Problems by Cabrera, 2018)
1. Existence or Occurrence – inventory exists as of the balance sheet date and qualifies as items held
for sale.
a. Inventory listing
b. Observe physical count (and do test counts)
c. Confirmation with consignees and other entities in possession of company’s inventory
2. Completeness – all transactions are recorded in the proper accounting period, both on hand and
in transit.
a. Check inventory listing for accuracy
b. Review cutoff purchases and sales transactions
c. Purchase requisition sequencing
d. Items in cost of goods sold
e. Analytical review
3. Rights and Obligations – if legal title or right of ownership is still with the company.
a. Inquiry with management
b. Review consignment agreements
c. Review purchase/sale agreements with goods in transit
4. Valuation or Allocation – costs are properly recorded and allocated, and inventory are reported
at lower of cost or NRV.
a. Review inventory valuation methods and test pricing
b. Quality check
5. Presentation and Disclosure – presented and classified in accordance with IAS.
a. Inventory with liens are properly disclosed.

CORRECTION OF ERRORS

Types of Errors
1. Omission – Accountant fails to make journal entry, or fails to include one or more item/s in the
ending balances (e.g., inventory)

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 2. Error as to amount (Sub: Transposition) – Amount debited or credit is incorrect. Transposition is
a special type of error as to amount wherein the digits of the correct amount exchanged places in
the entry made.
3. Duplication – A journal entry is made more than once.
4. Reversal (debit/credit) – The account debited and credited interchanged.

Errors can either be:

1. Counterbalancing error – Even without an adjusting entry, books will auto-correct within two (2)
years (at most) following the error. When a counterbalancing error is made, the effect is usually
reversed the following year. (Example: Error in ending inventory or purchases)
2. Non-counterbalancing error – When not discovered, books will remain in error and will not auto-
correct. (Example: Depreciation expense amount error)

Notes on selected problems from review books

Valix - Practical Accounting Volume 1

26-1 Items specifically segregated from inventory per sales contract – exclude from ending inventory
(considered sold already)
Freight on account of seller – exclude from inventory cost
26-2 Finished goods out on approval – include in ending inventory (not sold unless accepted by
customer)
27-4 Goods sold to a customer which are being held for the customer to call at the customer’s
convenience – exclude from ending inventory (considered sold)
Packing case marked “held for shipping instructions” – include in ending inventory (exception
would be if it is a special order)
Fabricated to order for a customer, finished and specifically segregated – excluding from ending
inventory

Roque – Auditing Problems 2018-2019

3-5 Hold for shipping instructions – include in ending inventory

Ocampo – Auditing Problems 2010

4-1 Interest costs on inventory – exclude from inventory cost
Repurchase agreement at a set price that covers all costs related to the inventory – include in
ending inventory (not yet sold unless the agreement expires)
4-2 Installment sale, and historically, full purchase price is expected to be collected – although legal
title has passed, it is considered sold due to the accompanying circumstances and historical data
– exclude from ending inventory
4-3 Commitment to buy – exclude from ending inventory (no liability and no transfer of legal title to
purchases unless there is actual sale)
Goods for approval – excluding from ending inventory, i.e. not considered purchases/sold. If
acceptance was made on or before the balance sheet date, however, it should be considered
purchased/sold, hence, included in the ending inventory of the purchaser.

BA 123 – 2nd Semester, S.Y. 2022-2023 Quick Notes on Expenditure and Disbursements Aratea/Magana/Placido