Chapter 11

Auditing the Purchasing Process

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Expense and Liability Recognition

Expenses are outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entitys ongoing major or central operations.

LO# 1

Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
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Overview of the Purchasing Process

A purchase transaction usually begins with a purchase requisition generated by the user department. The purchasing department prepares a purchase order that is sent to the vendor. When the goods are received or the services rendered, a liability is recorded. Finally, the entity pays the vendor.
Purchase requisition Purchase order Receiving report and liability recorded

LO# 2

Vendor

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LO# 3

Types of Transactions and Financial Statement Accounts Affected

Three types of transactions are processed through the purchasing process:
Type of Transaction Purchase Transaction Account Affected 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
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LO# 3

Flowchart of the Purchasing Process EarthWear Clothiers

Department
Requesting
Purchase requisition

Purchasing
Approved purchase requisition received Purchase order file

IT
Accounts payable master file

Input

Purchase order program Vendor

Purchase order (4 part)

Error corrections
PO #2 Filed
Numerically

Error report

A/P Receiving Purchasing

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LO# 3

Flowchart of the Purchasing Process EarthWear Clothiers

Department
Receiving
PO #1

Accounts Payable (A/P)

PO #A

Compare invoice to PO and RR Review account distribution Voucher packet

Goods received, counted, and inspected Receiving report (RR)

Enter vendor, quantity, and PO # Daily receiving log

Receiving report Vendor invoice

Input
Error correction

To IT

From IT 11-6

LO# 3

Flowchart of the Purchasing Process EarthWear Clothiers

Department
IT
Purchase order file A/P master file General ledger file
Open PO report Input from A/P

Accounts payable update

Weekly Monthly
Daily

A/P reporting A/P listing Cash disbursement report

Monthly reports

A/P expense distribution report Voucher register Cash disbursements journal

Report to A/P

Error report

Daily

General ledger
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LO# 3

Flowchart of the Purchasing Process EarthWear Clothiers

Department
IT
A/P master file

Accounts Payable (A/P)

Cash disbursement report

Cashier
Checks

Review documents and authorize payment

Cash disbursement program

Review checks and mail to vendors

Cash disbursement report

Checks

Checks

Input

To Vendors
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LO# 4

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 vendors 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. Check pays for goods or services. 10. Check Register contains columns to record credits to cash and debits to accounts payable and cash discounts.
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LO# 5

The Major Functions

Functions of the Purchasing Process Initiation and approval of requests for goods and services Requisitioning by authorized individuals consistent with management criteria. Approval of purchase orders and proper execution as to Purchasing price, quantity, quality, and vendor. Receiving Receipt of properly authorized goods and services. Processing of vendor invoices for goods and services Invoice processing received; also, processing of adjustments for allowances, discounts, and returns. Disbursements Processing of payment to vendors. Recording of all vendor invoices, cash disbursements, and Accounts payable adjustments in individual vendor accounts. Proper accumulation, classification, and summarization of General ledger purchases, cash disbursements, and payables in the general ledger.
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Key Functions and Duties

Segregation of Duties
The purchasing function should be segregated from the requisitioning and receiving functions.

LO# 6

Possible Errors or Fraud

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. If one individual is responsible for the invoiceprocessing and accounts payable function, purchase The invoice-processing function transactions can be processed at the wrong price or should be segregated from the terms, or a cash disbursement can be processed for accounts payable function. goods not received. This can result in overpayment of goods or the theft of cash. If one individual is responsible for the disbursement function and also has access to the accounts payable The disbursement function should be records, unauthorized checks supported by fictitious segregated from the accounts documents can be issued, and unauthorized payable function. transactions can be recorded. This can result in theft of the entity's cash. If one individual is responsible for the accounts The accounts payable function payable records and also for the general ledger, that should be segregated from the individual can conceal any defalcation that would general ledger function. normally be detected by reconciling subsidiary records with the general ledger control account.
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LO# 6

The Key Segregation of Duties

Purchasing and Accounts Payable
Preparation and approval of purchase order Receipt, counting, and inspection of purchased materials Receipt of vendor invoices/matching to supporting documents Coding of account distributions Updating of accounts payable records Preparation of vendor checks Signing and mailing of vendor checks Preparation of the voucher register Reconciliation of voucher register to general ledger

Department Accounts Purchasing Receiving Payable X X

Cashier

IT

X X X X X X X X

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LO# 7

Inherent Risk Assessment

Industry-Related Factors
1. Is the supply of raw materials adequate 2. How volatile are raw material prices

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LO# 7

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 auditors experience in past audits must be considered when assessing inherent risk.

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LO# 8

Control Risk Assessment

Major steps in setting the control risk in the purchasing process.
Understanding and documenting the purchasing process based on a reliance strategy.

