Learning Objectives: Acquisition and Expenditure Cycle

Chapter 08 - Acquisition and Expenditure Cycle
CHAPTER 08
Acquisition and Expenditure Cycle
LEARNING OBJECTIVES
Review
Checkpoints
Multiple Choice
Exercises,
Problems, and
Simulations
1. Identify significant inherent risks in the

acquisition and expenditure cycle.
25
43
2. Describe the acquisition and expenditure

cycle, including typical source
documents and controls.
2, 3, 4, 5, 6
23, 34
39(*)
3. Give examples of tests of controls over

purchases of inventory and services.
7, 8, 9
24, 27, 28, 32, 33,

38
39(*), 45(*)
4. Explain the importance of the

completeness assertion for the audit of
accounts payable, and list some
procedures for a search for unrecorded
liabilities.
10, 11
26, 29, 30, 31, 37
40, 41, 42, 50,

52, 53
5. Discuss audit procedures for other

accounts affected by the acquisition and
expenditure cycle.
12, 13, 14, 15,
35, 36
45(*), 46, 47,

48, 49, 51
6.
Specify some ways fraud can be found

in accounts payable and cash
disbursements.
16, 17, 18
39(*), 43, 45
7.
Describe some common errors and

frauds in the acquisition and expenditure
cycle and design some audit and
investigation procedures for detecting
them.
19, 20, 21, 22
39(*), 43, 44,

45(*)
8. Describe the payroll cycle, including

typical source documents and controls.
8C1, 8C2 8C3,

8C4, 8C5, 8C6,
8C7,
(*) Item relates to multiple learning objectives

8-1
8C8, 8C9, 8C10,

8C11, 8C12, 8C13,
8C14, 8C15
8C16, 8C17,
8C18, 8C19,
8C20
SOLUTIONS FOR REVIEW CHECKPOINTS

8.1
The short-term effect on the financial statements for improperly capitalizing expenditures is an increase in
net income because items that should be expensed are included as assets. The long-term effect is the same
because the assets are eventually expensed as depreciation.
8.2
A voucher is a package of documents, usually with a cover page. (The package can be a small envelope.)
The voucher package contains supporting documents for a transaction. For example, a purchase voucher
usually contains a purchase requisition, purchase order, receiving report, vendor invoice, and a negotiable
check (check copy when the vendor invoice has been paid). Required approvals and signatures are on the
documents. The voucher presents evidence of the documentation and control over a transaction.
Computerized systems may have all this documentation in memory.
In a voucher system, each voucher is payable and the detail of the payables is the vouchers themselves.
At any time, the company may owe a single vendor more than one invoice represented on several vouchers.
In a voucher system, there is no balance payable to each vendorjust a file of different vouchers payable.
8.3
A purchasing manager can direct purchases toward vendors who provide the manager kickbacks or other
inducements. This can be prevented by notifying suppliers that the company will not permit payment of
kickbacks to its employees. The company can also rotate purchasing managers to different vendors. Finally,
significant purchases should be reviewed and approved by a higher level manager.
8.4
A blind purchase order is one that does not show the quantity ordered. It is given to the receiving
department so personnel there will know what has been ordered, but they will have to do an independent
count. If a blind purchase order is not used, receiving personnel may not count the goods received and just
record the amount indicated on the purchase order.
8.5
You will find evidence about losses on purchase commitments in the open purchase order file. Evidence
about unrecorded liabilities to vendors is in the (a) unmatched invoice file and (b) unmatched receiving
report file.
8.6
Management reports that can be used for audit evidence, and information in them can be useful to auditors
are as follows:
8.7
Open purchase orders: Purchase commitments, losses on purchase commitments.
Unmatched receiving reports: Goods received but not recorded as purchases or liabilities.
Unmatched vendor invoices: Unrecorded invoices that may represent unrecorded liabilities or
items in dispute
Accounts payable trial balance: Subsidiary ledger of accounts payable that may show balances by
vendors, indicating small balances that should be large. Invoice dates may reveal failure to record
invoices late in the accounting period.
Purchases journal: Listing of all purchases available for analysis of purchasing patterns and
oddities. Population for sample of purchases for tests of controls.
Fixed asset reports: Fixed assets subsidiary ledger trial balance. Scan for negative balances,
capitalized repairs, and depreciation in excess of salvage value; depreciation recalculation.
The functions that should be separated to maintain internal control in a purchasing system include (a)
custody of the goods (receiving and stores departments), (b) authority to initiate a transaction (purchasing
8-2

department), (c) bookkeeping (accounts payable department, inventory record-keeping department), and (d)
periodic physical counts (reconciliation) of inventory and fixed assets.
8-3

8.8
(a)
(b)
(c)
(d)
(e)
(f)
Blank vouchers kept in secure location available only to authorized personnel.

