Solution manual auditing and services 2e by louwers chap008

Chapter 08 - Acquisition and Expenditure Cycle CHAPTER Acquisition and Expenditure Cycle LEARNING OBJECTIVES Review Checkpoints Exercises, Problems, and Simulations Identify significant inherent risks in the acquisition and expenditure cycle 43 Describe the acquisition and expenditure cycle, including typical source documents and controls 2, 3, 4, 5, 39 Give examples of tests of controls for auditing the controls over purchase of inventory and services, and disbursement of cash 7, 8, 39 Explain the importance of the completeness assertion for the audit of accounts payable liabilities, and list some procedures for a “search for unrecorded liabilities.” 10, 11 40, 41, 42, 49, 51, 52 Discuss audit procedures for other accounts affected by the acquisition and expenditure cycle 12, 13, 14, 15, 44, 45, 46, 47, 48, 50 Specify some ways fraud can be found in accounts payable and cash disbursements 16, 17, 18 39, 43, 44 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 Describe the payroll cycle, including typical source documents and controls 8C1, 8C2 8C3, 8C4, 8C5, 8C6, 8C7, 8C16, 8C17, 8C18, 8C19, 8C20 8-1 Chapter 08 - Acquisition and Expenditure Cycle 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 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: 8.7  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 The functions that should be separated to maintain internal control in a purchasing system include (1) custody of the goods (receiving and stores departments), (2) authority to initiate a transaction (purchasing department), (3) bookkeeping (accounts payable department, inventory record-keeping department) and (4) periodic physical counts (reconciliation) of inventory and fixed assets 8-2 Chapter 08 - Acquisition and Expenditure Cycle 8.8 Blank vouchers kept in secure location available only to authorized personnel Blank supporting documents (invoices, receiving reports, requisitions, purchase orders) kept in secure locations available only to authorized personnel Supporting documents cancelled by Cash Disbursement function when checks are prepared Separation of duties of preparers of supporting documents, preparation of vouchers, check preparation, and check signing Vouchers and other supporting documents reviewed by check signers 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 at fixed prices Obtain current prices and determine whether any adjustments for loss and liability for purchase 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 Determine which invoices, if any, should be recorded  Trace the unmatched receiving reports to accounts payable entries, and determine whether entries recorded in the next accounting period need to be adjusted to report them in the current accounting period 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 related liabilities were recorded in the proper accounting period  Confirm accounts payable with vendors, especially regular suppliers showing small or zero balances in the 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 8-3 Chapter 08 - Acquisition and Expenditure Cycle 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 the fictitious 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 8-4 Chapter 08 - Acquisition and Expenditure Cycle SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 8.23 a b Incorrect Incorrect c Correct d Incorrect a Correct b c Incorrect Incorrect d Incorrect Cost of Goods Sold should be matched with Sales by using inventory to record cost of goods not yet sold Research and Development is a period expense that is recorded as incurred Depreciation allocated over time on a systematic and rational basis, except in the unusual situation where units-of-production depreciation is used Sales are recorded when earned 8.25 a b c Incorrect Incorrect Correct Overstates net income in the period of capitalization Overstates net income This has no effect on net income It overstates cash and payables 8.26 a b c d Correct Incorrect Incorrect Incorrect The completeness assertion is very important in the audit of liabilities This would restrict a company’s ability to business Auditors are normally not concerned with whom the client’s vendors are Competitive bids are normally required for only large purchases 8.27 a b c d Incorrect Incorrect Incorrect Correct These duties should be separated This would not necessarily prevent a duplicate payment The voucher date may be several weeks before the payment is due Cancellation (“paid”) of vouchers prevent their use a second time 8.28 a d Incorrect Correct The requisition would not result in the improper delivery 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 b Incorrect Correct c d Incorrect Incorrect If the liability is unrecorded, it would not be on the trial balance Auditors may be able to determine that cash disbursements in the subsequent period are paying liabilities of the period under audit This is a cut-off test b is a more direct test This is only an indirect test b is a more direct test a b c Incorrect Incorrect Correct d Incorrect 8.24 8.30 Cash disbursements are an important part of the cycle 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 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 Prepaid Insurance is one of the many accounts in the Acquisition and Expenditure Cycle This is often performed before the balance sheet date This is often performed before the balance sheet date The search for unrecorded liabilities generally depends upon using accounting