Solution manual auditing and services 2e by louwers chap008

Explain the importance of the completeness assertion for the audit of accounts payable liabilities, and list some procedures for a “search for unrecorded liabilities.” 5.. Evidence about

CHAPTER 8

Acquisition and Expenditure Cycle

LEARNING OBJECTIVES

ReviewCheckpoints Exercises, Problems,and Simulations

1 Identify significant inherent risks in the

2 Describe the acquisition and expenditure

cycle, including typical source documents

and controls

3 Give examples of tests of controls for

auditing the controls over purchase of

inventory and services, and disbursement of

cash

4 Explain the importance of the completeness

assertion for the audit of accounts payable

liabilities, and list some procedures for a

“search for unrecorded liabilities.”

5 Discuss audit procedures for other accounts

affected by the acquisition and expenditure

cycle

12, 13, 14, 15, 44, 45, 46, 47, 48, 50

6 Specify some ways fraud can be found in

accounts payable and cash disbursements

7 Describe some common errors and frauds in

the acquisition and expenditure cycle, and

design some audit and investigation

procedures for detecting them

19, 20, 21, 22 39, 43, 44

8 Describe the payroll cycle, including typical

source documents and controls 8C1, 8C2 8C3, 8C4, 8C5, 8C6, 8C7, 8C16, 8C17, 8C18, 8C19, 8C20

SOLUTIONS FOR REVIEW CHECKPOINTS

8.1 The short-term effect on the financial statements for improperly capitalizing expenditures is to increase net

income because items that should be expensed are included as assets The long-term effect is the same because the assets are eventually charged to expense as depreciation

8.2 A “voucher” is a package of documents, usually with a cover page (The package can be a small envelope.)

The package-voucher contains supporting documents for a transaction For example, a purchase voucher usually contains a purchase requisition, purchase order, receiving report, vendor invoice, and a negotiable check (check copy when the vendor invoice has been paid) Required approvals and signatures are on the documents The voucher presents evidence of the documentation and control over a transaction

Computerized systems may have all this documentation in memory

In a voucher system, each voucher is “payable”, and the detail of the payables is the vouchers themselves

At any time, the company may owe a single vendor more than one invoice represented on several vouchers

In a voucher system, there is no balance payable to each vendor—just a file of different vouchers payable.8.3 A purchasing manager can direct purchases toward vendors who provide the manager kick-backs or other

inducements This can be prevented by notifying suppliers that the company will not permit payment of kick-backs to its employees The company can also rotate purchasing managers to different vendors Finally, significant purchases should be reviewed and approved by a higher level manager

8.4 A “blind” purchase order is one that does not show the quantity ordered It is given to the receiving

department so they will know what has been ordered, but they will have to do an independent count.8.5 You will find evidence about losses on purchase commitments in the open purchase order file Evidence

about unrecorded liabilities to vendors is in the (1) unmatched invoice file, and (2) unmatched receiving report file

8.6 Management reports that can be used for audit evidence, and information in them can be useful to auditors

are as follows:

 Open Purchase Orders: Purchase commitments, losses on purchase commitments

 Unmatched Receiving Reports: Goods received but not recorded as purchases or liabilities

 Unmatched Vendor Invoices: Unrecorded invoices, may represent unrecorded liabilities or items in

dispute

 Accounts Payable Trial Balance: Subsidiary ledger of accounts payable May show balances by

vendors, indicating small balances that should be large Invoice dates may reveal failure to record invoices late in the accounting period

 Purchases Journal: Listing of all purchases available for analysis of purchasing patterns and

oddities Population for sample of purchases for tests of controls

 Fixed Asset Reports: Fixed assets subsidiary ledger trial balance Scan for negative balances,

capitalized repairs, and depreciation in excess of salvage value Depreciation recalculation

8.8 1 Blank vouchers kept in secure location available only to authorized personnel