Blank supporting documents (invoices, receiving reports, requisitions, purchase orders) kept in
secure locations available only to authorized personnel.
Supporting documents canceled by the cash disbursement function when checks are prepared.
Separation of duties of preparers of supporting documents, preparation of vouchers, check
preparation, and check signing.
Vouchers and other supporting documents reviewed by check signers.
Checks mailed directly by signer and not returned to accounts payable.
8.9
(a) A low risk of material misstatement would normally result in a strategy by which the auditor relies on
controls and reduces substantive tests. First, the auditor would confirm the low control risk evaluation by
testing controls for effectiveness. More reliance would also be placed on analytical procedures. (b) High
risk of material misstatement would result in a more substantive approach with little control testing.
8.10
The purpose of the auditors search for unrecorded liabilities is to gather evidence as to whether the
completeness assertion is true. From an evidence-gathering perspective, it is much more difficult to gather
evidence on unrecorded transactions than to gather evidence that recorded account balances exist.
Inquire of client personnel about their procedures for ensuring that all liabilities are recorded.
Scan the open purchase order file at year-end for indications of material purchase commitments at
fixed prices. Obtain current prices and determine whether any adjustments for loss and liability for
purchase commitments are needed.
Examine the unmatched vendor invoices listing and determine when the goods were received, looking
to the unmatched receiving report file and receiving reports prepared after the year-end. Determine
which invoices, if any, should be recorded.
Trace the unmatched receiving reports to accounts payable entries, and determine whether entries
recorded in the next accounting period need to be adjusted to report them in the current accounting
period under audit.
Select a sample of cash disbursements from the accounting period following the balance sheet date.
Vouch them to supporting documents (invoice, receiving report) to determine whether the related
liabilities were recorded in the proper accounting period.
Confirm accounts payable with vendors (especially regular suppliers showing small or zero balances in
the year-end accounts payable.
8.11
Financial statement users are most troubled by overstated assets and understated liabilities. Therefore, they
need to audit for the existence of assets and the completeness of liabilities.
8.12
Typically, when auditing prepaids and accruals, the auditor uses audit documentation that shows beginning
balances, payments, expense, and ending balance. By agreeing beginning balance to prior-years audit
documentation, vouching payments, and calculating the accuracy of the ending balance, the auditor knows
that the amount charged to expense will be correct.
8.13
Noncurrent assets such as property, plant, and equipment and intangibles usually pertain to all four
management assertions about account balances: existence, completeness, rights and obligations, and
valuation and allocation. The auditor must ensure that they exist and are owned. In addition, the valuation
determined by depreciation, amortization, or impairment charges is usually an important issue. Of the four
assertions, completeness is probably the least important, but it cannot be ignored.
8-4
8.14
The auditor is primarily concerned with current-year transactions in property, plant, and equipment
accounts, assuming that the previous years balances were audited. Thus, additions, disposals, and
depreciation charges warrant the most attention.
8.15
Most expense accounts can be tested through analytical review procedures, substantive tests of transactions,
or by testing them in conjunction with tests of related assets and liabilities (e.g., depreciation). Some
expenses should be examined separately because of their unique nature (e.g., legal expenses or
miscellaneous expense).
8.16
The following are possible red flags indicating a risk of fraud:
Photocopies of invoices in the files.
Vendors invoices submitted in numerical order.
Vendors invoice amounts always in round numbers.
Vendors invoices always slightly lower than a review threshold.
Vendors with only post office box addresses.
Vendors with no listed telephone number.
Matching vendor and employee addresses or telephone numbers.
Multiple vendors at the same address and telephone number.
Vendors not on the approved vendor list.
Knowing the address of the local mail drops (e.g., shipping and packaging stores that accept client
mail). These stores could provide a street address for fraudulent companies, adding false
legitimacy to their fraudulent invoices.
8.17
The auditor should begin by inquiring of the client about its knowledge of fraud or fraud risks. Analytical
review procedures such as vertical and horizontal analyses can pinpoint accounts that appear to have
unusual fluctuations. Examining invoices and vendor files for the red flags noted in 8.16 will help find
phony billings. The purpose is to identify fraud risk, evaluate the significance of the risk, and determine the
amounts of any actual fraud on the financial statements.
8.18
These procedures are directed at misappropriation of assets by embezzlement. Embezzlement occurs when
employees and their associates are stealing assets from the company by having it pay phony expenses.
8.19
Argus did not have separation of duties. Different people should have authorized the copying services,
approved the bills for payment, and coded them to projects. A supervisor should have been reviewing the
expenses and comparing them to the budget.
8.20
The verbal inquiry procedure might produce knowledge of employees responsibilities to authorize
purchases of script copies, receive them, approve payment, and code invoices to projects.
8.21
Given Beta Magnetics poor internal controls, it is possible that Martha would never have been caught.
However, if the company ever contacted employees about their health claims, they would have revealed the
fictitious charges.
8.22
If Martha had taken a mandatory vacation, her replacement would probably have questioned the billings
from unknown physicians. If the billings stopped, the sharp drop in insurance costs for that period would
likely be questioned by Marthas superior.
8-5
SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

8.23
a.
b.
Incorrect
Incorrect
c.
Correct
d.
Incorrect
a.
Correct
b.
c.
Incorrect
Incorrect
d.
Incorrect
Cost of goods sold should be matched with sales by using inventory to record
cost of goods not yet sold.
Research and development is a period expense that is recorded as incurred.
Depreciation allocated over time on a systematic and rational basis except in the
unusual situation in which units-of-production depreciation is used.
Sales are recorded when earned.
8.25
a.
b.
c.
Incorrect
Incorrect
Correct
Overstates net income in the period of capitalization.

Overstates net income.
Has no effect on net income. It overstates cash and payables.
8.26
a.
b.
c.
d.
Correct
Incorrect
Incorrect
Incorrect
The completeness assertion is very important in the audit of liabilities.

This would restrict a companys ability to do business.
Auditors are normally not concerned with whom the clients vendors are.
Competitive bids are normally required for only large purchases.
8.27
a.
b.
c.
d.
Incorrect
Incorrect
Incorrect
Correct
These duties should be separated.

This would not necessarily prevent a duplicate payment.
The voucher date may be several weeks before the payment is due.
Cancellation of vouchers (PAID) prevents their use a second time.
8.28
a.
b.
c.
d.
Incorrect
Incorrect
Incorrect
Correct
The requisition would not result in the improper delivery.

No cash is received at Lake.
No inventory is ordered for Lake or entered into Lakes inventory records.
Nobody at Lake was reviewing purchase orders to notice the delivery and
payment by another party (Budds relatives store). This deviation caused no
direct loss to Lake, but it is a misuse of Lakes pricing agreements with its
vendors and puts Lake at risk.
8.29
a.
b.
Incorrect
Correct
c.
d.
Incorrect
Incorrect
If the liability is unrecorded, it would not be on the trial balance.

Auditors may be able to determine that cash disbursements in the subsequent
period are paying liabilities of the period under audit.
This is a cutoff test; (b) is a more direct test.
This is only an indirect test; (b) is a more direct test.
a.
b.
c.
Incorrect
Incorrect
Correct
d.
Incorrect
8.24
8.30
Cash disbursements are an important part of the cycle.

Although similar to sales because they are shipped out, purchase returns are
considered part of the acquisition and expenditure cycle because they affect
accounts payable.
Although similar to purchases because they require a receiving report, sales
returns are considered part of the revenue and collection cycle because they
affect accounts receivable.
Prepaid Insurance is one of the many accounts in the acquisition and expenditure
cycle.
This is often performed before the balance-sheet date.

