MODERN AUDITING 7th Edition.ppt

MODERN AUDITING 7th EditionDeveloped by:Gregory K.Lowry,MBA,CPASaint Pauls CollegeJohn Wiley&Sons,Inc.William C.BoyntonCalifornia Polytechnic State California Polytechnic State University at San Luis Obispo University at San Luis ObispoRaymond N.JohnsonPortland State University Portland State UniversityWalter G.KellUniversity of Michigan University of MichiganCHAPTER 15AUDITING THE EXPENDITURE CYCLEuNature of the Expenditure CycleuControl Activities Purchases TransactionsuControl Activities Cash Disbursements TransactionsuSubstantive Tests of Accounts Payable BalancesuValue-Added ServicesThe expenditure cycle consists of the activities related to the acquisition of and payment for goods and services.The core expenditure cycle activities are:1.purchasing goods and services purchase transactions,and2.making payments cash disbursement transactions.Purchases and cash disbursements have a pervasive effect on the financial statements,as depicted in Figure 15-1.Nature of the Expenditure CyclePurchases and Cash DisbursementsFigure 15-1Selected Specific Audit Objectives for the Expenditure CycleFigure 15-2Understanding the Clients Business and IndustryBefore designing an expenditures audit program,the auditor must consider the clients business,the external market forces driving the business sector,and how these forces impact the entitys expenditure cycle.Nature of the Expenditure CycleMaterialityThe expenditure cycle is a core process for many industries and given the amount and volume of transactions in this cycle the risk of material misstatement is high.Figure 15-1 illustrates the fact that the transactions in this cycle affect more financial statement accounts than other cycles.The allocation of materiality to accounts affected by transactions in this cycle will vary according to the considerations explained in Chapter 8.The importance of the expenditure cycle varies by the type of business.Nature of the Expenditure CycleInherent RiskIn assessing inherent risk for expenditure cycle assertions,the auditor should consider pervasive factors that may affect assertions throughout financial statements as well as factors pertaining only to specific assertions in the expenditure cycle.Pervasive factors that might motivate management to misstate expenditure cycle assertions include:1.Pressures to understate expenses in order to report achieving announced profitability targets or industry norms,which were not achieved in reality owing to factors such as global,national,or regional economic conditions that affect operating costs,the impact of technological developments on the entitys productivity,or poor management.Nature of the Expenditure Cycle2.Pressures to understate payables in order to report a higher level of working capital when the entity is experiencing liquidity problems or going-concern doubts.Both of these factors lead to a greater risk of understatement than overstatement of expenditures and payables.The auditor should also consider the industry-related factors of the availability and price volatility of the raw materials and products needed by the entity to remain in business.Nature of the Expenditure CycleAnalytical Procedures RiskAnalytical tests are effective in identifying expenditure cycle accounts that are misstated.Analytical procedures risk is the element of detection risk that analytical procedures will fail to detect material errors.Analytical procedures are extremely cost effective.Analytical procedures that focus only on purchases and accounts payable provide the most reliable information.If a company is growing,it is common to expect purchases,inventory,and accounts payable to grow at consistent rates.Nature of the Expenditure CycleAnalytical Procedures Commonly Used to Audit the Expenditure CycleFigure 15-3Consideration of Internal Control ComponentsThe auditors understanding of internal control components is obtained by reviewing prior experience with the client,when applicable,and by inquiring of management and other entity personnel,observing activities and conditions,and inspecting documents,records,manuals,and so forth.The understanding should be documented in the form of completed questionnaires,flowcharts,or narrative memoranda.Nature of the Expenditure CycleControl EnvironmentNumerous opportunities for employee fraud in processing purchase and cash disbursements transactions,and for fraudulent financial reporting by management of expenditure cycle account balances,make the control environment factor of integrity and ethical values extremely important in the expenditure cycle.Managements commitment to competence should be reflected in the hiring,assignment,and training of personnel involved in processing purchase and cash disbursement transactions,maintaining custody of purchased assets,and reporting on expenditure cycle activities.Nature of the Expenditure CycleThe clients organizational structure and managements assignment of authority and responsibility over expenditure cycle activities should be clearly communicated and provide for clear lines of authority,responsibility,and reporting relationships.When understanding how management is held accountable for resources,it is helpful to determine:1.The reports used by management to evaluate the entitys performance review.2.How often and how quickly management reports are reviewed.3.The decisions that are based on the reports.4.The entitys policies for following up on issues raised by key reports.Nature of the Expenditure CycleManagement Risk AssessmentManagement risk assessments related to expenditure cycle activities include consideration of such matters as:1.The entitys ability to meet cash flow requirements for purchase transactions.2.Loss contingencies associated with purchase commitments.3.The continued availability of important supplies and the stability of important suppliers.4.The effect of cost increases on the entity.5.Attention to the risk of duplicate payments by the entity.6.Attention to the risk of employee fraud by the entity.Nature of the Expenditure CycleInformation and Communication(Accounting System)An understanding of the accounting system requires knowledge of the methods of data processing and key documents and records used in processing expenditure cycle transactions.It is important to understand the flow of transactions through the accounting system from