Lecture Auditing and assurance services (Second international edition) Chapter 11 Auditing the purchasing process

In this chapter, the learning objectives are Understand why knowledge of an entitys expense and liability recognition policies is important to the audit, understand the purchasing process, know the types of transactions in the purchasing process and the financial statement accounts affected, be familiar with the types of documents and records used in the purchasing process.

Auditing the Purchasing Process

Chapter Eleven

Expense and Liability Recognition

(IASB)

Expenses are decreases in economic benefits during the

accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases

in equity, other than those relating to

distributions to equity participants

A liability is a present obligation of the entity arising from past

events, the settlement

of which is expected to result in an outflow from the entity of resources embodying economic benefits

Overview of the Purchasing Process

A purchase transaction usually begins with a

purchase requisition generated by the user department The purchasing department

vendor When the goods are received or the

Purchase

requisition Purchase

order

Receiving report and liability recorded

Vendor

Type of Transaction Account Affected

Purchase Transaction Accounts payable

Inventory Purchases or cost of goods sold Various asset and expense accounts Cash disbursement transaction Cash

Accounts payable Cash discounts Various asset and expense accounts Purchase return transaction Purchase returns

Purchase allowances Accounts payable Various asset and expense accounts

Types of Transactions and Financial

Statement Accounts Affected

Three types of transactions are processed through the purchasing process:

Flowchart of the Purchasing Process –

EarthWear Clothiers

Department

Purchase requisition

Approved purchase requisition received Input

Error corrections

Purchase order program

Purchase order file

Accounts payable master file

Error report Purchaseorder

(4 part)

Purchasing

Vendor A/P Receiving

PO #2 Filed Numer- ically

Flowchart of the Purchasing Process –

PO #

PO

#3

Receiving report

Vendor invoice

Compare invoice

to PO and RR

Review account distribution

Voucher packet Input Error

To IT

From IT

Flowchart of the Purchasing Process –

EarthWear Clothiers

Department

IT

Accounts payable update

Purchase order file A/P masterfile ledger fileGeneral

Error report

Input from A/P

Report

to A/P

A/P reporting

Weekly Monthly

A/P listing

Cash disbursement report

Daily

Daily

Monthly reports

General ledger

Open PO report A/P expense distribution report Voucher register

Cash disbursements journal

Flowchart of the Purchasing Process –

EarthWear Clothiers

Department

Cash disbursement report

Review documents and authorize payment

Cash disbursement report

A/P master file

Cash disbursement program

Cheques

Cheques

Review cheques and mail to vendors

Cheques

Types of Documents and Records

Purchasing documents and records

1 Purchase Requisition – request to purchase goods or services.

2 Purchase Order – includes description, quality, and quantity or goods

or services being purchased.

3 Receiving Report – records the receipt of goods.

4 Vendor Invoice – the bill from the vendor.

5 Voucher – serves as the basis for recording a vendor’s invoice.

6 Voucher Register – used to record vouchers for goods and services.

7 Accounts Payable Subsidiary Ledger – includes amount owed to

individual vendors.

8 Vendor Statement – represents the purchase activity with vendor.

9 Electronic Funds Transfer and Cheques – pays for goods or

services.

10 Cash Disbursements Journal – contains columns to record credits to cash and debits to accounts payable and cash discounts.

The Major Functions

Functions of the Purchasing Process

Requisitioning

Initiation and approval of requests for goods and services

by authorized individuals consistent with management criteria.

Purchasing Approval of purchase orders and proper execution as to

price, quantity, quality and vendor.

Receiving Receipt of properly authorized goods and services.

Invoice processing

Processing of vendor invoices for goods and services received; also, processing of adjustments for allowances, discounts and returns.

Disbursements Processing of payment to vendors.

Accounts payable Recording of all vendor invoices, cash disbursements and

adjustments in individual vendor accounts.

General ledger Proper accumulation, classification, and summarization of purchases, cash disbursements and payables in the

general ledger.

Key Functions and Duties

Segregation of Duties Possible Errors or Fraud

The purchasing function should be

segregated from the requisitioning

and receiving functions.

