CHAPTER 11 AUDITING INVENTORY, GOODS AND SERVICES, AND ACCOUNTS PAYABLE: THE ACQUISITION AND PAYMENT CYCLE - PDF

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A U D I T I N G A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT 9 th Edition Karla M. Johnstone Audrey A. Gramling Larry E. Rittenberg CHAPTER 11 AUDITING INVENTORY, GOODS AND SERVICES, AND ACCOUNTS
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A U D I T I N G A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT 9 th Edition Karla M. Johnstone Audrey A. Gramling Larry E. Rittenberg CHAPTER 11 AUDITING INVENTORY, GOODS AND SERVICES, AND ACCOUNTS PAYABLE: THE ACQUISITION AND PAYMENT CYCLE LEARNING OBJECTIVES 1. Identify the significant accounts, disclosures, and relevant assertions in the acquisition and payment cycle 2. Identify and assess inherent risks of material misstatement in the acquisition and payment cycle 3. Identify and assess fraud risks of material misstatement in the acquisition and payment cycle 4. Identify and assess control risks of material misstatement in the acquisition and payment cycle 11-2 LEARNING OBJECTIVES 5. Describe how to use preliminary analytical procedures to identify possible material misstatements in acquisition and payment cycle accounts, disclosures, and assertions 6. Determine appropriate responses to identified risks of material misstatement for acquisition and payment cycle accounts, disclosures, and assertions 11-3 LEARNING OBJECTIVES 7. Determine appropriate tests of controls and consider the results of tests of controls for acquisition and payment cycle accounts, disclosures, and assertions 8. Determine and apply sufficient appropriate substantive audit procedures for testing acquisition and payment cycle accounts, disclosures, and assertions 11-4 LEARNING OBJECTIVES 9. Apply the frameworks for professional decision making and ethical decision making to issues involving conducting the audit of acquisition and payment cycle accounts, disclosures, and assertions 11-5 THE AUDIT OPINION FORMULATION PROCESS 11-6 PROFESSIONAL JUDGMENT IN CONTEXT - THOR INDUSTRIES, INC. AND MARK SCHWARTZ OFF Fraud perpetrated by: Making fictitious journal entries Understating the cost of inventory purchases, thereby achieving lower cost of goods sold and higher net income Audit firm, Deloitte, issued unqualified audit opinions and agreed with management s assessment that internal controls were effective 11-7 PROFESSIONAL JUDGMENT IN CONTEXT - THOR INDUSTRIES, INC. AND MARK SCHWARTZ OFF Following the discovery of fraud, a material weakness in internal controls was also reported Company was fined $1 million and Schwartz off was permanently barred from serving as an officer or director of a public company, and was fined $394,830 by the SEC 11-8 PROFESSIONAL JUDGMENT IN CONTEXT - THOR INDUSTRIES, INC. AND MARK SCHWARTZ OFF What types of accounts are included in the audit of the acquisition and payment cycle? (LO 1) What are the inherent, fraud, and control risks that exist in this cycle? (LO 2, 3, 4) The Thor and Schwartz off case illustrates control deficiencies that enabled the fraud to go undetected. What do these types of control deficiencies imply about the approach the auditor will need to use to audit the inventory-related accounts and assertions? (LO 4, 6, 7) 11-9 PROFESSIONAL JUDGMENT IN CONTEXT - THOR INDUSTRIES, INC. AND MARK SCHWARTZ OFF What controls can mitigate the risks associated with accounts in the acquisition and payment cycle? (LO 4) What substantive audit procedures could have detected this type of fraud earlier? (LO 6, 8) 11-10 EXHIBIT MAJOR ACCOUNTS IN ACQUISITION AND PAYMENT CYCLE 11-11 INVENTORIES Items of tangible personal property held for sale in ordinary course of business, that are: In process of production for such sale To be currently consumed in production of goods or services to be available for sale Accounting for inventories is significant to balance sheet and income statement 11-12 ACTIVITIES INVOLVED IN ACQUISITION AND PAYMENT CYCLE Requisition for goods or services Cash disbursements