The search for unrecorded liabilities generally depends upon using accounting
records created in the period after the year end.
8-6
8.31
a.
b.
c.
Incorrect
Incorrect
Correct
d.
Incorrect
a.
b.
c.
Incorrect
Incorrect
Correct
d.
Incorrect
Approvals do not necessarily result in debits to the inventory.

Purchase requisitions may not represent the actual amount received.
Invoices supply relevant information about the quantities purchased and the
prices paid.
Purchase orders may not represent the actual amount received.
8.33
a.
b.
c.
d.
Incorrect
Incorrect
Incorrect
Correct
This would have ensured a proper count of the tables.

This would insure the invoice was for the amount received.
This would insure the check was for the amount received.
The purchase order and requisition would both show 84 tables.
8.34
a.
b.
Incorrect
Incorrect
c.
Correct
The check signer is probably not familiar with all the vendors.
This is possible, but the maintenance costs may not have been unusual (i.e., the
costs before the fraud were below budget).
Vendors should be approved by an independent purchasing department.
a.
Incorrect
b.
Incorrect
c.
d.
Incorrect
Correct
a.
b.
Correct
Incorrect
c.
d.
Incorrect
Incorrect
a, b,.
Incorrect
c.
Correct
d.
Incorrect
a.
Incorrect
b.
Correct
c.
Incorrect
8.32
8.35
8.36
8.37
8.38
Some liabilities may be incurred but not invoiced by the vendor.

Purchase orders do not normally incur liabilities.
The receiving reports are the population that contains the record of all goods
received for which liabilities should be recorded.
The invoice or receiving report must be examined to determine when the
liability occurred.
Payroll is generally audited by tests of controls, analytical procedures and

substantive tests of transactions.
Cost of goods sold is generally audited by tests of controls, analytical
procedures and substantive tests of transactions.
Supplies expense is generally audited in connection with supplies inventory.
The auditor examines the specific charges to determine potential litigation.
Property tax expense is audited in conjunction with accrued property taxes.
Payroll is generally audited by tests of controls, analytical procedures and
substantive tests of transactions.
Theres no asset directly related to R&D.
The auditor examines the specific charges to determine potential litigation.
Although auditors are always concerned about existence and rights and
obligations, these issues usually arise because of errors in the accounts.
However, it is unlikely that management would intentionally add nonexistent
liabilities, or accounts for which management has no obligation to pay.
Completeness is the most important assertion in this cycle. The hiding of
liabilities is a primary concern for all auditors in the liability and expense areas.
Supplies expense is generally audited in connection with supplies inventory.
Valuation and allocation would be the second best answer since recording
liabilities at an amount less than its proper value might be a ploy management
can use to cook the books. However, auditors are usually more concerned
about unrecorded liabilities affecting the completeness assertion.
Testing occurrence would require vouching from the vouchers recorded in the
voucher register to receiving reports.
This test ensures that liabilities generated by the receipt of goods are recorded in
the voucher register.
This does not test classification, which would require examining the chart of
accounts.
8-7

d.
Incorrect
This does not test cutoff, which would require comparing the date of the
receiving report to the date recorded.
SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

8.39
Payable ICQ Items: Assertions, Tests of Controls, and Possible Errors or Frauds
1.
2.
3.
4.
a.
Purchases and accounts payable are authorized to assure compliance with company
policy (authorization).
b.
For a sample of cash disbursements, vouch to approval signatures on invoices, receiving

reports and purchase orders.
c.
Costs and expenses might be incurred that are not properly supported.
d.
Select a sample of current-year debits in accounts (e.g., inventory, fixed assets, expenses),
and vouch them to supporting documents.
a.
Liabilities are recorded at the appropriate quantity and description (accuracy).
b.
Select a sample of invoices and agree them to the receiving report. Observe receiving
department counting receipts.
c.
Vendors could bill for quantities greater than the amount actually shipped, overstating
costs or expenses.
d.
Observe the clients inventory account and test the reconciliation of the count to the
perpetual inventory.
a.
Liabilities are recorded for actual purchases at the appropriate amounts (accuracy).
b.
Observe client personnel making comparisons. Examine initials for approval. Review
correcting journal entries that result from the comparison.
c.
Purchases or other liabilities may be recorded for transactions that didnt exist or at
incorrect amounts.
d.
Reperform comparison on a test basis.
a.
Journal entries are authorized and prepared in accordance with generally accepted
accounting principles (accuracy, classification).
b.
Examine entries for approval initials.
c.
The company might override controls to create fraudulent entries.
d.
Select a sample of recorded journal entries and reperform calculations and review for
appropriate accounts.
8-8
8.40
Unrecorded Liabilities Procedures

a.
The fact that the client made a journal entry to record vendors invoices that were received late
should simplify the auditors audit for unrecorded liabilities and reduce the possibility of a need
for a further adjustment, but the audit is nevertheless required. If the client has not journalized late
invoices, the auditors are compelled in their testing to substantiate what will ultimately be
recorded as an adjusting entry. In this examination, the auditors should audit entries in the voucher
register, for the year being audited, to ascertain that all items, which according to dates of
receiving reports or vendors invoices were applicable to that year, have been included in the
journal entry recorded by the client.
b.
No. The auditors should obtain a letter in which responsible executives of the clients organization
represent that to the best of their knowledge all liabilities have been recognized. However, this is
done as a normal audit procedure to afford additional assurance to the auditors, and it does not
relieve the responsibility for doing other substantive audit work.
c.
Whenever auditors are justified in relying on work done by an internal auditor, they should curtail
(but not eliminate) their own audit work. In this case, the auditors should have ascertained early in
the examination that Ozines internal auditor is qualified by being both technically competent and
objective. Once satisfied as to these points, the auditors should discuss the nature and scope of the
internal audit program with the internal auditor and review the working papers in order that the
auditors may properly coordinate the audit program with that of the internal auditor. If the Ozine
internal auditor is qualified and has made tests for unrecorded liabilities, the auditors may reduce
further audit work in this audit area.
d. In addition to the 2011 voucher register, the auditors should consider the following sources for possible
unrecorded liabilities:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
Unentered vendors invoice file.