If one individual is responsible for the requisition, purchasing, and receiving functions, fictitious purchases can be made This can result in the theft of goods and possibly payment for unauthorized purchases

The invoice-processing function

should be segregated from the

accounts payable function.

If one individual is responsible for the processing and accounts payable function, purchase transactions can be processed at the wrong price or terms, or a cash disbursement can be processed for goods not received This can result in overpayment of goods or the theft of cash.

invoice-The disbursement function should be

segregated from the accounts

payable function.

If one individual is responsible for the disbursement function and also has access to the accounts payable records, unauthorized checks supported by fictitious documents can be issued, and unauthorized

transactions can be recorded This can result in theft of the entity's cash.

The accounts payable function

should be segregated from the

general ledger function.

If one individual is responsible for the accounts payable records and also for the general ledger, that individual can conceal any defalcation that would normally be detected by reconciling subsidiary records with the general ledger control account

The Key Segregation of Duties

Purchasing and Accounts

Payable Purchasing Receiving Accounts Payable Cashier's IT Preparation and approval of

Coding of account distributions X

Updating of accounts payable

Preparation of payments to

Electronic funds transfer, and

signing and mailing of cheques X

Preparation of the voucher

Reconciliation of voucher register

Department

Inherent Risk Assessment

Industry-Related Factors

1.Is the supply of raw

materials adequate?

2.

How volatile are raw material prices?

Inherent Risk Assessment

Misstatements Detected in Prior Audits

Generally, the purchasing process is not difficult to audit and does not present

contentious accounting issues However, the auditor’s experience in past audits must be considered when assessing inherent risk

Control Risk Assessment

Major steps in setting the control risk in the

purchasing process.

Understand and document the purchasing process

based on a reliance strategy.

Plan and perform tests of controls of purchase

transactions.

Set and document the control risk for the purchasing

process.

Control Risk Assessment

Information Systems and Communication

For each major class of transactions in the purchasing process, the auditor must obtain the following

information:

1 How purchase, cash disbursements and purchase return transactions are initiated.

2 The accounting records, supporting documents and

accounts involved in processing purchases, cash

disbursements and purchase returns.

3 The flow of each type of transaction from initiation to

inclusion in the financial statements, including computer processing.

4 The process used to estimate accrued liabilities.

Control Risk Assessment

After testing controls, the auditor sets the level

of control risk When tests of controls support

the planned level of control risk, no modifications are necessary to detection risk The auditor may proceed with the substantive

procedures as planned

When tests do not support

the planned control risk, the

auditor lowers the level of

detection risk leading to more

substantive procedures.

Control Activities and Tests of Controls –

Purchase Transactions

Assertions about Classes of Transactions and Events for

the Period under Audit

Occurrence All purchases and cash disbursements have been

recorded and have occurred and pertain to the entity.

Completeness All purchases and cash disbursements that should

have been recorded have been recorded.

Authorization All purchase and cash disbursements are properly

authorized.

Accuracy Amounts relating to recorded purchases and cash

disbursements have been recorded properly and properly accumulated from journals to ledgers.

Cut-off Purchases and cash disbursements have been

recorded in the correct accounting period.

Classification Purchases and cash disbursements have been

recorded in the proper account.

Control Activities and Tests of Controls –

Purchase Transactions

Assertions Tests of Controls

Occurrence

Observe and evaluate proper segregation of duties Test a sample

of vouchers for the presence of an authorized purchase order and receiving report Examine paid vouchers and supporting documents for indication of cancellation.

Completeness

Review procedures for accounting for numerical sequence of purchase orders, receiving reports, and vouchers Trace a sample

of receiving reports to their vendor invoices and vouchers Trace

a sample of vouchers to the purchases journal.

Authorization Examine purchase requisitions or purchase orders for proper

approval Review client's competitive bidding process.

Accuracy

Recompute the mathematical accuracy of vendor invoice Agree information in the sample of vouchers for product, quantity, and price Examine reconciliation of vouchers to daily accounts payable report.

Cut-off

Compare the dates on receiving reports with the dates on the relevant vouchers Compare the dates of vouchers with the dates they were recorded in the purchases journal.

Classification Review purchases journal and general ledger for reasonableness

Examine a sample of vouchers for proper classification.

