Auditing Inventory, Goods and Services, and Accounts Payable - The Acquisition and Payment Cycle

Auditing Inventory, Goods and
CHAPTER
11 Services, and Accounts Payable:
The Acquisition and Payment Cycle
Johnstone, Auditing: A Risk-Based Approach, 11th Edition. ©2019 Cengage. All Rights Reserved. May
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Learning Objectives (1-5)
LO 1 Identify the significant accounts, disclosures, and relevant
assertions in the acquisition and payment cycle.
LO 2 Identify and assess inherent risks of material misstatement
in the acquisition and payment cycle.
LO 3 Identify and assess fraud risks of material misstatement in
the acquisition and payment cycle.
LO 4 Identify and assess control risks of material misstatement
in the acquisition and payment cycle.
LO 5 Describe how to use planning analytical procedures to
identify possible material misstatements in acquisition and
payment cycle accounts, disclosures, and assertions.
2
Learning Objectives (6-9)
LO 6 Determine appropriate responses to identified risks of
material misstatement for acquisition and payment cycle
accounts, disclosures, and assertions.
LO 7 Determine appropriate tests of controls and consider the
results of tests of controls for acquisition and payment
cycle accounts, disclosures, and assertions.
LO 8 Determine and apply sufficient appropriate substantive
audit procedures for testing acquisition and payment cycle
accounts, disclosures, and assertions.
LO 9 Apply the frameworks for professional decision making and
ethical decision making to issues involving conducting the
audit of acquisition and payment cycle accounts,
disclosures, and assertions.
3
What Do You Think? (p. 570)
● Refer to the feature on page 570.
● Consider the control environment of the COSO Framework;
which of these two types of fraud is worse from a
shareholder’s perspective?
● Consider the control activities and monitoring components of
the COSO Framework; what significant difficulties did top
management at GCC encounter with respect to controlling the
operations and financial reporting at the Brazilian subsidiary?
● What are your thoughts about the stock valuation history of
GCC? Notice that the share prices during the fraud period are
quite a bit higher than the prices currently reported. Also,
notice the stock market reaction to the revelation of the
frauds, and consider the implications for shareholders.
4
Significant Accounts, Disclosures, and Relevant
Assertions
● The significant accounts in the acquisition and payment
cycle are:
● inventory
● cost of goods sold
● accounts payable
● other related expense accounts
5
Accounting for Inventories
● Accounting for inventories is a major consideration for many
organizations because of its significance to both the balance sheet
and the income statement.
● Inventories are items of tangible property that are:
(1) held for sale in the ordinary course of business,
(2) in the process of production for such sale, or
(3) to be used in the production of goods or services to be available for sale.
● A major component of accounts payable relates to inventory
purchases.
● When shipments of raw materials and finished goods are received and
placed in inventory, this results in an account payable until payment is made.
● Accounts payable is also comprised of amounts owed to other suppliers
(such as suppliers of electricity or other goods and services not used in
production or resale).
6
Exhibit 11.1
7
Processing Transactions in the Acquisition
and Payment Cycle
● The acquisition and payment cycle consists of five distinct
activities.
1. Requisition (request) for goods or services
2. Purchase of goods and services
3. Receipt of goods and services
4. Approval of items for payment
5. Cash disbursements
8
Assertions Relevant to Inventory
1. Existence/occurrence
● Inventory balances exist at the balance sheet date.
2. Completeness
● Inventory balances include all inventory transactions that have taken
place during the period.
3. Rights and obligations
● The organization has title to the inventory as of the balance sheet date.
4. Valuation or allocation
● The recorded balances reflect the true underlying economic value of
those assets.
5. Presentation and disclosure
● Inventory is properly classified on the balance sheet and disclosed in
the notes to the financial statements.
9
What Do You Think? (p. 574)
● Consider the elements of the fraud triangle from the
perspective of Schwartzhoff’s activities described in the
Why It Matters feature on page 573.
● What were Schwartzhoff’s likely incentives, opportunities, and
rationalizations?