Status of tax returns for prior years still open.
Discussions with employees.
Representations from management.
Comparison of account balances with preceding year.
Examination of individual accounts during the audit.
Existing contracts and agreements.
Board minutes.
Attorneys bills and letter of representation.
Status of renegotiable business.
Correspondence with principal suppliers.
Audit testing of cutoff date for reciprocal accounts (e.g., inventory and fixed assets).
8-9

8.41
Accounts Payable Confirmations

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)
(2)
(3)
b.
Clark and Kent are not required to use accounts payable confirmation procedures. For accounts
payable the auditor can examine external evidence such as vendor invoices and vendor statements
that substantiate the accounts payable balance. Although not required, the accounts payable
confirmation is often used. The auditor might consider such use when:
(1)
(2)
(3)
(4)
(5)
(6)
c.
To determine the adequacy of internal control for processing and payment of invoices.
To prove that amounts shown on the balance sheet are in agreement with supporting
accounting records.
To determine that liabilities existing at the balance-sheet date have been recorded.
Internal controls are weak.

The company is in a tight cash position and bill-paying is slow.
Physical inventories exceed general ledger inventory balances by significant amounts.
Certain vendors do not send statements.
Vendor accounts are pledged by assets.
Vendor accounts include unusual transactions.
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 and so on.
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 years.
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.
8-10

8.42
Search for Unrecorded Liabilities

1.
Scan the open purchase order file at year-end for indications of material purchase commitments at
fixed prices. Obtain current prices and determine whether any adjustments for loss and liability for
purchase commitments are needed.
2.
List the unmatched vendor invoices and determine when the goods were received, focusing on the
unmatched receiving reports and receiving reports prepared after the year-end. Determine which
invoices, if any, should be recorded.
3.
Review the year-end unmatched receiving reports and determine whether entries are recorded in
the proper accounting period.
Select a sample of cash disbursements from the accounting period following the balance-sheet
date. Vouch them to supporting documents (invoice, receiving report) to determine whether the
related liabilities were recorded in the proper accounting period.
4.
5.
Study IRS examination reports for evidence of income or other taxes in dispute, and decide
whether actual or estimated liabilities need to be recorded.
6.
Confirm accounts payable with vendors, especially regular suppliers showing small or zero
balances in the year-end accounts payable. These are the ones most likely to be understated.
(Vendors monthly statements controlled by the auditors also may be used for this procedure.) Be
sure to verify the vendors addresses so that confirmations will not be misdirected, perhaps to
conspirators in a scheme to understate liabilities.
7.
Study the accounts payable trial balance for indications of dates showing fewer payables than
usual recorded near the year-end. (A financial officer may be delaying the recording of vendor
invoices.)
8.
Use a checklist of accrued expenses to determine whether the company has been conscientious
about expense and liability accruals including accruals for wages, interest, utilities, sales and
excise taxes, payroll taxes, income taxes, real property taxes, rent, sales commissions, royalties,
and warranty and guarantee expense.
9.
When auditing the details of sales revenue, pay attention to the terms of sales to determine
whether any amounts should be deferred as unearned revenue. Inquiries directed to management
about terms of sales can be used to obtain initial information, such as inquiries about customers
rights of cancellation or return. The terms may signal the need for deferred revenue accounting.
10.
Perform analytical procedures appropriate in the circumstances. Calculate and compare the gross
margin percent of the current year to that of prior year(s), and compare important expense account
balances to those of prior years to notice any that this year appear to be too low.
8-11

8.43
Fictitious Vendors, Theft, and Embezzlement

In this case, let your initial objective be to select one vendor for investigation. Instead of a tests of
controls section, name the one vendor you would select from those in Exhibit 8.43-1 and tell your reasons.
In the test of balances section, tell how you would investigate the situation. In the discovery summary
section, speculate about how your investigation might reveal the culprit.
Audit Approach
Objective: Select one vendor for investigation, and try to obtain evidence of purchasing at inflated prices.
Control: Purchasing operations should be performed under rules and procedures designed to motivate
purchasing agents to buy at the best prices available from competing vendors. Competitive bidding should
be required unless conditions make the best prices available without bid.
However, purchasing agents should have flexibility within operating procedures to move quickly to obtain
the best balance of quantities, delivery terms, and prices as events dictate. Thus, they may not always
obtain competitive bids.
A higher manager level should supervise and review the results of purchasing activity on a regular basis,
perhaps reperforming some price-obtaining actions occasionally to determine whether the agents are
achieving efficiency. Such review might also involve selecting odd situations for extensive review.
Tests of controls: The one vendor selected is Orion Corp. Key reasons for this selection are:
Volume is high and has increased almost 1000 percent, more than for any other vendor.
Last bid was obtained in 2007, older than other vendors bids.
The percent purchased on bid is lowest among those bids.
Collins, the manager, is in charge.
Collins purchases from several vendors without bids.
Audit of balance: Investigation of purchases from Orion:
Review purchase invoices to determine unit prices for paper.
Compare unit prices with other suppliers.
Interview other suppliers and their salespersons to try to determine whether Collins solicited kickbacks.
Review bid records to determine the dates of submitted bids and bid prices.
Examine Collins personnel file. Investigate references if they were not consulted earlier. Might investigate
again with more determination to notice telltale signs.
Conduct interviews with Collins and other purchasing agents under a front of learning about purchasing
procedures. Carefully seek information or impressions about Collins relations with Orion.
8-12
Inquire at secretary of state office for names of Orion incorporators to see if Collins is connected.
Look up officers in national executives directory to see if she is listed as an officer of Orion.
Covertly observe Collins lifestyle and spending habits. A ruse might be used to get information
about Collins bank balance and activity. (Overt action such as subpoena should not be used until
clear evidence of guilt is available.)
Discovery Summary
If Collins is taking kickbacks in return for causing Bailey to pay higher prices, the price comparison
information should show evidence. If this is the case, the other procedures should also bear fruitpast
employment history problems, police record, derogatory gossip from co-workers, more wealth than
justified by salary, maybe even a direct connection with Orion.
Collins has plenty of room to cause Bailey a significant financial drain. Purchases from Orion were
$1,220,000 over the last two years, and about $500,000 of supplies and sundries without bid from other
suppliers. If the overpricing to Bailey were 10 percent of all these purchases, it could amount to $172,000
for two years work.
P.S. The title of the case Purchasing Stars is a clue to the solution
8.44
(Orion)
Bidding Process
a.
While it might seem logical that the vendors would split the bids fairly evenly over time, in the real
world, this is not usually the case. As a matter of fact, an even split would likely be a red flag. (c).
Generally, one vendor turns out to be a low bidder the majority of the time. The fact that Wright has
been the winning bidder about half the time is not by itself a red flag.
b.
The situation in which Wright has been the last bidder in each of the winning bids changes the situation
dramatically. When the final bidder is the winning bidder the majority of the time, it may be an
indication of an information leak. The contracts being bid are worth a considerable amount of money,
and bribes paid for information must be considered. We can control this by keeping the bids locked
and unopened until the bidding deadline has passed. Bids should be opened by someone other than the
purchasing agent and should be opened and recorded by two people.
c.
It is unusual for venders to split contracts in such a manner. This may be indicative of collusion among
the venders. Controls might include having more than three vendors and having a different mix of
vendors bid on each contract. A detailed proposal listing all components of the bid may detect
collusion. Vendor approvals should be reviewed periodically for changes in management or ownership
(it is possible that one company has purchased another and may be operating under two different
names).
d.
This may or may not be a problem. Bids may be awarded on criteria other than just price. Delgado
may have been able to meet a deadline other bidders could not or might have special expertise that
make him preferable on a specific job. The auditor should inquire of management about the criteria for
awarding these bids. Controls might include documentation with the bids regarding the rationale for
choosing a specific vendor. This documentation should be reviewed and approved by an appropriate
member of management.
8-13

