Chapter 11 - Auditing the Purchasing Process

CHAPTER 11
AUDITING THE PURCHASING PROCESS

Answers to Review Questions

11-1 Expenses can be classified into three categories:

1. Product costs are expenses that can be matched directly with specific transactions or
events and are recognized upon recognition of the revenues. An example of a product
cost would be the expensing of inventory through cost of goods sold.
2. Period costs are expenses that are recognized during the period in which cash is spent
or liabilities incurred for goods and services that are used up at that time or shortly
thereafter. Such expenses cannot be directly related to specific transactions and are
assumed to provide no future benefit. Examples of such expenses are administrative
salaries, rent expense, and interest expense.
3. Allocable costs are allocated by systematic and rational procedures to the periods
during which the related assets are expected to provide benefits. Depreciation of
plant and equipment is an example of such an expense.

11-2 The three types of transactions that are processed through the purchasing process are:
• Purchase of goods and services for cash or credit
• Payment of the liabilities arising from such purchases
• Return of goods to suppliers for cash or credit

The more common accounts affected by each major type of transaction are:

Purchase transaction:
• Accounts payable
• Inventory
• Purchases or cost of goods sold
• Various asset and expense accounts

Cash disbursement transaction:

• Cash
• Accounts payable
• Cash discounts

Purchase return transaction:

• Purchase returns
• Purchase allowances
• Accounts payable
• Various asset and expense accounts

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Chapter 11 - Auditing the Purchasing Process

11-3 A purchase requisition is a request for goods and services by an authorized individual or
department within the entity. A purchase order contains the description, quality, quantity,
and other information on the goods and services being purchased. A receiving report is
used to record the receipt of goods. A vendor invoice is the bill from the vendor that
includes the description and quantity of the goods shipped or services provided, the price
including freight, the terms of trade including cash discounts, and the date billed. A
voucher is a document that is frequently used by entities to control the payment of
acquired goods and services.
An entity would combine all these documents into a "voucher packet" because such a
packet would contain all the information on a particular purchase transaction. If there are
questions about the transaction at a later time, the entity can obtain access to all the
documents and information more easily.

11-4 The key segregation of duties and the errors or fraud that can occur if such duties are not
segregated are:
Segregation of Duties
The purchasing function should be
segregated from the requisitioning and
receiving functions.
The invoice-processing function should
be segregated from the accounts payable
function.
The disbursement function should be
segregated from the accounts payable
function.
The accounts payable function should
be segregated from the general ledger
function.
Possible Errors or Fraud Resulting
from Conflicts of Duties
Theft of goods and possible payment for
unauthorized purchases.
Overpayment for goods and services or
theft of cash.
Theft of cash.
A defalcation that would normally be
detected by reconciling subsidiary records
with the general ledger control account.

11-5 Two inherent risk factors that directly affect the purchasing process are (1) industry-
related factors, and (2) misstatements detected in prior audits.
If the entity deals with a large number of vendors and prices tend to be relatively stable,
there is less risk that the entity's operations will be affected by raw-material shortages or
that production costs will be difficult to control. However, if an entity is dependent on a
single vendor to supply a critical component and the vendor is unable to provide the
component, the entity may suffer production shortages and shipping delays that
significantly affect financial performance. Additionally, industries that use commodities
such as oil, coal, and precious metals may be subject to both shortages and price
instability that significantly affect their financial results.
The presence of misstatements in previous audits is a good indicator that misstatements
are likely to be present during the current audit. If misstatements were present in
previous audits, the auditor should assess inherent risk to be high.

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Chapter 11 - Auditing the Purchasing Process
11-6 The following controls and related tests are utilized to ensure that the occurrence,
authorization, and completeness assertions are met for purchase transactions:
Assertion Control Procedures
Occurrence Segregation of duties
Purchase not recorded
without approved
purchase order and
receiving report
Accounting for numerical
sequences of receiving
reports and vouchers
Cancellation of documents
Authorization Approval of acquisitions
consistent with the client's
authorization dollar limits
Approved purchase
requisitions and purchase
orders
Competitive bidding
procedures followed
11-3
Tests of Controls
Observe and evaluate proper
segregation of duties.
Test of a sample of vouchers for
the presence of an authorized
purchase order and receiving
report; if IT application, examine
application controls.
Review and test client's procedures
for accounting for numerical
sequence of receiving reports and
vouchers; if IT application,
examine application controls.
Examine paid vouchers and
supporting documents for
indication of cancellation.
Review client's dollar limits
authorization for acquisitions.
Examine purchase requisitions or
purchase orders for proper
approval; if IT is used for
automatic ordering, examination of
application controls.
Review client's competitive
bidding procedures.
Chapter 11 - Auditing the Purchasing Process

Completeness Accounting for numerical Review and test client's procedures

sequences of receiving for accounting for numerical
reports and vouchers sequence of receiving reports and
vouchers; if IT application,
examine application controls.