● Are you surprised that despite the accounting manipulation,
Thor’s auditor, Deloitte, issued an unqualified audit opinion
and agreed with management’s assessment that internal
controls were effective?
● Should investors have expected Deloitte to detect this
misstatement?
10
Assertions Relevant to Accounts Payable
1. Existence/occurrence
● Accounts payable balances exist at the balance sheet date.
2. Completeness
● Accounts payable balances include all accounts payable transactions that
have taken place during the period.
3. Rights and obligations
● The organization actually owes a liability for the accounts payable as of the
balance sheet date.
4. Valuation or allocation
● The recorded balances reflect the true underlying economic value of those
liabilities.
5. Presentation and disclosure
● Accounts payable is properly classified on the balance sheet and disclosed
in the notes to the financial statements.
11
Check Your Basic Knowledge—True/False
11-1 The existence and presentation/disclosure assertions are
usually the most relevant for inventory. (T/F)
11-2 The most common concerns for inventory are that
purchases are understated or ending inventory is
overstated, both of which will result in lower cost of
goods sold and higher net income. (T/F)
12
Check Your Basic Knowledge (11-3)
11-3 Which of the following activities is not an activity
associated with the acquisition and payment cycle?
a. Receive a customer purchase order.
b. Purchase of goods and services.
c. Receipt of goods and services.
d. Approval of items for payment.
13
11-4 Which of the following tasks will an automated
purchasing system perform?
a. Apply preloaded specifications and materials lists to
the system to start the process.
b. Automatically flag invoices that do not reconcile with
purchase orders.
c. Create change orders and analyze variances from
purchase orders.
d. All of the above.
14
An Overview of the Audit Opinion Formulation
Process in the Revenue Cycle
● In auditing the acquisition and payment cycle, the auditor
will perform risk assessment procedures, tests of
controls, and substantive procedures—Phases II, III, and
IV of the audit opinion formulation process.
● As part of performing risk assessment procedures, the
auditor obtains information to assess the risk of material
misstatement.
● Once the risks of material misstatement have been
identified, the auditor then determines how best to
respond to them.
15
Identifying Inherent Risks
● Inventory is usually material, complex, and subject to manipulation,
because of the following factors:
● A great variety (diversity) of items exists in inventory.
● Inventory accounts typically experience a high volume of activity.
● Inventory accounts may be valued according to various alternative accounting
valuation methods.
● Identifying obsolete inventory and applying the lower of cost or market principle
to determine valuation are difficult tasks.
● Inventory is easily transportable.
● Inventory often exists at multiple locations, with some locations being remote
from the company’s headquarters.
● In terms of accounts payable and related expense accounts, the auditor
should consider the inherent risk that management is more likely to:
● (1) understate, rather than overstate, expenses and payables, and
● (2) classify expense items as assets.
16
11-5 The audit of inventory can be complex because inventory
is easily transportable, exists at multiple locations, may
become obsolete, and may be difficult to value. (T/F)
11-6 Two important complexities in auditing inventory arise
because inventory accounts experience a high volume of
activity and are valued according to various inventory
valuation methods. (T/F)
17
11-7 Which of the following is a common inherent risk relating
to accounts payable and related expenses?
a. Management would generally prefer to record assets
as expenses.
b. Because of debt covenants requiring that the client
maintain a certain level of the current ratio,
management may prefer to understate accounts
payable.
c. Ending inventory balances may be valued according to
various accounting valuation methods.
d. Because of the lower of cost or market requirements,
it may be difficult to value accounts payable.
18
11-8 Which of the following is not an inherent risk relating to
inventory?
a. Sales contracts may contain unusual terms, and
revenue recognition is often complex.
b. Inventory accounts typically experience a high volume
of activity.
c. Inventory accounts may be valued according to various
accounting valuation methods.
d. Identifying obsolete inventory and applying the lower
of cost or market principle to determine valuation are
difficult.
