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Tutorial 4 - Audit of Purchases System

Audit Practice (Singapore Institute of Technology)

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Tutorial 4

Question 1
EMGP Q11-20
Mincin is the auditor of the Raleigh Corporation. Mincin is considering the audit work to be
performed in the accounts payable area for the current year’s engagement. The prior year’s
working papers show that confirmation requests were mailed to 100 of Raleigh’s 1,000 suppliers.
The selected suppliers were based on Mincin’s sample, which was designed to select accounts
with large euro balances. A substantial number of hours were spent by Raleigh and Mincin in
resolving relatively minor differences between the confirmation replies and Raleigh’s accounting
records. Alternative audit procedures were used for suppliers who did not respond to the
confirmation requests.

Required:
a. Discuss the accounts payable assertions that Mincin must consider in determining the
audit procedures to be followed.

The principal objectives of the accounts payable examination are:

1. To determine adequacy of internal control for processing and payment of invoices.

2. To prove that amounts shown on the balance sheet are in agreement with supporting
accounting records.

3. To determine that liabilities existing at the balance sheet date have been reconciled.

The primary risks for auditing accounts payable are:

- AP and expenses are intentionally understated

- Payments made to inappropriate vendors
- Duplicate payments made to vendors

Mincin should consider the following assertions in determining the audit procedures to be followed

Completeness Proper inclusion of all accounts payable

Accuracy, Valuation and Allocation Recorded amounts are reasonably stated

b. Discuss situations in which Mincin should use accounts payable confirmations and
discuss whether Mincin is required to use them.

According to SSA505 External Confirmations, covers external confirmations including accounts payable
confirmations. External confirmation procedures frequently are relevant when addressing assertions
associated with account balances. However, there is no requirement to use AP confirmation procedures
but it is still often used in audit.

Situation in which Mincin should use AP confirmations:

1. If the internal control is ineffective

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2. If company’s solvency position is weak and average payment period is long

3. If the inventory count exceeds general ledger balance significantly
4. If there is collateral dealing with the vendor, such as pledge of assets
5. If there are any fictitious transactions recorded in the AP records
6. If the statements cannot be easily obtained from the vendors (in Singapore context, if the
document was not filed, they don’t keep the statements and reconciliation is needed to be
done)

If Mincin finds sufficient reliable evidence on the assertions of the company already, there is no
requirement to use AP confirmation procedures. However, AP confirmations are generally sent as there
are external parties involved, such as vendors who issue the payment statements of the company.

c. Discuss why the use of large euro balances as the basis for selecting accounts payable for
confirmation might not be the most efficient approach and indicate what more efficient
procedures could select accounts payable for confirmation.

Typically, when large balances of accounts are selected, they are testing for overstatements (i.e.
Accounts receivable audit procedure)

However, for Accounts payable, the primary audit risk is that the accounts are intentionally
understated or omitted. Hence, selection of the accounts with smaller or no balances for
confirmation is more efficient and understatements will be more likely to be uncovered during such
an approach.

The more efficient procedures should be as follows:

a) Review the accounts payable listing and group it into accounts with large, small, or zero
balances
b) Use a sampling method to select items based on criteria other than the monetary amount of
the items
c) Set up a statistical sampling plan that will select accounts with smaller or zero balances,
particularly when the entity has had substantial transactions with such vendors during the
year.
d) Select prior-year vendors who are no longer used.
e) Select new vendors used in the subsequent period.
f) Select vendors that do not provide periodic statements.
g) Select accounts reflecting unusual transactions during the year.
h) Select accounts secured by pledged assets.

Question 2

SSA 500 Audit Evidence states that the auditor shall design and perform audit procedures that
are appropriate in the circumstances for the purpose of obtaining sufficient appropriate audit
evidence.

You are the audit manager in-charge of the audit of Jade Electronics Pte Ltd and are reviewing
the audit working papers to ascertain whether sufficient and appropriate audit evidence has been

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collected by the audit team. The audit working paper on accounts payable reported on the
financial statements as at 31 December 2017 documented the following comments:

To test for the completeness of accounts payable, the following evidence was obtained:

(1) Confirmation replies from the three largest accounts payables that amount to 60% of the
total accounts payable balance. They have agreed to the outstanding balances stated on
the confirmation requests.

(2) Photocopies of supplier invoices and delivery orders that were received subsequent to 31
December 2017. These documents were not yet updated in the accounting records but
they reflected that goods have been received by Jade Electronics during December 2017.

(3) Oral explanation from the Chief Financial Officer regarding the decline in value of
accounts payable balance. He has explained that Jade Electronics has replaced a local
supplier with a supplier from Bangladesh.

Required:

For each evidence described in (1) to (3) relating to accounts payable,

(a) Explain the relevance and reliability of the evidence as a source of evidence to
confirm the completeness of the account payable balances.