Purchase of goods and services Approval of items for payment Receipt of, and accounting for, goods and services 11-13 ACTIVITIES INVOLVED IN THE ACQUISITION AND PAYMENT CYCLE Requisition: Request for purchase of goods or services by an authorized department or function Documented on paper or in a computer system Might involve an automated purchasing system: Networked software system linking a company s Web site to vendors whose offerings and prices have been preapproved by appropriate management Enables purchasers to negotiate favorable prices with vendors 11-14 BENEFICIAL TASKS PERFORMED BY AUTOMATED PURCHASING SYSTEM Applying preloaded specifications and materials lists to the system to start the process Automatically flagging invoices that do not reconcile with purchase orders Creating change orders and analyzing variances from purchase orders 11-15 SUPPLY CHAIN MANAGEMENT Management and control of materials in logistics process from acquisition of raw materials to delivery of finished products to the end user Acquisition and payment cycle within a company is a computerized process that is integrated with supply chain management 11-16 RELEVANT FINANCIAL STATEMENT ASSERTIONS - ASSERTIONS RELEVANT TO INVENTORY Existence or occurrence Inventory balances exist at balance sheet date Completeness Inventory balances include all inventory transactions that have taken place during the period Rights and obligations Company has title to inventory as of the balance sheet date Valuation or allocation Recorded balances reflect true underlying economic value of those assets Presentation and disclosure Inventory is properly classified on the balance sheet and disclosed in the notes to the financial statements 11-17 RELEVANT FINANCIAL STATEMENT ASSERTIONS - ASSERTIONS RELEVANT TO ACCOUNTS PAYABLE Existence or occurrence Accounts payable balances exist at the balance sheet date Completeness Accounts payable balances include all accounts payable transactions that have taken place during the period Rights and obligations Company owes a liability for accounts payable as of balance sheet date Valuation or allocation Recorded balances reflect true underlying economic value of those liabilities Presentation and disclosure Accounts payable is properly classified on the balance sheet and disclosed in the notes to the financial statements 11-18 LEARNING OBJECTIVE 2 IDENTIFY AND ASSESS INHERENT RISKS OF MATERIAL MISSTATEMENT IN THE ACQUISITION AND PAYMENT CYCLE PERFORMING RISK ASSESSMENT PROCEDURES Requires information about: Inherent risks at the: Financial statement level Account and assertion levels Fraud risks including feedback from audit team brainstorming sessions Strengths and weaknesses in internal control Results from preliminary analytical procedures 11-20 IDENTIFYING INHERENT RISKS Inventory is a complex accounting and auditing area It is usually material, complex, and subject to manipulation Large number of inventory-related frauds have been perpetrated Requires exercise of high levels of professional skepticism by the auditor 11-21 LEARNING OBJECTIVE 3 IDENTIFY AND ASSESS FRAUD RISKS OF MATERIAL MISSTATEMENT IN THE ACQUISITION AND PAYMENT CYCLE IDENTIFYING FRAUD RISK FACTORS Frauds in this cycle involve overstatement of inventory or assets and understatement of expenses Theft of inventory by the employee Inventory shrinkage: Reduction in inventory presumed to be due to physical loss or theft Employee schemes involving fictitious vendors as means to transfer payments to themselves 11-23 EXHIBIT APPROACHES FOR MANIPULATING INVENTORY AND COST OF GOODS SOLD 11-24 AUDITING IN PRACTICE - FRAUD IN THE ACQUISITION AND PAYMENT CYCLE AT WORLDCOM Recorded billions of line rental expenses as fixed assets Auditors were not suspicious because expenses were consistent with previous years Auditors should have been skeptical that WorldCom was able to achieve what other companies in its industry could not 11-25 AUDITING IN PRACTICE - FRAUD IN THE ACQUISITION AND PAYMENT CYCLE AT PHAR-MOR Diverted more than $10 million to support a now failed minor-league