ACC802 Lecture

Audit of Acquisition
Cycle and Inventory
Relevant Professional
Standards
 ASA 501 Existence and Valuation of
Inventory
 IAS:2 Inventories
 Overview of the
Acquisition Cycle
 The acquisition cycle covers the purchase, receipt,
payment and accounting for goods and services.
 Major accounts include inventory, accounts payable and
expenses.
 Main phases in the acquisition and payment process:
 authorised requisition
 authorised purchase
 receipt of goods and services
 approval for payment
 cash disbursement.
 Business Risk &
Business Environment
 Acquisition cycle deals with receipt of all goods and
services.
 Misstatements may occur just because of the volume of
transactions.
 Fraud is a major concern in the acquistion cycle. For
example:
 employee theft of inventory, causing inventory on the
books to be overstated
 employees setting up fictitious suppliers and paying
themselves for goods never received by the company
Business Risk & Business
Environment (cont.)
 kickbacks to employees
 executives abusing travel and entertainment
expenses for personal use
 capitalising expenses as assets to inflate earnings
 overestimating ‘restructuring reserves’ at the
time of acquisition so expenses can be reduced in
future periods.
 Red Flags in the Acquisition and
Payment Cycle
 There are a number of red flags unique to the acquisition and
payment cycle. These include:
 inventory growing at a rate greater than sales
 expenses significantly above or below industry norms
 capital assets growing faster than the business and for which
there are not strategic plans
 significant reduction of ‘reserves’
 expense accounts with significant credit entries
 travel and entertainment expense accounts that do not have
documentation
 inadequate follow-up to auditor recommendations on needed
controls.
Analysis for Likely Misstatements

 Analytical procedures to identify potential misstatements:

 calculate and analyse dollar and percentage change in
inventory, cost of goods sold and expense accounts
 compute and analyse ratios such as inventory turnover
and number of days’ sales in inventory
 prepare common sized income statement to identify cost
of goods sold or expense accounts that are out of line.
 Client analytics can be compared to client’s past
performance, industry results and auditor’s expectations.
Overview of Control Procedures and Control
Risk Assessment
 Requisition of goods or services
 Need identified.
 Pre-numbered requisition form completed and sent to
purchasing.
 Purchase of goods or services
 Purchase order shows quantity and price of goods
ordered, quality specifications, shipping terms.
 Purchaseorders are pre-numbered to establish
completeness.
 Purchase orders must be properly authorised.
Overview of
Control Procedures and
Control Risk Assessment (cont.)
 Many companies have a separate purchasing
department:
 The agent’s job is to find the best
combination of price, service and quality
 Reduces fraud by separating purchasing
from custody and recording.
 Centralises control in one location.
 Controls are set to stop purchasing agents
from abusing their positions.
Overview of
Control Procedures and
Control Risk Assessment (cont.)
 Receipt of goods and services
 Receiving department should ensure:
 Only authorised goods are received.
 The goods meet order specifications.
 An accurate count of goods received is taken.
 All receipts of goods are recorded.
 Receiving reports are pre-numbered to establish
completeness.
 Receiving department records quantity of goods
received.
 Goods also inspected for quality.
 Receiving reports sent to accounting.
Overview of
Control Procedures and
Control Risk Assessment (cont.)
 Approval of items for payment
 Accounting matches vendor invoice, purchase
order and receiving reports. If quantity and price
match, account payable is recorded.
 Cash disbursement
 Supporting documentation is reviewed and
approved for payment
 Documents are marked ‘paid’ to avoid duplicate
payment.
Testing Controls over Accounts Payable and
Related Expenses
 The primary risk is that accounts payable and expenses will
be understated.
 Therefore, controls related to the following are usually
significant:
 proper authorisation
 completeness of recording
 timeliness of recording
 correctness of valuation.
 Attribute sampling may be used to test control operation.
 The level of assessed control risk will impact the rigour of
the subsequent substantive testing of accounts payable and
expenses.
Substantive Tests of Accounts Payable

 The auditor’s main concern is that accounts payable

will be understated.
 Therefore, emphasis is placed on testing the
completeness assertion.
 Typical substantive tests include:
 reconcilingvendor statements or confirming
accounts payable.
 tests of subsequent disbursements.
 analytical review of related accounts.
Reconciling Vendor Statements
or Confirmations with
Recorded Payables

 Auditor requests suppliers’ monthly statements or sends

confirmation to major suppliers.

 Auditor reconciles supplier statement or confirmation

with client balance in the accounts payable subsidiary
ledger.
Testing Subsequent Disbursements

 Auditor samples cash disbursements after the end of

the year.
 Determines if disbursements are for audit year
transactions by vouching back to source documents
(purchase order, vendor invoice, receiving report).
 If disbursement is for audit year transaction, auditor
reprocesses the transaction to see if it was properly
recorded as a payable.
Analytical Review of Related
Expense Accounts

 Used to determine if accounting data indicates

understatement of expenses.

 If understatement likely, auditor expands tests of

accounts payable.