(b) If the evidence is assessed to be not relevant or reliable, explain what further
action the audit assistant should take to confirm the completeness of the account
payable balances.

Relevance of audit evidence refers to its relationship to the assertion or to the objective of the control
being tested. It depends on
a. The design of audit procedures used to test the assertion or control, whether it is designed to test
the assertion or control directly or to test for under/overstatement
b. The timing of the audit procedure used to test the assertion or control
Reliability of the audit evidence depends on the nature and source of evidence and the circumstances on
which it is obtained. For example:
a. Evidence obtained from knowledgeable source independent of the company is more reliable than
evidence from internal sources
b. Reliability of information generated internally increases when company’s control over that
information are effective
c. Evidence obtained directly by the auditor is more reliable than evidence obtained indirectly
d. Original docs more reliable than evidence provided by photocopies, digitized etc

(a) Is the evidence Reliable and Relevant? (b) If not, explain further actions that audit
assistant should take to confirm the
completeness of accounts payable
balances

Confirmation replies from the three largest accounts payables that amount to 60% of the

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total accounts payable balance. They have agreed to the outstanding balances stated on the
confirmation requests.

Reliability To test for Completeness, confirmations should

- The confirmations were obtained from be focused on nil or small balances of active
independent sources outside entity (i.e suppliers such as suppliers with large purchase
creditors) transactions
- Confirmations are obtained directly by
the auditor, and not indirectly or by Confirmation of 60% of total accounts payable
inference balance is not testing for completeness, and more
- Confirmations are received in original of existence assertion.
documents and not photocopied
Relevance
- Accounts payable audit procedures should
be directed towards inclusion of all
accounts payable transactions
(Completeness) and ensure that all
accounts are accurately recorded
(Accuracy)
- Less relevant in confirming the AP
balance as it does not address recording of
specific transactions in AP, but may only
reveal discrepancies in recording of
transactions
- Confirming the balance with external
vendors are more of auditing for its
existence

Photocopies of supplier invoices and delivery orders that were received subsequent to 31
December 2017. These documents were not yet updated in the accounting records but they
reflected that goods have been received by Jade Electronics during December 2017.

Reliability Test the completeness of the suppliers by tracing

- Photocopies of supplier invoices and GRN to supplier invoice and delivery order, and to
delivery notes were not reliable as it is accounts payable subsidiary ledger to test if the
not original documents transaction has been recorded. GRN should be
- Documents were not yet updated in the numerically sequenced.
accounting records but they reflected
goods have been received in Dec 2017 Don’t bother to look at photocopies!!!!! If
shows that the controls were not effective cannot get original, get the confirmation???
Relevance
- This is relevant to completeness assertion
because the documents were not updated
means that the transaction was not
recorded.

Oral explanation from the Chief Financial Officer regarding the decline in value of
accounts payable balance. He has explained that Jade Electronics has replaced a local
supplier with a supplier from Bangladesh.

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Reliability Enquire client which local supplier is being

- Oral evidence is not reliable as compared replaced.
to written evidence
Relevance Proceed to check that the balance of the local
- This is relevant to the Completeness supplier this year is NIL/smaller than prior year.
assertion as inquiring of the decline in
value of AP balance may be due to Test the completeness of the new supplier from
potential unrecorded liabilities. bangladesh by tracing GRN to supplier invoice
and delivery order, and to accounts payable
subsidiary ledger to test if the transaction has been
recorded. GRN should be numerically sequenced.

Check if they have PO? Purchase agreements?

Match them to the invoices

Question 3

You are the audit senior at Lim and Tan LLP. Below are the issues faced by your audit teams:

1. Zeedan Pharmacy is a drug company that carries about 100 of different product items at
its chain of drug stores located in China. 40% of its inventory can be found in distribution
centres in Chengdu and Guangzhou. The rest of the inventory is found in all its 77 stores
across China. The high value inventory items can only be found in stores in Beijing and
Shanghai and are stored in secured cabinets.

2. DeeDee Electronics is a contract manufacturer, manufacturing computer components on

behalf of a few Taiwanese computer companies. The computer components consist of
very minute electronic parts which are made exclusively for each customer and cannot be
used interchangeably. Due to patent issues, any excess inventory and scrap materials
must be destroyed.

3. Super Speed started out as a small engineering company, providing repair and
maintenance services to bumboats. In recent years, it started to offer services to
customers to custom fit their boats and yachts with sophisticated technological and
navigation gadgets. This year, it starts to pre-build high-end private boats and yachts in
anticipation of sales to the growing affluent upper and middle classes.

The company’s operations are based in a large discontinued jetty off which houses all its
repair, maintenance and production facilities. During the financial year end, in addition to
vessels under repair and maintenance services, up to ten vessels would be at the production
facilities of which some are for custom fitting services, while some are partially completed
vessels built by Super Speed. The company accounts for the partially completed vessels as its
inventory and maintains detailed inventory records of the items purchased and used in the
construction throughout the year.

