Audit of Acquisition Cycle and Inventory - PowerPoint PPT Presentation

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Audit of Acquisition Cycle and Inventory

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Title: Audit of Acquisition Cycle and Inventory


1
Chapter 11
  • Audit of Acquisition Cycle and Inventory

2
Overview of Acquisition Cycle
  • The acquisition cycle covers the purchase,
    receipt, payment, and accounting for goods and
    services
  • Major accounts include inventory, accounts
    payable, and expenses
  • Main phases in the acquisition and payment
    process
  • Authorized requisition
  • Authorized purchase
  • Receipt of goods and services
  • Approval for payment
  • Cash disbursement

3
Discuss Risk and Business Analysis
  • Acquisition cycle deals with receipt of all goods
    and services
  • Misstatements may occur just because of the
    volume of transactions
  • It is also an area where fraud is likely to take
    place. For example,
  • Employee theft of inventory causing inventory on
    the books to be overstated
  • Employees setting up fictitious vendors and
    paying themselves for goods never received by the
    company
  • Executives abusing travel and entertainment
    expenses for personal use
  • Capitalizing expenses as assets to inflate
    earnings
  • Overestimating "restructuring reserves" at the
    time of acquisition so expenses could be reduced
    in future periods

4
What are the red flags of the acquisition and
payment cycle?
  • There are a number of red flags unique to the
    acquisition and payment cycle. These include
  • Inventory growing at a rate greater than sales
  • Expenses significantly above or below industry
    norms
  • Capital assets growing faster than the business
    and for which there are not strategic plans
  • Significant reduction of "reserves"
  • Expense accounts that have significant credit
    entries
  • Travel and entertainment expense accounts that do
    not have documentation
  • Inadequate follow-up to auditor recommendations
    on needed controls

5
What analytical analysis can be done for
misstatements?
  • Analytical procedures to identify potential
    misstatements
  • Calculate and analyze dollar and percentage
    change in inventory, cost of goods sold, and
    expense accounts
  • Compute and analyze ratios like inventory
    turnover and number of day's sales in inventory
  • Prepare common sized income statement to identify
    cost of good sold or expense accounts that are
    out of line
  • Auditor compares client analytics to past client
    performance, industry results, and auditor's
    expectations

6
Overview of Control Procedures and Control Risk
Assessment
  • Requisition goods or services
  • Need identified
  • Pre-numbered requisition form completed and sent
    to purchasing
  • Purchase goods or services
  • Purchase order shows quantity and price of goods
    ordered, quality specifications, shipping terms
  • Purchase orders are pre-numbered to establish
    completeness
  • Purchase orders must be properly authorized
  • Many companies have separate purchasing
    department
  • Agents job is to find best combination of price,
    service, and quality
  • Reduces fraud by separating purchasing from
    custody and recording
  • Centralizes control in one location
  • Controls set to stop purchasing agents from
    abusing their positions

7
Overview of Control Procedures and Control Risk
Assessment
  • Receive goods
  • Receiving department should ensure
  • Only authorized goods are received
  • The goods meet order specifications
  • An accurate count of goods received is taken
  • All receipts of goods are recorded
  • Receiving reports are pre-numbered to establish
    completeness
  • Receiving department records quantity of goods
    received
  • Goods also inspected for quality
  • Receiving reports sent to accounting

8
Overview of Control Procedures and Control Risk
Assessment
  • Approve payment
  • Accounting matches vendor invoice, purchase
    order, and receiving reports - If quality and
    quantity match, account payable is recorded
  • Cash disbursement
  • Supporting documentation is reviewed and approved
    for payment
  • Documents are marked "paid" to avoid duplicate
    payment

9
Testing Controls over Accounts Payable and
Related Expenses
  • The primary risk is that Accounts Payable and
    expenses will be understated
  • Therefore, controls related to the following are
    usually significant
  • Proper authorization
  • Completeness of recording
  • Timeliness of recording
  • Correctness of valuation
  • Attribute sampling (Chapter 9) may be used to
    test control operation
  • The level of assessed control risk will impact
    the rigor of the subsequent substantive testing
    of Accounts Payable and expenses

10
What are some substantive tests of accounts
payable?
  • The auditor's main concern is that Accounts
    Payable will be understated
  • Therefore, emphasis is placed on testing the
    completeness assertion
  • Typical substantive tests include
  • Reconcile vendor statements or confirm accounts
    payable
  • Tests of subsequent disbursements
  • Analytical review of related accounts

11
1. Reconciling Vendor Statements or Confirm
Accounts Payable
  • Auditor requests vendors' monthly statements or
    sends confirmation to major vendors
  • Auditor reconciles vendor statement or
    confirmation with client balance in the accounts
    payable subsidiary ledger

12
2. Testing Subsequent Disbursements
  • Auditor samples cash disbursements after the end
    of the year
  • Determines if disbursements are for audit year
    transactions by vouching back to source documents
    (purchase order, vendor invoice, receiving
    report)
  • If disbursement is for audit year transaction,
    auditor reprocesses the transaction to see if it
    was properly recorded as a payable

13
3. Analytical Review of Related Expense Accounts
  • Used to determine if accounting data indicates
    understatement of expenses
  • If understatement likely, auditor expands tests
    of accounts payable
  • Analytics used on clients with low control risk

