Completing the Tests in the

Acquisition and Payment

Cycle: Verification of
Selected Accounts
Chapter 20

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 1

 Learning Objective 1

Recognize the many accounts

in the acquisition and
payment cycle.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 2

 Accounts Associated with the
Acquisition and Payment Cycle
Assets:
 Cash
 Inventory
 Supplies
 Property, plant, and equipment
 Patents, trademarks, and copyrights
 Prepaid rent
 Prepaid taxes
 Prepaid insurance

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 3

 Accounts Associated with the
Acquisition and Payment Cycle
Expenses:
 Cost of goods sold
 Rent expense
 Property taxes
 Income tax expense
 Insurance expense
 Professional fees
 Retirement benefits
 Utilities

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 4

 Accounts Associated with the
Acquisition and Payment Cycle
Liabilities:
 Accounts payable
 Rent payable
 Accrued professional fees
 Accrued property taxes
 Other accrued expenses
 Income taxes payable

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 5

 Methodology for Designing
Tests of Details of Balances
Identify client business
risks affecting Phase I
other accounts
Set tolerable misstatement
and assess inherent Phase I
risk for accounts

Assess control risk for

Phase I
accounts

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 6

 Methodology for Designing
Tests of Details of Balances
Design and perform
tests of controls and
substantive tests
Phase II
of transactions
for the acquisition
and payment cycle

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 7

 Methodology for Designing
Tests of Details of Balances
Design and perform
analytical procedures
Phase III
for the acquisition
and payment cycle
Design tests of details Audit procedures
of account balances Sample size
to satisfy Phase III
balance-related Items to select
audit objectives Timing
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 8
 Learning Objective 2

Design and perform audit tests of

property, plant, and equipment
and related accounts.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 9

 Classifications of Property,
Plant, and Equipment Accounts
 Land and land improvements
 Buildings and building improvements
 Manufacturing equipment
 Furniture and fixtures
 Autos and trucks
 Leasehold improvements
 Construction-in-process for property,
plant, and equipment

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 10

 Manufacturing Equipment
and Related Accounts
Manufacturing Accumulated
Equipment Depreciated
Beginning Disposals Disposals Beginning
balance balance
Acquisitions Current period
depreciation
Ending
balance Ending balance

Gain or Loss Depreciation

on Disposals Expense

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 11

 Auditing Manufacturing Equipment
and Related Accounts
Perform analytical procedures
Plus verify:
 Current year acquisitions
 Current year disposals
 Ending balance in the asset account
 Depreciation expense
 Ending balance in accumulated depreciation

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 12

 Analytical Procedures for
Manufacturing Equipment
Analytical procedure Possible misstatement

Compare depreciation expense Misstatement in

divided by gross manufacturing depreciation expense and
equipment cost with previous accumulated depreciation
years

Compare accumulated Misstatement in

depreciation divided by gross accumulated depreciation
manufacturing equipment cost
with previous years

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 13

 Analytical Procedures for
Manufacturing Equipment
Analytical procedure Possible misstatement

Compare monthly or annual Expensing accounts that

repairs and maintenance, should be capitalized
supplies expense, small tools
expense, and similar accounts
with previous years

Compare gross manufacturing Idle equipment or

cost divided by some measure equipment that was
of production with previous disposed of but not
years written off
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 14
 Verify Current Year
Acquisitions
The correct recording of current year additions
is important because of the long-term effect
the assets have on the financial statements.

Because of the importance of current period

acquisitions, seven of the eight balance-related
audit objectives are used as a frame of reference.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 15

 Balance-Related Audit
Objectives
Detail tie-in:
Current acquisitions agree
with the master file.
1. Foot the acquisition schedule.
2. Trace the individual acquisitions
to the master file.
3. Trace the total to the general ledger.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 16

 Balance-Related Audit
Objectives
Existence:
Current acquisitions as listed exist.

1. Examine vendors’ invoices and

receiving reports
2. Physically examine assets.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 17

 Balance-Related Audit
Objectives
Completeness:
Existing acquisitions are recorded.

1. Examine vendors’ invoices of closely

related accounts to uncover items that
should be manufacturing equipment.
2. Review lease and rental agreements.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 18

 Balance-Related Audit
Objectives
Accuracy:
Current year acquisitions as listed
are accurate.
1. Examine vendors’ invoices.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 19

 Balance-Related Audit
Objectives
Classification:
Current year acquisitions as listed
are correctly classified.
1. Examine vendors’ invoices in
manufacturing equipment account.
2. Examine vendors’ invoices of closely
related accounts.
3. Examine rent and lease expense
for capitalizable leases.
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 20
 Balance-Related Audit
Objectives
Cutoff:
Current year acquisitions are recorded
in the correct period.
1. Review transactions near the balance
sheet date for correct period.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 21

 Major Balance-Related
Audit Objectives
Rights:
The client has rights to current year
acquisitions.
1. Examine vendors’ invoices.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 22

 Verify Current Year Disposals

 Review whether newly acquired assets

replace existing assets
 Analyze gains and losses on disposal
 Review documents for indications of
deletion of equipment
 Make inquiries about the possibility of
the disposal of assets

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 23

 Verify Ending Balance
of Asset Accounts
1. All recorded equipment physically
exists on the balance sheet date.