Receiving report matched Trace a sample of receiving reports

to vendor invoices and to their respective vendor invoices
entered in purchases and vouchers.
journal
Trace a sample of vouchers to the
purchases journal.
11-7 When the information system is highly computerized, CAATs can be used to test
numerous controls in the purchasing process. For example, a generalized audit software
package can be used to account for the numerical sequence of purchase orders, receiving
reports, and vouchers. Another example involves the use of a CAAT to test programmed
controls over approval of purchase orders when IT is used for automatic ordering (e.g.,
electronic data interchange).

11-8 The analytical procedures that can be used to test accounts payable
and accrued expenses and the possible misstatements that can be
detected by each analytical procedure are:

Substantive Analytical Procedure Possible Misstatement Detected

Compare payable turnover and days Under- or overstatement of
outstanding in accounts payable with liabilities and expenses
previous years’ and industry data.

Compare current-year balances in accounts Under- or overstatement of

payable and accruals with prior years' liabilities and expenses
balances.

Compare amounts owed to individual vendors Under- or overstatement of

in the current year's accounts payable liabilities and expenses
listing to amounts owed in prior years.

Compare purchase returns and allowances as a Under- or overstatement of

percentage of revenue or cost of sales to purchase returns
prior years' and industry data.

11-9 The following audit procedures may be used as part of the search for unrecorded
liabilities:
• Inquiry of management about control procedures used to identify unrecorded
liabilities and accruals at the end of an accounting period.
• Obtain copies of vendors' monthly statements and reconcile the amount to client's

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Chapter 11 - Auditing the Purchasing Process

• accounts payable records.

• Confirm vendor accounts, including accounts with small or zero balances.
• Vouch large dollar items from the purchases journal and cash disbursements journal
for a limited time after year-end; examine the dates on each receiving report or
vendor's invoice to determine if the liability relates to the current audit period.
• Examine the files of unmatched purchase orders, receiving reports, and vendor
invoices for any unrecorded liabilities.

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Chapter 11 - Auditing the Purchasing Process

11-10 The following are examples of disclosures for the purchasing process and related
accounts:
• Payables by type (trade, officers, employee, affiliate, etc.).
• Short- and long-term payables.
• Long-term purchase contracts, including any unusual or adverse purchase
commitments.
• Purchases from and payables to related parties.
• Dependence on a single vendor or small number of vendors.
• Costs by reportable segment of the business.

11-11 Accounts payable confirmations are generally used less frequently by auditors than
accounts receivable confirmations because the auditor can test accounts payable by
examining vendor invoices and monthly vendor statements. Since these documents
originate from sources external to the client, this evidence is viewed as reliable.
Accounts payable confirmations primarily provide evidence on the completeness
assertion, while accounts receivable confirmations primarily provide information on the
validity (occurrence/existence) assertion. When confirming accounts payable, auditors
generally use a form of positive confirmation referred to as a "blank or zero-balance"
confirmation. This type of positive confirmation does not state the balance owed.
Instead, the confirmation requests that the recipient fill in the amount or furnish other
information. Both positive and negative confirmations are used for accounts receivable.
Lastly, accounts payable confirmations are generally mailed at year-end rather than at an
interim date because of the auditor's concerns about unrecorded liabilities. Accounts
receivable confirmations are sent at both dates.

11-12 Some of the typical procedures that might be applied to the audit of the tax provision by
the auditors and/or tax specialist include:
• Compare the size and trend in the tax provision and related balance sheet accounts
over time.
• Perform walkthroughs and test the design and operating effectiveness of internal
controls over the income tax provision (required for an integrated audit). Identify
issues that should be given particular attention in substantive testing and evaluate the
client’s documentation.
• Document the testing performed to evaluate the design and operating effectiveness of
internal controls over the income tax process (primarily integrated audits).
• Test the mathematical accuracy of the computations supporting the tax provision and
related balance sheet accounts and vouch underlying data to supporting
documentation.
• Identify and test significant permanent and temporary differences in the tax provision
calculation.
• Review and evaluate management’s position on significant uncertain tax positions for
appropriate disclosure and accounting under FIN 48.
• Consider the realizability of net deferred tax assets.
• Test the reconciliation of income taxes payable, deferred income tax assets/liabilities
(including any related valuation allowances), and FIN 48 liabilities to supporting

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Chapter 11 - Auditing the Purchasing Process

documentation, including the general ledger, financial statements, and related footnote

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Chapter 11 - Auditing the Purchasing Process

• disclosure.
• Ensure proper documentation in the audit working papers to allow for reperformance
of the audit procedures applied to the tax accounts.

