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Lecture 10

Lecture 10 - Auditing Acquisitions and PPE.docx

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Department
Accountancy
Course
AYB301
Professor
All Professors
Semester
Fall

Description
LECTURE 10 – AUDITNG ACQUISITIONS AND PROPERTY, PLANT AND EQUIPMENT AUDTING ACQUISITIONS AND INVENTORY Overview of the Acquisition Cycle  The acquisition cycle covers the purchase, receipt, payment and accounting for goods and services.  Main phases are: o Authorised requisitions o Authorised purchases o Receipt of goods and services o Approval for payment o Cash disbursement. Slide 4 Diagram HERE Business Risk and Environment  Acquisition cycle deals with receipt of all goods and services.  Misstatements may occur just because of the volume of transactions.  Fraud is a major concern in the acquisition cycle. For example: o Employee theft of inventory, causing inventory on the books to be overstated o Employees setting up fictitious suppliers and paying themselves for goods never received by the company o Kickbacks to employees o Executives abusing travel and entertainment expenses for personal use o Capitalising expenses as assets to inflate earnings o Overestimating ‘restructuring reserves’ at the time of acquisition so expenses can be reduced in future periods. Red Flags in the Acquisition and Payment Cycle  There are a number of red flags unique to the acquisition and payment cycle. These include: o Inventory growing at a rate greater than sales o Expenses significantly above or below industry norms o Capital assets growing faster than the business and for which there are not strategic plans o Significant reduction of ‘reserves’ o Expense accounts with significant credit entries o Travel & entertainment expense without documentation o Inadequate follow-up on control recommendations Analysis for Likely Misstatements  Analytical procedures to identify potential misstatements: o Calculate and analyse $ and % changes in inventory, cost of goods sold & expense a/cs o Compute & analyse ratios such as inventory turnover and number of days’ sales in inventory o Prepare common sized I/S to identify COGS or other expense accounts that are out of line.  Results can be compared to clients past performance, industry results and auditor’s expectations. Overview of Control Procedures and Control Risk Assessment  Requisition of goods or services o Need identified. o Pre-numbered requisition form completed and sent to purchasing.  Purchase of goods or services o Purchase order shows quantity and price of goods ordered, quality specifications, shipping terms. o Purchase orders are pre-numbered to establish completeness. o Purchase orders must be properly authorised.  Requisition of goods or services o Need identified. o Pre-numbered requisition form completed and sent to purchasing.  Purchase of goods or services o Purchase order shows quantity and price of goods ordered, quality specifications, shipping terms. o Purchase orders are pre-numbered to establish completeness. o Purchase orders must be properly authorised.  Many companies have a separate purchasing department: o The agent’s job is to find the best combination of price, service and quality o Reduces fraud by separating purchasing from custody and recording. o Centralises control in one location. o Controls are set to stop purchasing agents from abusing their positions.  Approval of items for payment o Accounting matches vendor invoice, purchase order and receiving reports. If quantity and quantity match, account payable is recorded.  Cash disbursement o Supporting documentation is reviewed and approved for payment o 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, significant controls are: o Proper authorisation o Completeness of recording o Timeliness of recording o Correctness of valuation.  Attribute sampling may be used to test control operation.  The level of assessed control risk will impact the rigour of the subsequent substantive testing of accounts payable and expenses. Substantive Testing of Accounts Payable  The auditor’s main concern is that accounts payable will be understated. o Therefore, emphasis is placed on testing the completeness assertion. o Typical substantive tests include:  Reconciling vendor statements or confirming accounts payable.  Tests of subsequent disbursements.  Analytical review of related accounts. Reconciling Vendor Statements or Confirmations with Recording Payables  Auditor requests suppliers’ monthly statements or sends confirmation to major suppliers.  Auditor reconciles supplier statement or confirmation with client balance in the accounts payable subsidiary ledger. Testing Subsequent Disbursements  Auditor samples cash disbursements after the end of the year.  Determines if disbursements are for audit year transactions by vouching back to source documents (purchase order, vendor invoice, receiving report).  If disbursement is for audit year transaction, auditor reprocesses the transaction to see if it was properly recorded as a payable. Analytical Review of Related Expense Accounts  Used to determine if accounting data indicates understatement of expenses.  If understatement likely, auditor expands tests of accounts payable. Audits of Expense Accounts  Auditing payables and cash disbursements provides indirect evidence about expense accounts. o Additional analysis of selected expense accounts is usually merited.  Auditor should consider that management is more likely to: o Understate rather than overstate expenses o Classify expenses as assets rather than vice versa.  