initiating the transaction to its recording in the general ledger and eventual summarization in the financial statements.Nature of the Expenditure CycleKey information the auditor should understand includes:1.How purchases,payments,and returns are initiated.2.How purchase transactions are accounted for as goods and services are received or goods are returned.3.What accounting records,documents,accounts,and computer files are involved in accounting for the various stages of each purchase cycle transaction?4.The process by which an entity initiates payment for goods and services.Nature of the Expenditure CycleNature of the Expenditure CycleMonitoringSeveral types of ongoing and periodic monitoring activities in this component may provide management with information concerning the effectiveness of the other internal control components in reducing the risk of misstatements related to expenditure cycle transactions and balances.Monitoring activities about which the auditor should obtain knowledge,when applicable,include:1.ongoing feedback from the entitys suppliers concerning any payment problems or future delivery problems,munications from external auditors regarding reportable conditions or material weakness in relevant internal controls found in prior audits,and3.periodic assessments by internal auditors of control policies and procedures related to the expenditure cycle.Nature of the Expenditure CycleNature of the Expenditure CycleInitial Assessments of Control RiskThe auditors procedures to obtain an understanding of the 4 internal control components just discussed extend to the design of policies and procedures and whether they have been placed in operation,but not to determining the effectiveness of such controls.Thus,based on the information from the understanding only,the auditors initial assessment of control risk must be at the maximum.The auditor may perform some tests of controls concurrently with the procedures to obtain the required understanding.In such cases,limited assurance may be obtained about the effectiveness of those controls.Control Activities Purchase TransactionsVirtually every company that requires an audit has a computerized accounting system.There are 2 types of computer controls:1.General controls,which relate to the computer environment and have a pervasive effect on computer applications.2.Application controls,which relate to the individual computerized accounting applications,such as the expenditure cycle.Common Documents and RecordsThe following documents and records are found in most accounting systems:1.Purchase requisition.Written request for goods or services by an authorized individual or department to the purchasing department.2.Purchase order.Written offer from the purchasing department to a vendor or supplier to purchase goods or services specified in the order.3.Receiving report.Report prepared on the receipt of goods showing the kinds and quantities of goods received from vendors.Control Activities Purchase Transactions4.Vendor invoice.The bill from the vendor stating the items shipped or services rendered,the amount due,the payment terms,and the date billed.5.Voucher.An internal form indicating the vendor,the amount due,and payment date for purchases received.It is used to authorize recording and paying a liability.Many purchase systems require a complete voucher packet before approving payment.The voucher packet usually contains a copy of the appropriate purchase requisition,purchase order,receiving report,vendor invoice,and voucher all the documentation supporting the purchase transaction.Control Activities Purchase Transactions 6.Exception reports.Reports with information about transactions identified for further investigation by computer application controls.7.Voucher summary.Report of total vouchers processed in a batch or during a day.8.Voucher register.Formal accounting record of recorded liabilities approved for payment.9.Approved vendor master file.Computer file containing pertinent information on vendors and suppliers that have been approved to purchase services from and make payments to.10.Open purchase order file.Computer file of purchase orders submitted to vendors for which the goods or services have not been received.Control Activities Purchase Transactions11.Receiving file.Computer file with receiving information on quantities of inventory received from vendors.12.Purchase transactions file.Computer file containing data for approved vouchers for purchases that have been received.Used to print the voucher register and update the accounts payable,inventory,and general ledger files.Control Activities Purchase Transactions13.Accounts payable master file.Computer file containing data on approved unpaid vouchers.The file may be organized by vendor.It should sum to the balance in the accounts payable control account.14.Suspense files.Computer file that hold transactions that have not been processed because they have been rejected by computer application controls.Control Activities Purchase TransactionsControl Activities Purchase TransactionsFunctionsThe processing of purchase transactions involves the following purchasing functions:1.Initiating purchases.The request by an entity for a transaction with another entity,including:a.Placing vendors on an authorized vendor list.b.Requisitioning goods and services.c.Preparing purchase orders.Control Activities Purchase Transactions2.Receipt of goods and services.The physical receipt or shipment of a product or service,including:a.Receiving the goods.b.Storing goods received for inventory.c.Returning goods to a vendor.3.Recording liabilities.The formal recognition by an entity of a legal obligation,including:a.Preparing the payment voucher and recording the liability.b.Accountability for recorded transactions.Control Activities Purchase TransactionsObtaining an Understanding and Assessing Control RiskThe auditor should obtain an understanding of the purchase cycle that is sufficient to plan the audit.If the auditor plans to assess control risk as low for an assertion,it is particularly important that he or she obtain an understanding of control procedures for that assertion.Tests of controls provide the means for determining the effectiveness of such controls.The extent of the auditors consideration of factors related to assessing control risk for any given assertion depends on audit strategy.