Answers to Multiple-Choice Questions

11-13 c 11-19 c
11-14 c 11-20 d
11-15 b 11-21 c
11-16 d 11-22 c
11-17 b 11-23 a
11-18 b

Solutions to Problems

11-24 This is a relatively straightforward analytical procedures problem. Here are some of the
concerns the auditor might have about potential misstatements in both accounts:
• Both inventory and accounts payable have increased significantly in absolute
dollar terms from 2008 to 2009.
• The inventory increase is 69 percent while the accounts payable increase is 28
percent.
• An auditor would have expected the increase in inventory to be approximately the
same as the increase in accounts payable.
• Based on the auditor’s expectations and the client’s data, the auditor might
suspect that there are at least two possible misstatements: (1) inventory is overstated
because obsolete and/or slow-moving products have not been written down to fair
market value and (2) there are unrecorded accounts payable. Other misstatements are
possible.

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Chapter 11 - Auditing the Purchasing Process

11-25 The internal control procedures that most likely would provide reasonable assurance that
specific control objectives for the financial statement assertions regarding purchases and
accounts payable will be achieved are:

• The purchasing, receiving, and accounts payable functions are segregated.

Requisitioning Department:
• Proper authorization of requisitions by department head is required
before purchase orders are prepared.
• The requisitioning department head independently verifies the
quantity and quality of the goods received.

Purchasing Department:
• The purchasing department ensures that requisitions are within
budget limits before purchase orders are prepared.
• The adequacy of each vendor's past record as a supplier is verified.

Receiving Department:
• Secure facilities limit access to the goods during the receiving
activity.
• The receiving department makes a blind count of the goods
received, independently of any other department.

Accounts Payable Department:

• Requisitions, purchase orders, and receiving reports are matched
with vendor invoices as to quantity and price.
• The accounts payable department recomputes the
mathematical accuracy of each invoice.
• The voucher register is independently reconciled to the
control accounts monthly.
• All supporting documentation is required for payments and
is made available to the treasurer.

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Chapter 11 - Auditing the Purchasing Process

11-26 a. The flowchart for Kida Company is shown on the following page:

11-10
 b. Kida Company's major internal control weaknesses are:

Purchasing:
• The buyer does not verify that the department head's request is within budget
limitations.
• No procedures have been established to ensure that the best price is obtained.
Large-dollar requisitions should be ordered after receiving quotes and/or sealed
bids.
• Prior to placing an order, the buyer does not determine the adequacy of the
vendor's past record as a supplier to Kida.

Receiving:
• Receiving clerk does not make blind counts for all special equipment or at least for
large-dollar items.
• Written notice of equipment received is not sent to the purchasing department.
• Written notice of equipment received is not sent to accounts payable department.

Accounts Payable:
• The mathematical accuracy of the invoice is not recomputed.
• Invoice quantity is not compared with a report of quantity received.
• Notification of the acceptability of the equipment from the requisitioning
department is not obtained before the payable is recorded.
• No alphabetic file of vendors from which purchases are made is maintained.

Treasurer:
• Documentation supporting the checks is not sent by the accounts payable
department to the cashier in order for the cashier or treasurer to be assured that the
check is for properly authorized and received equipment.
• Checks for large-dollar purchases are not signed by two officers of Kida Company
to ensure that material expenditures are proper.
• All documentation to support a check is not canceled by the check signer and
returned to the accounts payable department.
• The cashier alone has custody of the key, the signature plate, and record of usage.
• The controller is authorized to sign checks.

11-27 Test of details of transactions (substantive test of transactions).

1. Tests of details of transactions (cutoff test).
2. Tests of details of account balances.
3. Analytical procedure.
4. Tests of details of account balances.
5. Analytical procedure.

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11-28 The substantive audit procedures Coltrane should apply to Jang's trade accounts payable
balances include the following:
• Foot the schedule of the trade accounts payable.
• Agree the total of the schedule to the general ledger trial balance.
• Compare a sample of individual account balances from the schedule with the
accounts payable subsidiary ledger.
• Compare a sample of individual account balances from the accounts payable
subsidiary ledger with the schedule.
• Investigate and discuss with management any old or disputed payables.
• Investigate debit balances and, if significant, consider requesting positive
confirmations and propose reclassification of the amounts.
• Review the minutes of the board of directors' meetings and any written agreements
and inquire of key employees as to whether any assets are pledged to collateralize
payables.
• Perform cutoff tests.
• Perform analytical procedures.

Confirm or verify recorded accounts payable balances by:

• Reviewing the voucher register or subsidiary accounts payable ledger and consider
confirming payables for a sample of vendors.
• Requesting a sample of vendors to provide statements of account balances as of the
date selected.
• Investigating and reconciling differences discovered during the confirmation
procedures.
• Testing a sample of unconfirmed balances by examining the related vouchers,
invoices, purchase orders, and receiving reports.

