Week 10 - Lecture 10 - Auditing Capital Acquisition and Repayment PDF

AUDIT PRACTICE AND PROCEDURES II Auditing the Capital Acquisition and Repayment, Cash Balances Week Ten Recap of Last Class  ACCOUNTS AND CLASSES OF TRANSACTIONS IN THE ACQUISITION AND PAYMENT CYCLE The objective in the audit of the acquisition...

AUDIT PRACTICE AND PROCEDURES II Auditing the Capital Acquisition and Repayment, Cash Balances Week Ten Recap of Last Class  ACCOUNTS AND CLASSES OF TRANSACTIONS IN THE ACQUISITION AND PAYMENT CYCLE The objective in the audit of the acquisition and payment cycle is to evaluate whether the accounts affected by the acquisitions of goods and services and the cash disbursements for those acquisitions are fairly presented in accordance with accounting standards. There are three classes of transactions included in the cycle: 1. Acquisitions of goods and services 2. Cash disbursements 3. Purchase returns and allowances and purchase discounts BUSINESS FUNCTIONS IN THE CYCLE AND RELATED DOCUMENTS AND RECORDS The acquisition and payment cycle involves the decisions and processes necessary for obtaining the goods and services for operating a business. The cycle typically begins with the initiation of a purchase requisition by an authorized employee who needs the goods or services, and it ends with payment on accounts payable. The request for goods or services by the client’s personnel is the starting point for the cycle. The exact form of the request and the required approval depend on the nature of the goods and services and company policy. Common documents include: 1. Purchase Requisition 2. Purchase Order 3. Receiving report 4. Vendor’s invoice 5. Debit memo 6. Voucher 7. Acquisitions transaction file 8. Acquisitions journal or listing 9. Accounts payable master file 10.Accounts payable trial balance 11.Vendor’s statement 12.Check or electronic payment 13.Cash disbursements transaction file 14.Cash disbursements journal or listing  Business Function - Processing Purchase Orders Purchase Requisition A purchase requisition is used to request goods and services by an authorized employee. This may take the form of a request for such acquisitions as materials by production staff or the storeroom supervisor, outside repairs by office or plant personnel, or insurance by the vice president in charge of property and equipment. Companies often rely on pre-specified reorder points used by the computer to initiate inventory purchase requisitions automatically. Purchase Order A purchase order is a document used to order goods and services from vendors. It includes the description, quantity, and related information for goods and services the company intends to purchase and is often used to indicate authorization of the acquisition. Companies often submit purchase orders electronically to vendors who have made arrangements for electronic data interchange (EDI).  Receiving Goods and Services The receipt by the company of goods or services from the vendor is a critical point in the cycle because it is when most companies first recognize the acquisition and related liability on their records. When goods are received, adequate control requires examination for description, quantity, timely arrival, and condition. A receiving report is a paper or electronic document prepared at the time goods are received. It includes a description of the goods, the quantity received, the date received, and other relevant data.  Business Function - Recognizing the Liability The proper recognition of the liability for the receipt of goods and services requires prompt and accurate recording. The initial recording affects the financial statements and the actual cash disbursement; therefore, companies must take care to include all acquisition transactions, only acquisitions that occurred, and at the correct amounts. Common documents and records include: Vendor’s Invoice - A vendor’s invoice is a document received from the vendor and shows the amount owed for an acquisition. It indicates the description and quantity of goods and services received, price (including freight), cash discount terms, date of the billing, and total amount. The vendor’s invoice is important because it indicates the amount recorded in the acquisition transaction file. For companies using EDI, the vendor’s invoice is transmitted electronically, which affects how the auditor evaluates evidence. Debit Memo - A debit memo is also a document received from the vendor and indicates a reduction in the amount owed to a vendor because of returned goods or an allowance granted. It often takes the same form as a vendor’s invoice, but it supports reductions in accounts payable rather than increases. Voucher - A voucher is commonly used by organizations to establish a formal means of recording and controlling acquisitions, primarily by enabling each acquisition transaction to be sequentially numbered. Vouchers include a cover sheet or folder for containing documents and a package of relevant documents such as the purchase order, copy of the packing slip, receiving report, and vendor’s invoice. After payment, a copy of the check or electronic funds transfer is added to the voucher package. Acquisitions Transaction File - This is a computer-generated file that includes all acquisition transactions processed by the accounting system for a period, such as