basketball league To cover up - Inflated the inventory costs at each store Overstatements were needed to balance the cash outflow to the creation of an asset 11-26 LEARNING OBJECTIVE 4 IDENTIFY AND ASSESS CONTROL RISKS OF MATERIAL MISSTATEMENT IN THE ACQUISITION AND PAYMENT CYCLE IDENTIFYING CONTROL RISKS A need to understand the controls that the client designs and implements to address the inherent and fraud risks of material misstatement For gaining an overall understanding of internal controls, auditor considers entity-wide controls and transaction controls at the account and assertion levels Such understanding is normally gained by means of a walkthrough of the process, inquiry, observation, and review of the client s documentation 11-28 ENTITY-WIDE CONTROL Auditor considers the control environment that includes such principles as: Commitment to integrity and ethical values Holding individuals accountable for their internal control responsibilities 11-29 REASONABALE ASSURANCE REQUIRED FROM INVENTORY CONTROL SYSTEM All purchases are authorized Existence of timely, accurate, and complete recording of inventory transactions Receipt of inventory is properly accounted for and independently tested to verify quality in adherence to company standards Cost accounting system is up-to-date 11-30 REASONABLE ASSURANCE REQUIRED FROM INVENTORY CONTROL SYSTEM Periodic inventory system: No continuous record of changes in inventory is kept Ending inventory is determined by an actual physical count of every item Perpetual inventory system: Book inventory is continuously in agreement with inventory on hand within specified time periods, useful in: Useful in keeping track of actual availability of goods Determining what the correct time to reorder might be 11-31 REASONABLE ASSURANCE REQUIRED FROM INVENTORY CONTROL SYSTEM Cycle counts: Periodic testing of accuracy of perpetual inventory record by counting all inventories on a cyclical basis Products are systematically reviewed for obsolescence Management periodically Reviews inventory Takes action on excessive inventory Manages inventory to minimize losses caused by technological obsolescence 11-32 REASONABLE ASSURANCE REQUIRED FROM INVENTORY CONTROL SYSTEM New products are introduced only after market studies and quality-control tests are made Long-term contracts are closely monitored 11-33 EXHIBIT OVERVIEW OF COMMON CONTROLS IN THE REQUISITION PROCESS 11-34 CONTROLS RELATED TO PURCHASE OF GOODS AND SERVICES Approval of a contract with suppliers Restricted access to the computer program Monitoring of inventory and purchase levels by management To avoid the risk of purchasing agents entering into kickback arrangements with vendors, controls include: Requiring competitive bids for large purchases Rotating purchase agents across product lines 11-35 AUDITING IN PRACTICE - WEAK INTERNAL CONTROLS, UNETHICAL DECISIONS, AND A FICTITIOUS VENDOR Weak controls led to a fraud in the automotive parts production industry Manager in charge Asked vendors to provide money and gifts and later required a commission (bribe) on sales Set up a fictitious vendor and embezzled nearly $200,000 over about 18 months 11-36 AUDITING IN PRACTICE - WEAK INTERNAL CONTROLS, UNETHICAL DECISIONS, AND A FICTITIOUS VENDOR Lessons from this fraud: If controls are not followed, employees may exploit this situation Fraud hotlines required for employees, vendors, and third parties to report inappropriate activity without fear of retaliation Professional skepticism is required by the company and its external auditors Controls must be strong in the purchasing area Mandating vacations for all employees can be a useful control in trying to prevent and detect fraud 11-37 CONTROLS RELATED TO PURCHASE OF GOODS AND SERVICES Companies may consider the following additional controls Maximum quantity that can be ordered within a given time period Minimum amount of previous usage during a specified time period Required review by a purchasing agent for some accounts or for high-dollar levels 11-38 RECEIPT OF, AND ACCOUNTING FOR, GOODS AND