Audit of Acquisition Cycle and Inventory

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Chapter 11

• Audit of Acquisition Cycle and Inventory

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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)

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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

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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

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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

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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

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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