2 Blank supporting documents (invoices, receiving reports, requisitions, purchase orders) kept in

secure locations available only to authorized personnel

3 Supporting documents cancelled by Cash Disbursement function when checks are prepared

4 Separation of duties of preparers of supporting documents, preparation of vouchers, check

preparation, and check signing

5 Vouchers and other supporting documents reviewed by check signers

6 Checks mailed directly by signer and not returned to accounts payable

8.9 A low risk of material misstatement would normally result in a strategy where the auditor relies on controls

and reduces substantive tests First, the auditor would confirm the low control risk evaluation by testing controls for effectiveness Greater reliance would also be placed on analytical procedures High risk of material misstatement would result in a more substantive approach with little control testing

8.10 The purpose of the auditor’s search for unrecorded liabilities is to gather evidence as to whether the

completeness assertion is true From an evidence gathering perspective, it is much more difficult to gather evidence on unrecorded transactions than to gather evidence that recorded account balances exist

 Inquire of client personnel about their procedures for ensuring that all liabilities are recorded

 Scan the open purchase order file at year-end for indications of material purchase commitments atfixed prices Obtain current prices and determine whether any adjustments for loss and liability forpurchase commitments are needed

 Examine the unmatched vendor invoices listing and determine when the goods were received, looking

to the unmatched receiving report file and receiving reports prepared after the year-end Determinewhich invoices, if any, should be recorded

 Trace the unmatched receiving reports to accounts payable entries, and determine whether entriesrecorded in the next accounting period need to be adjusted to report them in the current accountingperiod under audit

 Select a sample of cash disbursements from the accounting period following the balance sheet date.Vouch them to supporting documents (invoice, receiving report) to determine whether the relatedliabilities were recorded in the proper accounting period

 Confirm accounts payable with vendors, especially regular suppliers showing small or zero balances inthe year-end accounts payable

8.11 Financial statement users are most troubled by missing overstated assets and understated liabilities

Therefore, they need to audit for the existence of assets and the completeness of liabilities

8.12 Typically, when auditing prepaids and accruals the auditor uses audit documentation that shows beginning

balances, payments, expense and ending balance By agreeing beginning balance to prior year’s audit documentation, vouching payments, and calculating the accuracy of the ending balance, the auditor knows that the amount charged to expense has to be correct

8.13 Non current assets such as property, plant and equipment and intangibles usually pertain to all four

management assertions about account balances The auditor must ensure that they exist and are owned In addition, the valuation determined by depreciation, amortization, or impairment charges, is usually an important issue Of the four assertions, completeness is probably the least important, but it cannot be ignored

8.14 The auditor is primarily concerned with current year transactions in property, plant and equipment

accounts, assuming that the previous year’s balances were audited Thus, additions, disposals and

depreciation charges warrant the most attention

8.15 Most expense accounts can be tested through analytical review procedures, substantive tests of transactions

or by testing them in conjunction with tests of related assets and liabilities (e.g., depreciation) Some expenses should be examined separately because of their unique nature (e.g legal expenses or

miscellaneous expense)

8.16 The following are possible “red flags” indicating a risk of fraud:

 Photocopies of invoices in the files

 Vendor’s invoices submitted in numerical order

 Vendor’s invoice amounts always in round numbers

 Vendor’s invoices always slightly lower than a review threshold

 Vendors with only post office box addresses

 Vendors with no listed telephone number

 Matching vendor and employee addresses or telephone numbers

 Multiple vendors at the same address and telephone

8.17 The auditor should begin with inquiry of the client about their knowledge of fraud or fraud risks Analytical

review procedures such as vertical and horizontal analyses can pinpoint accounts that appear to have unusual fluctuations Examining invoices and vendor files for the red flags noted above will help find phony billings The purpose is to identify fraud risk, evaluate the significance of the risk and determine the amounts of any actual fraud on the financial statements

8.18 These procedures are directed at misappropriation of assets by embezzlement Employees and their

associates are stealing assets from the company by having it pay phony expenses

8.19 Argus did not have separation of duties Different people should have authorized the copying services, and

approve the bills for payment, and coding them to projects A supervisor should have been reviewing the expenses and comparing them to the budget