Perform a search for unrecorded liabilities by:

• Examining files of receiving reports unmatched with vendors' invoices and searching
for items received before the balance sheet date but not yet billed or on the schedule.
• Inspecting files of unprocessed invoices, purchase orders, and vendors' statements.
• Reviewing support for the cash disbursements journal, the voucher register, or
canceled checks for disbursements after the balance sheet date to identify
transactions that should have been recorded at the balance sheet date but were not.
• Inquiring of key employees about additional sources of unprocessed invoices or
other trade payables.

11-29 a. 3
b. 4
c. 5
d. 1

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11-30
a. No adjustment is needed. The goods were received before December 31, 2009
and recorded in the Purchases Journal in December.

b. An adjustment is required. The $45,000 payment covers a 3-month period

starting on December 1, 2009. The total amount was charged to consulting
expenses while only 1 month of services was used by year-end. The entry to
correct is:

Prepaid Consulting Expenses 30,000

Consulting Expenses 30,000

c. No adjustment is needed. The goods were received before December 31, 2009
and recorded in the Purchases Journal in December.

d. No adjustment is needed. The truck was received in 2010 as evidenced by RR#

49746 and recorded in the Purchases Journal in January.

e. An adjustment is required. The paper products were received in December

2009 as evidenced by the RR# 49743 (RR #49745 is the last receiving report in
December). Thus, these goods should have been recorded in December 2009. The
entry to correct is:

Supplies 42,000
Accounts Payable 42,000

f. An adjustment is required. The telephone bill applies to December 2009 and the
$32,450 should be an accrued expense. The entry to correct is:

Telephone expense 32,450

Accrued Expenses 32,450

Solution to Discussion Case

11-31 a. The accounts payable audit procedures should be directed toward searching for
proper inclusion of all accounts payable and ascertaining that recorded amounts are
reasonably stated because the primary audit purpose is to reveal any possible
material understatements.
The principal objectives of the accounts payable examination are:
1. To determine adequacy of internal control for processing and payment of
invoices.
2. To prove that amounts shown on the balance sheet are in agreement with
supporting accounting records.
3. To determine that liabilities existing at the balance sheet date have been
reconciled.

11-13
b. Mincin is not required to use accounts payable confirmation procedures. The
auditor, with three exceptions, is required to obtain direct confirmation of accounts
receivable, since the primary audit test is for possible material overstatements and
generally the client has available only internal documents such as sales invoices. For
accounts payable, however, the auditor can examine external evidence such as
vendor invoices and vendor statements which substantiate the accounts payable
balance. Although not required, the accounts payable confirmation is often used.
The auditor might consider such use when:
1. Internal controls are weak.
2. The company is in a "tight" cash position and bill paying is slow.
3. Physical inventories exceed general ledger inventory balances by significant
amounts.
4. Certain vendors do not send statements.
5. Vendor accounts are pledged by assets.
6. Vendor accounts include unusual transactions.
7. Change in personnel or management behavior related to payables.

c. A selection technique using the large dollar balances of accounts is generally used
when the primary audit objective is to test for overstatements (e.g., accounts
receivable audit work). Accounts with zero balances or relatively small balances
would not be subjected to selection under such an approach. When auditing
accounts payable, the auditor is primarily concerned with the possibility of
unrecorded payables or understatement of recorded payables. Selection of accounts
with relatively small or no balances for confirmation is the more efficient direction
of testing, since understatements are more likely to be detected when examining
such accounts.
When selecting accounts payable for confirmation, the following procedures
could be followed:
1. Analyze the accounts payable population and stratify it into accounts with large
balances, accounts with small balances, accounts with zero balances, etc.
2. Use a sampling technique that selects items based on criteria other than the dollar
amount of the items (e.g., select based on terminal digits, select every nth item
based on predetermined interval, etc.).
3. Design a statistical sampling plan that will place more emphasis on selecting
accounts with zero balances or relatively small balances, particularly when the
client has had substantial transactions with such vendors during the year.
4. Select prior-year vendors who are no longer used.
5. Select new vendors used in the subsequent period.
6. Select vendors that do not provide periodic statements.
7. Select accounts reflecting unusual transactions during the year.
8. Select accounts secured by pledged assets.

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Solution to Internet Assignment

11-32 It may be difficult to get information directly on some of EarthWear’s competitors.

Lands’ End is owned by Sears, while Eddie Bauer is part of The Spiegel Group.
Timberland is a publicly traded company. L.L. Bean and Patagonia are privately held
companies and there are no publicly available financial statements.

11-33 A search of the SEC’s website should identify a recent company that has been cited by
the SEC for issues related to the recognition of expenses.

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