records created in the period after the year end This is often performed before the balance sheet date 8-5 Chapter 08 - Acquisition and Expenditure Cycle 8.31 a b c Incorrect Incorrect Correct d Incorrect a b c Incorrect Incorrect Correct d Incorrect Approvals not necessarily result in debits to the inventory Purchase requisitions may not represent the actual amount received Invoices supply relevant information about the quantities purchased and the prices paid Purchase orders may not represent the actual amount received 8.33 a b c d Incorrect Incorrect Incorrect Correct This would have insured a proper count of the tables This would insure the invoice was for the amount received This would insure the check was for the amount received The P O and requisition would both show 84 tables 8.34 a b Incorrect Incorrect c Correct The check signer is probably not familiar with all the vendors This is possible, but the maintenance costs may not have been unusual (i.e., the costs before the fraud were below budget) Vendors should be approved by an independent purchasing department a Incorrect b Incorrect c d Incorrect Correct a b Correct Incorrect c d Incorrect Incorrect 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 b Correct c Incorrect d Incorrect Testing occurrence would require vouching from the vouchers recorded in the voucher register to receiving reports This test ensures that liabilities generated by the receipt of goods are recorded in the voucher register This does not test classification, which would require examining the chart of accounts This does not test cutoff, which would require comparing the date of the receiving report to the date recorded 8.32 8.35 8.36 Some liabilities may be incurred but not invoiced by the vendor Purchase orders not normally incur liabilities The receiving reports are the population that contains the record of all goods received for which liabilities should be recorded The invoice or receiving report must be examined to determine when the liability occurred Payroll is generally audited by tests of controls, analytical procedures and substantive tests of transactions Cost of goods sold is generally audited by tests of controls, analytical procedures and substantive tests of transactions Supplies expense is generally audited in connection with supplies inventory The auditor examines the specific charges to determine potential litigation Property tax expense is audited in conjunction with accrued property taxes Payroll is generally audited by tests of controls, analytical procedures and substantive tests of transactions There’s no asset directly related to R&D The auditor examines the specific charges to determine potential litigation 8-6 Chapter 08 - Acquisition and Expenditure Cycle SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 8.39 Payable ICQ Items: Assertions, Tests of Controls, and Possible Errors or Frauds 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 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 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 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 8-7 Chapter 08 - Acquisition and Expenditure Cycle 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: 10 11 12 Unentered vendors’ invoice file Status of tax returns for prior years still open Discussions with employees Representations from management Comparison of account balances with preceding year Examination of individual accounts during the audit Existing contracts and agreements Minutes Attorney’s bills and letter of representation Status of renegotiable business Correspondence with principal suppliers Audit testing of cutoff date for reciprocal accounts, e.g., inventory and fixed assets 8-8 Chapter 08 - Acquisition and Expenditure Cycle 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 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 c To determine adequacy of internal control for processing and payment of invoices To prove that amounts shown on the balance sheet are in agreement with supporting accounting records To determine that liabilities existing at the balance sheet date have been recorded Internal controls are weak The company is in a “tight” cash position and bill-paying is slow Physical inventories exceed general ledger inventory balances by significant amounts Certain vendors not send statements Vendor accounts are pledged by assets Vendor accounts include unusual transactions When auditing accounts payable the auditor is primarily concerned with the possibility of unrecorded payables or understatement of recorded payables Selection of accounts with relatively small 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: Analyze the accounts payable population and stratify it into accounts with large balances, accounts with small balances, accounts with zero balances, etc 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) 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 Select prior-year vendors who are no longer used Select new vendors used in the subsequent years Select vendors that not provide periodic statements Select accounts reflecting unusual transactions during the year Select accounts secured by pledged assets 8-9 Chapter 08 - Acquisition and Expenditure Cycle 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 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 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 Study IRS examination reports for evidence of income or other taxes in dispute, and decide whether actual or estimated liabilities need to be recorded 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 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.) 