8.20 The verbal inquiry procedure might produce knowledge of employee’s responsibilities to authorize

purchases of script copies, receive them, approve payment, and code invoices to projects

8.21 Given Beta Magnetic’s poor internal controls, it is possible that Martha would never have been caught

However, if the company ever contacted employees about their health claims, they would have revealed thefictitious charges

8.22 If Martha had taken a mandatory vacation, her replacement would probably have questioned the billings

from unknown physicians If the billings stopped the sharp drop in insurance costs for that period would likely be questioned by Martha’s superior

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

8.23 a Incorrect Cash disbursements are an important part of the cycle

b Incorrect Although similar to sales because they are shipped out, purchase returns are

considered part of the Acquisition and Expenditure cycle because they affect accounts payable

c Correct Although similar to purchases because they require a receiving report, sales

returns are considered part of the Revenue and Collection cycle because they affect accounts receivable

d Incorrect Prepaid Insurance is one of the many accounts in the Acquisition and

Expenditure Cycle

8.24 a Correct Cost of Goods Sold should be matched with Sales by using inventory to record

cost of goods not yet sold

b Incorrect Research and Development is a period expense that is recorded as incurred

c Incorrect Depreciation allocated over time on a systematic and rational basis, except in the

unusual situation where units-of-production depreciation is used

d Incorrect Sales are recorded when earned

8.25 a Incorrect Overstates net income in the period of capitalization

b Incorrect Overstates net income

c Correct This has no effect on net income It overstates cash and payables

8.26 a Correct The completeness assertion is very important in the audit of liabilities

b Incorrect This would restrict a company’s ability to do business

c Incorrect Auditors are normally not concerned with whom the client’s vendors are

d Incorrect Competitive bids are normally required for only large purchases

8.27 a Incorrect These duties should be separated

b Incorrect This would not necessarily prevent a duplicate payment

c Incorrect The voucher date may be several weeks before the payment is due

d Correct Cancellation (“paid”) of vouchers prevent their use a second time

8.28 a Incorrect The requisition would not result in the improper delivery

d Correct Nobody at Lake was reviewing purchase orders to notice the delivery and

payment by another party (Budd’s relative’s store) This deviation caused no direct loss to Lake, but it is a misuse of Lake’s pricing agreements with its vendors and puts Lake at risk

8.29 a Incorrect If the liability is unrecorded, it would not be on the trial balance

b Correct Auditors may be able to determine that cash disbursements in the subsequent

period are paying liabilities of the period under audit

c Incorrect This is a cut-off test b is a more direct test

d Incorrect This is only an indirect test b is a more direct test

8.30 a Incorrect This is often performed before the balance sheet date

b Incorrect This is often performed before the balance sheet date

c Correct The search for unrecorded liabilities generally depends upon using accounting

records created in the period after the year end

d Incorrect This is often performed before the balance sheet date

8.31 a Incorrect Some liabilities may be incurred but not invoiced by the vendor.

b Incorrect Purchase orders do not normally incur liabilities

c Correct The receiving reports are the population that contains the record of all goods

received for which liabilities should be recorded

d Incorrect The invoice or receiving report must be examined to determine when the

liability occurred

8.32 a Incorrect Approvals do not necessarily result in debits to the inventory

b Incorrect Purchase requisitions may not represent the actual amount received

c Correct Invoices supply relevant information about the quantities purchased and the

prices paid

d Incorrect Purchase orders may not represent the actual amount received

8.33 a Incorrect This would have insured a proper count of the tables

b Incorrect This would insure the invoice was for the amount received

c Incorrect This would insure the check was for the amount received

d Correct The P O and requisition would both show 84 tables

8.34 a Incorrect The check signer is probably not familiar with all the vendors

b Incorrect This is possible, but the maintenance costs may not have been unusual (i.e., the

costs before the fraud were below budget)

c Correct Vendors should be approved by an independent purchasing department

8.35 a Incorrect Payroll is generally audited by tests of controls, analytical procedures and