Substantive audit procedures include: o Detailed tests of transactions o Analytical review o Review of unusual entries. Audit of Inventory and COGS  Audit of inventory is complicated by: o Variety (diversity) of items o High volume of activity o Various (sometimes complex) valuation methods o Difficulty in identifying obsolete or defective inventory  Many frauds involve inventory, because it: o Is easily transportable, making it subject to double counting o May be stored at multiple/remote locations o May be returned by customers. Internal Controls for Inventory  A well-designed inventory control system should ensure: o All purchases are authorised o The accounting system ensures timely, accurate and complete recording o Receipt of inventory is properly accounted for o Inventory is tested for quality when received or manufactured o Costs are properly identified and assigned to products o Customer returns of inventory are examined for defects o Inventory is reviewed for obsolescence o New products are introduced only after market studies and quality control tests have been made o Management actively manages inventory o Long-term contracts are closely monitored. Key Processes and Risks  Automated purchases and potential obsolete inventory  Accounting system  Accounting for returned items  Quality control process  Cost accounting system  Existence of an accurate perpetual inventory system  Systematic review for obsolescence  New product introductions Substantive Tests of Inventory and COGS  Existence: o Observe year-end physical inventory  Completeness: o Cut-off tests  Rights: o Review long-term contracts, etc.  Valuation: o Direct tests and analytics  Disclosure: o Review proposed disclosure for compliance with accounting standards Procedures for Observing a Client’s Physical Inventory  Meet with client to discuss plan to count inventory.  Review plan for counting and tagging inventory.  Review counting procedures with audit personnel.  Determine whether specialists are needed  Upon arriving at each site: o Meet with client, and obtain map and schedule of inventory count area. o Obtain list of sequential tag numbers for each area. o Observe procedures to shut down receipt or shipment of goods; obtain document numbers for last receipt and shipment for cut-off tests.  Observe the counting of inventory. o Note the first and last tag numbers in each section. o Account for all tag numbers to prevent later insertion of additional inventory items. o Make selected test counts. o List items that appear obsolete or defective. o Note high-dollar value items in inventory. o Note movement of inventory during counting.  Document conclusion as to quality of the inventory counting process. After the Count  After the inventory count, the auditor should trace: o Test counts to the client’s inventory records o The number of high-dollar items to the client’s inventory records o Obsolete or damaged inventory to the client’s inventory records to see if the items have been written down. Counting Inventory Before or After year-end  On occasion, it may not be feasible to count inventory at year-end.  It is acceptable to count inventory before or after year-end if: o Controls are strong o The opportunity and motivation to misstate inventory is low o The auditor can test the year-end balance using analytics and tests of transactions between the physical count and year-end o The auditor reviews intervening transactions for unusual activity. Completeness  Inventory cutoff tests: o Obtain information on last items shipped and received at year-end. o Compare this information to transactions recorded in the sales and purchases journal. o Determine if transaction is recorded in correct accounting period.  Auditor should inquire about any inventory out on consignment or stored in public warehouse.  Tracing test counts and number of high-dollar items to the client’s inventory records tests completeness 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 Rights  Most of the work regarding ownership of inventory is performed during the auditor’s testing of purchases.  Auditor should also review long-term contracts to determine obligations.  Inquiry should be made about inventory on consignment. Valuation  Most complex assertion related to inventory: o Volume of transactions o Diversity of products o Variety of costing methods o Difficulty in estimating NRV of products.  Auditor uses direct tests and analytics to assess inventory valuation.  Direct tests include verifying cost by reviewing supplier invoices.  Auditor usually examines current market data etc. That might indicate inventory obsolescence.  Management inquiry and review of industry publications can help the auditor identify obsolete units.  Analytics, e.g. Inventory turnover or days’ sales in inventory, may identify slow-moving inventory  write down.  Auditor looks for obsolete stock during inventory count  write down. Disclosure  Auditor reviews client disclosure for compliance with standards  Disclosure should include: o Accounting policies adopted in measuring inventories, including the cost formula used o Carrying amount o Carrying amount of inventories at fair value less costs to sell o Amount of inventories recognised as an expense o Write-downs and reversal of write-downs and reasons for the reversal. Cost of Goods Sold  Audit of cost of goods sold can be directly tied to the audit of inventory.  If beginning and ending inventories have been verified and acquisitions have been tested, cost of goods sold can be directly calculated.  Auditor should also apply analytics to cost of goods sold to see if there are any significant variations, either overall or by product line. Sampling  Objective evidence on correctness of a/c balance or processing  Statistical sampling – efficiency & effectiveness of audit procedures to test balances, controls compliance  Samples – representative of population – projections of results portray characteristics of total population  Sample size is determined by: o Statistical r
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