8.45
Grounds for Dismissal

Audit Approach
Objective: To detect the fraudulent hiring of a consulting firm.
Control: The contract should have been approved by someone above Does level. Payments should not
have been made without such approval. After being signed, checks should be mailed directly from the
treasurers office.
Test of controls: Examine disbursements for indication of authorization. Endorsements on checks can be
examined for double signatures.
Audit of balance: Tests of charges to the capital account should reveal the large amount of expenses being
capitalized. In addition to vouching these charges, auditors should inquire about whether they are properly
capitalized as long-term assets.
Discovery Summary
Company employees in charge of capital projects began noticing the large charges. In March 2001, Doe
and her husband were named in a $2.4 million civil judgment, the largest fraud in the history of King
County, Washington. The settlement required a list of possessions the Does had acquired. The 19-page list
contained 489 items. Cars, pianos, and other items were sold at auction and netted The Coffee Co. about
$1.8 million.
Doe was a compulsive shopper. The police reported there was only a small path through the rooms of her
house because boxes of her purchases were stacked to the ceiling.
Red flags that should have tipped off her supervisor and co-workers included:
Doe was evasive and never satisfactorily answered questions about FCC.
When the supervisor asked to meet with FCC, he was told they were working out of the office.
FCC was not registered in the State of Washington or listed in telephone directories.
FCCs mailing address was a P.O. box. The physical address was Does residence.
Doe requested special handling for FCC checks whereby she picked them up personally.
8-14

8.46
Audit Simulation: Audit the PP&E and Depreciation Schedule

a.
The Computer B system is depreciated for a full year ($583,000), but depreciation should be
calculated for only eight months. Correct amount is $389,000.
The depreciation on the press should be $75,000 instead of $150,000. Somebody doubled the
depreciation expense for this year.
Accumulated Depreciation
Cost of Goods Sold
Inventory
General and Admin. Expense
b.
269,000
67,500
7,500
194,000
The best way to approach this requirement is to write a procedure for each assertion.
Building 2
Existence: Inspect the building to determine that it is in productive use (evidence of existence).
Rights (ownership): Vouch the legal title papers and recorded deed for evidence of ownership.
Valuation: Vouch the contractors billings and the payments for evidence of appropriate cost
valuation.
Presentation and disclosure: Study any related loan agreements for pledge as security for loans in
relation to necessary disclosure. Inspect insurance policies for evidence of adequate insurance
(inadequate insurance may require disclosure).
Computer B system
Existence: Inspect the computer and observe it in operation.
Rights (ownership) and valuation: Vouch purchase and title documents (ownership and cost
valuation).
Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for
installation and testing costs that should be capitalized (evidence of completeness of recording
asset cost).
Auto 2
Existence: Inspect the auto and observe it in operation.
Rights and valuation: Vouch purchase and title documents (ownership and cost valuation).
Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for
typical additional costs (e.g., tax, title, and license) that should be capitalized (evidence of
completeness of recording asset cost).
c.
The loss on the sale of the Computer A system should be $542,000 ($5,000,000 - $3,958,000 $500,000). The gain on the sale of Auto 1 (fully depreciated) should be $1,000. The cash flow
from investing activities should show cash inflow from sale of assets in the amount of $501,000.
There should be cash outflow for purchase of assets in the amount of $45,522,000.
8-15

8.47
PP&E Assertions and Substantive Procedures

1.
Rights evidence:
d.
2.
Existence evidence:
a.
3.
Examine deeds and title insurance certificates.
Physically examine all major property and equipment additions.
Valuation evidence:
b.
Review the provision for depreciation expense and determine whether depreciable lives
and methods used in the current year are consistent with those used in the prior year.
8.48
Assertions and Substantive Procedures for Property, Plant, and Equipment (PP&E)
a.
Valuation, Existence
b.
Valuation
c.
Valuation
d.
Valuation and Allocation
e.
Existence
f.
Existence
g.
Completeness
h.
Valuation and Allocation
i.
Rights and Obligations
j.
Rights
k.
Valuation
8-16

8.49
CAATS ApplicationPP&E
a.
The information needed to reconcile subsidiary detail records to general ledger balances:
Asset type.
Location code.
Cost.
Accumulated depreciation, end of year.