14
Auditing of Expense Accounts
  • Auditing payables and cash disbursements provides
    indirect evidence about expense accounts
  • Additional analysis of selected expense accounts
    is usually merited
  • The auditor should consider management is more
    likely to
  • Understate rather than overstate expenses
  • Classify expenses as assets rather than vice
    versa
  • Substantive audit procedures include
  • Detailed tests of transactions
  • Analytical review
  • Review of unusual entries

15
Auditing of Inventory Cost of Goods Sold
  • Audit of inventory is complicated by a number of
    factors including
  • Variety (diversity) of items
  • High volume of activity
  • Various (sometimes complex) valuation
  • Difficulty in identifying obsolete or defective
    inventory
  • Many frauds involve the inventory account
  • Easily transportable making it subject to double
    counting
  • May be stored at multiple locations, some may be
    remote
  • May be returned by customers

16
What are some internal controls for inventory?
  • A well-designed inventory control system should
    ensure
  • All purchases are authorized
  • Accounting system ensures timely, accurate, and
    complete recording
  • Receipt of inventory properly accounted for
  • Inventory tested for quality when
    received/manufactured
  • Costs properly identified and assigned to
    products
  • Customer returns of inventory examined for
    defects
  • Inventory reviewed for obsolescence
  • New products introduced only after market studies
    and quality control tests have been made
  • Management actively manages inventory
  • Long term contracts are closely monitored

17
Substantive Tests of Inventory Cost of Goods
Sold
  • Existence observe year-end physical inventory
  • Completeness cutoff tests
  • Rights review long-term contracts, etc.
  • Valuation direct tests and analytics
  • Disclosure review GAAP

18
Procedures for Observing a Client's Physical
Inventory - Existence
  • Meet with client to discuss their plan to count
    inventory
  • Review client's plans for counting and tagging
    inventory
  • Review inventory counting procedures with audit
    personnel
  • Determine whether specialists are needed to
    identify inventory items
  • Upon arriving at each site
  • Meet with client, and obtain map and schedule of
    inventory count area
  • Obtain list of sequential tag numbers for each
    area
  • Observe procedures to shut down receipt or
    shipment of goods obtain document numbers for
    last receipt and shipment for cutoff tests

19
Procedures for Observing a Client's Physical
Inventory - Existence
  • Observe the counting of inventory and note the
    following
  • The first and last tag numbers in each section
  • Account for all tag numbers to prevent later
    insertion of additional inventory items
  • Make selected test counts
  • Items that appear obsolete or defective
  • High-dollar value items in inventory
  • Movement of inventory during counting process
  • Document conclusion as to quality of the
    inventory counting process

20
What does the auditor do after the inventory
count? - Existence
  • After the inventory count, the auditor should
  • Trace the test counts to the client's inventory
    records
  • Trace the number of high-dollar items to the
    client's inventory records
  • Trace the obsolete or damaged inventory to the
    client's inventory records to see if the items
    have been written down

21
Counting Inventory Before or After Year-end -
Existence
  • On occasion, it may not be feasible to count
    inventory at year-end
  • Acceptable to count inventory before or after
    year-end if
  • Controls are strong
  • The opportunity and motivation to misstate
    inventory is low
  • Auditor can test the year-end balance using
    analytics and tests of transactions between the
    physical count and year-end (called the
    roll-forward or rollback period)
  • Auditor reviews intervening transactions for
    unusual activity

22
Cut Off - Completeness
  • Inventory cutoff tests
  • Obtain information on last items shipped and
    received at year-end
  • Compare this information to transactions recorded
    in the sales and purchases journal
  • Determine if transaction is recorded in correct
    accounting period
  • Auditor should also inquire about any inventory
    out on consignment or stored in a public
    warehouse
  • Tracing test counts and number of high-dollar
    items to the client's inventory records tests
    completeness (as well as existence)

23
Comment on Allowance for Returns - Valuation
  • In most situations, expected returns of inventory
    are not material
  • However, some companies provide return guarantees
    and expect significant returns
  • Management can use previous experience, updated
    for current economic conditions, to develop
    estimates of returns

24
Rights
  • Most of the work regarding ownership of inventory
    is performed during the auditor's testing of
    purchases
  • Auditor should also review long-term contracts to
    determine obligations
  • Inquiry should be made about inventory on
    consignment

25
Inventory Valuation - Valuation
  • Most complex assertion related to inventory
    because of the
  • Volume of transactions
  • Diversity of products
  • Variety of costing methods
  • Difficulty in estimating net realizable value of
    products
  • Auditor uses direct tests and analytics to assess
    inventory valuation
  • Direct tests include verifying cost by reviewing
    vendor invoices
  • Auditor usually examines current market data and
    other conditions that might indicate inventory
    obsolescence
  • Management inquiry and review of industry
    publications can help the auditor identify
    obsolete units
  • Analytics, like inventory turnover or day's sales
    in inventory, may identify slow-moving
    inventory which may need to be written down
  • Auditor looks for obsolete units during the
    counting of inventory these units may need to be
    written down

26
Disclosure
  • Auditor reviews client disclosure for compliance
    with GAAP
  • Disclosure should include
  • Costing method(s) used
  • Frequency of accounting
  • Inventory pledged as collateral
  • Any other unusual circumstance

27
Cost of Goods Sold
  • Audit of cost of goods sold can be direct tied to
    the audit of inventory
  • If beginning and ending inventories have been
    verified and acquisitions have been tested, cost
    of goods sold can be direct calculated
  • Auditor should also apply analytics to cost of
    goods sold to see if there are any significant
    variations - either overall or by product line
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