substantive tests of transactions

b Incorrect Cost of goods sold is generally audited by tests of controls, analytical

procedures and substantive tests of transactions

c Incorrect Supplies expense is generally audited in connection with supplies inventory

d Correct The auditor examines the specific charges to determine potential litigation.8.36 a Correct Property tax expense is audited in conjunction with accrued property taxes

b Incorrect Payroll is generally audited by tests of controls, analytical procedures and

substantive tests of transactions

c Incorrect There’s no asset directly related to R&D

d Incorrect The auditor examines the specific charges to determine potential litigation.8.37 c Correct Completeness is the most important assertion in this cycle Supplies expense is

generally audited in connection with supplies inventory

8.38 a Incorrect Testing occurrence would require vouching from the vouchers recorded in the

voucher register to receiving reports

b Correct This test ensures that liabilities generated by the receipt of goods are recorded in

the voucher register

c Incorrect This does not test classification, which would require examining the chart of

accounts

d Incorrect This does not test cutoff, which would require comparing the date of the

receiving report to the date recorded

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

8.39 Payable ICQ Items: Assertions, Tests of Controls, and Possible Errors or Frauds

1 a Purchases and accounts payable are authorized to assure compliance with company

policy (accuracy)

b For a sample of cash disbursements, vouch to approval signatures on invoices, receiving

reports and purchase orders

c Costs and expenses might be incurred that are not properly supported

d Select a sample of current-year debits in accounts (e.g., inventory, fixed assets, expenses),

and vouch them to supporting documents

2 a Liabilities are recorded at the appropriate quantity and description (accuracy)

b Select a sample of invoices and agree them to the receiving report Observe receiving

department counting receipts

c Vendors could bill for quantities greater than the amount actually shipped, overstating

costs or expenses

d Observe the client’s inventory account and test the reconciliation of the count to the

perpetual inventory

3 a Liabilities are recorded for actual purchases at the appropriate amounts (accuracy)

b Observe client personnel making comparisons Examine initials for approval Review

correcting journal entries that result from the comparison

c Purchases or other liabilities may be recorded for transactions that didn’t exist or at

incorrect amounts

d Reperform comparison on a test basis

4 a Journal entries are authorized and prepared in accordance with generally accepted

accounting principles (accuracy, classification)

b Examine entries for approval initials

c The company might override controls to create fraudulent entries

d Select a sample of recorded journal entries and reperform calculations and review for

appropriate accounts

8.40 Unrecorded Liabilities Procedures

a The fact that the client made a journal entry to record vendors’ invoices which were received late

should simplify the auditors’ audit for unrecorded liabilities and reduce the possibility of a need for a further adjustment, but the audit is nevertheless required If the client has not journalized late invoices, the auditors are compelled in their testing to substantiate what will ultimately be

recorded as an adjusting entry In this examination the auditors should audit entries in the voucher register for the year being audited to ascertain that all items which according to dates of receiving reports or vendors’ invoices were applicable to that year have been included in the journal entry recorded by the client

b No The auditors should obtain a letter in which responsible executives of the client’s organization

represent that to the best of their knowledge all liabilities have been recognized However, this is done as a normal audit procedure to afford additional assurance to the auditors and it does not relieve the responsibility for doing other substantive audit work

c Whenever auditors are justified in relying on work done by an internal auditor, they should curtail

(but not eliminate) their own audit work In this case, the auditors should have ascertained early in the examination that Ozine’s internal auditor is qualified by being both technically competent and objective Once satisfied as to these points, the auditors should discuss the nature and scope of the internal audit program with the internal auditor and review the working papers in order that the auditors may properly coordinate the audit program with that of the internal auditor If the Ozine internal auditor is qualified and has made tests for unrecorded liabilities, the auditors may reduce further audit work in this audit area

d In addition to the next-year voucher register, the auditors should consider the following sources for

possible unrecorded liabilities:

1 Unentered vendors’ invoice file

2 Status of tax returns for prior years still open

3 Discussions with employees

4 Representations from management

5 Comparison of account balances with preceding year

6 Examination of individual accounts during the audit

7 Existing contracts and agreements

9 Attorney’s bills and letter of representation

10 Status of renegotiable business

11 Correspondence with principal suppliers

12 Audit testing of cutoff date for reciprocal accounts, e.g., inventory and fixed assets

8.41 Accounts Payable Confirmations

a The accounts payable audit procedures should be directed toward searching for proper inclusion of

all accounts payable and ascertaining that recorded amounts are reasonably stated because the primary audit purpose is to reveal any possible material understatements

The principal objectives of the accounts payable examination are

1 To determine adequacy of internal control for processing and payment of invoices

2 To prove that amounts shown on the balance sheet are in agreement with supporting

accounting records

3 To determine that liabilities existing at the balance sheet date have been recorded

b Clark and Kent are not required to use accounts payable confirmation procedures For accounts

payable the auditor can examine external evidence such as vendor invoices and vendor statements that substantiate the accounts payable balance Although not required, the accounts payable confirmation is often used The auditor might consider such use when

1 Internal controls are weak

2 The company is in a “tight” cash position and bill-paying is slow

3 Physical inventories exceed general ledger inventory balances by significant amounts

4 Certain vendors do not send statements

5 Vendor accounts are pledged by assets

6 Vendor accounts include unusual transactions

c When auditing accounts payable the auditor is primarily concerned with the possibility of

unrecorded payables or understatement of recorded payables Selection of accounts with relativelysmall or no balances for confirmation is the more efficient direction of testing since

understatements are more likely to be detected when examining such accounts

When selecting accounts payable for confirmation, the following procedures could be followed:

1 Analyze the accounts payable population and stratify it into accounts with large balances,

accounts with small balances, accounts with zero balances, etc

2 Use a sampling technique that selects items based on criteria other than the dollar amount

of the items (e.g., select based on terminal digits, select every nth item based on predetermined interval, etc)

3 Design a statistical sampling plan that will place more emphasis on selecting accounts

with zero balances or relatively small balances, particularly when the client has had substantial transactions with such vendors during the year

4 Select prior-year vendors who are no longer used

5 Select new vendors used in the subsequent years

6 Select vendors that do not provide periodic statements

7 Select accounts reflecting unusual transactions during the year

8 Select accounts secured by pledged assets

8.42 Search for Unrecorded Liabilities

Scan the open purchase order file at year-end for indications of material purchase commitments at fixed

prices Obtain current prices and determine whether any adjustments for loss and liability for purchase commitments are needed

List the unmatched vendor invoices and determine when the goods were received, looking to the

unmatched receiving report file and receiving reports prepared after the year-end Determine which invoices, if any, should be recorded

3 Trace the year-end unmatched receiving reports to accounts payable entries, and determine

whether ones recorded in the next accounting period need to be adjusted to report them in the current accounting period under audit

4 Select a sample of cash disbursements from the accounting period following the balance sheet

date Vouch them to supporting documents (invoice, receiving report) to determine whether the related liabilities were recorded in the proper accounting period

5 Study IRS examination reports for evidence of income or other taxes in dispute, and decide

whether actual or estimated liabilities need to be recorded

6 Confirm accounts payable with vendors, especially regular suppliers showing small or zero

balances in the year-end accounts payable These are the ones most likely to be understated (Vendors’ monthly statements controlled by the auditors also may be used for this procedure.) Be sure to verify the vendors’ addresses so confirmations will not be misdirected, perhaps to

conspirators in a scheme to understate liabilities

7 Study the accounts payable trial balance for indications of dates showing fewer payables than

usual recorded near the year-end (A financial officer may be delaying the recording of vendor invoices.)