a day, week, or month. It contains all information entered into the system and includes information for each transaction, such as vendor name, date, amount, account classification or classifications, and description and quantity of goods and services purchased. The file can also include purchase returns and allowances or there can be a separate file for those transactions. Acquisitions Journal or Listing -The acquisitions journal or listing, often referred to as the purchases journal, is generated from the acquisitions transaction file and typically includes the vendor name, date, amount, and account classification or classifications for each transaction, such as repair and maintenance, inventory, or utilities. It also identifies whether the acquisition was for cash or accounts payable. The journal or listing can cover any time period, typically a month. The journal or listing includes totals of every account number included for the time period. Accounts Payable Master File - An accounts payable master file records acquisitions, cash disbursements, and acquisition returns and allowances transactions for each vendor. The master file is updated from the acquisition, returns and allowances, and cash disbursement computer transaction files. The total of the individual account balances in the master file equals the total balance of accounts payable in the general ledger. A printout of the accounts payable master file shows, by vendor, the beginning balance in accounts payable, each acquisition, acquisition return and allowance, cash disbursement, and the ending balance. Many companies do not maintain an accounts payable master file by vendor. Accounts Payable Trial Balance - An accounts payable trial balance listing includes the amount owed to each vendor or for each invoice or voucher at a point in time. It is prepared directly from the accounts payable master file. Vendor’s Statement - A vendor’s statement is a document prepared monthly by the vendor and indicates the beginning balance, acquisitions, returns and allowances, payments to the vendor, and ending balance. These balances and activities are the vendor’s representations of the transactions for the period, not the client’s. Except for disputed amounts and timing differences, the client’s accounts payable master file should be the same as the vendor’s statement.  Business Function: Processing and Recording Cash Disbursements The payment for goods and services represents a significant activity for all entities. This activity directly reduces balances in liability accounts, particularly accounts payable. Documents associated with the disbursement process that auditors examine include: Check This document is commonly used to pay for the acquisition when payment is due. Most companies use computer-prepared checks based on information included in the acquisition transactions file at the time goods and services are received. Checks are typically prepared in a multi-copy format, with the original going to the payee, one copy filed with the vendor’s invoice and other supporting documents, and another filed numerically. In most cases, individual checks are recorded in a cash disbursements transaction file. After a check includes the signature of an authorized person, it is an asset. Therefore, signed checks should be mailed by the signer or a person under the signer’s control. Cash Disbursements Transaction File This is a computer-generated file that includes all cash disbursements transactions processed by the accounting system for a period, such as a day, week, or month. It includes the same type of information discussed for the acquisitions transaction file Cash Disbursements Journal or Listing This is a listing or report generated from the cash disbursements transaction file that includes all transactions for any time period. The same transactions, including all relevant information, are included in the accounts payable master file and general ledger  METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTION In a typical audit, the most time-consuming accounts to verify by substantive tests of details of balances are accounts receivable, inventory, fixed assets, accounts payable, and expense accounts. Notice that four of these five are directly related to the acquisition and payment cycle. If the auditor can reduce tests of details of the account balances by using tests of controls and substantive tests of transactions to verify the effectiveness of internal controls for acquisitions and cash disbursements, the net time saved can be dramatic. Tests of controls and substantive tests of transactions for the acquisition and payment cycle receive a considerable amount of attention, especially when the client has effective internal controls. Tests of controls and substantive tests of transactions for the acquisition and payment cycle are divided into two broad areas: 1. Tests of acquisitions, which concern three of the four business functions discussed earlier in this chapter: processing purchase orders, receiving goods and services, and recognizing the liability 2. Tests of payments, which concern the fourth function, processing, and recording cash disbursements  Understand Internal Control The auditor gains an understanding of internal control for the acquisition and payment cycle as part of performing risk assessment procedures