19
Identifying Fraud Risks
● Examples of fraud in the acquisition and payment cycle
include:
● Theft of inventory by the employee
● Inventory shrinkage
● Employee schemes involving vendor fraud
● Employees recording fictitious inventory or inappropriately
recording higher values for existing inventory
● Large manual adjustments to inventory accounts
● Schemes to classify expenses as assets
● Executives misusing travel and entertainment accounts and
charging them as company expenses
20
Exhibit 11.2
21
11-9 One of the common ways that managers have committed
fraud in the acquisition and payment cycle involves
inappropriately classifying assets (e.g., inventory) as
expenses. (T/F)
11-10 The following are possible manipulations that may occur
when employees perpetrate fraud during the purchase of
inventory: under-recording purchases, recording
purchases in a later period, and not recording purchases.
(T/F)
22
11-11 Which of the following is an example of fraud in the
acquisition and payment cycle?
a. Theft of inventory by an employee.
b. Employee schemes involving fictitious vendors as
means to transfer payments to themselves.
c. Executives recording fictitious inventory or
inappropriately recording higher values for existing
inventory.
d. All of the above.
23
11-12 Refer to Exhibit 11.2 to identify the possible inventory or
cost of goods sold manipulation that might occur when
inventory is sold.
a. Overstate returns.
b. Overcount inventory.
c. Not record cost of goods sold nor reduce inventory.
d. Under-record purchases.
24
Identifying Control Risks
● The auditor needs to understand the controls that the
client has designed and implemented to address the
inherent and fraud risks of material misstatement in the
acquisition and payment cycle.
● The auditor typically obtains this understanding by
● A walkthrough of the process
● Inquiry
● Observation
● Review of the client’s documentation
● The auditor considers both entity-wide controls and
transaction controls at the account and assertion levels.
25
Overview of Internal Controls in the Acquisition and
Payment Cycle
● A well-conceived inventory control system should provide
reasonable assurance that:
● All purchases are authorized.
● There exists a timely, accurate, and complete recording of
inventory transactions.
● Receipt of inventory is properly accounted for and
independently tested to verify quality in adherence to
company standards.
● The cost accounting system is up-to-date; costs are properly
identified and assigned to products; and variances are
analyzed, investigated, and properly allocated to inventory and
cost of goods sold.
26
Inventory Systems
● Management may use two types of inventory systems for reporting
purposes and for assisting in inventory management:
● Periodic inventory system
● System of inventory recordkeeping in which management does not keep a continuous
record of changes in inventory (receipts, uses, sales of inventory items).
● At the end of an accounting period, management determines the ending inventory by a
physical count of every item, and computes its value using a suitable method.
● Perpetual inventory system
● System of inventory recordkeeping where book inventory is continuously in agreement
with inventory on hand within specified time periods.
● In some systems, book inventory and inventory on hand may be reconciled with each
transaction; in other systems, these two numbers may be reconciled less often.
● This process is useful in keeping track of availability of goods and determining the correct
time to reorder from suppliers.
● Cycle counts are part of a perpetual inventory system.
● Cycle counts involve periodic testing of the accuracy of the perpetual inventory record by
counting all inventories on a cyclical, or periodic, basis.
27
Other Controls in the Acquisition and Payment
Cycle
● Assigned employees systematically review all products for
obsolescence, and follow up with appropriate accounting
action.
● Management periodically reviews inventory, takes action on
excessive inventory, and manages inventory to minimize
losses caused by technological obsolescence.
● Market studies and quality-control tests are performed
before new products are introduced.
● Assigned employees closely monitor long-term contracts
and excess purchase requirements, and follow up with
appropriate accounting action (e.g., recognize potential
losses).
28
Five Activities in the Acquisition and Payment Cycle
1. Requisition (Request) for Goods and Services
2. Purchase of Goods and Services
3. Receipt of Goods and Services
4. Approval of Items for Payment
5. Cash Disbursements
29
Exhibit 11.3
30
Exhibit 11.4
31
Documenting Controls
● Auditors need to document their understanding of internal
controls for both integrated audits and financial statement
only audits.