Planning and performing tests of controls of purchase transactions. Setting and documenting the control risk for the purchasing process.
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LO# 8

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.
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LO# 8

Control Risk Assessment

After testing controls, the auditor sets the achieved 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.
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Control Activities and Tests of Controls Purchase Transactions

Occurrence Completeness Authorization

LO# 9

Assertions about Classes of Transactions and Events for the Period under Audit
All purchases and cash disbursements have been recorded and have occurred and pertain to the entity. All purchases and cash disbursements that should have been recorded have been recorded. All purchase and cash disbursements are properly authorized. Amounts relating to recorded purchases and cash disbursements have been recorded appropriately and properly accumulated from journals and ledgers. Purchases and cash disbursements have been recorded in the correct accounting period. Purchases and cash disbursements have been recorded in the proper account.
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Accuracy

Cutoff Classification

Control Activities and Tests of Controls Purchase Transactions

Assertions
Occurrence

LO# 9

Tests of Controls
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. 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. Examine purchase requisitions or purchase orders for proper approval. Review client's competitive bidding process. 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. 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. Review purchases journal and general ledger for reasonableness. Examine a sample of vouchers for proper classification.
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Completeness

Authorization

Accuracy

Cutoff Classification

LO# 9

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 clients record when no payment was made. The primary control procedures to prevent such misstatements include proper segregation of duties, independent reconciliation and review of vendor statements, and monthly bank reconciliations.
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LO# 9

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 records. In addition to the example control tests discussed for occurrence, the auditor should also account for the numerical sequence of checks and reconcile the daily cash disbursements with posting to the accounts payable subsidiary records.

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LO# 9

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.

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LO# 9

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 the checks issued each day with the daily cash disbursements report.

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LO# 9

Control Activities and Tests of Controls Cash Disbursement Transactions

Cutoff of Cash Disbursement Transactions
The auditors tests of controls include reviewing the reconciliation of checks 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.

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LO# 9

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.

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LO# 9

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 analytical procedures are used to test the reasonableness of the amount.

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LO# 10

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.

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LO# 10

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.
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LO# 10

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.
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LO# 11

Auditing Accounts Payable and Accrued Expenses

Substantive Analytical Procedures
Substantive Analytical Procedure
Compare payables turnover and days outstanding in accounts payable to previous years' and industry data. Compare current-year balances in accounts payable and accruals with prior years' balances. Compare amounts owed to individual vendors in the current year's accounts payable listing to amounts owed in prior years.

Possible Misstatement Detected

Under- or overstatment of liabilities and expenses. Under- or overstatment of liabilities and expenses.

Under- or overstatment of liabilities and expenses.

Compare purchase returns and allowances as a percentage of revenue or Under- or overstatement of purchase returns. cost of sales to prior years' and industry data.
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LO# 12 & 13

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.

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Tests of Details of Transactions, Account Balances, and Disclosures

Completeness
The auditor should conduct a search for unrecorded liabilities that includes the following:
1. Ask management about control procedures used to identify unrecorded liabilities at the end of the period. 2. Obtain copies of vendors monthly statements and reconcile the amounts to the clients accounts payable records. 3. Confirm vendor accounts, including accounts with small or zero balances. 4. Vouch large-dollar items from the purchases journal and cash disbursements journal for a limited time after year-end. 5. Examine the files of unmatched purchase orders, receiving reports, and vendor invoices for any unrecorded liabilities.
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LO# 12 & 13

Tests of Details of Transactions, Account Balances, and Disclosures

Existence

LO# 12 & 13

The auditors major concern is whether the recorded liabilities are valid obligations of the entity. The auditor should vouch a sample of items on the listing of accounts payable to other supporting documents.

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Tests of Details of Transactions, Account Balances, and Disclosures

Cutoff
The auditor attempts to determine if all purchase transactions are recorded in the proper period. On most audits, the purchase cutoff is coordinated with the clients physical inventory count. Proper cutoff should also be determined for purchase return transactions.

LO# 12 & 13

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Tests of Details of Transactions, Account Balances, and Disclosures

Rights and Obligations
There is little risk related to this assertion because clients seldom have an incentive to record liabilities that are not obligations of the entity.

LO# 12 & 13

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LO# 12 & 13

Tests of Details of Transactions, Account Balances, and Disclosures

Valuation
Accounts payable are recorded at either the gross amount of the invoice or net of cash discount amount. The valuation of accruals depends upon the type and nature of the accrued expense. Most accruals are relatively easy to value.

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Tests of Details of Transactions, Account Balances, and Disclosures

Classification, Presentation, and Disclosure
Major classification issues include . . .
1. Identifying and reclassifying any material debits contained in accounts payable. 2. Segregating short-term and long-term payables. 3. Ensuring that different types of payables are properly classified.

LO# 12 & 13

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Tests of Details of Transactions, Account Balances, and Disclosures

Payables by type (trade, officers, employees, etc.). Purchases from and payables to related parties.

LO# 12 & 13

Disclosure Items for the Purchasing Process

Short- and long-term payables. Long-term purchase contracts, including any unusual purchase commitments.

Dependence on a single vendor or a small number of vendors.

Costs by reportable segment of the business.

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LO# 14

Accounts Payable Confirmation

Accounts payable confirmations are used less often than accounts receivable confirmations. The auditor is able to examine externally created source documents relating to accounts payable. When confirmations are used, they are usually positive and referred to as blank confirmations. The vendor is asked to supply the balance owed by the client.

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LO# 15

Evaluating the Audit Findings

All identified misstatements should be aggregated (including any consideration for sampling risk). The likely misstatement is then compared to tolerable misstatement. If the likely misstatement is less than the tolerable misstatement, the auditor has evidence that the account is fairly presented. Conversely, if the likely misstatement exceeds the tolerable misstatement, the auditor should conclude that the account is not fairly presented.

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Auditing the Tax Provision and Related Balance Sheet Accounts

The basics:
GAAP accounting vs. Tax accounting.

LO# 16

Use of specialist:
Multiple locations/foreign operations.

Temporary differences. Permanent differences.

Business combinations.
Changes in ownership or tax status.

Accounting for Uncertain Tax Positions.

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