CH 15

C HAPTER 15
Auditing the Expenditure Cycle
Learning Objectives
Chapter 15 is the first of the application chapters that explains how to audit the expenditure
cycle. The learning objectives for Chapter 15 have been stated in terms of Audit Decisions that
the student should be able to make when auditing the expenditure cycle. They are:
Audit Decisions
D1: What is the nature of the expenditure cycle and how are specific audit objectives
developed for the expenditure cycle?
D2: How does understanding the entity and its environment affect audit planning decisions in
the expenditure cycle?
D3: What are important inherent risks in the expenditure cycle?
D4: How might the results of analytical procedures indicate potential misstatements in the
expenditure cycle?
D5: What are the relevant aspects of internal control components for the expenditure cycle?
D6: What should be considered in evaluating control activities for purchase transactions?
D7: What should be considered in evaluating control activities for cash disbursements
transactions?
D8: What should be considered in evaluating control activities for purchase adjustments?
D9: What are the relevant aspects of tests of controls when the auditor plans to assess control
risk below the maximum for expenditure cycle transactions?
D10: What are the factors involved in determining acceptable level of tests of details risk for
accounts payable assertions?
D11: How does the auditor determine the elements of an audit program for substantive tests to
achieve specific audit objectives for accounts payable?
D12: How does the auditor use the knowledge obtained during the audit of the expenditure
cycle to support other assurance services?
Chapter Outline
1. Chapter-opening Vignette: Poor Internal Controls Results in a Material Understatement of

Accounts Payable and Net Income, 688
2. Preview of Chapter 15, 689
3. Focus on Audit Decisions, 689
4. Risk Assessment Procedures in the Expenditure Cycle, 690 ……....(Figure 15-1: The
Expenditure Cycle)
Instructor’s Manual to Modern Auditing: Copyright © 2005, John Wiley and Sons, Inc. 15-1
4.1. Develop Audit Objectives, 691…………………………….(Figure 15-2: Specific Audit
Objectives for the Expenditure Cycle)
4.2. Understand the Entity and its Environment, 691 …………..(Figure 15-3: Understanding
the Entity’s Expenditure Cycle)
4.3. Inherent Risk, Including the Risk of Fraud, 692
4.4. Analytical Procedures 695 ………………………………….(Figure 15-4: Analytical
Procedures Commonly Used in the Expenditure Cycle)
4.5. Consideration of Internal Control Components, 696
4.5.1. Control Environment, 696
4.5.2. Risk Assessment, 696
4.5.3. Information and Communication (Accounting System), 697………..(Figure 15-5:
System Flowchart – Purchase Transactions)
4.5.4. Monitoring, 697
5. Control Activities for Purchase Transactions, 699
5.1. Common Documents and Records, 700
5.2. Functions and Control Activities, 701……………………..(Figure 15-6: Control Risk
Considerations: Purchase Transactions)
5.2.1. Initiating Purchases, 701
5.2.1.1. Placing Vendors on an Authorized Vendor List, 701
5.2.1.2. Requisitioning Goods and Services, 703
5.2.1.3. Preparing Purchase Orders, 703
5.2.2. Receipt of Goods or Services, 704
5.2.2.1. Preparing a Receiving Report, 704
5.2.2.2. Storing Goods Received for Inventory, 704
5.2.3. Recording Liabilities, 705
5.3. Illustrative System for Purchase Transactions, 706
6. Control Activities for Cash Disbursement Transactions, 707
6.2. Functions and Control Activities, 608 ………………………(Figure 15-7: Control Risk
Considerations -- Cash Disbursement Transactions)
6.2.1. Paying the Liability and Recording the Disbursement, 708
6.3. Illustrative System for Cash Disbursement Transactions, 710 ….(Figure 15-8: System
Flowchart: Cash Disbursement Transactions)
7. Control Activities, for Purchases Adjustment Transactions and Other Controls, 712
7.2. Functions and Control Activities, 713
7.2.1. Purchase Returns and Allowances, 713
7.3. Other Controls in the Expenditure Cycle, 713
7.4. Tests of Controls, 714
8. Substantive Tests of Accounts Payable Balances, 715
8.1. Determine Detection Risk for Tests of Details, 715 …………………..(Figure 15-9:
Example Risk Matrix for Accounts Payable Assertions)
8.1.1. Existence and Occurrence, 715
8.1.2. Completeness, 716
8.1.3. Rights and Obligations, 717
8.1.4. Valuation and Allocation, 717
8.1.5. Presentation and Disclosure, 718
8.2. Designing Substantive Tests, 718 ………………………….(Figure 15-10: Possible
Substantive Tests of Accounts Payable Assertions)
8.2.1. Initial Procedures, 719
8.2.2. Analytical Procedures, 721
8.2.3. Tests of Details of Transactions, 721
8.2.3.1. Vouch Recorded Payables to Supporting Documentation, 721
8.2.3.2. Perform Cutoff Tests, 721
8.2.3.3. Perform Search for Unrecorded Liabilities, 722
8.2.4. Tests of Details of Balances, 723
8.2.4.1. Accounts Payable Confirmations, 723……….(Figure 15-11: Accounts
Payable Confirmation)
8.2.4.2. Reconcile Unconfirmed Payable to Vendor Statements, 723
8.2.5. Tests of Details of Disclosures, 724
9. Other Assurance Services, 725
10. Focus on Audit Decisions, 726 ……………………………… (Figure 15-12: Summary of
Audit Decisions Discussed in Chapter 15)
11. Objective Questions, online at www.wiley.com/college/boynton
12. Comprehensive Questions, 729
13. Cases, 734
14. Professional Simulation, 738
New to the 8th Edition
The 8th edition has several new features:

