Moroney, Campbell, Hamilton, Warren Auditing: A Practical Approach, Fourth Canadian Edition

Solutions Manual
to accompany

Auditing: A Practical
Approach
Fourth Canadian Edition

by

Robyn Moroney
Fiona Campbell
Jane Hamilton
Valerie Warren

Chapter 11
Auditing Purchases, Payables and Payroll

John Wiley & Sons Canada, Ltd.

2021

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 Moroney, Campbell, Hamilton, Warren Auditing: A Practical Approach, Fourth Canadian Edition

Chapter 11
Auditing Purchases, Payables and Payroll
SOLUTIONS TO REVIEW QUESTIONS

REVIEW QUESTION 11.1

The main audit objectives derived from management’s assertions for purchases,
payables, and payroll are:

Occurrence
• Recorded purchase transactions represent goods and services received during
the period under audit.
• Recorded payment transactions represent payments made during the period to
suppliers and creditors.
• Recorded payroll expenses relate to employee services received in the period.
• Disclosed purchase and payroll events have occurred and pertain to the entity.

Existence
• Recorded accounts payable represent amounts owed by the entity at the end of
the reporting period.
• Accrued payroll liability balances represent amounts owed at the end of the
reporting period.

Completeness
• All purchase and payment transactions that occurred during the period and that
should have been recorded have been recorded.
• Recorded payroll expenses include all such expenses incurred during the year.
• Accounts payable includes all amounts owed by the entity to suppliers of goods
and services at the end of the reporting period.
• Accrued payroll liabilities include all amounts owed in respect of payroll and
deductions at the end of the reporting period.
• Accounts payable, accrued payroll liabilities, and related expenses are properly
identified and included in the financial statements.
• Disclosures pertaining to commitments, contingent liabilities, and related party
creditors are adequate.

Rights and obligations

• Accounts payable and accrued payroll liabilities are liabilities of the entity at the
end of the reporting period.

Accuracy, valuation, and allocation.

• Purchase transactions, payment transactions, and payroll transactions are
properly (accurately) recorded.

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• Purchase cycle and payroll information is disclosed accurately and at

appropriate amounts.
• Accounts payable and accrued payroll liabilities are stated at the correct amount
owed.
• Related expense balances conform to applicable accounting standards.

Classification
• All purchases, payments, and payroll transactions are recorded in the correct
accounts.
• Payables, accrued payroll liabilities, and related expenses are recorded in the
correct accounts.

Presentation
• Purchase cycle and payroll transactions and events are appropriately
aggregated or disaggregated, and related disclosures are clearly expressed,
relevant, and understandable.

REVIEW QUESTION 11.2

Segregating the functions of personnel and payroll reduces the risk of payments to
fictitious employees, as only the personnel department may add new employees to the
personnel master file and only the payroll department may process payment of payroll.
This segregation of function is also an important control in the function of authorization
of payroll changes. Thus, personnel department employees cannot benefit from
falsifying personnel records, while payroll department employees can process payroll
only for employees listed in the personnel records and at payroll rates specified therein.

REVIEW QUESTION 11.3

Programmed application controls are those controls that apply to the processing of
specific types of transactions such as preparing payroll. These controls include proper
authorization, documents and records, and independent checks. Examples in a
computerized payroll system would include an exceptions and control report, authorized
personnel data change log, and authorized rates of pay file.
Audit procedures to test controls in a computerized system would be through using
generalized audit software, for example:
• To verify that personnel are classified according to their correct award code and
are receiving valid payments according to that code
• To assess and investigate the volume of sick pay benefits and absenteeism
against established norms
• To ensure that master file data used in payroll computations are accurate by
checking for valid employee number and valid SIN numbers, and checking for
duplicate names
• To ensure the accuracy of hours worked, a reasonableness check for hours
worked

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REVIEW QUESTION 11.4

Such procedures could include using audit software to:
• Check arithmetical accuracy of the purchase journal and accounts payable
ledger
• Match purchase orders with receiving reports and supplier’s invoice details
• Test pricing against pre-approved supplier price lists
• Check pre-numbering and sequencing of purchase orders and receiving reports
• Check matching of cut-off information at balance sheet date.

Other application controls allow the auditor to use test data to determine whether the
entity’s system will process or accept transactions where there is missing or invalid
supplier numbers, account classifications, missing or unreasonable amounts, and
missing dates.

REVIEW QUESTION 11.5

The effect of payment transactions is to reduce the accounts payable balance. If an
account were to be reduced by a recorded payment that was fictitious or a duplicated
entry, then that payables balance would be incorrectly shown as being reduced. That is,
the recorded balance would be incomplete as a result of the effect of reflecting a
payment transaction that had not, in fact, occurred.

REVIEW QUESTION 11.6

The purchases cut-off test involves determining that purchase transactions occurring
near the end of the reporting period are recorded in the proper period. Unlike
receivables, it may take several days for all transactions occurring before the end of the
reporting period to be invoiced by the suppliers. The emphasis is on completeness for
which inherent and control risks are likely to be assessed as high. Reduction of audit
risk with respect to this assertion is achieved by tracing receiving reports issued in the
days immediately prior to the end of the reporting period to purchase journal entries, or
to the closing journal entry of purchase accruals. This procedure provides evidence that
they are recorded in the current accounting period.
For purchases that do not result in the issue of a receiving report (such as services),
after the end of the reporting period purchases are vouched to supporting
documentation to ensure that they do not relate to goods or services received prior to
the end of the reporting period.
Although the emphasis of the test is on completeness, some receiving reports issued
after the period end will also be traced to suppliers’ invoices to ensure that they are
recorded in the subsequent period’s purchase transaction file. In addition, recorded
purchases before the end of the reporting period will be vouched to receiving reports
dated before the end of the reporting period. This provides evidence as to the
occurrence assertion. These tests usually cover a period of five to ten business days
before the end of the reporting period, and as long after as appears necessary. In
performing this test, the auditor should determine that a proper cut-off is achieved at the
physical inventory count as well as in the recording of the purchase transactions. Where

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inventory is counted other than at the end of the reporting period, cut-off for purchases
of inventory will need to be checked at the physical inventory count date as well as at
the end of the reporting period.

REVIEW QUESTION 11.7

Examples of controls would include:
• Use of, and accounting for, pre-numbered cheques
• Logs to record authorizations for cheque runs
• Controls over the use of the electronic signature
• Reconciliation of payments with supporting records
• Independent bank reconciliations
• Programmed maximum amounts per cheque
• Reasonableness tests for each computer run

REVIEW QUESTION 11.8

Gross profit is impacted by sales and cost of goods sold. An adverse change could
indicate rising costs and the possibility of overstatement of purchases or
understatement of sales. A positive change could be indicative of the opposite situation.
Changes could also be indicative of mismatches through incorrect treatment of cut-off at
the end of the reporting period.

REVIEW QUESTION 11.9

Cut-off tests are related more to the closing balance than to transactions. Cut-off
procedures are applied to receiving reports to ensure completeness, i.e., that all
transactions occurring before the year end are recorded. Cut-off tests are also
necessary for liabilities, as under- or overstatement of accruals will have a direct impact
on profit. For example, goods received before year end and included in inventory, but
not recorded in purchases and accounts payable until after year end, will overstate profit
by the amount of the purchases.

REVIEW QUESTION 11.10

Cut-off is critical only once a year, namely at the end of the reporting period, because of
the impact of cut-off errors on the financial statements. A receipt of inventory before the
end of the reporting period, without the corresponding recording of the purchase, will
overstate inventory and thus profit. Alternatively, a sale before the end of the reporting
period should be matched with inventory movements to ensure that inventory sold, but
still in the warehouse, is not included in the inventory on hand and thus overstate
profits.