SERVICES Receiving department should make sure that: Only authorized goods are received Goods meet order specifications Accurate count of the goods received is taken Accountability is established to assure that all receipts are recorded 11-39 ALTERNATIVE METHODS OF RECORDING THE RECEIPT OF GOODS Preparing prenumbered receiving documents to record all receipts by the receiving department Electronically scanning bar codes on the goods received to record quantity by the receiving department Receiving goods directly in the respective departments, such as office supplies, and approving payment for the merchandise Receiving goods directly into the production process 11-40 EXHIBIT COMPARISON OF CONTROLS IN TRADITIONAL AND AUTOMATED SYSTEMS 11-41 THREE-WAY MATCH: CONTROL FOR PAYMENT APPROVAL Type of control that determines accuracy of vendor s invoice by matching: Purchase Order Receiving Information Vendor invoice In case of discrepancies: Review with purchasing agent Supporting documentation and authorization are presented to accounts payable department for payment 11-42 AUTOMATED MATCHING PROCESS Purchase orders are entered into a purchase order database that is accessed by the receiving department Receipt of goods recorded through scanning the bar code and cross-referencing the receipt to the purchase order Computerized application matches the three documents. If the three-way match is within a prespecified tolerance limit, the invoice is approved for payment A payment date is scheduled, and a check is automatically generated on the scheduled date and is signed using an authorized signature plate 11-43 CONTROL PROCEDURES IN AUTOMATED MATCHING PROCESS Authorized vendors Restricted access Automatic processes Reconciliations inherent in the process Automation of error-prone activities Restricted access to transferring funds Monitoring 11-44 CONTROLS FOR AUTOMATED CASH DISBURSEMENTS Review of transactions - Involves reviewing the expenditures and comparing them to other key data Direction of vendor disputes to someone outside the process Periodic review of the system by the internal audit department Periodic reconciliation of inventory on hand with inventory per the books 11-45 EXHIBIT CONTROL RISK ASSESSMENT QUESTIONNAIRE: ACQUISITION AND PAYMENT CYCLE 11-46 LEARNING OBJECTIVE 5 DESCRIBE HOW TO USE PRELIMINARY ANALYTICAL PROCEDURES TO IDENTIFY POSSIBLE MATERIAL MISSTATEMENTS IN ACQUISITION AND PAYMENT CYCLE ACCOUNTS, DISCLOSURES, AND ASSERTIONS EXHIBIT USING RATIOS IN PRELIMINARY ANALYTICAL PROCEDURES IN THE ACQUISITION AND PAYMENT CYCLE 11-48 FACTORS SUGGESTING A HEIGHTENED RISK OF FRAUD IN ACQUISITION AND PAYMENT CYCLE Unexpected increases in gross margin Inventory that is growing at a rate greater than sales Expenses that are either significantly above or below industry norms Unexpected increases in the number of suppliers Capital assets that seem to be growing faster than the business and for which there are no strategic plans 11-49 FACTORS SUGGESTING A HEIGHTENED RISK OF FRAUD IN ACQUISITION AND PAYMENT CYCLE Expense accounts that have significant credit entries Travel and entertainment expense accounts, but no documentation or approval of expenditures Inadequate follow-up to the auditor s recommendations on needed controls 11-50 LEARNING OBJECTIVE 6 DETERMINE APPROPRIATE RESPONSES TO IDENTIFIED RISKS OF MATERIAL MISSTATEMENT FOR ACQUISITION AND PAYMENT CYCLE ACCOUNTS, DISCLOSURES, AND ASSERTIONS RESPONDING TO IDENTIFIED RISKS OF MATERIAL MISSTATEMENT Developing an audit approach that includes: Tests of controls, if applicable Substantive procedures Tests of details Substantive analytical procedures, if applicable Appropriateness and sufficiency of selected procedures vary for each relevant assertion 11-52 EXHIBIT PANEL A: SUFFICIENCY OF EVIDENCE FOR EXISTENCE OF INVENTORY 11-53 EXHIBIT PANEL B: APPROACHES TO OBTAINING AUDIT EVIDENCE FOR EXISTENCE OF INVENTORY 11-54 LEARNING OBJECTIVE 7 DETERMINE APPROPRIATE TESTS OF CONTROLS AND CONSIDER THE RESULTS OF TESTS OF CONTROLS FOR ACQUISITION AND PAYMENT CYCLE ACCOUNTS, DISCLOSURES, AND