The task of footing the subsidiary ledger and comparing the recalculation to the general ledger
balance(s) does not complete the audit of fixed assets. Additional evidence is needed to be
persuaded of existence of the assets (observation), valuation (vouching invoices, recalculating
depreciation), completeness (vouching and tracing transactions dated around the year-end), and
presentation and disclosure (in-use-status, inquiries about hypothecation, liens).
b.
8.50
The assistant will also need to know the asset number, description, as well as asset type and
location code mentioned in (a).
Search for Unrecorded Liabilities

a.
Audit plan
Procedure
Performed by
1. Obtain a trial balance of recorded accounts payable as

of year-end and vouch to receiving reports to ensure
goods were received in the current year
2. Select a sample of cash disbursements from the accounting
period following the balance-sheet date. Vouch disbursements to
supporting documents (invoice, receiving report) to determine
whether the related liabilities were recorded in the proper
accounting period.
3. Send confirmations
(a) to creditors with small or zero balances
(b) to creditors with whom the company has done significant
business
3. Inquire of client personnel about their procedures for ensuring
that all liabilities are recorded.
4. Obtain a list of unmatched vendor invoices and review
receiving reports to identify when the goods were received.
5. Trace the unmatched receiving reports to accounts payable,
and determine whether items recorded in the next accounting
period need to be adjusted.
8-17
Ref
b.
Adjusting journal entry

Vouchers Payable
Rent Expense
53,000
53,0001
To reverse January rent expense recorded in December

Miscellaneous Expense
Cost of Goods Sold
Office Expense
Vouchers Payable
6,300.00
12,889.66
8,644.862
27,834.52
To record unrecorded liabilities
8.51
Kaplan CPA Exam Simulation
Based on knowledge of the company and its environment, including its internal control,
auditors have assessed the risk of material misstatement in the client's financial
statements and have designed the nature, timing, and extent of further audit
procedures. As a result of conducting these risk assessment procedures, the audit
plan for year 2 includes several changes and revisions from the audit plan that was
developed for this client in year 1.
In conducting year 2 audit procedures for "unrecorded liabilities," the materiality level
was assessed by the auditors at $6,000. Adjustments are recorded only for items
equal to or exceeding the level of materiality.
For the items reflected in the client's January and February year 3 check registers that
follow, amounts that are not recorded in the accounts payable ledger or the accrued
liability schedule as of December 31, year 2, determine whether any of these items
require an adjustment to be made to the client's financial statements at the end of year
2. If an adjustment is necessary, also determine the amount that should be
journalized. If no adjustment is required, you must enter "$0".
Client's Check
1
2
May omit if students assume the charge was made to prepaid rent.
Includes unbilled amount for December
8-18
Register
Vendor
Check Check
#
Date
Water World
Distributors, Inc.
1333
1/6
year 3
$3,500
Water coolers for office and

warehouse delivered 12/31/year 2
Daniel Breen,
Esquire
1334
1/6
year 3
$6,000
Corporate legal services for

December, year 2
Telephone
Services, Inc.
1335
1/8
year 3
$6,500
December, year 2, telephone and

computer services
Payroll processing
Paychecks
1336
1/10
year 3
$25,500
Bi-weekly payrollpay period

12/25/year 2 through 1/7/year 3
Pitt Ohio Trucking

Company
1337
1/10
year 3
Trucking services 12/4/year 2 through

$45,601 1/3/year 3; deliveries were made
evenly throughout the period
Petty cash
1338
1/17
year 3
$2,002
Replenish petty cash box
Smith's Forklift
Repairs
1339
1/22
year 3
$11,000
Received new fork lift on 12/29/year

2; ordered unit on 12/18/year 2
Glenn's Glass
1340
Distribution Center
1/23
year 3
$12,230
Specialty goods ordered 12/20/year 2

and delivered 12/31/year 2
Payroll processing
Paychecks
1341
1/24
year 3
$25,500
Biweekly payrollpay period 1/8/year

3 through 1/21/year 3
Daniel Breen,
Esquire
1342
2/6
year 3
$6,800
Corporate legal services for January,

year 3
Amount Nature of the Expenditure
Double-click on each of the shaded cells adjacent to the check number and select
from the two lists provided whether or not any action or adjustment is required, as well
as the dollar value of the adjustment. Again, you must enter "$0" if no adjustment is
required. Each selection may be used once, more than once, or not at all.
Check #
Adjustment needed?
Amount
1333
No action required
$0
1334
Adjustment needed
$6,000
1335
Adjustment needed
$6,500
1336
Adjustment needed
$12,750
1337
Adjustment needed
$41,188
1338
No action required
$0
1339
Adjustment needed
$11,000
1340
Adjustment needed
$12,230
1341
No action required
$0
1342
No action required
$0
8-19
APPENDIX 8C
The Payroll Cycle
SOLUTIONS FOR REVIEW CHECKPOINTS
8C.1
The functions in a payroll cycle include:
8C.2
Personnel and labor relations - hiring and firing (authorization).

Supervision - approval of work time (authorization).
Timekeeping and cost accounting - payroll preparation and cost accounting (recordkeeping).
Payroll accounting - check preparation and related payroll reports (custody of cash).
Check signing (custody).
Payroll distribution - actual custody of checks and distribution to employees (custody of cash).
In a payroll cycle, the functional responsibilities which should be separated include:

1.
2.
3.
4.
5.
Personnel or labor relations department.

Supervision.
Timekeeping and cost accounting.
Payroll accounting.
Payroll distribution.
8C.3
When employees are terminated, they should be interviewed by the personnel department, who can then
remove them from the payroll files. Separation of responsibility for handing out paychecks from
authorization and record keeping can reduce the incentive for supervisors to keep terminated employees on
the payroll. Labor cost analyses also reduce incentives for supervisors to have too many employees listed in
their departments. Finally, W-2s should be sent directly to the employees homes so they can spot any
fictitious wages.
8C.4
a.
A walkthrough of a personnel and payroll transaction would include discussions with each person
handling personnel and payroll records. The following illustrates the steps and documents
collected.
Steps
Hiringpersonnel department
Deductionspersonnel department
Timekeeping
Shops
Cost distribution
Accounts payable
Cash disbursement
8-20
Document(s) Collected
Authorization to hire and rate assignment
Personnel forms, employee authorization for
deductions (e.g., W-4 form)
Clock card
Production time ticket
Labor distribution work sheet
Payroll voucher
Payroll checks
b.
8C.5
Important documents in employees personnel files:
8C.6
a.
b.
8C.7
If the payroll is processed by computer, the clock cards and production time tickets would be
traced to batch control in the timekeeping and production departments, to data preparation (input),
to edit and validation error reports and other computer output indicating control, and finally to
computer-prepared checks, labor distribution reports, and summary general ledger entries.
Employment application.
Background investigation report.
Notice of hiring.
Job classification with pay rate authorization.
Authorizations for deductions (e.g., health insurance, life insurance, retirement contribution, union
dues, W-4 form for income tax exemptions).
Termination notice.
Prevent or detect payment to a fictitious employee:
Paychecks prepared only for persons with employment authorization from the personnel
department.
Paychecks prepared only for persons with approved work attendance, time.
Paychecks distributed only in person to persons identified as employees (or by electronic

