© the mcgraw-hill companies 2010 auditing the purchasing process chapter eleven

© The McGraw-Hill Companies 2010

Auditing the Purchasing Process

Chapter Eleven


Expense and Liability Recognition (IASB)

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants

Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits


Overview of the Purchasing Process

A purchase transaction usually begins with a purchase requisition generated by the user

department. The purchasing department prepares a purchase order that is sent to the vendor. When the goods are received or the

services rendered, a liability is recorded. Finally, the entity pays the vendor.

A purchase transaction usually begins with a purchase requisition generated by the user

department. The purchasing department prepares a purchase order that is sent to the vendor. When the goods are received or the

services rendered, a liability is recorded. Finally, the entity pays the vendor.

Purchase requisition

Purchase requisition

Purchase order

Purchase order

Receivingreport and

liability recorded

Receivingreport and

liability recorded

Vendor


Type of Transaction Account AffectedPurchase Transaction Accounts payable

InventoryPurchases or cost of goods soldVarious asset and expense accounts

Cash disbursement transaction CashAccounts payableCash discountsVarious asset and expense accounts

Purchase return transaction Purchase returnsPurchase allowancesAccounts payableVarious asset and expense accounts

Types of Transactions and Financial Statement Accounts Affected

Three types of transactions are processed Three types of transactions are processed through the purchasing process:through the purchasing process:


Flowchart of the Purchasing Process – EarthWear Clothiers

DepartmentDepartmentRequesting Purchasing IT

Purchaserequisition

Approvedpurchaserequisitionreceived

Input

Errorcorrections

Purchaseorder

program

Purchaseorder file

Accountspayable

master file

Errorreport

Purchaseorder

(4 part)

Purchasing

VendorA/PReceiving

PO #2Filed

Numer-ically



Daily receiving log

DepartmentDepartmentReceiving Accounts Payable (A/P)

PO #1

Goodsreceived,

counted andinspected

Receivingreport (RR)

Enter vendor,quantity, and

PO #

PO #3

Receivingreport

Vendorinvoice

Compare invoiceto PO and RR

Reviewaccount

distribution

Voucherpacket

Input

Errorcorrection

To IT

From IT



DepartmentDepartmentIT

Accountspayableupdate

Purchaseorder file

A/P masterfile

Generalledger file

Errorreport

Input

from A/P

Reportto A/P

A/P reportingWeekly

Monthly

A/P listing

Cashdisbursement

report

Daily

Daily

Monthlyreports

Generalledger

Open PO report

A/P expensedistribution report

Voucher register

Cash disbursementsjournal



To Vendors

DepartmentDepartmentAccounts Payable (A/P) IT Cashier

Cashdisbursement

report

Review documentsand authorize payment

Cashdisbursement

report

Input

A/P masterfile

Cashdisbursement

program

Cheques

Cheques

Review chequesand mail to

vendors

Cheques


Types of Documents and Records

Purchasing documents and records . . .1. Purchase Requisition – request to purchase goods or services.

2. Purchase Order – includes description, quality, and quantity or goods or services being purchased.

3. Receiving Report – records the receipt of goods.

4. Vendor Invoice – the bill from the vendor.

5. Voucher – serves as the basis for recording a vendor’s invoice.

6. Voucher Register – used to record vouchers for goods and services.

7. Accounts Payable Subsidiary Ledger – includes amount owed to individual vendors.

8. Vendor Statement – represents the purchase activity with vendor.

9. Electronic Funds Transfer and Cheques – pays for goods or services.

10. Cash Disbursements Journal – contains columns to record credits to cash and debits to accounts payable and cash discounts.

Purchasing documents and records . . .1. Purchase Requisition – request to purchase goods or services.

2. Purchase Order – includes description, quality, and quantity or goods or services being purchased.

3. Receiving Report – records the receipt of goods.

4. Vendor Invoice – the bill from the vendor.

5. Voucher – serves as the basis for recording a vendor’s invoice.

6. Voucher Register – used to record vouchers for goods and services.

7. Accounts Payable Subsidiary Ledger – includes amount owed to individual vendors.

8. Vendor Statement – represents the purchase activity with vendor.

9. Electronic Funds Transfer and Cheques – pays for goods or services.

10. Cash Disbursements Journal – contains columns to record credits to cash and debits to accounts payable and cash discounts.


The Major FunctionsFunctions of the Purchasing Process

RequisitioningInitiation and approval of requests for goods and services by authorized individuals consistent with management criteria.

PurchasingApproval of purchase orders and proper execution as to price, quantity, quality and vendor.

Receiving Receipt of properly authorized goods and services.

Invoice processingProcessing of vendor invoices for goods and services received; also, processing of adjustments for allowances, discounts and returns.

Disbursements Processing of payment to vendors.

