Audit of Acquisition Cycle and Inventory - PowerPoint PPT Presentation

About This Presentation

Audit of Acquisition Cycle and Inventory


The acquisition cycle covers the purchase, receipt, payment, and accounting for ... New products introduced only after market studies and quality control tests have ... – PowerPoint PPT presentation

Number of Views:606
Avg rating:3.0/5.0
Slides: 28
Provided by: Michae8


Transcript and Presenter's Notes

Title: Audit of Acquisition Cycle and Inventory

Chapter 11
  • Audit of Acquisition Cycle and Inventory

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

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
  • Executives abusing travel and entertainment
    expenses for personal use
  • Capitalizing expenses as assets to inflate
  • Overestimating "restructuring reserves" at the
    time of acquisition so expenses could be reduced
    in future periods

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
  • 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
  • Travel and entertainment expense accounts that do
    not have documentation
  • Inadequate follow-up to auditor recommendations
    on needed controls

What analytical analysis can be done for
  • Analytical procedures to identify potential
  • 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

Overview of Control Procedures and Control Risk
  • 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
  • Purchase orders must be properly authorized
  • Many companies have separate purchasing
  • 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

Overview of Control Procedures and Control Risk
  • 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
  • Receiving department records quantity of goods
  • Goods also inspected for quality
  • Receiving reports sent to accounting

Overview of Control Procedures and Control Risk
  • 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

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

What are some substantive tests of accounts
  • 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
  • Tests of subsequent disbursements
  • Analytical review of related accounts

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

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
  • If disbursement is for audit year transaction,
    auditor reprocesses the transaction to see if it
    was properly recorded as a payable

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

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
  • Substantive audit procedures include
  • Detailed tests of transactions
  • Analytical review
  • Review of unusual entries

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
  • Many frauds involve the inventory account
  • Easily transportable making it subject to double
  • May be stored at multiple locations, some may be
  • May be returned by customers

What are some internal controls for inventory?
  • A well-designed inventory control system should
  • All purchases are authorized
  • Accounting system ensures timely, accurate, and
    complete recording
  • Receipt of inventory properly accounted for
  • Inventory tested for quality when
  • Costs properly identified and assigned to
  • Customer returns of inventory examined for
  • 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

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

Procedures for Observing a Client's Physical
Inventory - Existence
  • Meet with client to discuss their plan to count
  • Review client's plans for counting and tagging
  • Review inventory counting procedures with audit
  • 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
  • Observe procedures to shut down receipt or
    shipment of goods obtain document numbers for
    last receipt and shipment for cutoff tests

Procedures for Observing a Client's Physical
Inventory - Existence
  • Observe the counting of inventory and note the
  • 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

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
  • 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

Counting Inventory Before or After Year-end -
  • 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

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
  • Tracing test counts and number of high-dollar
    items to the client's inventory records tests
    completeness (as well as existence)

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

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

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
  • 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
  • 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

  • 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

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
Write a Comment
User Comments (0)