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SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS

PROFESSIONAL APPLICATION 11.1 — Audit objectives over purchases,

payables, and payroll

a) Completeness
b) Rights and Obligations, Existence
c) Completeness, accuracy, and cut-off
d) Cut-off
e) Classification
f) Occurrence
g) Existence

PROFESSIONAL APPLICATION 11.2 — Purchases, payables, and payroll

documents
a) Purchase order: A form showing the description of the goods, the quantity
ordered, and other relevant data. It is signed by the purchasing officer as
evidence of the approval of the purchase. Purchase orders should contain
a precise description of the goods and services required, quantities, price,
delivery instructions, and the supplier’s name and address. Purchase orders
should be pre-numbered and signed or electronically approved by an
authorized purchasing officer. The original is sent to the supplier and copies are
distributed internally to the receiving department, the accounting department,
and the requisitioner. The purchase orders also become part of the transaction
trail of documentary evidence that supports the occurrence
assertion for purchase transactions. A file of unfilled purchase orders is
generally maintained on the computer or as hard copy. A subsequent
independent check on the disposition of purchase orders to determine that the
goods and services were received and recorded relates to the
completeness assertion for purchase transactions.

b) Receiving report: A pre-numbered form issued by the receiving department

detailing the description and quantity of the goods delivered by the
supplier. It is an important document in supporting the occurrence assertion for
purchase transactions because it provides evidence that the goods have
been received. A copy of the receiving report is forwarded to the accounts
payable department. A subsequent periodic independent check on the
sequence of pre-numbered receiving reports (to determine that a supplier’s
invoice has been recorded for each) relates to the completeness assertion.

c) Accounts payable master file: a computer file containing details of suppliers,

transactions with suppliers, and the balance owing. This is an additional
control over the accuracy of the data entry process. This can be compared

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to statements to provide additional controls over completeness, accuracy,

valuation, and
allocation, and occurrence.

d) Suppliers’ invoices: Forms issued by the supplier detailing the goods or services
supplied and the amount owing. The accounting department checks and
approves them. Procedures applicable to this function include:
• Numbering suppliers’ invoices on receipt so that subsequent checks of
numerical continuity can confirm that all invoices are recorded
• Establishing the three-way match of the details of suppliers’ invoices with
the related receiving reports and purchase orders to ensure that all
invoices relate to valid purchase transactions
• Determining the mathematical accuracy of the suppliers’ invoices
• Coding the account distributions on the suppliers’ invoices (i.e., indicating
the asset and expense accounts to be debited)
• Approving invoices for payment by having an authorized person sign the
invoices
• Preparing a daily prelist of suppliers’ invoices approved for payment

e) Personnel master file: a computer file containing details of employees, such as

approved wage rate and date of hiring. Segregating the functions of
personnel and payroll reduces the risk of payments to fictitious employees
because only the personnel department may add new employees to the personnel
master file and only the payroll department may process the payment of
wages.

f) Payroll register: a document that contains details of wages paid, withholding

taxes, and a cumulative record of wages paid per employee, per
department, and in total. It is common practice for a senior accounting officer to
approve the payroll details before payroll cheques or bank transfers are
prepared. In smaller entities, the authorizing officer could verify payroll by
reconciling it with the previous period’s payroll, allowing for hiring,
terminations, or changes in hours
worked.

PROFESSIONAL APPLICATION 11.3 — Purchase controls

a)
• Requisitioning authority within the production and other departments should be
established and should be related to seniority and function.
• Orders should be raised only on receipt of a requisition raised by the department
requiring the goods, signed by a staff member with the requisite authority.
• Orders should be placed with suppliers on the most favourable terms. This is
likely to involve identifying a list of approved suppliers with whom special
discount terms have been agreed. Orders may be consolidated, as a means of
obtaining further discounts where available.

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• Orders should be placed in writing, signed by an authorized purchasing

department staff member, on official pre-numbered order forms with copies to
the requisitioner, and the receiving and accounting departments.
• Blank order forms should be kept in a secure place to avoid misuse.
• Orders should require goods to be delivered to the receiving department, which
should be independent of both the purchasing and production departments.
• On receipt, the goods should be inspected by the receiving department and only
accepted if they are as ordered.
• Details of goods received should be recorded on a pre-numbered receiving
report and the order form amended to indicate receipt of the goods.
• Copies of the receiving report should be sent to the ordering department so that
they can keep track of outstanding orders, and the accounting department for
agreement with the invoice.

b)
• Invoices should be sequentially numbered on receipt to provide a basis for
ensuring that all are subsequently recorded.
• Invoices should be checked for clerical accuracy, i.e., that the quantity times the
price is correctly calculated, and the invoice is properly totaled.
• Invoices should be matched with orders and receiving reports, and agreed as to
quantity, description, and price.
• Account distribution should be noted. This will usually be noted on the order but
will need to be checked.
• Any discrepancies should be checked with the requisitioning, purchasing, or
receiving departments as appropriate and approval recorded on the invoice.
• The invoice will be approved for payment by a senior officer within the
accounting department only when there is indication that all the above checks
have been satisfactorily performed.

c) Services, such as electricity and water, do not arrive in the form of goods whose
delivery can be recorded. Procedures for verifying the delivery of services must,
therefore, differ from those relating to physical goods. Most invoices for services
will need to be verified by the department benefiting from the service. The vehicle
department manager will need to approve invoices for repairs and service to motor
vehicles, the finance director for accounting and auditing services, and the
personnel manager for staff recruitment services. Some services are subject to
recurring supply such as rent, utilities, and subscriptions. The accounting
department may set up pre-approvals so that expected invoices are approved for
payment. Approval may extend to the amount only if it is regular.
Certain services may be the subject of requisitioning and ordering as with the
supply of goods. In such cases, approval of invoices with respect to purchase
authorization will be the same as for the supply of goods. Where there is no
purchase approval, the accounting department must consider whether this is
reasonable. It may be necessary to remind department managers of appropriate
procedures for requisitioning and purchasing. In certain cases, the requisitioner
may be of sufficient standing that it is reasonable for them to be exempt from

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normal purchasing routines, such as the sales director with respect to advertising
campaigns, the finance director for accounting and auditing services, and the
company secretary for legal services. Payment of such invoices must be approved
by a person of appropriate authority.

PROFESSIONAL APPLICATION 11.4 — Internal control evaluation—cash

payments

Consistency Strengthens or weakens internal control

1. Consistent Purchase requisitions provide the authorization for
purchasing to place an order.

2. Consistent The use of pre-numbered purchase order forms

provides a control over purchase commitments.

3. Inconsistent The copy of the purchase order forwarded to

receiving should have the quantity order blanked
out. Knowledge of the quantity ordered might bias
the receiving department's count of items
received.

4. Inconsistent The receiving department should count and

inspect the goods received, not simply make a
notation that the order was received.

5. Consistent The matching of purchase order, receiving report,

and vendor invoice assures that an order was
placed, the shipment was received, and the
vendor has a proper claim.

6. Consistent Proving the mathematical accuracy of the vendor

invoice assures that the billing is correct.

7. Inconsistent The plant controller is responsible for record

keeping and should not have the responsibility of
authorizing disbursement vouchers (or cheque
requisitions). Incompatible duties are vested in the
plant controller.

8. Inconsistent Corporate headquarters received the approved

disbursement voucher that was approved by the
plant controller. All the supporting documentation
supporting the validity of the transaction and
obligation are filed at the plant.

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9. Inconsistent The cheques issued list should be reconciled with

the submitted disbursement before being filed.