Accounts payableRecording of all vendor invoices, cash disbursements and adjustments in individual vendor accounts.

General ledgerProper accumulation, classification, and summarization of purchases, cash disbursements and payables in the general ledger.


Key Functions and Duties

Segregation of Duties Possible Errors or Fraud

The purchasing function should be segregated from the requisitioning and receiving functions.

If one individual is responsible for the requisition, purchasing, and receiving functions, fictitious purchases can be made. This can result in the theft of goods and possibly payment for unauthorized purchases.

The invoice-processing function should be segregated from the accounts payable function.

If one individual is responsible for the invoice-processing and accounts payable function, purchase transactions can be processed at the wrong price or terms, or a cash disbursement can be processed for goods not received. This can result in overpayment of goods or the theft of cash.

The disbursement function should be segregated from the accounts payable function.

If one individual is responsible for the disbursement function and also has access to the accounts payable records, unauthorized checks supported by fictitious documents can be issued, and unauthorized transactions can be recorded. This can result in theft of the entity's cash.

The accounts payable function should be segregated from the general ledger function.

If one individual is responsible for the accounts payable records and also for the general ledger, that individual can conceal any defalcation that would normally be detected by reconciling subsidiary records with the general ledger control account.


The Key Segregation of Duties

Purchasing and Accounts Payable Purchasing Receiving

Accounts Payable Cashier's IT

Preparation and approval of purchase order XReceipt, counting and inspection

of purchased materials XReceipt of vendor invoices/matching to supporting documents XCoding of account distributions XUpdating of accounts payable records X XPreparation of payments to vendors XElectronic funds transfer, and signing and mailing of cheques XPreparation of the voucher register XReconciliation of voucher register to general ledger X

Department


Inherent Risk Assessment

Industry-Related Factors

1.Is the supply of rawmaterials adequate?

2.How volatile are

raw materialprices?


Inherent Risk Assessment

Misstatements Detected in Prior Audits

Generally, the purchasing process is not difficult to audit and does not present

contentious accounting issues. However, the auditor’s experience in past audits must be considered when assessing inherent risk.

Generally, the purchasing process is not difficult to audit and does not present

contentious accounting issues. However, the auditor’s experience in past audits must be considered when assessing inherent risk.


Control Risk Assessment

Major steps in setting the control risk in the purchasing process.

Understand and document the purchasing process based on a reliance strategy.

Understand and document the purchasing process based on a reliance strategy.

Plan and perform tests of controls of purchase transactions.

Plan and perform tests of controls of purchase transactions.

Set and document the control risk for the purchasing process.

Set and document the control risk for the purchasing process.


Control Risk AssessmentInformation Systems and Communication

For each major class of transactions in the purchasing process, the auditor must obtain the following information:1. How purchase, cash disbursements and purchase return

transactions are initiated.

2. The accounting records, supporting documents and accounts involved in processing purchases, cash disbursements and purchase returns.

3. The flow of each type of transaction from initiation to inclusion in the financial statements, including computer processing.

4. The process used to estimate accrued liabilities.


Control Risk Assessment

After testing controls, the auditor sets the level of control risk. When tests of controls support

the planned level of control risk, no modifications are necessary to detection risk. The auditor may proceed with the substantive

procedures as planned.

When tests do not support the planned control risk, the auditor lowers the level of

detection risk leading to more substantive procedures.

When tests do not support the planned control risk, the auditor lowers the level of

detection risk leading to more substantive procedures.


Control Activities and Tests of Controls – Purchase Transactions

Assertions about Classes of Transactions and Events for the Period under Audit

OccurrenceAll purchases and cash disbursements have been recorded and have occurred and pertain to the entity.

Completeness All purchases and cash disbursements that should have been recorded have been recorded.

AuthorizationAll purchase and cash disbursements are properly authorized.

AccuracyAmounts relating to recorded purchases and cash disbursements have been recorded properly and properly accumulated from journals to ledgers.

Cut-off Purchases and cash disbursements have been recorded in the correct accounting period.

Classification Purchases and cash disbursements have been recorded in the proper account.

OccurrenceAll purchases and cash disbursements have been recorded and have occurred and pertain to the entity.

Completeness All purchases and cash disbursements that should have been recorded have been recorded.

AuthorizationAll purchase and cash disbursements are properly authorized.

AccuracyAmounts relating to recorded purchases and cash disbursements have been recorded properly and properly accumulated from journals to ledgers.

Cut-off Purchases and cash disbursements have been recorded in the correct accounting period.

Classification Purchases and cash disbursements have been recorded in the proper account.


Control Activities and Tests of Controls – Purchase Transactions

Assertions Tests of Controls

Occurrence

Observe and evaluate proper segregation of duties. Test a sample of vouchers for the presence of an authorized purchase order and receiving report. Examine paid vouchers and supporting documents for indication of cancellation.