Control Activities and Tests of Controls –

Cash Disbursement Transactions

Occurrence of Cash Disbursement Transactions

The auditor is concerned with a misstatement

caused by a cash disbursement being recorded in the client’s record when no payment was made The primary control activities to prevent such misstatements

vendor statements, and monthly bank

reconciliations

Control Activities and Tests of Controls –

Cash Disbursement Transactions

Completeness of Cash Disbursement

Transactions

The major audit concern is that a cash disbursement is made but not recorded in the

client’s procedures for reviewing vendor

disbursements with posting to the accounts

payable subsidiary records

Control Activities and Tests of Controls –

Cash Disbursement Transactions

Authorization of Cash Disbursement Transactions

Proper segregation of duties reduces the likelihood that unauthorized cash disbursements

are made The individual who approves a purchase should not have direct access to the

cash disbursement

Control Activities and Tests of Controls –

Cash Disbursement Transactions

Accuracy of Cash Disbursement Transactions

One of the major audit concerns is that the payment amount is recorded incorrectly To detect such an error, client personnel should

reconcile the total of electronic cash disbursements transfer and the cheques issued each day with the daily cash disbursements

report.

Control Activities and Tests of Controls –

Cash Disbursement Transactions

Cut-off of Cash Disbursement Transactions

The auditor’s tests of controls include reviewing the reconciliation of payments transfers with postings to the cash disbursements journal and accounts payable subsidiary records The auditor also tests cash disbursements before and after

year-end to ensure that transactions are

recorded in the proper period

Control Activities and Tests of Controls –

Cash Disbursement Transactions

Classification of Cash Disbursement

Transactions

The auditor is concerned that a cash disbursement may be charged to the wrong general ledger account The use of a chart of accounts, as well as independent approval and review of the account code on the voucher

should provide adequate control

Control Activities and Tests of Controls –

Purchase Return Transactions

Generally, the number and magnitude of purchase return transactions are not material The auditor normally does not test controls relating to purchase returns Substantive testing

is used to test the reasonableness of the amount

Relating the Assessed Level of Control

Risk to Substantive Procedures

If the results of the tests of controls support the

achieved level of control risk, the auditor conducts substantive procedures at the planned level If the results do not support the achieved level of control risk, the auditor reduces the detection risk, which will increase substantive

procedures

Auditing Accounts Payable and Accrued

Expenses

Assertions about Account Balances at the Period End:

Existence Accounts payable and accrued expenses are valid liabilities.

Rights and obligations Accounts payable and accrued expenses are obligations of the entity.

Completeness All accounts payable and accrued expenses have been recorded.

Valuation and allocation Accounts payable and accrued expenses are included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments are appropriately recorded.

Auditing Accounts Payable and Accrued

Expenses

Assertions about Presentation and Disclosure:

Occurrence and rights and obligations All disclosed events, transactions, and other matters relating to accounts payable and accrued expenses have occurred and pertain to the entity.

Completeness All disclosures relating to accounts payable and accrued expenses that should have been included in the financial statements have been included.

Classification and understandability Financial information relating to accounts payable and accrued expenses is appropriately presented and described, and disclosures are clearly expressed.

Accuracy and valuation Financial and other information relating to accounts payable and accrued expenses are disclosed fairly and at appropriate amounts.

Auditing Accounts Payable and Accrued

Expenses

Substantive Analytical Procedures

Substantive Analytical Procedure Possible Misstatement Detected

Compare payables turnover and days outstanding in accounts payable to previous years' and industry data.

Under- or overstatement of liabilities and expenses.

Compare current-year balances in accounts payable and accruals with prior years' balances.

Under- or overstatement of liabilities and expenses.

Compare amounts owed to individual vendors in the current year's accounts payable listing to amounts owed in prior years.

Under- or overstatement of liabilities and expenses.

Compare purchase returns and allowances

as a percentage of revenue or cost of sales

to prior years' and industry data.

Under- or overstatement of purchase returns.

Tests of Details of Transactions,

Account Balances and Disclosures

Accuracy

Obtain a listing of accounts payable, foot the listing, and agree it to the general ledger control account Selected vouchers or vendor accounts should be traced to the supporting documents or subsidiary accounts payable records to verify the accuracy of the details