PROFESSIONAL APPLICATION 11.5 — Strengths and weaknesses of controls

a)
• Inventory is kept in a separate locked area.
• Supplies are kept in a separate area from inventory (this prevents employees
from having access to inventory when obtaining supplies).
• Purchase orders are serially pre-numbered.
• Cheques are not prepared without a matching purchase order.
• Cheque preparation and approval are segregated.
• Requisition cards for supplies are serially pre-numbered.

b)
• The receiving reports are based only on an email. These are not serially pre-
numbered. A report could be lost or altered by the accounting department and it
would be very difficult to reconcile to goods received or ordered.
• The receiver has online access to the purchase orders. This means that they do
not have to actually count the goods being received.
• The receiver has access to edit the purchase order online. The receiver could
therefore change the amount on the purchase order, and steal goods that were
actually received.
• The controller also relies on an email to authorize a cheque. Staff in the
accounting department could prepare a cheque and send an email, and the
controller would have no way of knowing if goods had been ordered or received.

PROFESSIONAL APPLICATION 11.6 — Payroll—in-house payroll processing

a) Strengths:
1. No changes are made to the employee master list without the tax forms and
the owner authorization – this ensures having only approved employees and
prevents fictitious employees from being added to the payroll master list.
Test: Take a sample of employees and go back to the employee files to
ensure they exist.
2. Only the owner-manager can authorize hiring of new employees – only
authorized additions are made to the payroll.
Test: Take a sample of new employees and review hiring forms for
evidence of approval.
3. Supervisors fill in the time cards for each individual day noting the hours
worked and initials each of the time cards. This ensures employees are only
paid for actual hours worked.
Test: Select a sample of time cards and review for the supervisor’s initials.
4. The payroll module is integrated with the general ledger and prepares and
posts the journal entry to the payroll expense accounts. This ensures the

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payroll expense is recorded in the general ledger and recorded at the right
amounts and in the correct general ledger accounts.
Test: Take a sample of payroll journal entries and ensure they are posted
correctly.
5. All employees are on direct deposit and remittance advices are given to
supervisors for distribution, therefore there is no risk cheques will be
distributed to unauthorized people.
Test: Witness the distribution of pay stubs.
6. The accounting system calculates the wages and the withholding taxes. This
prevents calculation errors with respect to wages as well as tax deductions.
This ensures the payroll expense is correctly calculated.
Test: Test the system using a sample of hours and ensure it is calculating
all items correctly.

b)
1. Weakness: There is no periodic review of the employee master list by the
owner.
Implication: Payroll manager could add fictitious employees.
Recommendation: Owner should periodically review employee master file.

2. Weakness: The payroll clerk who compiles the total hours worked and codes
the hours to the appropriate job number then enters the hours worked per
person in the payroll system without any review before the payroll is
processed.
Implication: Hours worked may be inaccurate due to data-entry errors –
employees may be over- or underpaid.
Recommendation: Someone other than the payroll clerk should review the
hours worked and the hours entered into the payroll module or “batch totals”
should be run to ensure the accuracy of the data entry.

3. Weakness: When staff are terminated, they should be removed from the
payroll master list.
Implication: Former employees may continue to be paid in error.
Recommendation: Once the final paycheque and the record of employment
is prepared for terminated employees, the person should be removed from
the payroll master list.

4. Weakness: A change in job classification is only verbally communicated and

employee files are not updated.
Implication: Employment files to determine an employee’s job classification
are not current. There is no documentation to support approved wage rates.
Recommendation: Changes to job classifications should be documented
and maintained in employee personnel files.

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PROFESSIONAL APPLICATION 11.7 — Transaction-level controls over the payroll

cycle
The new accountant’s plan does not provide strong internal control over payroll.
• The personnel manager has hiring authorization and establishes pay rates for
new employees — this is an effective control over these functions.
• The new accountant has incompatible duties because he prepares and also
distributes the paycheques.
• Overall, there is no strong control because the accountant can prepare a false
paycheque and cash it himself.

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PROFESSIONAL APPLICATION 11.8 – Segregation of duties and documentation

a)

Requisition for inventory initiated at

inventory reorder levels or by sales staff

Refer to purchases
manager to source
approved supplier
No
Approved vendor
available?

Yes

Create purchase order and

send to vendor

Receiving report and supplier

invoice received Inventory receipt
process

Do quantities and unit price

agree to purchase order?

Contact supplier to resolve

No
discrepancy

Yes

Process purchase in purchase Supplier payment

ledger process

b) As indicated on the flowchart, the sales staff who create the requisition and the
receiving department are separate from the purchasing process. The sales staff
are not permitted to make purchases directly with suppliers because there needs
to be a segregation of the authority to commit the entity to purchasing goods and
the custody of the goods. The recording of purchases into the inventory account
is separated from the receiving department.

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Also, the payment process is separate from the purchases process. At various
points in the process, permission is sought from the purchasing department and
the accounting department for action. The purchasing department selects
suppliers from an approved suppliers list. Only approved suppliers are used to
ensure that they are reliable and the items meet the entity’s specifications.
Payment is not approved for processing until the purchase order, receiving
report, and supplier invoice are matched and reconciled, and approved by the
cash payments department.
Therefore, requisitioning of goods, preparing purchase orders, receiving goods,
storing goods received, checking and approving supplier invoices, recording the
liability, and processing the payment should be segregated.

PROFESSIONAL APPLICATION 11.9 — Computer information system controls—

purchasing and cash payments
a) General
• There should be segregation of duties between the user, purchasing,
receiving, and accounting departments.
• Employees should have computer passwords identifying their separate
level of authority and responsibility.

Requisitions
• The computer should:
• Check the requisition against the inventory master file to confirm that
the re-order point has been reached.
• Only accept requisitions against the account code entered from
employees whose password identifies them as having that
requisitioning authority.
• Check the file of unfilled requisitions to ensure that a similar
requisition does not already exist, in order to prevent duplication.
• Confirm the requisition only if all relevant data fields are properly
completed.

Purchasing
• The purchasing department should maintain a list of authorized suppliers
providing agreed discounts and other benefits to the company.
• The purchasing department should determine the supplier for each
requisition and consolidate requisitions as necessary to secure bulk
purchase discounts.
• A purchase order should be raised identifying the requisitions to which it
relates.
• The computer should accept purchase orders only from authorized
purchasing department employees identified from their password.
• Orders placed against suppliers not on the approved list should only
be accepted if authorized by the purchasing department manager.
• Orders should only be processed when all data fields are properly

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completed.
• Details of the order should be automatically communicated to the
requisitioners, the receiving departments at the locations to which
delivery is to be made, and the accounting department.
• A copy of the order should be printed out and sent to the supplier
who is requested to quote the order number on delivery and on
invoicing.

Receiving
• Receiving department personnel should:
• Inspect the goods for damage.
• Identify the order details and match the goods with those ordered.
• Refuse delivery of damaged or unordered goods.
• Enter details of goods received on the computer against the order.
• The computer will:
• Advise user, purchasing, and accounting departments of goods
received
• Update the order if any items remain undelivered.

Purchase accounting
• Details of invoices should be entered into the computer on receipt and the
computer will:
• Match the invoice with the order and receiving details agreeing
descriptions, quantities, and prices.
• Check discount, payment delivery terms, etc. with the details
recorded on the supplier master file (list of approved vendors).
• The invoice will then be sent to the user department for approval.
• On return, the invoice will be authorized for payment and the computer will:
• Check that the authorization is given by an approved accounting
department employee.
• Update purchase and accounts payable records.
• There should be a periodic check of:
• Invoices where no goods have been received.
• Goods received where no invoice has been posted to the accounts
payable ledger.
• Purchase orders where not all the goods have been received.
• Invoices that have been sent to a user department, but which have
not been returned to the accounting department.

b)
• Access to the main computer should be password controlled with each
employee having a unique password.
• Passwords should be regularly changed.
• The computer should be programmed to allow access to the computer files at an
appropriate level only. This ranges from read and write to read only to access
denied.