by studying the client’s flowcharts, reviewing internal control questionnaires, and performing walkthrough tests for acquisition and cash disbursement transactions. The procedures for understanding internal control in the acquisition and payment cycle are similar to the procedures performed in other transaction cycles, as discussed in earlier chapters  Assess Planned Control Risk Authorization of Purchases - Proper authorization for acquisitions ensures that the goods and services acquired are for authorized company purposes, and it avoids the acquisition of excessive or unnecessary items. Most companies require different levels of authorization for different types of acquisitions or dollar amounts. For example, acquisitions of fixed assets in excess of a specified dollar limit require approval by the board of directors; items acquired relatively infrequently, such as insurance policies and longterm service contracts, are approved by certain officers; supplies and services costing less than a designated amount are approved by supervisors and department heads; and some types of raw materials and supplies are reordered automatically when they fall below a predetermined level, often by direct communication with vendors’ computers. Separation of Asset Custody from Other Functions - To prevent theft and misuse, the goods should be physically controlled from the time of their receipt until their use or disposal. The personnel in the receiving department should be independent of the storeroom personnel and the accounting department. Finally, the accounting records should transfer responsibility for the goods each time they are moved, from receiving to storage, from storage to manufacturing, etc. Determine Extent of Testing of Controls - After auditors identify key internal controls and deficiencies, they assess control risk. When auditors intend to rely on controls to support a preliminary control risk assessment below maximum, the auditor performs tests of controls to obtain evidence that controls are operating effectively. As the operating effectiveness of controls improves and is supported by additional tests of controls, the auditor is able to reduce substantive testing. Of course, if the client is an accelerated filer public company, the auditor must document and test controls sufficiently to issue an opinion on internal control over financial reporting Design Tests of Controls and Substantive Tests of Transactions for Acquisitions Four of the six transaction-related audit objectives for acquisitions deserve special attention and are therefore examined more closely. The correctness of many asset, liability, and expense accounts depends on the correct recording of transactions in the acquisitions journal, especially related to these four objectives.  Attributes Sampling for Tests of Controls and Substantive Tests of Transactions There are three important differences in acquisitions and payments compared to other cycles. 1. As discussed in the beginning of the chapter, there are a larger number of accounts involved in this cycle, including both income statement and balance sheet accounts. The effect is an increased potential for classification misstatements, some of which are likely to affect income. An example is a misclassification between repair and maintenance expenses and fixed assets. As a result, auditors often reduce the tolerable exception rate, especially for the classification attribute. 2. It is more common in this cycle for transactions to require significant judgment, such as for leases and construction costs. These judgment requirements result in an increased likelihood of misstatements. As a result, auditors often reduce the tolerable exception rate for the accuracy attribute. 3. The dollar amounts of individual transactions in the cycle cover a wide range. As a result, auditors commonly segregate large and unusual items and test them on a 100 percent basis If tests of controls and related substantive tests of transactions show that controls are operating effectively, and if analytical procedures results are satisfactory, the auditor is likely to reduce tests of details of balances for accounts payable. However, because accounts payable tend to be material for most companies, auditors almost always perform some tests of details of balances. Out-of-Period Liability Tests Because of the emphasis on understatements in liability accounts, out- of-period liability tests are important for accounts payable. The extent of tests to uncover unrecorded accounts payable, often called the search for unrecorded accounts payable, depends heavily on assessed control risk and the materiality of the potential balance in the account. The same audit procedures used to uncover unrecorded payables are applicable to the accuracy objective. The following are typical audit procedures: Difference Between Vendors’ Statements and Confirmations The most important distinction between a vendor’s statement and a confirmation of accounts payable is the source of the information. A vendor’s statement has been prepared by the vendor (an independent third party) but is in the hands of the client at the time the auditor examines it. This provides the client with an opportunity to alter a vendor’s statement or to withhold certain statements from the auditor.  