 This approach used on clients with low

control risk.
 Audits of Expense Accounts

 Auditing payables and cash disbursements provides indirect

evidence about expense accounts.
 Additional analysis of selected expense accounts is usually
merited.
 The auditor should consider that management is more likely to:
 understate rather than overstate expenses
 classify expenses as assets rather than vice versa.
 Substantive audit procedures include:
 detailed tests of transactions
 analytical review
 review of unusual entries.
 Audit of Inventory
& Cost of Goods Sold
 Audit of inventory is complicated by a number of factors, including:
 variety (diversity) of items
 high volume of activity
 various (sometimes complex) valuation methods
 difficulty in identifying obsolete or defective inventory
 Many frauds involve inventory, because it:
 is easily transportable, making it subject to
double counting
 may be stored at multiple locations, some of
which may be remote
 may be returned by customers.
Internal Controls
for Inventory

 A well-designed inventory control system should

ensure:
 all purchases are authorised
 theaccounting system ensures timely, accurate and
complete recording
 receipt of inventory is properly accounted for
 inventoryis tested for quality when received or
manufactured
Internal Controls for
Inventory (cont.)
 costs are properly identified and assigned
to products
 customer returns of inventory are
examined for defects
 inventory is reviewed for obsolescence
 new products are introduced only after
market studies and quality control tests
have been made
 management actively manages inventory
 long-term contracts are closely monitored.
Key Processes and Risks

 Automated purchases and potential obsolete

inventory
 Accounting system
 Accounting for returned items
 Quality control process
 Cost accounting system
 Existence of an accurate perpetual inventory
system
 Systematic review for obsolescence
 New product introductions
Substantive Tests of Inventory & Cost of
Goods Sold

 Existence: observe year-end physical inventory

 Completeness: cutoff tests
 Rights: review long-term contracts, etc.
 Valuation: direct tests and analytics
 Disclosure: review proposed disclosure for compliance
with accounting standards
(see AASB 102).
Procedures for Observing a Client’s Physical
Inventory
 Meet with client to discuss plan to count inventory.
 Review plan for counting and tagging inventory.
 Review inventory counting procedures with audit personnel.
 Determine whether specialists are needed to identify inventory
items.
 Upon arriving at each site:
 Meet with client, and obtain map and schedule of inventory
count area.
 Obtain list of sequential tag numbers for each area.
 Observe procedures to shut down receipt or shipment of goods;
obtain document numbers for last receipt and shipment for
cutoff tests.
Procedures for Observing a Client’s Physical
Inventory (cont.)
 Observe the counting of inventory.
 Note the first and last tag numbers in each section.
 Account for all tag numbers to prevent later
insertion of additional inventory items.
 Make selected test counts.
 List items that appear obsolete or defective.
 Note high-dollar value items in inventory.
 Note movement of inventory during counting.
 Document conclusion as to quality of the inventory
counting process.
After the Inventory Count

 After the inventory count, the auditor should trace:

 test counts to the client’s inventory records
 the number of high-dollar items to the client’s
inventory records
 obsolete or damaged inventory to the client’s
inventory records to see if the items have been
written down.
 Counting Inventory Before
or After Year-end
 On occasion, it may not be feasible to count inventory at
year-end.
 It is acceptable to count inventory before or after year-end
if:
 controls are strong
 the opportunity and motivation to misstate inventory is
low
 the auditor can test the year-end balance using analytics
and tests of transactions between the physical count and
year-end (called the roll-forward or rollback period)
 the auditor reviews intervening transactions for unusual
activity.
 Completeness
 Inventory cutoff tests:
 Obtain information on last items shipped and
received at year-end.
 Compare this information to transactions recorded in
the sales and purchases journal.
 Determine if transaction is recorded in correct
accounting period.
 Auditor should also inquire about any inventory out on
consignment or stored in a public warehouse.
 Tracing test counts and number of high-dollar items to
the client’s inventory records tests completeness (as
well as existence).
Allowance for Returns

 In most situations, expected returns of inventory are

not material.
 However, some companies provide return guarantees
and expect significant returns.
 Management can use previous experience, updated for
current economic conditions, to develop estimates of
returns.
Rights

 Most of the work regarding ownership of

inventory is performed during the
auditor’s testing of purchases.
 Auditor should also review long-term
contracts to determine obligations.
 Inquiry should be made about inventory
on consignment.
Valuation
 This is the most complex assertion related to
inventory:
 volume of transactions
 diversity of products
 variety of costing methods
 difficulty in estimating net realisable value of
products.
 Auditor uses direct tests and analytics to assess
inventory valuation.
 Direct tests include verifying cost by reviewing
supplier invoices.
Valuation

 Auditor usually examines current market data and

other conditions that might indicate inventory
obsolescence.
 Management inquiry and review of industry
publications can help the auditor identify obsolete
units.
 Analytics, like inventory turnover or days’ sales in
inventory, may identify slow-moving inventory
which may need to be written down.
 Auditor looks for obsolete units during the counting
of inventory; these units may need to be written
down.
Disclosure

 Auditor reviews client disclosure for compliance with

AASBs (see AASB 102 Inventories).
 Disclosure should include:
 accounting polices adopted in measuring
inventories, including the cost formula used
 carrying amount
 carrying amount of inventories at fair value less
costs to sell
 amount of inventories recognised as an expense
 write-downs and reversal of write-downs and
reasons for the reversal.
Cost of Goods Sold

 Audit of cost of goods sold can be directly tied to the

audit of inventory.
 If beginning and ending inventories have been verified
and acquisitions have been tested, cost of goods sold
can be directly calculated.
 Auditor should also apply analytics to cost of goods sold
to see if there are any significant variations, either
overall or by product line.
Questions???

Thank you!!