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• Terminals themselves may be programmed to restrict access of a nature

appropriate to the location of the terminal. For example, terminals in the goods
received area may only permit access to data relevant to the goods received
function.
• Access to the terminal should be physically restricted as far as possible.
• The terminal should automatically log off if unused for a set time period.
• Access may be restricted to normal working hours unless overridden by a staff
member at an appropriate level of authority.
• Where access is via a modem connection over the phone line, such as from
shops, the head office terminal may accept data only from designated phone
numbers.
• Details of failed access attempts should be investigated.

c) i) Standing data, such as a supplier master file, is relied on by the computer for
the processing of all transactions to which that data is relevant. The potential for
error from incorrect standing data is thus much greater than for transaction data.
For example, if an unauthorized supplier is entered into the supplier file,
purchases may be processed to that supplier at inflated prices. Since the supplier
is approved neither the computer nor any staff member will bring such purchases
to management's attention. It is unlikely that any staff member will be aware of
such transactions since they will be automatically approved by the computer.
This is why application controls over changing supplier details in the supplier
master file are important to prevent fraud.

ii) Controls over supplier details.

• Access to supplier details should be restricted by means of a password.
• The changes should only be made on a specific computer terminal.
• Staff may input changes but the supplier details may not be changed until
the central accounting department authorizes the change using a
password.
• Each batch of changes should be given a sequential number.
• The computer should print out all changes to supplier details when they
take place.
• Periodically, a person independent of the accounting department (e.g.,
internal auditor) should check the names and addresses of a sample of
suppliers to the manual records to ensure they are correct.
• The computer should print out suppliers where there has been no
transaction for a specific period (e.g., six months). An assessment should
be made whether these suppliers should be removed from the file.

PROFESSIONAL APPLICATION 11.10— Payroll at a not-for-profit entity

Strengths:
1. There is restricted access to personnel records and payroll records and access
to the Paystub data entry (used to prepare the direct deposits). This prevents
unauthorized employees from being added to the payroll or changes being made

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in error. To test this, the auditor should try to access the spreadsheet to see if
access is given without the password.
2. Approval, in writing, is required to add new employees to payroll. There are
stated standard procedures the accounting staff has to follow. This is to ensure
unauthorized employees are not added to the payroll. To test this, the auditor
would select a sample of employees added during the year and vouch to hiring
approval maintained in the employee’s personnel file.
3. Employee's pay rate, job classification, employment agreement, and job
description are on file. This is to ensure unauthorized employees are not included
in the payroll. To test this, the auditor would select a sample of employees and
vouch to the employee personnel file.
4. Venture Volunteers uses a reputable outside service organization (Paystub Inc.)
to process payroll and calculate employee deductions. Additionally, the service
provider requests and remits the payroll deductions at the time of the payment of
the payroll and therefore ensures the deductions are paid in a timely and efficient
manner on behalf of the organization. To test this, the auditor needs to obtain a
report on the controls of the service provider as the auditor will be relying on the
reports provided by Paystub Inc. Sufficient and appropriate audit evidence is
needed to document the reliability of these reports
5. When an employee is terminated, Maddie is informed in writing from the
employee’s manager and there is a termination checklist that ensures that people
who no longer work for the organization are removed from the payroll. To test
this, take a sample of terminated employees, inspect termination checklists, and
inspect employee master files to ensure they have been removed from the
payroll.
6. Official letters are produced, and subsequently kept on the employee's personnel
file, for changes in an employee's rate of pay. This letter is reviewed and signed
by the executive director and a copy is forwarded to Ricardo, who then adjusts
the pay rate. This ensures all increases to the payroll are documented and
authorized. It also ensures the accuracy of the payroll expense and the
withholding taxes. To test this, select a sample of employees that received pay
increases. Vouch to the official letter signed by the executive director and match
this to the paid amount in the employee master file.
7. Segregation of incompatible duties exists between adding and removing
personnel and timekeeping of the employees. The master file is reviewed
periodically by Ricardo. This ensures only authorized employees are on the
payroll. To test this, obtain a copy of the master file reviewed by Ricardo and
check for his signature as evidence of this review.
8. Ricardo reviews the journal entry prepared by Maddie before it is posted. He
looks for unexpected variances or unusual amounts. This ensures the accuracy
of the payroll expense. To test this, select a sample of journal entries and look for
evidence they have been reviewed (look for Ricardo’s signature).

PROFESSIONAL APPLICATION 11.11- Accounts payables documentation

The working paper is the lead schedule for payables. It shows the following information:
• Pre-adjusted balances for both trade payables and other payables

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• Comparison between the current year’s pre-adjusted amount with the prior
year’s amount
• Variance amount, which is the difference between the pre-adjusted amount
(2023) and the prior-year amount (2022)
• Variance expressed as a percentage
• TB stands for the trial balance
• PY is for the previous year
The tests are at a high level, i.e., comparisons of balances, rather than details of
transactions or vouching of balances. The working papers called NO1, linked to the lead
schedule, contain details of other tests. In step 3, the auditor shows the calculated
average payment period, which also provides an overview of the reasonableness of the
payables.

The auditor has concluded that the payables balances are reasonable because they are
consistent with the previous period and in line with expectations. The expectations are
that the payables balances and creditors days will not vary due to the nature of the
client’s business and the stability of the markets in which it operates. The auditor has
concluded that a 21% change in total payables is reasonable. This would need to be
considered in the context of other information for the client.

PROFESSIONAL APPLICATION 11.12 – Accounts payable – substantive testing

a)
1. Why did the balance in accounts payable decrease by $184,000 from 2022 to
2023?
2. The accounts payable balance may be immaterial compared to the overall
materiality, but it is probably not immaterial compared to the materiality
allocated to accounts payable.
3. Potential errors in relation to accounts payable may be material. This is
because the main risk associated with accounts payable is understatement.
4. The sample selected is not appropriate. It would be preferable for the auditor
to use statistical techniques to select the sample size. Selection of the three
largest balances is also inappropriate because the main risk associated with
payables is understatement not overstatement.
5. The balances of the creditors selected for testing should be reconciled to the
original suppliers’ statements.
6. What audit work has been performed to ensure that there are no unrecorded
liabilities?

b)
7. The auditor should obtain adequate explanations for such a substantial drop
in payables from 2022 to 2023.
8. The errors in accounts payable may not be immaterial. The auditor should
perform work searching for unrecorded liabilities through review of
subsequent period’s purchase and payment transactions.

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9. A random sample (using statistical sampling techniques) should be selected

from the whole population of payables to reconcile to original suppliers’
statements. The auditor should ensure that accounts payable that have
decreased significantly from 2022 are included in the sample. It should also
be determined if there are suppliers with large balances in past years that
have small balances in the current year, and if so why.
10. More audit work should be done on cut-off of purchases and payables.

PROFESSIONAL APPLICATION 11.13 — Payroll control and substantive testing

a)
• What were your expectations with respect to monthly trends of payroll? Were
you expecting any abnormal trends? (This could relate to changes in the number
of staff during the year.)
• What level of control risk was assessed for payroll? If it is less than high, then
tests of control need to be carried out on the service entity’s procedures.
• Have controls of the service entity been reviewed?
• Has a report regarding the service entity’s procedures been requested or
received from the service entity auditor?

b)
• Compare monthly figures to expectations.
• Ascertain the level of control risk assessed for payroll.
• Obtain a report from the service entity auditor.
• Determine whether the report issued, plus results of other tests performed,
constitute sufficient appropriate audit evidence on which to form a conclusion on
payroll.