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Required:

a. For each audit mentioned above, describe issues the auditor should consider when
determining the locations to visit to physically observe the client’s inventory count.

b. For Zeedan Pharmacy, how would you determine which location your teams should visit?

c. How does the type of inventory held by your client pose potential risks of material
misstatements in the inventory balances?

d. How might your team address the risks noted in part (c)?

Zeedan Pharmacy

(a) Issues to consider in - Two distribution centers in Chengdu and Guangzhou consists majority of the
determining locations to visit inventory
to physically observe the - Stores in Beijing and Shanghai consists of high dollar value inventories and
inventory count they are stored in secured areas

There might be potential issues in inaccurate amounts as their inventory consists of

100 different types of products with significant difference in the unit costs in each
product.

(b) How would you determine the - Test controls related to inventory at the store level and select samples from
location your teams should the 77 stores to visit
visit - Focus on testing inventory in the secure areas

Because there is significant value of inventory located in the distribution centers

Chengdu and Guangzhou and high dollar value inventory are at the secured areas.

(c) How does the type of inventory - Risk of theft due to the high dollar value inventories
held by your client pose potential risks - Risk of obsolescence as medicines have expiry dates
of material misstatements in the - Hard for auditors to differentiate the various types of medicines since most
inventory balances of the medicines look similar
- Risk of inaccuracy of inventory amounts as there are a large number of
products with wide variations in unit costs.

(d) Team’s response to the risks - Engage in pharmaceutical specialist to help auditors differentiate the
mentioned in part c medicines for inventory observation purposes
- Observe the effectiveness of the inventory management controls in
preventing risk of theft.

Deedee Electronics

(a) Issues to consider in - Customised items according to customer’s specifications

determining locations to visit
to physically observe the It may be difficult to determine the value of the inventories and it will be difficult to
inventory count observe the inventory as there is a lack of expertise in the area of products.

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(b) How would you determine the NA - only applicable for Zeedan
location your teams should
visit

(c) How does the type of inventory - Risk of inaccurate valuation (i.e. pricing) due to customised products for
held by your client pose potential risks different customers
of material misstatements in the - Risk of theft due to the small parts of the products which may result in
inventory balances inventory recorded in the FS that does not exist in the BS date.

(d) Team’s response to the risks - Engage specialists to help identify the electronic parts and help in the
mentioned in part c inspection and valuation of inventory

Superseed

(a) Issues to consider in determining - Superseed’s own built vessels are in the same place as customer’s vessels
locations to visit to physically observe - As Superseed manufactures its own vessels, there could be different stages
the inventory count of completion to be evaluated and there could be potential issues to identify
in the stages of completion accurately for costing purposes

(b) How would you determine the NA - only applicable for Zeedan
location your teams should visit

(c) How does the type of inventory - Risks of being unable to differentiate entity’s and customer’s vessel
held by your client pose potential risks - Risks of inaccurate inventory amounts included in the financial statements
of material misstatements in the as each vessel is different from each other and has its own manufacturing
inventory balances process of converting raw materials into finished product (i.e. assigning
costs to raw material, WIP, and FG)

(d) Team’s response to the risks - Review the controls in place to ensure the entity’s own vessels are
mentioned in part c segregated from customers and can be clearly identified. For vessels
included as the entity’s, test that the vessel is supported with a job cost card
or report.

- Extensively test inventory costing systems to evaluate the operating

effectiveness of internal controls over raw materials, WIP, and FG inventory.

- Test perpetual inventory records to determine that recorded raw materials

WIP and FG inventory are on hand at the balance sheet date.

Question 4
EMGP Q13-18
An auditor is examining the financial statements of a wholesale cosmetics distributor with an
inventory consisting of thousands of individual items. The distributor keeps its inventory in
its own distribution centre and in two public warehouses. An electronic inventory file is
maintained on a computer disk, and at the end of each business day the file is updated. Each
record of the inventory file contains the following data:
 Item number.
 Location of item.

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 Description of item.
 Quantity on hand.
 Cost per item.
 Date of last purchase.
 Date of last sale.
 Quantity sold during year.

The auditor plans to observe the distributor’s physical count of inventory as of a given date. The
auditor will have available a computer tape of the data on the inventory file on the date of the
physical count and a generalized audit software package.

Required:
The auditor is planning to perform basic inventory-auditing procedures. Identify the basic
inventory-auditing procedures and describe how the use of the generalized audit software
package and the tape of the inventory file data might help the auditor perform such auditing
procedures. Organize your answer as follows:

Basic Inventory Auditing Procedures How a general purpose computer software package
and tape of the inventory file date might be helpful

Comparison of physical count data to inventory By comparing the total amounts of all inventory items
records and the values of each inventory item counted to the
inventory records.