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 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 8-10 Chapter 08 - Acquisition and Expenditure Cycle 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 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 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.) g h 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 8-12 (Orion) Chapter 08 - Acquisition and Expenditure Cycle 8.44 Grounds for Dismissal AUDIT APPROACH Objective: To detect fraudulent hiring of consulting firm Control: The control should have been approved by someone above Doe’s level Payments should not have been made without such approval After being signed, checks should be mailed directly from the treasurer’s office Test of Controls: Examine disbursements for indication of authorization Endorsements on checks can be examined for double signatures Audit of Balance: Tests of charges to the capital account should reveal the large amount of expenses being capitalized In addition to vouching these charges, auditors should inquire about whether they are properly capitalized as long-term assets 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 8-13 Chapter 08 - Acquisition and Expenditure Cycle 8.45 Audit Simulation: Audit the PP&E and Depreciation Schedule a The Computer B system is depreciated for a full year ($583,000), but depreciation should be calculated for only months Correct amount is $389,000 The depreciation on the Press should be $75,000 instead of $150,000 Somebody doubled the depreciation expense for this year Accumulated Depreciation Cost of Goods Sold Inventory General and Admit Expense b 269,000 67,500 7,500 194,000 The best way to approach this requirement is to write a procedure for each assertion Building 2: Existence: Inspect the building to determine that it is “in productive use” (evidence of existence) Rights (Ownership): Vouch the legal title papers and recorded deed for evidence of ownership Valuation: Vouch the contractor’s billings and the payments for evidence of appropriate cost valuation Presentation and Disclosure: Study any related loan agreements for pledge as security for loans in relation to necessary disclosure Inspect insurance policies for evidence of adequate insurance (inadequate insurance may require disclosure) Computer B system Existence: Inspect the computer and observe it in operation Rights (Ownership) and Valuation: Vouch purchase and title documents (ownership and cost valuation) Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for installation and testing costs that should be capitalized (evidence of completeness of recording asset cost) Auto Existence: Inspect the auto and observe it in operation Rights and Valuation: Vouch purchase and title documents (ownership and cost valuation) Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for typical additional costs (e.g tax, title, and license) that should be capitalized (evidence of completeness of recording asset cost) c The loss on the sale of the Computer A system should be $542,000 ($5,000,000 - $3,958,000 $500,000) The gain on the sale of Auto (fully depreciated) should be $1,000 The cash flow from investing activities should show cash inflow from sale of assets in the amount of $501,000 There should be cash outflow for purchase of assets in the amount of $ $45,522,000 8-14 Chapter 08 - Acquisition and Expenditure Cycle 8.46 PP&E Assertions and Substantive Procedures Rights evidence: D Existence evidence: G Physically examine all major property and equipment additions Valuation evidence: B 8.47 Examine deeds and title insurance certificates Review the provision for depreciation expense and determine whether depreciable lives and methods used in the current year are consistent with those used in the prior year Assertions and Substantive Procedures for Property, Plant, and Equipment (PP&E) Valuation, Existence Valuation Valuation Valuation and Allocation Existence Existence Completeness Valuation and Allocation Rights and Obligations 10 Rights 11 Valuation 8-15 Chapter 08 - Acquisition and Expenditure Cycle 8.48 CAATS Application—PP&E a The information needed to reconcile subsidiary detail records to general ledger balances:  Asset type  Location code  Cost  Accumulated depreciation, end of year The task of footing the subsidiary ledger and comparing the recalculation to the general ledger balance(s) does not complete the audit of fixed assets Additional evidence is needed to be persuaded of existence of the assets (observation), valuation (vouching invoices, recalculating depreciation), completeness (vouching and tracing transactions dated around the year-end), presentation and disclosure (in-use-status, inquiries about hypothecation, liens) b 8.49 The assistant will also need to know the asset number, description, as well as Asset Type and Location Code mentioned in (a) above Audit Simulation: Search for Unrecorded Liabilities a Audit Program Obtain a trial balance of recorded accounts payable as of year-end Send confirmations to creditors with small or zero balances and those with whom the company has done significant business Ask client personnel about their procedures for ensuring that all liabilities are recorded Obtain a list of unmatched vendor invoices and determine when the goods were received Trace the unmatched receiving reports to accounts payable, and determine whether items recorded in the