● Exhibit 11.5 provides an example of a partial internal control
questionnaire for the acquisition and payment cycle.
● Each negative (no) answer in the questionnaire represents a
potential internal control deficiency.
● Given a negative answer, the auditor should consider the effect of
the response on the initial assessment of control risk.
● Unless another control compensates for a control deficiency, the
auditor will likely have a control risk assessment of high in this area
and, therefore, have to rely more on substantive audit procedures.
32
Exhibit 11.5
33
11-13 A well-conceived inventory control system should provide
reasonable assurance that all purchases are authorized
and that inventory transactions are recorded accurately,
completely, and in a timely manner. (T/F)
11-14 Because a purchase order is an external document, its
level of reliability is higher than that of a requisition,
which is an internal document. (T/F)
34
11-15 Refer to Exhibit 11.3 to identify which of the following is a
typical control associated with the requisition process for
inventory purchases in a just-in-time manufacturing
process.
a. The store manager’s ability to issue a purchase order may
be subject to overall corporate limits, usually specified in
dollars.
b. An agreement is signed with the supplier whereby the
supplier agrees to ship merchandise according to the
production schedule set by the manufacturer.
c. Overall authorization to purchase product lines is delegated
to individual buyers by the marketing manager.
d. The limits for individual goods can be exceeded only on
specific approval by the marketing manager.
35
11-16 Which of the following controls is related to the payment
of inventory purchases?
a. Cycle counts.
b. A disclosure committee.
c. A three-way match.
d. Both a. and c.
36
Performing Planning Analytical Procedures
● Step 1: Identify Suitable Analytical Procedures
● Step 2: Evaluate Reliability of Data Used to Develop
Expectations
● Step 3: Develop Expectations
● Step 4 and Step 5: Define and Identify Significant
Unexpected Differences
● Step 6 and Step 7: Investigate Significant Unexpected
Differences and Ensure Proper Documentation
37
Exhibit 11.6
38
11-17 In terms of planning analytical procedures, assume that
the client has introduced a new product with a low price
point and significant customer demand. The auditor
would expect inventory turnover to increase and days’
sales in inventory to also increase. (T/F)
11-18 A planning analytical procedure in the acquisition and
payment cycle that might indicate fraud is that inventory
is growing at a rate greater than sales. (T/F)
39
11-19 Which of the following expected relationships is
reasonable in terms of performing planning analytical
procedures in the acquisition and payment cycle?
a. Assume that the company’s production and pricing strategies
have remained the same during the past year. Gross margin is
expected to improve because of the stability.
b. Assume that the company has introduced a new product with a
low price point and significant customer demand. Inventory
turnover is expected to increase and days’ sales in inventory is
expected to decrease.
c. Assume that the company has invested in a new manufacturing
process resulting in significantly less waste and overall increases
in efficiency during the production process. Cost of goods sold is
expected to increase, and gross margin is expected to decrease.
d. All of the above are reasonable expected relationships.
40
11-20 Which of the following planning analytical relationships is
most typically suggestive of a heightened risk of fraud in
the acquisition and payment cycle?
a. Unexpected increases in gross margin.
b. Unexpected decreases in gross margin.
c. Inventory that is growing at a rate slower than sales.
d. Expense accounts that have significant debit entries.
41
Responding to Identified Risks of Material
Misstatement
● Once the auditor understands the risks of material
misstatement, the auditor determines the appropriate audit
procedures to perform.
● Audit procedures should be proportional to the assessed risks
● Responding to identified risks typically involves developing an audit
approach that contains substantive procedures (e.g., tests of details
and, when appropriate, substantive analytical procedures) and tests
of controls, when applicable.
● The sufficiency and appropriateness of selected procedures will vary
to achieve the desired level of assurance for each relevant assertion.
● Standardized audit program for the acquisition and payment
cycle should be customized based on the assessment of risk of
material misstatement.