PROFESSIONAL APPLICATION 11.14 – Payroll system – substantive testing

a) & b)
Assertion at risk Substantive test
Occurrence of payroll expense is at risk Select a sample of payments from the
because it is important to ensure that only payroll schedules and agree the time paid
hours actually worked are being paid for. for to time sheets ensuring the time worked
All payroll payments should relate to hours on the time sheets are authorized by a
worked. This is particularly important supervisor.
because of the high level of casual staff. Select a sample of records of employment
Secondly, high turnover of staff increases prepared during the year and review the
the risk that staff have left but are not payroll register to ensure no payments
removed from the payroll. were made after the last date of
employment.

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Assertion at risk Substantive test

Accuracy of payroll expense as there are Select a sample of payments from the
many different rates of pay, so there is the payroll and agree the rate of pay to an
risk of an individual being paid the wrong authorized pay award to ensure the correct
rate. rate of pay is being used.

c) No – payroll is high risk, there have been many changes in staff, there are many
casual staff, there are many different pay awards, and the internal controls
are weak. Therefore, detailed substantive testing will be required.

11.15 Payroll Case Study—Blake Co.

a) Control Objectives – payroll system
Ensure that the entity has:
• Paid employees only for work completed
• Correctly calculated gross pay
• Authorized gross pay
• Correctly calculated net pay
• Accurately recorded gross and net pay in the general ledger
• Paid only genuine employees
• Paid taxation authorities the correct amounts

b)
The Directors
December 3, 2023
Dear Sirs
Management letter
We write to inform you that our audit has uncovered weaknesses in your company’s
internal control systems. Below we provide recommendations to alleviate those
weaknesses.
(i) Weakness: (ii) Possible effect: (iii) Recommendation:
Your company is not Employees might be paid The shift manager should
monitoring the signing-in for work not completed. visually count the number of
process. This could occur if an employees in the assembly
employee scans in the plant and reconcile the count
sign-in card for an absent with the number of cards
employee as if they were scanned in for the shift.
present.

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A responsible official is Employees may be The manager should

not authorizing overtime. clocking out past their authorize all overtime either
shift without actually with an estimate in advance or
working and get paid by confirming the hours
overtime for work not worked in the computerized
done. system after the shift is over
and the overtime hours have
been completed.
The payroll system code Employees not authorized A random sequence of
word used to approve the to use the payroll system numbers and letters should be
time worked is the name may be able to guess the used for the code word, which
of the department head’s code word because should be changed regularly.
cat. names of pets are
common passwords.
Total wages paid to Employees in the The financial accountant
employees are not agreed accounting department should agree the total of the
to the total payroll as could create “dummy payments list to the total of
compiled by the payroll employees” and make wages generated by the
department. payments to these fake payroll department before
employees. payments are made to
employees.

When an employee The personnel department The payroll department should

leaves, the personnel does not check to ensure implement controls such as
department notifies the that the payroll prenumbering employee
payroll department by department receives all departure notification emails
email. the e-mail notifications of or tagging emails to ensure a
employee departures, so receipt is sent back to it.
there is a risk that a
departed employee could
still be receiving wages.
An accounting clerk in A junior employee might A senior manager or the
accounting authorizes the not be able to identify director of finance should be
payment of net wages to payroll errors or might be required to authorize payroll
employees. authorizing payments to payments.
“dummy” employees.

If you require any further information on the above, please do not hesitate to contact us.

Yours faithfully,

An audit firm

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c)
10. Compare annual salary with actual annual wages paid. The expectation of
the result of the procedure would be that the amount paid is equal to the
actual annual salary allotted to the manager, since there are no overtime
payments. Take into consideration any bonuses.
11. Compare the manager’s salary of the previous year to the salary of this
year. A 3% increase is expected after July; therefore we would expect to see
an increase in salary for the months from July to the year end as compared to
last year. Take into consideration any wage increases in the previous year.
12. Review the bonus payment and review any discrepancies. The November
payment is expected to be 5% of salary.

d) Payroll fraud is a major concern for the auditor. Employees involved in preparing
and paying the payroll may process data for fictitious employees or for
employees whose services have already been terminated, and then
divert the wages for their own use. Of particular concern is the risk of
overstatement of payroll through:
• Payments to fictitious employees
• Payments to actual employees for hours not worked
• Payments to actual employees at higher than authorized rates
The risk of understatement (the completeness assertion) is of minimal concern
because employees will complain when they are underpaid. Accordingly,
tests of payroll are directed to detect overstatements. Audit evidence can
be obtained by executing the following procedures:

13. Recalculate the gross wages, deductions, net pay, and payroll liabilities.
This can be done as control testing to ensure that the system can be relied
upon. Trace the calculations to the appropriate general ledger account and
ensure it is appropriate. This will test classification.

14. Vouch data for a sample of employees in the payroll register to approved
clock card data and authorized pay rates.

15. There is a risk that staff could be “clocking in” for other staff. To address
this risk:
1. Review expected staff costs based on average pay rates and average
numbers of staff. Investigate any discrepancies.
2. Calculate average wages per employee, which should not be
dissimilar from previous years, subject only to known wage increases,
and payroll expenses as a percentage of sales.
3. Have shift managers review salaries for their employees to note any
unusual or unexpected wage payments.

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16. Select a sample of termination notices and scan subsequent payroll

registers to determine that the terminated employees did not continue to
receive paycheques. This will test for occurrence.

11.16 Purchases and Payables Case Study —Greystone Co.

a)
Management
Greystone Co.

December 8, 2023

Dear Sirs,

Audit of Greystone Co. for year ended September 30, 2023

Enclosed please find our report to management on significant deficiencies in internal

controls we identified during our audit for the year ended September 30, 2023.
Specifically, we found deficiencies in the purchases system. Below we discuss the
implications of those deficiencies and provide recommendations to address those
deficiencies.

(i) Deficiency (ii) Implication (iii) Recommendation

Inventory levels in each The purchasing manager Before ordering goods, the
store are determined by might not know the local purchasing manager should
the purchasing manager market’s purchasing habits meet with as many area store
without input from the and might order the wrong managers as possible and
store manager or sales goods, resulting in understand local markets
manager. overstock that might before jointly agreeing on
require heavy discounting purchases.
or lead to obsolete
inventory

If the goods do not meet

local customers’ tastes or
key fashion trends, they
may shop elsewhere.
A purchasing director The purchasing director Each country’s senior
reviews and authorizes does not review the buying purchasing manager should
purchase orders in the decisions in detail and may review and discuss orders
aggregate, by region. not know if the types and with local purchasing

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quantities of goods ordered managers for their

are appropriate. Because authorization. The purchasing
the purchasing director is director should then conduct
the only level of the final review and sign-off
authorization, this could before orders are placed.
result in an inappropriate
type and amount of goods
being ordered for particular
markets.
Goods for each store are Because the reordering The inventory management
reordered by the store process can take up to four systems should be set up to
manager through the weeks, if store managers automatically notify the
purchasing manager. forget an order or place the purchasing manager to order
order too late, this could goods when they reach
result in significant certain levels.
stockouts and loss of
sales.
Stores cannot order out- Customers are unlikely to The company should set up a
of-stock goods from other contact individual stores, system to transfer goods
local stores; instead, resulting in lost sales. between stores, which would
customers are told to help stores with slow-moving
contact the stores directly items transfer them to stores
or use the company with stockouts that are
website. awaiting restock.

Stores are accepting The store would have little Stores should accept
supplier deliveries recourse if its sales deliveries only during
without checking them assistants discover specified times, such as the
first. Sales assistants discrepancies, such as the first two hours of opening, to
only check the quantity of quality of goods, after ensure a quiet time to check
goods received, not the accepting delivery. the deliveries. Staff should
quality. examine the quantity and
quality of goods received.

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The receiving reports are Assigning responsibility for Each store should designate
being produced by the producing receiving reports an official responsible for
sales assistants after used to authorize invoices producing a receiving report
receiving the goods. to sales assistants who as the goods are received.
may not have enough
experience may result in
errors, which could lead to
under- or overpayments.
Preparing them after the
goods are received may
lead to additional errors.