1. Chapter-opening vignette that material misstatements that resulted from inadequate controls
over accounts payable at TruServ, a hardware buying cooperative.
2. Focus on audit decisions at the beginning of the chapter, in the margin throughout the chapter
and an end of chapter summary that focus on important audit decisions covered in the
chapter.
3. Audit objectives that mirror the assertions discussed in a May 2005 exposure draft from the
auditing standards board.
4. A discussion of preliminary audit strategies for each major assertion. See pages 715-718.
5. A comprehensive case that focuses on the risk of fraud in the purchases cycle (problem 15-
31). This case was developed out of an actual experience with a private company.
6. A CPA exam style professional simulation has been added at the end of the chapter.
Focus on Audit Decisions and Teaching Notes
An explicit focus on audit decisions is new to the 8th edition. In this chapter on applying auditing
theory to the expenditure cycle, all of the learning objectives are stated as audit decisions.
Chapter 15 has been laid out very similar to Chapter 14 to reinforce the logic of audit planning,
assessing control risk, and planning substantive tests. The following discussion addresses each
learning objective and the relevant teaching notes that go with each audit decision.
As an introduction students need to understand the nature of the expenditure cycle.

Figure 15-1 explains the types of transactions that occur in the expenditure. Figure 15-2
lays out the specific audit objectives for the expenditure cycle.
It is also important for students to recognize the underlying economic substance

associated with the expenditure cycle. Figure 15-3 uses five industries that are covered
throughout this section of the book to address different characteristics of various
industries. Figure 15-3 explains how knowledge of the entity may be used to help the
auditor develop expectations of the client’s financial statements and to assess the risk of
material misstatement. Potential concerns include cutoff problems with purchases,
vendor price concessions, and various issues associated with unrecorded liabilities.
Accounts payable is less of a concern with a hotel or a school district than it is with a
manufacturing company or a retailer.
The expenditure cycle has several high inherent risk assertions.