Completeness

Review procedures for accounting for numerical sequence of purchase orders, receiving reports, and vouchers. Trace a sample of receiving reports to their vendor invoices and vouchers. Trace a sample of vouchers to the purchases journal.

AuthorizationExamine purchase requisitions or purchase orders for proper approval. Review client's competitive bidding process.

Accuracy

Recompute the mathematical accuracy of vendor invoice. Agree information in the sample of vouchers for product, quantity, and price. Examine reconciliation of vouchers to daily accounts payable report.

Cut-offCompare the dates on receiving reports with the dates on the relevant vouchers. Compare the dates of vouchers with the dates they were recorded in the purchases journal.

ClassificationReview purchases journal and general ledger for reasonableness. Examine a sample of vouchers for proper classification.

Assertions Tests of Controls

Occurrence

Observe and evaluate proper segregation of duties. Test a sample of vouchers for the presence of an authorized purchase order and receiving report. Examine paid vouchers and supporting documents for indication of cancellation.

Completeness

Review procedures for accounting for numerical sequence of purchase orders, receiving reports, and vouchers. Trace a sample of receiving reports to their vendor invoices and vouchers. Trace a sample of vouchers to the purchases journal.

AuthorizationExamine purchase requisitions or purchase orders for proper approval. Review client's competitive bidding process.

Accuracy

Recompute the mathematical accuracy of vendor invoice. Agree information in the sample of vouchers for product, quantity, and price. Examine reconciliation of vouchers to daily accounts payable report.

Cut-offCompare the dates on receiving reports with the dates on the relevant vouchers. Compare the dates of vouchers with the dates they were recorded in the purchases journal.

ClassificationReview purchases journal and general ledger for reasonableness. Examine a sample of vouchers for proper classification.


Control Activities and Tests of Controls – Cash Disbursement Transactions

Occurrence of Cash Disbursement Transactions

The auditor is concerned with a misstatement caused by a cash disbursement being recorded in the client’s record when no

payment was made. The primary control activities to prevent such misstatements

include proper segregation of duties, independent reconciliation and review of

vendor statements, and monthly bank reconciliations.

The auditor is concerned with a misstatement caused by a cash disbursement being recorded in the client’s record when no

payment was made. The primary control activities to prevent such misstatements

include proper segregation of duties, independent reconciliation and review of

vendor statements, and monthly bank reconciliations.



Completeness of Cash Disbursement Transactions

The major audit concern is that a cash disbursement is made but not recorded in the

records. The auditor should examine and test the client’s procedures for reviewing vendor

payments lists and reconcile the daily cash disbursements with posting to the accounts

payable subsidiary records.

The major audit concern is that a cash disbursement is made but not recorded in the

records. The auditor should examine and test the client’s procedures for reviewing vendor

payments lists and reconcile the daily cash disbursements with posting to the accounts

payable subsidiary records.



Authorization of Cash Disbursement Transactions

Proper segregation of duties reduces the Proper segregation of duties reduces the likelihood that unauthorized cash disbursements likelihood that unauthorized cash disbursements

are made. The individual who approves a are made. The individual who approves a purchase should not have direct access to the purchase should not have direct access to the

cash disbursement.cash disbursement.

Proper segregation of duties reduces the Proper segregation of duties reduces the likelihood that unauthorized cash disbursements likelihood that unauthorized cash disbursements

are made. The individual who approves a are made. The individual who approves a purchase should not have direct access to the purchase should not have direct access to the

cash disbursement.cash disbursement.



Accuracy of Cash Disbursement Transactions

One of the major audit concerns is that the payment amount is recorded incorrectly. To detect such an error, client personnel should

reconcile the total of electronic cash disbursements transfer and the cheques issued

each day with the daily cash disbursements report.



Cut-off of Cash Disbursement Transactions

The auditor’s tests of controls include reviewing the reconciliation of payments transfers with

postings to the cash disbursements journal and accounts payable subsidiary records. The auditor also tests cash disbursements before and after

year-end to ensure that transactions are recorded in the proper period.



Classification of Cash Disbursement Transactions

The auditor is concerned that a cash The auditor is concerned that a cash disbursement may be charged to the wrong disbursement may be charged to the wrong

general ledger account. The use of a chart of general ledger account. The use of a chart of accounts, as well as independent approval and accounts, as well as independent approval and

review of the account code on the voucher review of the account code on the voucher should provide adequate control.should provide adequate control.

The auditor is concerned that a cash The auditor is concerned that a cash disbursement may be charged to the wrong disbursement may be charged to the wrong

general ledger account. The use of a chart of general ledger account. The use of a chart of accounts, as well as independent approval and accounts, as well as independent approval and

review of the account code on the voucher review of the account code on the voucher should provide adequate control.should provide adequate control.