next accounting period need to be adjusted 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 8-16 Chapter 08 - Acquisition and Expenditure Cycle 8.49 Audit Simulation: Search for Unrecorded Liabilities (Continued) b Adjusting Journal Entry Vouchers Payable Rent Expense 53,000 53,0001 To reverse January rent expense recorded in December Miscellaneous expense Cost of Goods Sold Office expense Vouchers Payable 6,300.00 12,889.66 8,644.862 27,834.52 To record unrecorded liabilities 8.50 Kaplan CPA Exam Simulation: Obtaining Evidence—Sales and Expense Amberly’s Comparative Income Statement Sales Returns Discounts Net Sales Year $15,000,000 ( 400,000) (150,000) $14,450,000 Year $12,000,000 ( 600,000) (140,000) $11,260,000 COGS Selling General Administrative Total expenses $ 9,000,000 2,000,000 1,000,000 1,500,000 $13,500,000 $6,000,000 2,500,000 900,000 1,200,000 $10,600,000 Net income before taxes $950,000 $1,400,000  Additional returns relating to Year were recorded in Year totaling $150,000  Amberly routinely bills for goods that customers have agreed to purchase and holds the shipment until the customer is ready for delivery May omit if students assume the charge was made to prepaid rent Includes unbilled amount for December 8-17 Chapter 08 - Acquisition and Expenditure Cycle 8.50 Kaplan CPA Exam Simulation: Obtaining Evidence—Sales and Expense (Continued) Option Procedure True The evidence gained via the standard audit procedures for accounts receivable will support that Amberly’s sales returns are properly valued Evidence supporting the valuation of sales returns will be gained via the audit procedures for accounts receivable Specifically, audit procedures for the allowance for doubtful accounts should reveal any material misstatements of sales and/or sales returns False Vouching expenses, performed as part of the search for unrecorded liabilities, should uncover any material misclassifications of expenses that occurred during the year Vouching expenses performed as part of the search for unrecorded liabilities will only uncover any material misclassifications of expenses that occurred during the year and were paid subsequent to year end To gain assurance that expenses were not misclassified for the entire year, the auditor must vouch a sample of expenses based on materiality levels True An unexplained increase in the gross profit ratio may suggest the presence of unrecorded expenses An unexplained increase in the gross profit ratio may suggest the presence of unrecorded expenses in COGS since unrecorded expenses would understate total expenses and falsely increase the profitability ratios (i.e., net income) False Amberly’s bill and hold transactions may increase audit risk because the sales may be understated at the end of the year Amberly’s bill and hold transactions may increase audit risk because such transactions may result in sales being overstated at year end Bill and hold transactions usually involve selling products for large discounts to retailers and holding them (perhaps in third-party warehouses) to be delivered at a later date Clearly the risk is of prematurely recorded or uncollectible sales 8-18 Chapter 08 - Acquisition and Expenditure Cycle 51 Kaplan CPA Exam Simulation: Accounts Payable Confirmations a False Confirmations not need to be sent to vendors that show no amount owing in Southland’s accounts payable records Confirmations should be sent to all vendors regardless of whether a payable is recorded since the objective is to search for unrecorded items that may have resulted in an understatement of accounts payable True Southland’s vendor payment terms may be a factor in determining whether to send vendor confirmations Given the 60-day payment terms, Southland will probably not pay some of its vendor balances relating to the end of Year by the completion of fieldwork on February 15 of Year Therefore, sending vendor confirmations early may provide timely evidence to corroborate the accounts payable balance True Materiality of the individual vendor balances recorded is not a factor when determining which vendor balances need to be confirmed Since the emphasis is on detecting understated payables, materiality is a less important or even irrelevant factor when determining which vendor accounts should be confirmed False Since vendor statements are not sent to North River, confirmations will be the most effective procedure to corroborate the account payable assertions Because of the 14-day payment terms, North River will have likely paid their invoices open at December 31, Year prior to the start of the audit field work in February, Year Therefore, the review of subsequent payments is the most effective procedure to gather evidence for the accounts payable assertions, including completeness False It may be appropriate to confirm the Southland accounts payable at an interim date as a test of the effectiveness of the internal controls Since the control risk was assessed as low, it may be appropriate to confirm the Southland accounts payable at an interim date This is to ensure that control risk was appropriately assessed as low and that the internal controls are operating effectively True The confirmation procedure may provide evidence supporting the rights and obligations assertion Confirmations provide evidence supporting the rights and obligations assertion since all accounts payable are considered obligations; they are liabilities False Vendors should be selected from the Southland year-end payables listing to address the completeness and