Staff is not comparing the Not checking goods The company should send a
receiving reports to the received against purchase copy of the approved
purchase orders. orders could result in purchase order to the store so
Greystone paying for that it can be compared to the
goods it did not order, or receiving report. Once
not knowing that it has checked, it should send the
unfulfilled orders, which order to head office so the
could result in lost sales. order is logged as complete.
The purchasing clerk should
regularly check the
outstanding order list for any
remaining items.

The individual stores’ Due to the high volume of Greystone should automate
receiving reports are receiving reports from the process by logging the
manually matched stores, there is a greater checked receiving reports into
against the purchase risk of error in a manual the purchasing system and
invoices. process, which could result matching them against the
in invoices being relevant order number. The
incorrectly accepted or system then would
rejected. automatically match the order
number against the invoice.
The purchasing clerk should
check the system to identify
any unmatched items.

The purchase invoice is The delay in logging Invoices should be kept in a

not logged into the purchase invoices into the file of unmatched invoices
system until it is system could result in when received. Once
authorized by the misplaced invoices, which matched and authorized,
purchasing director. would not be settled on a invoices should be moved into
timely basis. It could also the purchase journal. To
result in understating ensure liabilities are not

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accounts payable at year understated, unmatched

end if invoices from the invoices should be accrued
current year have been for at year end.
received but are not
entered in the correct
accounting period.

Please note that this report only addresses any significant deficiencies identified during
the audit and that more deficiencies may have been found if further testing had been
performed.

This report is solely for the use of management. Please do not hesitate to contact us if
you have any questions.

Yours faithfully,

An audit firm

b) Substantive procedures over year-end trade payables include:

• Agree the total of the trade payables ledger to the general ledger and the
financial statements.
• Review the list of trade payables against prior years to identify any
significant omissions.
• Calculate the trade payable days and compare with amounts in prior years.
If there are any significant differences, investigate.
• Review payments made after year end. To ensure completeness, if they
relate to the current year then follow through to the payables ledger or
accrual listing.
• Review invoices and credit notes made after year end to ensure that no
further items need to be accrued.
• Obtain supplier statements and reconcile these to the payables ledger. If
there are any reconciling items, investigate.
• Send out trade payables’ confirmations. Focus on account balances that
have significantly decreased from the prior year or nil balances with
significant suppliers. If there are any non-replies, follow up on these and
on any reconciling items between the balance confirmed and the trade
payables’ balance.
• Ask management to explain its process for identifying goods that are
received but not invoiced or recorded. Determine whether the process is
reasonable to ensure completeness of payables.
• To ensure cut-off is applied correctly, select a sample of receiving reports.
Each store should designate an official responsible for producing a
receiving report before the year end. Follow through to inclusion in the
year-end payables balance.

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• Scan the purchase journal for any debit balances. If there are any
significant amounts, discuss with management and consider
reclassification as current assets.
• Ensure that the financial statements classify all payables as current
liabilities.

11.17 Accounts Payable Reconciliation Case Study—Blackburn Ltd.

a) Whitebone Ltd. Account

Balance per Blackburn’s purchase ledger $ 5,980

(1) Add: Invoices not recorded #6210 4,735
#6355 6,298
(2) Add: Discounts taken by Blackburn but not recorded by 126
Whitebone
123
(3) Add: Payment not received by Whitebone Alloc. 2 6,005
(4) Invoice incorrectly recorded by Blackburn #6080 (3,572)
3,752
Balance per supplier statement $ 23,447

b)
17. These two invoices should be included in Blackburn’s purchase ledger
and its accounts payable. The fact that they are on the supplier’s statement is
adequate evidence of their existence. However, you would want to check
them with management first.
18. Inquiries should be made to ascertain whether Blackburn has properly
taken these discounts. The fact that they have not been recorded on the
supplier’s statement would indicate that they should be added back into
Blackburn’s accounts payable. A check of the terms and conditions of the
invoices would verify whether the discounts have been correctly taken or not.
The cheques dated May 31 and June 30 would not likely reach Whitebone in
the correct month.
19. No adjustment would be required for this timing difference. Payment
should be checked to the payments journal to ensure that the cheque was
prepared on June 30. Payment should be checked to the subsequent period’s
bank statement.

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20. This amount should be checked to the original invoice. It is more likely that
the supplier is correct and the correct balance should be adjusted in Black’s
purchase ledger and accounts payable.
21. The balance to be included in the financial statements would be $17,442.

Opening balance $5,980

Missing invoices 4,735
6,298
Discounts not allowed 126
123
Correction to invoice 680 (3,572)
3,752
Corrected balance $17,442

c) (i) Possible ways of selecting suppliers’ statements:

• Analyze accounts payable population and stratify it into accounts with large
balances.
• Accounts with small balances, accounts with zero balances, or accounts
that have changed significantly since the prior year.
• Use a sampling technique that selects items based on criteria other than
the dollar amount of the item (e.g., select based on account number, 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 entity 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 period.
• Select vendors that do not provide periodic statements.
• Select accounts reflecting unusual transactions during the year.
• Select accounts secured by pledged assets, if any.

(ii)
If there is no supplier’s statement you may consider verifying the account
balance by vouching to invoices. This would need to be performed in
conjunction with extensive cut-off testing. However, a better option in this
situation would be to confirm accounts payable for the balances that do
not have a supplier’s statement, particularly if the required detection
risk is low.
The positive form should be used in making the confirmation request. The test
provides evidence for all accounts payable assertions. However, the
evidence provided about the completeness assertion is only limited because
of the possible failure to identify and send confirmation requests to
suppliers with which the entity has unrecorded obligations. This is why extensive
cut-off testing would still be required.

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11.18 Integrative Case Study—Integrated Measurement Systems Inc.

a)
1. The purchase request (PR) is authorized (signed) by personnel with the
appropriate level of authority.
• This control ensures that the purchasing activities that result in a purchase
transaction are properly authorized. The different levels of authority ensure
that sufficiently senior personnel review and approve significant
expenditures.

2. PRs are reviewed and approved by the purchasing manager.

• This control ensures that all requests are authorized by a senior,
independent manager before the purchase order is completed, and
requests for purchases of unusual items or quantities, etc., can be
questioned through the review process.

3. There is a pre-qualified list of suppliers and a bidding process for larger

purchases.
• The use of a pre-qualified list and a bidding process ensures that vendors
have met the prequalification criteria before being given an order. The
criteria used are likely performance-related and size-related and probably
include references. The bidding process ensures that all qualified vendors
have the opportunity to fill the order and ensures a competitive price,
thereby preventing collusion with a particular vendor and price gouging.

4. The purchasing manager reviews the purchase orders (PO).

• A review by the purchasing manager acts as a deterrent to any buyer
trying to circumvent the control system. The purchasing manager is able to
review
the details of the purchase order (such as the vendor selected and the
prices to be paid). The use of approved purchase orders also ensures that
all purchases are authorized.

5. The receiver matches the quantities received against the bill of lading (BL) and
signs the BL.
• This control ensures that the company will not pay for goods it did not
receive, and that documentation exists for missed items, over-shipments,
etc. The signature is proof of performance by the receiver.

6. All goods are received in the warehouse.

• Central receiving of goods allows for better control of the goods, thereby
safeguarding assets.

7. The signed copy of the BL (receiving document) is matched to the PR and PO.

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• This control ensures that the goods that have been received were ordered.
The PO commits the company to the transaction. Thus, only goods that
have been received are paid for and the correct amount/price is paid. The
information provided on the PR and PO, when matched to the BL
information, provides control over existence, completeness, and accuracy
of the transactions. The matching of the three documents initiates the
requirement for entries to record Accounts Payable and Inventory.