transfer to validated employee bank accounts).
Payroll register or list re-approved by supervisor after paychecks are prepared or

distributed.
Employees are expected to complain if they are not paid!
The common errors and frauds in the personnel and payroll cycle are (a) recorded employee transactions
are not valid (fictitious employee), (b) recorded attendance transactions are not valid (fictitious hours), and
(c) incorrect cost accounting classification for labor. Auditors look for separation of duties, proper
authorizations and good reconciliations to prevent or correct these errors or frauds. Auditors should be alert
to a supervisor having too many incompatible responsibilities (e.g., hiring, authorization of hours,
authorization of pay rate, distribution of pay checks and dismissal--only authorization of hours is a proper
responsibility).
SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

8C.8
c.
Correct
The payroll department should be independent of the personnel department,

which would be responsible for authorizing all payroll rate changes for the
employees of the entity. A supervisor would be authorized, however, to initiate
requests for rate increases for supervised employees.
8C.9
a.
Correct
The personnel department provides the authorization for payroll-related

transactions (e.g., hiring, termination, and changes in pay rates and deductions).
8-21

8C.10
a.
Incorrect
b.
8C.11
8C.12
8C.13
8C.14
8C.15
c.
d.
Incorrect
Incorrect
a.
b.
c.
Incorrect
Incorrect
d.
Incorrect
a.
b.
Incorrect
Incorrect
c.
d.
Incorrect
Correct
a.
A generalized program would not be sufficiently sophisticated to test this

procedure.
Correct
In a manual payroll system, a paper trail of documents would
be created to provide audit evidence that controls over each step in processing
were in place and functioning. One element of a computer system that
differentiates it from a manual system is that a transaction trail useful for
auditing purposes might exist only for a brief time or only in computer-readable
form.
This may be true, but there is not enough information about built-in controls.
This is a real-time system as records are updated when employees record their
time.
The payroll clerk has access to recording and custody.
Unclaimed pay should be given to the treasurer.
Correct
Under a cash payroll system, the receipt signed by the
employee is the only document in support of payment. The signed receipt is
essential to verify proper payment.
This would not be applicable to cash payroll.
An absence of an approved time record would prevent the employee being paid.
This is a good by-product of the policy, but it is unlikely that real employees
would fail to pick up their checks for several weeks.
This procedure would not prevent another employee from picking up the check.
A follow-up of unclaimed checks may result in identification of fictitious or
terminated employees, thus eliminating an employees opportunity to claim a
paycheck belonging to a terminated employee. The unclaimed checks should
then be turned over to a custodian so the internal audit function does not assume
operating responsibilities.
b.
c.
Incorrect
Incorrect
d.
Incorrect
Correct
Ordinarily, the auditor examines the endorsements on payroll
checks while obtaining an understanding of and testing the payroll cycle, which
includes consideration of clock cards.
The voucher system does not pertain to payroll.
This is a possibility, but (a) is better. As part of the cash audit, the auditor would
normally only examine checks returned with the cut-off bank statement.
Test of accruals would not involve examination of canceled paychecks.
b.
c.
d.
Incorrect
Incorrect
Incorrect
Correct
In considering whether transactions actually occurred, the
auditor is most concerned about the proper separation of duties between the
personnel department (authorization) and the payroll department (processing the
transactions).
This relates to completeness.
This relates to accuracy.
This would not provide evidence about occurrence of payroll transactions.
c.
Correct
a.
The payroll department assembles payroll information, which is a recording

function. Custody of assets, such as unclaimed payroll checks, is incompatible
with record keeping.
8-22
SOLUTIONS FOR EXERCISES AND PROBLEMS

8C.16
Major Risks in Payroll Cycle

Payroll Cycle Risk
Assertion
Paying fictitious employees
Occurrence, employees exist
Overpaying for time or production Accuracy of payroll amounts, proper inventory, cost of goods sold,
and expense amounts
Incorrect accounting for costs and
expenses
8C.17
Accuracy, classification
Payroll Authorization in a Computer System

Because authorization is an important control activity, the point(s) of authorization should be determined.
Authorization of payroll transactions cannot be determined without understanding the complete flow of
transaction processing (manual and computer).
The following could be points in the flow where authorization takes place:
8C.18
When the computer application program is written (and approved) to accept certain employee codes
and to compute the gross payroll and the net amount.
When the foreperson initials the time card. (Alternatively, the time may be automatically entered from
a time clock into the computer files without forepersons initialsthen the employee clocking in
and out is the authorization.)
When payroll batches of time cards are totaled and submitted to data conversion.
When the time cards are input.
When the payroll programs are run using the time clock transactions and the payroll master file.
When the signature plate is installed on the printer and checks are printed.
When the pay rate is entered into the employee master file.
Payroll Processed by a Service Organization