existence assertions Selecting vendors from the year-end payables listing only addresses the existence assertion 8-19 Chapter 08 - Acquisition and Expenditure Cycle 51 Kaplan CPA Exam Simulation: Accounts Payable Confirmations (Continued) b Case Vendor No adjustment is necessary since the item is properly included in accounts payable at the end of Year The telephone service period was for Year Citywide Telephone Co No adjustment is necessary since the electrical supplies were received in Year and properly included in accounts payable at the end of Year Bayside Electrical Supply Co An adjustment is necessary since no liability for the insurance premium is recorded at the end of Year An adjustment should be made to record the one-month (12/1/Y1 - 12/31/Y1) insurance expense included in the service period South Central Insurance Co No adjustment is necessary since the item is properly excluded from accounts payable at the end of Year The feed inventory was not received until Year and because it was also a one-time deal, there is no guiding precedent in terms of determining when the liability was actually incurred Thus, based on the facts, Southland has NOT likely incurred a legal obligation to pay until Year when the inventory was received In this case, the invoice date of 12/29/Y1 is not relevant to Southland in terms of determining when the liability was incurred Countryside Feed & Grain An adjustment is necessary since no liability for the inventory is recorded at the end of Year It was noted that the inventory was received by Southland prior to the end of Year on 12/30/Y1, so a liability should have been recorded at that time Fargo Livestock Brokers Expenses are overstated since the item should have been capitalized No adjustment is needed to accounts payable since it is properly included at the end of Year Lawson Machinery Inc As it is currently recorded by Southland, accounts payable and inventory are overstated by $9,300, the amount of the second shipment that was not received until after the end of Year Bill Jones Farms No adjustment is necessary since the item is properly included in accounts payable at the end of Year The water service period was for Year Country Water Co 8-20 Chapter 08 - Acquisition and Expenditure Cycle 8.52 ACL Assignment Go to the  ACL Web  site at  www.mhhe.com/louwers3e, click  on “ACL Assignments” and  review  the solution for Chapter 8 APPENDIX 8C The Payroll Cycle SOLUTIONS FOR REVIEW CHECKPOINTS 8C.1 The functions in a personnel and payroll cycle:       8C.2 Personnel and labor relations - hiring and firing (Authorization) Supervision - approval of work time (Authorization) Timekeeping and cost accounting - payroll preparation and cost accounting (Recordkeeping) Payroll accounting - check preparation and related payroll reports (Custody of cash) Check signing (Custody) Payroll distribution - actual custody of checks and distribution to employees (Custody of Cash) In a payroll system, the functional responsibilities which should be separated include: Personnel or Labor Relations Department Supervision Timekeeping and Cost Accounting Payroll Accounting Payroll Distribution 8C.3 When employees are terminated, they should be interviewed by the personnel department, who can then remove them from the payroll files Separation of responsibility for handing out paychecks from authorization and record-keeping can reduce the incentive for supervisors to keep terminated employees on the payroll Labor cost analyses also reduce incentives for supervisors to have too many employees listed in their departments Finally, W-2s should be sent directly to the employee’s home so they can spot any fictitious wages 8C.4 a A “walk through” of a personnel and payroll transaction would include discussions with each person handling personnel and payroll records The following illustrates the steps and documents collected Steps Hiring personnel department Deductions personnel dept Document(s) Collected Authorization to hire and rate assignment Personnel forms, employee authorization for deductions (e.g., W-4 form) Clock card Production time ticket Labor distribution work sheet Payroll voucher Payroll checks Timekeeping Shops Cost distribution Accounts payable Cash disbursement 8-21 Chapter 08 - Acquisition and Expenditure Cycle b 8C.5 Important information in employee’s personnel files:       8C.6 a b 8C.7 If the payroll is processed by computer, the clock cards and production time tickets would be traced to batch control in the timekeeping and production departments, to data preparation (input), to edit and validation error reports and other computer output indicating control and finally to computer prepared checks, labor distribution reports and summary general ledger entries Employment application Background investigation report Notice of hiring Job classification with pay rate authorization Authorizations for deductions (e.g health insurance, life insurance, retirement contribution, union dues, W-4 form for income tax exemptions) Termination notice Prevent or detect payment to a fictitious employee:  Paychecks prepared only for persons with employment authorization from the personnel department  Paychecks prepared only for persons with approved work attendance, time  Paychecks distributed only in person to persons identified as employees (or by electronic transfer to validated employee bank accounts)  Payroll register or list re-approved by supervisor after paychecks are prepared or distributed Employees are expected to complain if they are not paid! The