ASSERTIONS SELECTING CONTROLS TO TEST The internal controls to be tested are those that help to assure that all purchases are: Authorized and all payments are for goods received, Made at appropriate amount and in correct time period Paid only once to the authorized vendor 11-56 TYPICAL TESTS OF CONTROLS Inquiry of relevant personnel Observation of the control being performed Examination of documentation corroborating that the control has been performed Reperformance of the control by the auditor testing the control 11-57 PERFORMING TESTS OF CONTROLS Evidence of proper authorization Paper-based systems Signatures and appropriate documentation Computerized systems Controlled through access controls and exception reports that are tested using computerized audit techniques Inquiry and examination of documentation 11-58 OUTCOMES OF CONSIDERING THE RESULTS OF TESTS OF CONTROLS When control deficiencies are identified Assess those deficiencies to determine their severity Modify the preliminary control risk assessment Document the implications of the control deficiencies 11-59 OUTCOMES OF CONSIDERING THE RESULTS OF TESTS OF CONTROLS When no control deficiencies are identified Determine whether the preliminary assessment of control risk as low is still appropriate Determine the extent that controls can provide evidence on the correctness of account balances Determine planned substantive audit procedures 11-60 AUDITING IN PRACTICE - INVENTORY CONTROLS AT CSK AUTO CORPORATION Highlights the implications of ineffective controls over inventory Control deficiencies were assessed to be material weaknesses CSK s auditors would have to rely heavily on substantive tests of details to obtain sufficient evidence related to inventory 11-61 LEARNING OBJECTIVE 8 DETERMINE AND APPLY SUFFICIENT APPROPRIATE SUBSTANTIVE AUDIT PROCEDURES FOR TESTING ACQUISITION AND PAYMENT CYCLE ACCOUNTS, DISCLOSURES, AND ASSERTIONS SUBSTANTIVE TESTS OF INVENTORY AND COST OF GOODS SOLD Requires assurance that inventory: Exists Is actually owned by the company Is valued accurately Should be performed for all relevant assertions related to: Significant acquisition and payment cycle accounts Disclosures 11-63 EXHIBIT ASSERTIONS AND SUBSTANTIVE AUDIT PROCEDURES FOR INVENTORY AND COST OF GOODS SOLD 11-64 SUBSTANTIVE ANALYTICAL PROCEDURES Reasonableness test Example - To estimate account balance and to determine whether that amount is close to what the client has recorded Regression analysis 11-65 AUDITING IN PRACTICE - WEAKNESSES IN PERFORMING SUBSTANTIVE ANALYTICAL PROCEDURES Deloitte s PCAOB Inspection Report - Example of the inappropriate use of substantive analytical procedures Firm failed to perform sufficient procedures to test existence of issuer s inventory Used a substantive analytical procedure to test the year-end inventory balance, but the procedure was inappropriately used 11-66 AUDITING IN PRACTICE - WEAKNESSES IN PERFORMING SUBSTANTIVE ANALYTICAL PROCEDURES Used inventory balances from small number of locations at which it had performed inventory observations during the first half of the year to predict the inventory balances Did not obtain evidence that inventory balances at the issuer s retail locations were similar 11-67 INVENTORY AND COST OF GOODS SOLD: EXISTENCE OR OCCURRENCE ASSERTION Reviewing client s proposed physical inventory procedures to determine whether they are likely to result in a complete and correct physical inventory Observing client s count of annual physical inventory Randomly selecting items from client s perpetual inventory record and observing the items on hand Sample should emphasize high-dollar-value items 11-68 COMPLETE YEAR-END PHYSICAL INVENTORY Observe the client taking inventory to determine the accuracy of the procedures Make selected test counts that can later be traced into the client s inventory compilation Test client s inventory compilation by tracing test counts to the compilation and independently test the client s computation of extended cost Look for evi
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