8. A copy of the BL goes to the user department with the goods, and the user
department agrees the quantity it received to the BL copy.
• By receiving a copy of the BL and agreeing the quantities, the person
placing the order knows what amount was received in the warehouse and
whether it was the actual number they received, thus legitimizing the
transaction for the payment cycle.

b)
1. PR authorizing signatures are not confirmed.
Currently, the operating departments are responsible for ensuring that their PR
forms are signed by individuals with the appropriate level of authority, and
the purchasing clerk is not required to check the specifics of the signatures.
Although the purchasing clerk ensures that an authorizing signature appears on the
PR, there is no confirmation that the person signing the PR has the requisite
level of authority. It is thus possible for an order to be placed that is beyond
that person’s authorization limit, for whatever reason, and it would not be caught.
Since the purchasing clerk is not monitoring the specific names, they do not
know if the limits
have been exceeded or if some unauthorized person has placed an order. The
company risks being committed to a purchase contract that is not a legitimate
company expense.

Corrective action: Provide the purchasing clerk with a list of authorizing

individuals based upon the tiered approval process to allow them to check
for
appropriate approval of the PR. Ensure that the list is regularly updated as
changes in personnel occur.

2. The purchase requests are numbered by the purchasing clerk only as filled
out.
Because the purchase request forms are not pre-numbered, the clerk could
assign the same number to two purchases or skip a number. There is the
risk of a false order being processed in the case where two orders with the same
number exist.

Corrective action: The forms should be sequentially pre-numbered, and the

purchasing clerk should log the assigned numbers to allow for all orders to
be tracked through the purchasing and accounting system.

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3. Buyer has discretion in selecting vendors.

For items costing between $5,000 and $25,000, buyers currently are permitted to
select a vendor from a pre-approved list. There is a risk of the buyer always
selecting the same vendor, and then receiving kickbacks for doing so. For
items
costing less than $5,000, the buyer currently has the discretion not to use the list
at all. There is the additional risk that buyers could use smaller increments (e.g.,
of less than $5,000) to get around using vendors on the pre-approved list. Again,
the buyer could be in collusion with a particular supplier for personal gain.
Currently, the buyer can also waive the formal bidding process, if deemed to be
cost inefficient, for items costing more than $25,000. This again creates
opportunities for buyers and vendors to collude.

Corrective action: Additional procedures should be put in place to ensure that the
vendors are fairly selected. Consider a process whereby a purchase
automatically defaults to the next vendor of that product for a subsequent
purchase. For purchases in excess of $25,000, any waivers of the
formal bidding process should be approved by a senior manager, and the
reasons for the waiver should be noted. When reviewing the POs, the manager
should be looking for tendencies to purchase from the same vendors and
should be questioning why it is happening. To make the review easier,
reports could be created (if they don t already exist) that sort the purchases by
buyer, showing their activity levels and who they regularly deal with. These
reports should be reviewed by the manager.
4. Purchasing manager sends PO back to buyer who delivers it to vendor.
Sending the PO back to the buyer before it is sent to the vendor makes it
possible for the buyer to alter the PO before it is delivered. The buyer
could, for example, change the order amount to a larger quantity. When the
goods are
received, the buyer could keep the extra goods, and approve the BL going to the
user indicating that more goods were received and that the buyer has
agreed to ship them back. The copy of the BL going to accounts payable
would show the full shipment amount and would get paid. The buyer could
also collude with the vendor since they are the one delivering the PO to the
vendor.

Corrective action: Once approved by the purchasing manager, the PO should be

sent directly to the supplier. The buyer would not have the opportunity to
modify the PO or collude with the vendor.
5. All employees have access to the warehouse.
IMS manufactures high-end measuring devices. All employees currently have
access to the warehouse; access to goods is therefore not restricted.
Many of the

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goods are shipped directly to the users. However, depending on the nature and
size of the component parts that are used in the manufacturing process,
employees could pilfer some of the inventory that is simply stocked
on the warehouse shelves or waiting to be stocked on the shelves.
Even the goods that go to the users are subject to theft while in transit
from the warehouse to the user
department. When there is a freely accessible warehouse, there is also the risk
of goods being taken for use in the manufacturing process before being recorded
as an inventory withdrawal.

Corrective action: Access to the warehouse should be restricted or monitored,

through the use of access cards or keys. Non-warehouse employees
should not have unrestricted access to goods. The warehouse should have a
secure receiving area.

6. BL is not matched to PO by receiver.

Currently, the receiver checks the bill of lading to ensure it agrees to the goods
physically received. There is no check to determine that the goods were
ordered. With the other weaknesses noted in the system, the absence of a check
could result in goods being accepted and paid for that were not ordered.

Corrective action: Receiver should have a carbon copy of the PO in order to

check that goods received have in fact been ordered before accepting the
goods from the vendor.

7. Receiver currently sends BL to user group, which then files it.

Currently, the receiver sends a photocopy of the BL to the user department,
where it is filed away. The receiver also sends a copy of the BL to the
payables group for settlement. The user department should send the signed
copy of the BL to accounts payable rather than file it. The receiver could be
pilfering goods and reporting them as short shipments to the user department,
while accounts payable receives a copy that indicates everything has
been received, thus triggering full payment. This may already be
occurring, as the user departments have noted an increasing number of
manual adjustments on the BLs.

Corrective action: The user department should sign off the BL confirming that the
goods were received and forward it to accounts payable rather than filing it. If
users want to keep a copy for their records, they could make a photocopy
of the signed document.

8. Discrepancy between BL and PR is being resolved by buyer.

The purchasing clerk matches the PR, PO, and BL. If there are any differences
between the BL and the PO, the BL is forwarded to the buyer for
resolution with the vendor. Depending on the nature of the discrepancy,
there is the possibility of a buyer having colluded with a particular vendor. IMS has a

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system in place to capture set prices and quantities on the PO. However, if it
simply takes the buyer
signature to approve any differences, the control related to using a PO is being
overridden and could present an opportunity for fraud. The differences in
shipment amounts (over or under) or pricing differences could
simply be approved by the buyer with the idea that the buyer would get
a kickback for co- operating. The buyer can then simply explain away the
differences to the purchasing clerk.

Corrective action: The purchasing manager should be the only person allowed to
approve discrepancies. That way, the person initiating the purchase is not
the same person who approves the differences. All discrepancies should be
well documented by the buyer.

9. The buyer is asked about the BLs that have no matching PO and PR for
follow- up.
How an order can have a BL without a PR and PO is a separate concern, as all
orders are supposed to have a PR and PO. (Perhaps the problem is
occurring with orders that are shipped in two parts: the loose BL might be
sent with the
second part of the shipment, while the PO/PR was sent with the first shipment
and
forwarded to accounts payable. These situations should be investigated.) Having
the buyer do the follow-up may not be the best control. If operational
departments
are circumventing the controls by placing orders without a PO/PR, then this
situation should be brought to the attention of management. There is no
guarantee that the buyer will report their findings, particularly if the buyer is doing
a favour for someone by approving a non-authorized order and receiving
compensation for doing so.

Corrective action: The purchasing clerk should delay forwarding the BL to

accounts payable until after the BL has been approved by a manager from
the operating department and the purchasing manager. See note below
regarding inefficiency in this area.

10. Unmatched BL is sent to accounts payable.

Accounts payable should not be sent the BL at the same time that the purchasing
clerk is following up with the buyer. The purchasing clerk should send accounts
payable only approved and matched orders or, in the case of part
shipments, the
BL should only be sent after the exception has been approved by the person who
placed the order and/or the purchasing manager. Otherwise, items could be
purchased that are not approved, e.g., items of a personal nature or items that
do
not meet safety specifications, etc.

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Corrective action: The BL should be approved by a manager from the operating

department and the purchasing manager to indicate the order is
authorized. The BL should be sent to accounts payable only after the
discrepancy has been investigated and resolved.