common errors and frauds in the personnel and payroll cycle are (1) recorded employee transactions are not valid (fictitious employee), (2) recorded attendance transactions are not valid (fictitious hours), and (3) incorrect cost accounting classification for labor Auditors look for separation of duties, proper authorizations and good reconciliations to prevent or correct these errors or frauds Auditors should be alert to a supervisor having too many incompatible responsibilities (e.g., hiring, authorization of hours, authorization of pay rate, distribution of pay checks and dismissal only authorization of hours is a proper responsibility) SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS 8C.8 c Correct The payroll department should be independent of the personnel department, which would be responsible for authorizing all payroll rate changes for the employees of the entity A supervisor would be authorized, however, to initiate requests for rate increases for supervised employees 8C.9 a Correct The personnel department provides the authorization for payroll-related transactions, e.g., hiring, termination, and changes in pay rates and deductions 8-22 Chapter 08 - Acquisition and Expenditure Cycle 8C.10 a procedure b Incorrect A generalized program would not be sufficiently sophisticated to test this Correct c d Incorrect Incorrect In a manual payroll system, a paper trail of documents would be created to provide audit evidence that controls over each step in processing were in place and functioning One element of a computer system that differentiates it from a manual system is that a transaction trail useful for auditing purposes might exist only for a brief time or only in computer-readable form This may be true, but there is not enough information about built-in controls This is a real-time system as records are updated when employees record their time a b c Incorrect Incorrect Correct d Incorrect a b Incorrect Incorrect c d Incorrect Correct a Correct b c Incorrect Incorrect d Incorrect a Correct b c d Incorrect Incorrect Incorrect c Correct 8C.11 8C.12 8C.13 8C.14 8C.15 The payroll clerk has access to recording and custody Unclaimed pay should be given to the Treasurer Under a cash payroll system, the receipt signed by the employee is the only document in support of payment The signed receipt is essential to verify proper payment This would not be applicable to cash payroll An absence of an approved time record would prevent the employee being paid This is a good byproduct of the policy, but it is unlikely that real employees would fail to pick up their checks for several weeks This procedure would not prevent another employee from picking up the check A follow-up of unclaimed checks may result in identification of fictitious or terminated employees, thus eliminating an employee’s opportunity to claim a paycheck belonging to a terminated employee The unclaimed checks should then be turned over to a custodian so the internal audit function does not assume operating responsibilities Ordinarily, the auditor examines the endorsements on payroll checks while obtaining an understanding of and testing the payroll cycle, which includes consideration of clock cards The voucher system does not pertain to payroll This is a possibility, but answer a is better As part of the cash audit, the auditor would normally only examine checks returned with the cut-off bank statement Test of accruals would not involve examination of cancelled paychecks In considering whether transactions actually occurred, the auditor is most concerned about the proper separation of duties between the personnel department (authorization) and the payroll department (processing the transactions) This relates to completeness This relates to accuracy This would not provide evidence about occurrence of payroll transactions The payroll department assembles payroll information, which is a recording function Custody of assets, such as unclaimed payroll checks is incompatible with record keeping 8-23 Chapter 08 - Acquisition and Expenditure Cycle SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 8C.16 Major Risks in Payroll Cycle Payroll Cycle Risk Assertion Paying fictitious “employees” Occurrence, employees exist Overpaying for time or production Accuracy of payroll amounts, proper inventory, cost of goods sold, and expense amounts Incorrect accounting for costs and expenses 8C.17 Accuracy, classification, Payroll Authorization in a Computer System Since authorization is an important control activity, the point(s) of authorization should be determined Authorization of payroll transactions cannot be determined without understanding the complete flow of transaction processing (manual and computer) The following could be points in the flow where authorization takes place:        8C.18 When the computer application program is written (and approved) to accept certain employee codes and to compute the gross payroll and the net amount When the foreman initials the time card (Alternatively, the time may be automatically entered from a time clock into the computer files without foreman initials—then the employee clocking in and out is the authorization.) When payroll batches of time cards are totaled and submitted to data conversion When the time cards are input When the payroll programs are run using the time clock transactions and the payroll master file When the signature plate is installed on the printer and checks are printed When the pay rate is entered into the employee master file Audit Simulation: Payroll Processed by a Service Organization This discussion question brings up the auditors’ responsibility when payroll is processed by a service bureau, a common occurrence in many smaller businesses The main point is that the audit control concerns are the same wherever the data is processed Following are some of the discussion points that have come up in the past use of this question     Audit planning will require determination of whether a report is available from the service bureau, prepared by independent auditors (service auditors) Of particular interest is whether the service auditor’s report covers “design only” or covers both “design and certain tests of controls.” When a service bureau is used, client personnel are responsible for user input and output control, e.g., authorization, completeness (batching), reconciliation of input controls to output Specific contractual agreements of control responsibilities between the client and the service bureau need to be examined and evaluated General controls are the responsibility of the service bureau, e.g., system and program documentation; backup for computer processing, data files, documentation and staff; and restrictions over access to computer equipment, data files and programs 8-24 Chapter 08 - Acquisition and Expenditure Cycle   8C.19 Service bureau processing requires increased emphasis on client procedures for verifying continuing authority, completeness and accuracy of master file Service bureau processing requires increased emphasis on error correction and resubmission procedures Audit Simulation: Payroll Audit Procedures, Computers, and Sampling a Audit procedures: Obtain a sample of weekly batches of time cards and recalculate the totals of labor hours and social security numbers Labor hour data distributed by the cost accounting department may serve as a cross-check These control totals should then be compared to the payroll register totals for the same period (and to control totals obtained after keyboard entry, if available) Deviation rate: The expected deviation rate should be zero Although some input errors might occur, they should be detected and corrected using the control totals for labor hours and social security numbers Tolerable rate: Since payroll costs probably represent a significantly large cost item in a manufacturing company, the tolerable rate might be quite low, say 2% or 3% Sample items: The sample items should be from appropriate populations; in this case, either the batches as described above, the 300 employee files or each employee’s weekly payroll (52 x 300 = 15,600 worker/week payments) Sample size factor: Include: expected deviation rate, tolerable deviation rate, risk of assessing control risk too low, and the population size (if small) 8C.19 Audit Simulation: Payroll Audit Procedures, Computers, and Sampling (Continued) b Select personnel files at random and compare the authorized job classification and pay rate to the union contract and to the data base (tape or cards) that contains the table used in computer memory This procedure yields evidence that the internal computer table is accurate By reviewing documented changes in the table, its contents throughout the period under audit may be reviewed Extract a sample of names-classifications-rates from the table itself and vouch these to the personnel files to detect errors of commission in the table To determine whether rates are actually used properly, the auditor may test the computer application with simulated transactions or he/she may audit “around” the calculations by vouching payroll register output to time cards and personnel files, and by retracing samples from time cards and personnel files forward to the payroll register These procedures differ from a completely manual system only with respect to the need to test the adequacy of the machine-stored rate table and in the test data application Otherwise, the procedures are equally applicable to a manual system for preparing the payroll 8-25 Chapter 08 - Acquisition and Expenditure Cycle 8C.20 Payroll Tests of Controls Procedure Evidence Sample of Clock Cards: Note supervisors’ approval Trace to periodic payroll registers Missing approval deviation Wrong hours deviation Wrong employee deviation Sample of Payroll Register Entries: Vouch hours paid to clock cards and supervisors’ approval Wrong hours deviation Missing approval deviation Recalculate gross pay, deductions, net pay Inaccurate pay calculation deviation Recalculate payroll registers Inaccurate payroll summary deviation Examine canceled payroll checks and endorsements Inaccurate check amt deviation Invalid endorsement deviation Vouch periodic payroll totals to payroll bank account transfer vouchers and deposit Inaccurate payroll transfer deviation Missing payroll transfer deviation Trace payroll entries to YTD records Reconcile YTD records with total payrolls Incomplete update deviations Inaccurate payroll (tax return) deviation Trace payroll to management reports and to general ledger Accounting incomplete deviation Accounting incomplete deviation 8-26 ... 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. .. Acquisition and Expenditure Cycle SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 8.39 Payable ICQ Items: Assertions, Tests of Controls, and Possible Errors or Frauds a Purchases and accounts... computer and observe it in operation Rights (Ownership) and Valuation: Vouch purchase and title documents (ownership and cost valuation) Completeness: Vouch expenses in the repairs and maintenance