8 Use a checklist of accrued expenses to determine whether the company has been conscientious

about expense and liability accruals; including accruals for wages, interest, utilities, sales and excise taxes, payroll taxes, income taxes, real property taxes, rent, sales commissions, royalties, and warranty and guarantee expense

9 When auditing the details of sales revenue, pay attention to the terms of sales to determine

whether any amounts should be deferred as unearned revenue Inquiries directed to management about terms of sales can be used to obtain initial information, such as inquiries about customers’ rights of cancellation or return The terms may signal the need for deferred revenue accounting

10 Apply analytical procedures appropriate in the circumstances Calculate and compare the gross

margin percent of the current year to prior year(s), and compare important expense account balances to prior years to notice any that this year appear to be too low

8.43 Fictitious Vendors, Theft, and Embezzlement

In this case, let your initial objective be to select one vendor for investigation Instead of a “tests of controls” section, name the one vendor you would select from those in Exhibit 8.43-1 and tell your reasons

In the “test of balances” section, tell how you would investigate the situation In the “discovery summary” section, speculate about how your investigation might reveal the culprit

However, purchasing agents should have flexibility within operating procedures to move quickly to obtain the best balance of quantities, delivery terms, and prices as events dictate Thus they may not always obtaincompetitive bids

A higher manager level should supervise and review the results of purchasing activity on a regular basis, perhaps reperforming some price-obtaining actions occasionally to determine whether the agents are achieving efficiency Such review might also involve selecting odd situations for extensive review

Tests of Controls:

The one vendor selected is Orion Corp Key reasons for this selection are:

 Volume is high and has increased almost 1000%, more than any other vendor

 Last bid was obtained last year, older than other vendors’ bids

 The percent purchased on bid is lowest among those bid

 Collins, the manager, is in charge

 Collins purchases from several vendors without bids

8.43 Fictitious Vendors, Theft, and Embezzlement (Continued)

Audit of Balance:

Investigation of purchases from Orion:

a Review purchase invoices to determine unit prices for paper

b Compare unit prices with other suppliers

c Interview other suppliers and their salespersons to try to determine whether Collins solicited

kickbacks

d Review bid records to determine the dates of submitted bids and bid prices

e Examine Collins’ personnel file Investigate references if they were not consulted earlier Might

investigate again with more determination to notice telltale signs

f Conduct interviews with Collins and other purchasing agents under a front of learning about

purchasing procedures Carefully seek information or impressions about Collins relations with Orion

g Inquire at secretary of state office for names of Orion incorporators to see if Collins is connected

Look up officers in national executives directory to see if she is listed as an officer of Orion

h Covertly observe Collins’ lifestyle and spending habits A ruse might be used to get information

about Collins’ bank balance and activity (Overt action such as subpoena should not be used until clear evidence of guilt is available.)

DISCOVERY SUMMARY

If Collins is taking kickbacks in return for causing Bailey to pay higher prices, the price comparison information should show evidence If this is the case, the other procedures should also bear fruit—past employment history problems, police record, derogatory gossip from coworkers, more wealth than justified

by salary, maybe even a direct connection with Orion

Collins has plenty of “room” to cause Bailey a significant financial drain Purchases from Orion were

$1,220,000 over the last two years, and about $500,000 of supplies and sundries without bid from other suppliers If the overpricing to Bailey were 10% on all these purchases, it could amount to $172,000 for two years’ “work.”

P.S The title of the case “Purchasing Stars” is a clue to the solution (Orion)

8.44 Grounds for Dismissal

DISCOVERY SUMMARY

Company employees in charge of capital projects began noticing the large charges In March 2001, Doe and her husband were named in a $2.4 million civil judgment, the largest fraud in the history of King County, Washington The settlement required a list of possessions the Does had acquired The 19-page list contained 489 items Cars, pianos, and other items were sold at auction and netted The Coffee Co about

$1.8 million

Doe was a compulsive shopper The police reported there was only a small path through the rooms of her house, with boxes of her purchases stacked to the ceiling

Red flags that should have tipped off her supervisor and co-workers included:

 Doe was evasive and never satisfactorily answered questions about FCC

 When the supervisor asked to meet with FCC he was told they were working out of the office

 FCC was not registered in the State of Washington or listed in telephone directories

 FCC’s mailing address was a P.O box The physical address was Doe’s residence

 Doe requested special handling for FCC checks whereby, she picked them up personally