This discussion question brings up the auditors responsibility when payroll is processed by a service
bureau, a common occurrence in many smaller businesses. The main point is that the audit control concerns
are the same wherever the data is processed. Following are some of the discussion points that have come up
in the past use of this question.
Audit planning will require determination of whether a report person is available from the service
bureau. Of particular interest is whether the service auditors report covers design only or both
design and certain tests of controls.
When a service bureau is used, client personnel are responsible for user input and output control (e.g.,
authorization, completeness (batching), reconciliation of input controls to output.
Specific contractual agreements of control responsibilities between the client and the service bureau
need to be examined and evaluated.
8-23
8C.19
General controls are the responsibility of the service bureau (e.g., system and program documentation);
backup for computer processing, data files, documentation and staff; and restrictions over access
to computer equipment, data files and programs.
Service bureau processing requires increased emphasis on client procedures for verifying continuing
authority, completeness, and accuracy of master file.
Service bureau processing requires increased emphasis on error correction and resubmission
procedures.
Payroll Audit Procedures, Computers, and Sampling

a.
Audit procedures: Obtain a sample of weekly batches of time cards and recalculate the totals of
labor hours and social security numbers. Labor hour data distributed by the cost accounting
department may serve as a cross-check. These control totals should then be compared to the
payroll register totals for the same period (and to control totals obtained after keyboard entry, if
available).
Deviation rate: The expected deviation rate should be zero. Although some input errors might
occur, they should be detected and corrected using the control totals for labor hours and social
security numbers.
Tolerable rate: Because payroll costs probably represent a significantly large cost item in a
manufacturing company, the tolerable rate might be quite low, say 2 percent or 3 percent.
Sample items: The sample items should be from appropriate populations; in this case, either the
batches as described above, the 300 employee files, or each employees weekly payroll (52 x 300
= 15,600 worker/week payments).
Sample size factor: Include expected deviation rate, tolerable deviation rate, risk of assessing
control risk too low, and the population size (if small).
b.
Select personnel files at random and compare the authorized job classification and pay rate to the
union contract and to the database (tape or cards) that contains the table used in computer memory.
This procedure yields evidence that the internal computer table is accurate. By reviewing
documented changes in the table, its contents throughout the period under audit may be reviewed.
Extract a sample of namesclassificationsrates from the table itself and vouch these to the
personnel files to detect errors of commission in the table. To determine whether rates are actually
used properly, the auditor may test the computer application with simulated transactions
or she or he may audit around the calculations by vouching payroll register output to time cards
and personnel files, and by retracing samples from time cards and personnel files forward to the
payroll register.
These procedures differ from a completely manual system only with respect to the need to test the
adequacy of the machine-stored rate table and in the test data application. Otherwise, the
procedures are equally applicable to a manual system for preparing the payroll.
8-24
8C.20
Payroll Tests of Controls

Procedure
Evidence
Sample of clock cards:

Note supervisors approval.
Trace to periodic payroll registers.
Sample of payroll register entries:
Vouch hours paid to clock cards and supervisors
approval.
Missing approval deviation

Wrong hours deviation.
Wrong employee deviation.
Recalculate gross pay, deductions, net pay.
Wrong hours deviation.

Missing approval deviation
Inaccurate pay calculation deviation.
Recalculate payroll registers.
Inaccurate payroll summary deviation.
Examine canceled payroll checks and endorsements.
Inaccurate check amount of deviation.

Invalid endorsement deviation.
Vouch periodic payroll totals to payroll bank account transfer

vouchers and deposit.
Inaccurate payroll transfer deviation.

Missing payroll transfer deviation.
Trace payroll entries to year-to-date records.
Incomplete update deviations.
Reconcile year-to-date records with total payrolls.
Inaccurate payroll (tax return) deviation.
Trace payroll to management reports and to general ledger.
Accounting incomplete deviation.

Accounting incomplete deviation.
8-25

Learning Objectives: Acquisition and Expenditure Cycle

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Chapter 08 - Acquisition and Expenditure Cycle

1. Identify significant inherent risks in the

2. Describe the acquisition and expenditure

3. Give examples of tests of controls over

24, 27, 28, 32, 33,

4. Explain the importance of the

26, 29, 30, 31, 37

40, 41, 42, 50,

5. Discuss audit procedures for other

12, 13, 14, 15,

45(*), 46, 47,

Specify some ways fraud can be found

Describe some common errors and

19, 20, 21, 22

39(*), 43, 44,

8. Describe the payroll cycle, including

8C1, 8C2 8C3,

(*) Item relates to multiple learning objectives

8C8, 8C9, 8C10,

Chapter 08 - Acquisition and Expenditure Cycle

SOLUTIONS FOR REVIEW CHECKPOINTS

Open purchase orders: Purchase commitments, losses on purchase commitments.

Chapter 08 - Acquisition and Expenditure Cycle

Chapter 08 - Acquisition and Expenditure Cycle

Blank vouchers kept in secure location available only to authorized personnel.

Chapter 08 - Acquisition and Expenditure Cycle

The following are possible red flags indicating a risk of fraud:

Photocopies of invoices in the files.

Vendors invoices submitted in numerical order.

Vendors invoice amounts always in round numbers.

Vendors invoices always slightly lower than a review threshold.

Vendors with only post office box addresses.

Vendors with no listed telephone number.

Matching vendor and employee addresses or telephone numbers.

Multiple vendors at the same address and telephone number.

Vendors not on the approved vendor list.

Chapter 08 - Acquisition and Expenditure Cycle

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

Overstates net income in the period of capitalization.

The completeness assertion is very important in the audit of liabilities.

These duties should be separated.

The requisition would not result in the improper delivery.

If the liability is unrecorded, it would not be on the trial balance.

Cash disbursements are an important part of the cycle.

This is often performed before the balance-sheet date.

Chapter 08 - Acquisition and Expenditure Cycle

Approvals do not necessarily result in debits to the inventory.

This would have ensured a proper count of the tables.

Some liabilities may be incurred but not invoiced by the vendor.

Payroll is generally audited by tests of controls, analytical procedures and

Chapter 08 - Acquisition and Expenditure Cycle

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

For a sample of cash disbursements, vouch to approval signatures on invoices, receiving

Liabilities are recorded at the appropriate quantity and description (accuracy).

Reperform comparison on a test basis.

Examine entries for approval initials.

The company might override controls to create fraudulent entries.

Chapter 08 - Acquisition and Expenditure Cycle

Unrecorded Liabilities Procedures

Unentered vendors invoice file.

Chapter 08 - Acquisition and Expenditure Cycle

Accounts Payable Confirmations

Internal controls are weak.