Rittenberg/Schwieger/Johnstone

Auditing: A Business Risk Approach

Sixth Edition

Chapter 12

Audit of Acquisition
Cycle and Inventory

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and South-Western are trademarks used herein under license.
Overview of 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:
 Authorized requisition
 Authorized purchase
 Receipt of goods and services
 Approval for payment
 Cash disbursement
 Risk and Business Analysis
Acquisition cycle deals with receipt of all goods and services
Misstatements may occur just because of the volume of
transactions
It is also an area where fraud is likely to take place. For
example,
 Employee theft of inventory causing inventory on the books to be
overstated
 Employees setting up fictitious vendors and paying themselves for
goods never received by the company
 Executives abusing travel and entertainment expenses for
personal use
 Capitalizing expenses as assets to inflate earnings
 Overestimating "restructuring reserves" at the time of acquisition
so expenses could be reduced in future periods
 What are the red flags of 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 that have significant credit entries
 Travel and entertainment expense accounts that do not have
documentation
 Inadequate follow-up to auditor recommendations on needed
controls
 What analytical analysis can be
done for misstatements?
Analytical procedures to identify potential
misstatements:
 Calculate and analyze dollar and percentage change in
inventory, cost of goods sold, and expense accounts
 Compute and analyze ratios like inventory turnover and
number of day's sales in inventory
 Prepare common sized income statement to identify
cost of good sold or expense accounts that are out of
line
Auditor compares client analytics to past client
performance, industry results, and auditor's
expectations
Overview of Control Procedures
and Control Risk Assessment
Requisition goods or services
 Need identified
 Pre-numbered requisition form completed and sent to
purchasing
Purchase goods or services
 Purchase order shows quantity and price of goods ordered,
quality specifications, shipping terms
 Purchase orders are pre-numbered to establish completeness
 Purchase orders must be properly authorized
 Many companies have separate purchasing department:
 Agents job is to find best combination of price, service, and quality
 Reduces fraud by separating purchasing from custody and
recording
 Centralizes control in one location
 Controls set to stop purchasing agents from abusing their positions
Overview of Control Procedures
and Control Risk Assessment
(continued)
Receive goods
 Receiving department should ensure
Only authorized 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
(continued)
Approve payment
 Accounting matches vendor invoice, purchase order,
and receiving reports - If quantity and quantity 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 authorization
 Completeness of recording
 Timeliness of recording
 Correctness of valuation
Attribute sampling (Chapter 9) may be used to test
control operation
The level of assessed control risk will impact the
rigor of the subsequent substantive testing of
Accounts Payable and expenses
What are some 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:
Reconcile vendor statements or confirm
accounts payable
Tests of subsequent disbursements
Analytical review of related accounts
 Reconciling Vendor Statements or
Confirm Accounts Payable
Auditor requests vendors' monthly
statements or sends confirmation to
major vendors
Auditor reconciles vendor 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
Analytics used on clients with low
control risk
 Auditing 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 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
Auditing of Inventory and 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
 Difficulty in identifying obsolete or defective inventory
 Many frauds involve the inventory account
 Easily transportable making it subject to double
counting
 May be stored at multiple locations, some may be
remote
 May be returned by customers
 What are some internal controls
for inventory?
A well-designed inventory control system should ensure:
 All purchases are authorized
 Accounting system ensures timely, accurate, and complete
recording
 Receipt of inventory properly accounted for
 Inventory tested for quality when received/manufactured
 Costs properly identified and assigned to products
 Customer returns of inventory examined for defects
 Inventory reviewed for obsolescence
 New products introduced only after market studies and quality
control tests have been made
 Management actively manages inventory
 Long term contracts are closely monitored
 Substantive Tests of Inventory
and 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 GAAP
Explain Procedures for Observing a
Client's Physical Inventory
Meet with client to discuss their plan to count
inventory
 Review client's plans 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
Observe the counting of inventory and note the
following:
 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
Items that appear obsolete or defective
High-dollar value items in inventory
Movement of inventory during counting process
 Document conclusion as to quality of the inventory
counting process
 What does the auditor do after
the inventory count?
After the inventory count, the auditor should:
Trace the test counts to the client's
inventory records
Trace the number of high-dollar items to
the client's inventory records
Trace the 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
Acceptable to count inventory before or after year-
end if:
 Controls are strong
 The opportunity and motivation to misstate inventory
is low
 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)
 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
 Inventory Valuation
Most complex assertion related to
inventory because of the:
Volume of transactions
Diversity of products
Variety of costing methods
Difficulty in estimating net realizable value of
products
 Inventory Valuation (continued)
Auditor uses direct tests and analytics to assess
inventory valuation:

 Direct tests include verifying cost by reviewing vendor invoices

 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 day's 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
 Appropriate Disclosure

Auditor reviews client disclosure for

compliance with GAAP
Disclosure should include:
Costing method(s) used
Frequency of accounting
Inventory pledged as collateral
Any other unusual circumstance
 Cost of Goods Sold
Audit of cost of goods sold can be direct
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 direct
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