o There may be pressures to understate expenditure and payables and overstate
earnings.
o Cutoff problems are common in the expenditure cycle as goods may be received
before vendor’s invoices.
o The existence assertion for cash disbursements may be a significant inherent risk
associated with the misappropriation of assets.
o The fictitious purchase adjustment transactions (existence and occurrence) may be
used understate payables and expenses.
The chapter provides additional examples of significant inherent risks.
expenditure cycle?
Figure 15-4 provides a number of examples that an auditor might use for analytical
procedures in audit planning. The formulas are explained along with the significance of
the financial ratio. Homework problem 15-23 might go will with this discussion.
This section should be a review for students, as in reviews the COSO framework with the
exception of control activities (discussed in the next learning objectives). The goal here
is to get student to recognize when other elements of the system of internal controls are
weak or strong. It is always helpful to drive home the fact that it is less likely that
controls will operate effectively when the control environment is weak. It may also be
helpful to review the business risks, inherent risks, and fraud risks that should be
considered by management when designing good internal controls. Particular risk that
should be considered when designing internal controls are:
o The risk of purchasing kickbacks.
o The risk of employee fraud through fraudulent purchases or cash disbursements.
o The entity’s ability to meet cash flow requirements for purchase transactions.
o Loss contingencies associated with purchase commitments.
o The continued availability of important supplies and the stability of important
suppliers.
o The effect of cost increases on the entity.
This section is about understanding the common control activities that would control
assertions for purchases.
Before talking about control activities, it is normally important for students to understand
the documents and records that are commonly used in the purchases cycle. Students may
be unfamiliar with some of these documents, such as a voucher which is used to record
payables. It may be helpful to walk through the flowchart depicted in Figure 15-5.
Figure 15-6 describes a number of controls that may be effective at preventing, or

detecting and correcting, misstatements in various assertions. The controls are organized
by three primary functions associated with making purchases: (1) initiating and
authorizing purchases, (2) receiving goods or services, and (3) recording liabilities. It is
often helpful for students to understand that completeness controls behave very similar to
tracing procedures. Controls over the accurate recording of transactions usually have
more of a vouching character to the control. Figure 15-6 places an emphasis on the
design of programmed control procedures that might be used in an automated
environment.
transactions?
This section is about understanding the common control activities that would control
assertions for disbursing cash.
Figure 15-7 describes a number of controls that may be effective at preventing, or

detecting and correcting, misstatements in various assertions for cash receipts
transactions. An illustrative system for cash receipts was previously presented in Figure
15-8 (page 711). Once again, the book places an emphasis on the design of programmed
control procedures that might be used in an automated environment.
Purchase adjustment transactions relate to purchase returns and purchase discounts. The
narrative describes important controls. It is also helpful to remind students that if a
company has poor controls over these less routine transactions that fictitious purchase
returns may used to understate liabilities and expenses.
This section continues to drive home some key points that were previously presented in
Chapter 11. It is placed here to reemphasize the importance of several concepts related to
test of controls. If the auditor is testing a programmed control procedure and plans to
assess control risk as low, the auditor will usually have to test the effectiveness of (1)
computer general controls, (2) the programmed control, and (3) the manual follow-up
procedures for follow-up of exceptions.
Several examples are provided on page 714 of how the auditor might use test data to test
programmed controls.
This section of the chapter revolves around the conclusion of risk assessment procedures
and forming a decision about audit strategy. Each assertion is discussed in the context of
common inherent risks, control risks, analytical procedures, which leads to a conclusion
about tests of details risk.
Figure 15-9 provides some example risk assessments. It is help to point out to students
that the control risk for the completeness of accounts payable is normally related to the
completeness of purchases and the existence and occurrence of cash disbursements and
purchase adjustments.
The goal in this section is to develop an audit program for substantive tests. Such an
audit program is presented in Figure 15-10. This section is organized by
o Initial procedures to ensure that the auditor is auditing the right data and that the
auditor understands the economic substance of the transaction stream.
o Analytical procedures that might be performed. This refers back to the previous
discussion of analytical procedures.
o Tests of details of transactions. This focuses on traditional vouching procedures,
cutoff tests, and the search for unrecorded liabilities.
o Tests of details of balances. This section focuses on the use of confirmations when
testing accounts payable.
o Test of details of disclosures. The disclosures associated with classification of
payables and related party transactions are discussed in this section.
This discussion is about how the auditor uses the knowledge obtained during the audit to
provide other services to the client. Based on issues identified during the audit, the
auditor might have other recommendations for the client in terms of how to benchmark
performance against others in the industry, particularly with respect to managing
payables and working capital. It is always important to drive home the fact that the
auditor cannot make management decisions for a client. Otherwise, independence has
been violated.
Key Questions for Students
Following is a list of common questions for students that instructors might want to weave into
class discussion of Chapter 15 topics.
o Describe the nature of the expenditure cycles and identify the major classes of
transactions in the cycle.
o State the audit objectives for expenditure cycle transactions and balances that relate to
each financial statement assertion category.
o Describe the nature of one entity where the expenditure cycle is significant to its
financial statements and one entity where it is not. Explain the differences between
the two. How would these differences affect audit strategy?
o Identify several pervasive factors that might motivate management to misstate