42
Exhibit 11.7
43
11-21 When conducting the audit of the acquisition and
payment cycle for a client with a high risk of material
misstatement in its inventory accounts, the following mix
of evidence would be appropriate: significant tests of
internal control, significant reliance on substantive
analytical procedures, and limited tests of details. (T/F)
11-22 When considering the appropriate mix of evidence, the
sufficiency and appropriateness of selected procedures
vary across inventory assertions to achieve the desired
level of assurance for each relevant assertion. (T/F)
44
11-23 Which mix of evidence would be most appropriate for the
following scenario?
Assume a client where the auditor has assessed the risk of material
misstatement related to the existence of inventory as high. This client
has incentives to overstate income to achieve profit targets that
affect management bonuses. Oversight of the vice president of
finance is relatively weak because of a lack of supervision by top
management. Other controls are effectively designed.
a. 100% tests of details.
b. 50% tests of details, 30% analytics, 20% tests of controls.
c. 30% tests of details, 40% analytics, 30% tests of controls.
d. 20% tests of details, 40% analytics, 40% tests of controls.
45
11-24 Which mix of evidence would be most appropriate for the
following scenario?
Assume a client where the auditor has assessed the risk of material
misstatement related to the existence of inventory as low. Top
management appears to have a high level of integrity. Management
has spent the resources necessary to ensure effective design,
implementation, and operation of controls.
a. 100% tests of details.
b. 70% tests of details, 10% substantive analytics, 20% tests of
controls.
c. 50% tests of details, 10% substantive analytics, 40% tests of
controls.
d. 20% tests of details, 40% substantive analytics, 40% tests of
controls.
46
Obtaining Evidence About Internal Control Operating
Effectiveness in the Acquisition and Payment Cycle
● For integrated audits, the auditor will test the operating
effectiveness of important controls throughout the year,
with a heightened focus on controls as of the client’s
year-end.
● If the auditor wants to rely on controls for the financial
statement audit, the auditor will test the operating
effectiveness of those controls throughout the year.
47
Selecting Controls to Test and Performing Tests of
Controls
● The auditor selects both entitywide and transaction controls for testing.
● The auditor tests internal controls that are designed to provide
reasonable assurance that:
● (1) all purchases are authorized,
● (2) all payments are for goods received,
● (3) payments are made at the appropriate amount and in the correct period,
and
● (4) payments are paid only once to the authorized vendor.
● Typical tests of controls include:
● Inquiry of relevant personnel
● Observation of the control being performed
● Examination of documentation corroborating that the control has been
performed
● Reperformance of the control by the auditor testing the control
48
Considering the Results of Tests of Controls
● Two potential outcomes
● Auditor identifies control deficiencies
● Assess those deficiencies to determine their severity
● Modify the preliminary control risk assessment
● Document the implications of the control deficiencies
● Determine appropriate modifications to planned substantive audit
procedures based on the types of misstatements that are most likely to
occur because of the control deficiency
● Auditor does not identify any control deficiencies
● Determine that the preliminary assessment of control risk as low is still
appropriate
● Determine the extent that controls can provide evidence on the accuracy
of account balances
● Determine planned substantive audit procedures
49
Exhibit 11.8
50
11-25 When selecting controls to test and performing tests of
controls in the acquisition and payment cycle, the auditor
might reasonably take a sample of receiving reports and
trace them through the system to test controls related to
the completeness assertion for inventory and accounts
payable. (T/F)
11-26 When conducting the audit of acquisition and payment
cycle accounts, the auditor will likely conduct less
substantive tests for companies with effective internal
controls than for companies with ineffective internal
controls. (T/F)
51
11-27 Which of the following statements is false regarding obtaining
evidence about internal control operating effectiveness in the
acquisition and payment cycle?
a. For integrated audits, the auditor will test the operating
effectiveness of important controls as of the client’s year-end.
b. The auditor will select controls to test that are important to the
auditor’s conclusion about whether the client’s controls
adequately address the assessed risk of material misstatement in
the acquisition and payment cycle.
c. Evidence of proper payment is not necessary for each purchase
and payment, but is only necessary for those that are material.
d. The auditor will take a sample of receiving reports and review
whether independent counts were made of the goods received.