11. Unmatched PRs/POs are sent back to the operational departments on the
assumption that the goods must have been received. User group is
responsible for follow-up.
If the purchasing clerk is regularly matching all PR, PO, and BL documents, it is
unlikely that the goods were received and that the paperwork was just
missed,
unless the processing of part shipments is flawed. It is more likely that the order
was cancelled or that the goods are on back-order. However, mismatched
information on the outstanding POs/PRs might be indicative of unrecorded
receipts. The partial-shipment tracking system should be checked to make sure it
is working properly. Ninety days is too long to wait to follow up. It is much easier
to follow up on an order when the information is current. The purchasing clerk
should be following up on open orders once a week. In addition, pushing follow-
up
responsibility to the operational departments can result in processing
inefficiencies. This approach relies on the operational departments performing
purchasing activities that are not part of their core competence.

Corrective action: The purchasing group should promptly follow up on all issues
regarding the timing of receipts and unmatched PRs/POs.

c) An internal audit group is a useful addition to a corporate entity to independently

report on the functioning of controls, both accounting- and non-
accounting-related within an organization.
• In order to be most effective, the department should not report directly to
the accounting and finance group. The department should report to senior
management and should also have access to the audit committee.
• The internal audit group would be responsible for evaluating controls (both
financial and non-financial) and adherence to prescribed procedures and
policies. Through the completion of operational audits, the department
would evaluate the functioning of the controls, monitor adherence to
prescribed policies, and consider the effectiveness of those policies. The
reporting of their findings and recommendations for improvement is a
useful tool for ensuring that an organization is achieving good control, and
their recommendations should be acted upon.
• Internal audit staff must have adequate technical training and competence
as internal auditors, as well as knowledge of the areas subject to audit.
During the hiring process, you should inquire about the background and
training of any applicants, as well as their professional qualifications.

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• The internal audit group could provide useful assistance in determining

whether the company is achieving its corporate governance framework
goals. In addition, their work may be used by the external auditors at year
end.

CASE STUDY—CLOUD 9
NOTE: The percentages used to determine testing thresholds are based on the aud-
itor’s professional judgement. Students do not have to have the same percentages but
should demonstrate an understanding of performance materiality.

Balance Sheet

COMMON COMMON
31-Dec-23 31-Dec-22
SIZE SIZE

Cash $246,965 1% $1,753,765 9%

Receivables 10,912,937 55% 9,843,708 50%
Inventory 5,824,136 29% 6,163,242 32%
Prepaid expenses 1,112,028 6% 666,054 3%
Deferred tax asset 271,659 2% 277,559 2%
Plant and equipment 1,449,331 7% 852,965 4%
Total assets $19,817,056 100% $19,557,293 100%

Accounts payable and

$4,522,409 22% $3,570,207 18%
accrued liabilities

Long-term debt 8,872,482 45% 9,560,224 49%

Current tax liability 159,866 1% 207,893 1%
Deferred taxes 198,647 1% 170,284 1%
Total liabilities 13,753,404 69% 13,508,608 69%

Share capital 5,448,026 28% 5,448,026 28%

Retained earnings 615,626 3% 600,659 3%
Total equity 6,063,652 31% 6,048,685 31%

Total Liabilities and

Shareholders’ Equity $19,817,056 100% $19,557,293 100%

Note: Assets and liabilities are shown based on the balance sheet from the Appendix.

Comments:
 Total assets have increased slightly, and liabilities have remained at 69% of total
assets.

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 Cash is a lower proportion of total assets, whereas receivables have increased.

Inventory has declined despite opening a new store, and property, plant, and
equipment (PPE) has grown – due to the addition of a new retail store. Prepaid
expenses have increased because of prepaid insurance.
 Growth in dollars of liabilities has come from increase in payables
 Total equity remains at 31% of total assets.

Implications:
 The lower cash balance and the increase in payables increase concerns about
solvency. However, overall position is still strong.
 Inventory balance is not increased, despite new store, consider reasons.
 Additional testing required for PPE to verify additions and valuations.
 Increase in payables is consistent with new operations, but is not reflected in
higher inventory balances. Consider adequacy of provisions.
 Special disclosures required for loans and other transactions with directors.

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Statement of Comprehensive Income

Total Revenue
COM-
31-Dec-23 MON 31-Dec-22 COMMON SIZE
SIZE
Revenue
Revenue – stores $854,376 2.3% -
Revenue - Wholesales 36,340,556 $37,194,932 97.7% 100% $34,038,192 $33,987,595

less COGS
COGS – Stores 640,781 1.7% -
COGS – Wholesales 16,453,395 17,094,176 44.2% 46.0% 16,393,394 16,393,394

Gross profit 20,100,756 54.0% 17,594,201

Other revenue
Interest from bank 60,576 0.2% 28,642
FX gain/loss 47,289 0.1% 29,568
Gain on disposals 0 7,714
Other revenue 251,453 359,318 0.7% 1% 246,523 312,447

Selling expenses
Storage - rent expense, store 166,667 0.4% -
Storage - Rent expense, warehouse 2,959,257 8.0% 2,959,257
Distribution expenses 2,038,255 5.5% 2,008,015
Advertising and promotion - print 1,685,812 4.5% 1,046,668
Trade shows 327,687 0.9% 384,934
Advertising and promotion - TV 841,901 2.3% 496,996

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Cloud 9 (Continued)

Advertising and promotion – sponsor- 1,713,008 9,732,587 4.6% 26.2% $ - $6,895,870

ships

Administration expenses
Salaries and employee benefits 5,044,460 13.6% 4,842,343
Telephone 59,537 0.2% 0
Computer and IT costs 252,469 0.7% 450,907
Rent expense - office 309,170 0.8% 309,170
Depreciation - furniture and equipment 701,187 1.9% 339,852
Depreciation - leasehold improvements 201,309 0.5% 96,326
Entertainment 220,576 0.6% 320,703
Professional fees 318,205 0.9% 458,903
Insurance expense 2,153,461 5.7% 1,597,463
Recruitment 352,436 9,612,810 0.9% 25.8% 343,720 8,759,387

Finance Expenses 0
Bad debt expense 75,712 0.2% 120,000
Interest expense - loan from bank 1,017,583 ,093,295 2.7% 2.9% 701,576 821,576

Net income before income tax $21,382 0.1% 1,429,815

Income tax expense 6,415 0.0% 379,074
Net income 14,967 0.0% 1,051,741

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Case Study — Cloud 9 (Continued)

Comments:
 Common-size statements allow valid comparisons because individual items are
expressed as a proportion of the total revenue.
 Cost of sales as a proportion of revenue has fallen, increasing gross profit as a
proportion of revenue.
 Significant increases in selling expenses, mainly the new sponsorship costs and
other advertising costs.
 Administration expenses have increased. There is additional insurance, in part
related to the new store.
 Finance expenses are greater, despite the lower debt level.
 Overall, increasing costs are contributing to a much smaller net income for the
period. Total selling and administration expenses have increased from 46% of
sales to 52% of sales.

Implications:
 Consider reasons for reduction in cost of sales (COS).
 Advertising is a new large expenditure item; consider authorizations and
classifications of expenses. Insurance is larger – why?
 Some costs are lower despite new store opening, consider reasons.
 Bad debts and warranty – consider adequacy of provisions.
 Expense growth – consider whether any items should be capitalized.
 Determine explanation for increase in interest expense given lower debt level.

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Research Question 11.1

In answering this question, the student would first need to explain what is meant by
earnings management and the underlying reasons why it has been practised. This could
include reference to corporate governance issues, excessive management
remuneration, pressure to maintain share prices, and the use of stock options. The
student may discuss what happened to Nortel in the early 2000s.

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