assertions in the expenditure cycle.
o Identify several industry-related factors that might influence the risk of material
misstatement in the expenditure cycle.
o What other factors might influence the risk of material misstatement in the
expenditure cycle?
o Why are auditors more concerned about the understatement of liabilities rather than
the overstatement of liabilities?
expenditure cycle?
o Identify several analytical procedures that the auditor might use to assess the
likelihood that a material misstatement exists in the expenditure cycle.
o Why would the analysis of accounts payable turnover provide for more accurate
analysis of accounts payable than analyzing the current ratio?
o Identify elements of the control environment that are relevant to initiating and
recording purchases.
o What risks should management explicitly consider when designing internal controls?
o State the functions that apply to purchase transactions.

o For each purchasing function, indicate (1) the department that performs the function,
and (2) the principal document or record, if any, produced in performing the function.
o For each of the following potential misstatements for purchase transactions, indicate a
potential control procedure and a possible test of controls:
o Vouchers may not be recorded for goods received.
o Vouchers may be prepared for goods not ordered or received.
o Goods may be taken from storage areas.
o Goods received may not have been ordered.
o Vouchers are recorded in the wrong accounting period.
o Vouchers are recorded in the wrong amount.
o Vouchers are charged to the wrong account.
transactions?
o For each of the following control procedures pertaining to cash disbursement

transactions, indicate the potential misstatement and possible tests of controls.
o Checks are prenumbered and accounted for.
o Check signers mail checks.
o Computer compares check information with supporting voucher information.
o Run-to-run totals compare beginning cash, less cash disbursements, with the
ending cash balance.
o Computer performs a limit test on large disbursements, which must be manually
signed.
o An appropriate level of management monitors cash daily, including the amount of
checks written daily, the reasonableness of such amounts, and the amount of
debits to accounts payable daily.
o Explain the economic substance of purchase adjustments.

o State three types of controls pertaining to purchase adjustment transactions and
identify their common focus.
o Explain the primary control over the accounts payable balance itself.
o How is the rights and obligations assertion controlled for accounts payable?
o It the auditor wants to assess control risk as “low” based on a programmed control
procedure, what is the package of evidence that the auditor needs to support this
control risk assessment?
o How would this be affected if the auditor found a weak control environment?
o Which assertion is of primary importance to the auditor in auditing accounts payable?

Why?
o Indicate the relationship of control risk assessments for expenditure cycle transactions to
the completeness assertion for accounts payable.
o Identify the substantive tests that apply to the completeness assertion for accounts
payable.
o Is the auditor’s responsibilities for confirming accounts payable are the same as for
accounts receivable?
o How does the auditor perform (1) a purchases cutoff test and (2) a cash disbursement
cutoff test?
o Explain the standard procedures to search for unrecorded liabilities.
o What assertions are affected by these tests?
o Vouch recorded payables to supporting documentation.
o Examine subsequent payments.
o Explain how the auditor might use information learned during the audit of the
expenditure cycle to make recommendations about improved performance measures
for the client.
o How would making recommendations regarding performance measures affect the
auditor’s independence?

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CH 15

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C HAPTER 15

Auditing the Expenditure Cycle

1. Chapter-opening Vignette: Poor Internal Controls Results in a Material Understatement of

New to the 8th Edition

The 8th edition has several new features:

Focus on Audit Decisions and Teaching Notes

As an introduction students need to understand the nature of the expenditure cycle.

It is also important for students to recognize the underlying economic substance

D3: What are important inherent risks in the expenditure cycle?

The expenditure cycle has several high inherent risk assertions.

Figure 15-6 describes a number of controls that may be effective at preventing, or

Figure 15-7 describes a number of controls that may be effective at preventing, or

Key Questions for Students

D3: What are important inherent risks in the expenditure cycle?

o Identify several pervasive factors that might motivate management to misstate

o State the functions that apply to purchase transactions.

o For each of the following control procedures pertaining to cash disbursement

o Explain the economic substance of purchase adjustments.

o Which assertion is of primary importance to the auditor in auditing accounts payable?

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