2. All equipment owned is recorded.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 24

 Verify Depreciation Expense
The most important objective is accuracy.

 Consistent depreciation policy

 Correct calculations

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 25

 Verify Ending Balance in
Accumulated Depreciation
1. Accumulated depreciation as stated
in the property master file agrees
with the general ledger.

2. Accumulated depreciation in the

master file is accurate.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 26

 Learning Objective 3

Design and perform audit tests

of prepaid expenses.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 27

 Audit of Prepaid Expenses
 Prepaid rent
 Organization costs
 Prepaid taxes
 Patents
 Prepaid insurance
 Trademarks
 Deferred charges
 Copyrights

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 28

 Prepaid Insurance and
Related Accounts
Prepaid Insurance Insurance Expense
Beginning Current period
balance insurance
expense
Acquisitions

Ending
balance

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 29

 Internal Controls
 Acquisition and recording of insurance

 Insurance register

 Insurance expense

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 30

 Audit Tests

 Compare total prepaid insurance and

insurance expense with previous years
 Compute the ratio of prepaid insurance
to insurance expense and compare
it with previous years
 Compare the individual insurance policy
coverage on the schedule of insurance
obtained with the preceding year’s schedule

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 31

 Audit Tests

 Compare the computed prepaid insurance

balance for the current year on a policy-by-
policy basis with that of the preceding year.
 Review the insurance coverage listed on
the prepaid insurance schedule with an
appropriate client official or insurance broker.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 32

 Balance-related Audit
Objectives
Existence and completeness:
Insurance policies in the prepaid insurance
schedule exist and existing policies are listed.

Rights:
The client has rights to all insurance policies
in the prepaid insurance schedule.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 33

 Balance-related Audit
Objectives
Accuracy and detail tie-in:
Prepaid amounts are accurate and the total
is correctly added and agrees with the
general ledger.
Classification:
Insurance expense is properly classified.
Cutoff:
Insurance transactions are recorded in the
proper period.
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 34
 Learning Objective 4

Design and perform audit tests

of accrued liabilities.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 35

 Audit of Accrued Liabilities
 Accrued payroll
 Accrued payroll taxes
 Accrued officers’ bonuses
 Accrued commissions
 Accrued professional fees
 Accrued rent
 Accrued interest

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 36

 Accrued Property Taxes
and Related Accounts
Accrued Property Taxes Property Tax Expense
Payments Beginning
(property taxes) balance

Current period
property tax
expense

Ending
balance

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 37

 Learning Objective 5

Design and perform audit tests of

income and expense accounts.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 38

 Approach to Auditing Income
and Expense Accounts
 Analytical procedures

 Tests of controls and substantive

tests of transactions

 Tests of details of account balances

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 39

 Analytical Procedures for
Income and Expense Accounts
Analytical procedure Possible misstatement
Compare individual expenses Overstatement or
with previous years understatement of a
balance in an expense
account
Compare individual asset and Overstatement or
liability balances with previous understatement of a
years balance sheet account that
will also affect an income
statement account

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 40

 Analytical Procedures for
Income and Expense Accounts
Analytical procedure Possible misstatement
Compare individual expenses Misstatement of expenses
with budgets and related balance
sheet accounts
Compare gross margin Misstatement of cost of
percentage with previous goods sold and inventory
years
Compare inventory turnover Misstatement of cost of
ratio with previous years goods sold and inventory

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 41

 Analytical Procedures for
Income and Expense Accounts
Analytical procedure Possible misstatement
Compare prepaid insurance Misstatement of insurance
expense with previous years expense and prepaid
insurance
Compare commission expense Misstatement of
divided by sales with commission expense and
previous years accrued commissions
Compare individual Misstatement of individual
manufacturing expenses manufacturing expenses
divided by total manufacturing and related balance
expenses with previous years sheet accounts
©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 42
 Tests of Controls and Substantive
Test of Transactions
Both tests of controls and substantive
tests of transactions have the effect of
simultaneously verifying balance sheet
and income statement accounts.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 43

 Tests of Details of Account
Balances – Expense Analysis
Expense account analysis:

 Repairs and maintenance

 Rent and lease

 Legal expense

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 44

 Tests of Details of Account
Balances – Allocation
Several expense accounts result from the allocation
of accounting data rather than discrete transactions.

These include depreciation, depletion, and the

amortization of copyrights and catalog cost.

The allocation of manufacturing overhead between

inventory and cost of goods sold is an example of
a different type of allocation that affects expenses.

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 45

 End of Chapter 20

©2008 Prentice Hall Business Publishing, Auditing 12/e, Arens/Beasley/Elder 20 - 46