AUDIT OF PROPERTY, PLANT, AND EQUIPMENT Property, plant, and equipment are assets that have expected lives of more than one year, are used in the business, and are not acquired for resale. The intent to use the assets as part of the operation of the client’s business and their expected lives of more than one year are the significant characteristics that distinguish these assets from inventory, prepaid expenses, and investments. Auditors verify equipment differently from current asset accounts for three reasons: 1. There are usually fewer current period acquisitions of equipment, especially large equipment used in manufacturing. 2. The amount of any given acquisition is often material. 3. The equipment is likely to be kept and maintained in the accounting records for several years. In the audit of equipment and related accounts, it is helpful to separate the tests into the following categories: Perform analytical procedures Verify current year acquisitions Verify current year disposals Verify the ending balance in the asset account Verify depreciation expense Verify the ending balance in accumulated depreciation Verify Current Year Acquisitions Companies must correctly record current year additions because the assets have long-term effects on the financial statements. The failure to capitalize a fixed asset, or the recording of an acquisition at the incorrect amount, affects the balance sheet until the company disposes of the asset. The income statement is affected until the asset is fully depreciated. Verify Current Year Disposals Transactions involving the disposal of equipment are often misstated when company internal controls lack a formal method to inform management of the sale, trade-in, abandonment, or theft of recorded machinery and equipment. If the client fails to record disposals, the original cost of the equipment account will be overstated indefinitely, and net book value will be overstated until the asset is fully depreciated. Formal methods of tracking disposals and provisions for proper authorization of the sale or other disposal of equipment help reduce the risk of misstatement. There should also be adequate internal verification of recorded disposals to make sure that assets are correctly removed from the accounting records. Verify Ending Balance of Asset Account Two of the auditor’s objectives when auditing the ending balance in the equipment accounts include determining that: 1. All recorded equipment physically exists on the balance sheet date (existence) 2. All equipment owned is recorded (completeness) When designing audit tests to meet these objectives, auditors first consider the nature of internal controls over equipment. Ideally, auditors are able to conclude that controls are sufficiently effective to allow them to rely on balances carried forward from the prior year. Important controls include the use of a master file for individual fixed assets, adequate physical controls over assets that are easily movable (such as computers, tools, and vehicles), assignment of identification numbers to each plant asset, and periodic physical count of fixed assets and their reconciliation by accounting personnel. A formal method of informing the accounting department of all disposals of fixed assets is also an important control over the balance of assets carried forward into the current year. Verify Depreciation Expense Depreciation expense is one of the few expense accounts not verified as part of tests of controls and substantive tests of transactions. The recorded amounts are determined by internal allocations rather than by exchange transactions with outside parties. When depreciation expense is material, more tests of details of depreciation expense are required than for an account that has already been verified through tests of controls and substantive tests of transactions. The most important balance-related audit objective for depreciation expense is accuracy. Auditors focus on determining whether the client followed a consistent depreciation policy from period to period and whether the client’s calculations are correct. In determining the former, auditors must weigh four considerations: 1. The useful life of current period acquisitions 2. The method of depreciation 3. The estimated salvage value 4. The policy of depreciating assets in the year of acquisition and disposition Verify Ending Balance in Accumulated Depreciation The debits to accumulated depreciation are normally tested as a part of the audit of disposals of assets, while the credits are verified as a part of depreciation expense. If the auditor traces selected transactions to the accumulated depreciation records in the property master file as a part of these tests, then little additional testing should be required for the ending balance in accumulated depreciation. Two objectives are usually emphasized in the audit of the ending balance in accumulated depreciation: 1. Accumulated depreciation as stated in the property master file agrees with the general ledger. This objective can be satisfied by test-footing the accumulated depreciation in the property master file and tracing the total to the general ledger. 2. Accumulated depreciation in the master file is accurate.  See Chapter 19 of the text for Information on the Following: AUDIT OF PREPAID EXPENSES AUDIT OF ACCRUED LIABILITIES AUDIT OF INCOME AND EXPENSE ACCOUNTS See you Next Week