Observation of the physical count, making and Selecting a random sample of a representative number of
recording test counts where applicable items from the inventory file to test count at the date of
the physical count.

Ascertainment that all inventories are located in By listing items located in public warehouses
public warehouses

Comparison of the auditor’s test counts to the By arranging test counts identical to the inventory file
inventory records and matching the data files.

Testing the mathematical accuracy of inventory By mathematically computing the value of each
inventory item by multiplying the quantity on hand by
the cost per unit.

Testing of inventory pricing by obtaining a list of By preparing an electronic data file in a format identical
costs per item from customers and vendors to the inventory file and matching the data files.

Examination of purchases and sales cut-off By listing a sample of items on the inventory file for
which the date of the last purchase and last sale are on or
immediately prior to the date of the physical count.

Analysis of inventory for evidence of possible By listing items on the inventory file for which the
obsolescence quantity on hand is excessive in relation to the quantity

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Analysis of inventory for evidence of possible sold during the year

overstocking or slow moving items

Question 5
EMGP Q13-20
Harris decided that the easiest way to make the Fabricator Division appear more profitable was
through manipulating the inventory, which was the largest asset on the books. Harris found that
by increasing inventory by 2%, income could be increased by 5 per cent. With the weakness in
inventory control, he felt it would be easy to overstate inventory.

Employees count the goods using count sheets, and Harris was able to add two fictitious sheets
during the physical inventory, even though the auditors were present and were observing the
inventory. A significant amount of inventory was stored in racks that filled the
warehouse. Because of their height and the difficulty of test counting them, Harris was able to
cover an overstatement of inventory in the upper racks.

After the count was completed, Harris added four additional count sheets that added €350,000, or
8.6 per cent, to the stated inventory. Harris notified the auditors of the ‘omission’ of the sheets
and convinced them that they represented overlooked legitimate inventory.

The auditors traced the items on these additional sheets to purchase invoices to verify their
existence and approved the addition of the €350,000 to the inventory. They did not notify
management about the added sheets. In addition, Harris altered other count sheets before sending
them to the auditors by changing unit designations (for example, six engine blocks became six
‘motors’), raising counts, and adding fictitious line items to completed count sheets. These other
fictitious changes added an additional €175,000 to the inflated inventory. None of them was
detected by the auditors.

Required:
a. What audit procedures did the auditors apparently not follow that should have detected
Harris’s fraudulent increase of inventory?
The auditors did not undertake the following audit procedures in a satisfactory manner:

1. There was a lack of control of count sheets during and after the inventory. There was evidently
insufficient supervision of the inventory observation carried out by the auditors, in spite of the auditors
being present and watching the physical inventory. There was also no evidence that there was any
adequate pre planning of the inventory count. Even though it is difficult to spend continuous time in the
upper decks, there must be a careful control over their contents and planned counting should have been
observed.

2. Although the late addition of such sheets is irregular, the auditors did not perform sufficient checks to
check for accuracy. The altering of count sheets after the auditors left could have been prevented by
“lining out” unused portions of the count sheet prior to leaving the inventory observation. Test counts of
lines on sheets could also have played a part in detecting the changes.

3. Tracing the items to purchase invoices does not prove existence at the inventory date, only that the

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items were at one time bona fide.

4. Questions about inventory turnover and similar comparisons should have been raised and addressed.

5. A review of the inventory balances and comparison with previous years would have indicated unusual
increases. Because of the deficiencies in inventory control, audit procedures should have been expanded.

b. What implications would there be to an auditor of failure to detect material fraud as

described here?

The failure to obtain adequate evidence to support management’s assertions could result in legal
liability from injured third parties and in sanctions by the supervisory authorities (eg. suspension
or revoke license to practice, fines or reprimands)

c. What responsibility did the auditors have to discuss their concerns with those charged
with governance?

ISA 260 (SSA260) Communication with those charged with governance deals with the
auditor’s responsibility to communicate with those charged with governance.

Other ISAs refer to additional matters to be communicated. The items to be

communicated are organized into three categories: the auditor's responsibilities under
auditing standards, an overview of the planned scope and timing of the audit, and
significant findings from the audit. Communication of significant findings include:

1. The auditor’s views about qualitative aspects of the entity’s significant

accounting practices, including accounting policies, estimates, and financial
statement disclosures.
2. Significant difficulties, if any encountered during the audit, for example
restrictions imposed on the auditor by management.
3. Significant matters if any arising from the audit that were discussed or subject to
correspondence with management.
4. Significant deficiencies in internal control identified. Identified fraud or
information that indicates fraud.
5. Significant matters in connection with the entity’s related parties - to ensure
arms-length transactions, related parties may hide losses.
Events or conditions identified that may cast significant doubt on the entity’s ability to continue
as a going concern.

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