52
11-28 Refer to the Why It Matters feature “Inventory Controls
at Flow International Corporation.” Which of the
following represents an implication of weaknesses in the
company’s controls over inventory?
a. The company could not adequately process and
account for the valuation of inventory.
b. The board of directors fired the CEO because of the
internal control deficiencies.
c. The company developed a plan to remediate its
material weaknesses related to inventory.
d. Both a. and c.
e. Both a. and b.
53
Substantive Tests of Inventory and Cost of Goods
Sold
● Inventory and cost of goods sold:
● Performing substantive analytical procedures
● Substantive tests of details for the existence/occurrence assertion
● Substantive tests of details for the completeness assertion
● Substantive tests of details for rights and obligations assertion
● Substantive tests of details for valuation/allocation assertion
● Direct tests of product costs
● Testing for obsolete inventory (net realizable value tests)
● Testing a standard costing system
● Testing a perpetual inventory system
● Using the work of a specialist or expert when auditing inventory
● Substantive tests of details for the presentation and disclosure assertion
● Performing substantive fraud-related procedures for inventory and
cost of goods sold
54
Exhibit 11.9
55
Exhibit 11.10
56
Exhibit 11.11
57
Exhibit 11.12
58
Substantive Tests of Accounts Payable and Related
Expense Accounts
● Accounts payable and related expense accounts:
● Performing substantive analytical procedures
● Substantive test of details for the existence/occurrence assertion
● Substantive test of details for the completeness assertion
● Testing subsequent disbursements
● Reconciling vendor statements or confirmations with recorded payables
● Related expense accounts
● Substantive test of details for the rights and obligations assertion
● Substantive test of details for the valuation/allocation assertion
● Substantive test of details for the presentation and disclosure assertion
● Review of unusual entries to expense accounts
● Performing substantive fraud-related procedures for accounts
payable and related expenses
59
Exhibit 11.13
60
Documenting Substantive Procedures
● Substantive analytical procedures conducted, conclusions reached, and
related actions that were taken
● Evidence about physical inventory observations for all material amounts
● Evidence about product costing, such as the audit program for auditing
the standard costing system and related evidence that was obtained
● Evidence pertaining to net realizable valuable calculations
● Evidence from inventory specialists
● Summaries of evidence obtained and conclusions reached about material
amounts of inventory on consignment
● Evidence from evaluating subsequent disbursements for accounts payable
● Vendor statements
● Confirmations with vendors regarding accounts payable
● Evidence regarding conducting a review of unusual entries, including
documentation of such entries and the explanations for them
61
11-29 A substantive procedure appropriate for testing the
existence of inventory would be to perform year-end
cutoff tests by noting the last shipping and receiving
document numbers used before the physical inventory
count is taken. (T/F)
11-30 A substantive procedure appropriate for testing rights
and obligations associated with inventory would be to
review vendor invoices when testing disbursements to
determine that proper title is conveyed. (T/F)
62
11-31 Which of the following audit procedures would an
auditor use to test the existence assertion for inventory?
a. Perform year-end cutoff tests by noting the last
shipping and receiving document numbers used
before the client takes physical inventory.
b. Make inquiries of the client regarding the segregation
of duties between the purchasing department and the
receiving department.
c. Review the client’s proposed physical inventory
procedures to determine whether they are likely to
result in a complete and correct physical inventory.
d. Make inquiries of the client regarding allowances
made for expected returns.
63
11-32 Which of the following audit procedures would an
auditor use to test the valuation or allocation assertion
for inventory?
a. Inquire of production and warehouse personnel about
the existence of obsolete inventory.
b. Test inventory cost by taking a sample of recorded
inventory, and trace to source documents indicating cost
of inventory.
c. Review trade journals for changes in product technology.
d. Inquire of the client about sales adjustments
(markdowns) that have been offered to sell any products.
e. All of the above.
64

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