Control Activities and Tests of Controls – Purchase Return Transactions

Generally, the number and magnitude of purchase return transactions are not material.

The auditor normally does not test controls relating to purchase returns. Substantive testing

is used to test the reasonableness of the amount.


Relating the Assessed Level of Control Risk to Substantive Procedures

If the results of the tests of controls support the If the results of the tests of controls support the achieved level of control risk, the auditor achieved level of control risk, the auditor

conducts substantive procedures at the planned conducts substantive procedures at the planned level. If the results do not support the achieved level. If the results do not support the achieved

level of control risk, the auditor reduces the level of control risk, the auditor reduces the detection risk, which will increase substantive detection risk, which will increase substantive

procedures.procedures.

If the results of the tests of controls support the If the results of the tests of controls support the achieved level of control risk, the auditor achieved level of control risk, the auditor

conducts substantive procedures at the planned conducts substantive procedures at the planned level. If the results do not support the achieved level. If the results do not support the achieved

level of control risk, the auditor reduces the level of control risk, the auditor reduces the detection risk, which will increase substantive detection risk, which will increase substantive

procedures.procedures.


Auditing Accounts Payable and Accrued Expenses

Assertions about Account Balances at the Period End:Existence. Accounts payable and accrued expenses are valid liabilities.

Rights and obligations. Accounts payable and accrued expenses are obligations of the entity.

Completeness. All accounts payable and accrued expenses have been recorded.

Valuation and allocation. Accounts payable and accrued expenses are included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments are appropriately recorded.

Assertions about Account Balances at the Period End:Existence. Accounts payable and accrued expenses are valid liabilities.

Rights and obligations. Accounts payable and accrued expenses are obligations of the entity.

Completeness. All accounts payable and accrued expenses have been recorded.

Valuation and allocation. Accounts payable and accrued expenses are included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments are appropriately recorded.



Assertions about Presentation and Disclosure:Occurrence and rights and obligations. All disclosed events, transactions, and other matters relating to accounts payable and accrued expenses have occurred and pertain to the entity.

Completeness. All disclosures relating to accounts payable and accrued expenses that should have been included in the financial statements have been included.

Classification and understandability. Financial information relating to accounts payable and accrued expenses is appropriately presented and described, and disclosures are clearly expressed.

Accuracy and valuation. Financial and other information relating to accounts payable and accrued expenses are disclosed fairly and at appropriate amounts.



Substantive Analytical ProceduresSubstantive Analytical Procedure Possible Misstatement DetectedCompare payables turnover and days outstanding in accounts payable to previous years' and industry data.

Under- or overstatement of liabilities and expenses.

Compare current-year balances in accounts payable and accruals with prior years' balances.


Compare amounts owed to individual vendors in the current year's accounts payable listing to amounts owed in prior years.


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

Under- or overstatement of purchase returns.


Tests of Details of Transactions, Account Balances and Disclosures

Accuracy

Obtain a listing of accounts payable, foot the listing, and agree it to the general ledger

control account. Selected vouchers or vendor accounts should be traced to the supporting documents or subsidiary accounts payable records to verify the accuracy of the details.



CompletenessThe auditor should conduct a test for unrecorded liabilities that include the following procedures:The auditor should conduct a test for unrecorded liabilities that include the following procedures:1. Ask management about control activities used to identify

unrecorded liabilities at the end of the period.

2. Obtain copies of vendors’ monthly statements and reconcile the amounts to the client’s accounts payable records.

3. Confirm vendor accounts, including accounts with small or zero balances.

4. Vouch large monetary items from the purchases journal and cash disbursements journal for a limited time after year-end.

5. Examine the files of unmatched purchase orders, receiving reports, and vendor invoices for any unrecorded liabilities.

1. Ask management about control activities used to identify unrecorded liabilities at the end of the period.

2. Obtain copies of vendors’ monthly statements and reconcile the amounts to the client’s accounts payable records.

3. Confirm vendor accounts, including accounts with small or zero balances.

4. Vouch large monetary items from the purchases journal and cash disbursements journal for a limited time after year-end.

5. Examine the files of unmatched purchase orders, receiving reports, and vendor invoices for any unrecorded liabilities.



Existence

The auditor’s major concern is whether the recorded liabilities are valid obligations of the entity. The auditor should vouch a sample of items on the listing of accounts payable to

other supporting documents.



Cut-off

The auditor attempts to determine if all purchase transactions are recorded in the

proper period. On most audits, the purchase cut-off is coordinated with the client’s physical inventory count. Proper cut-off should also be determined for purchase return transactions.

The auditor attempts to determine if all purchase transactions are recorded in the

proper period. On most audits, the purchase cut-off is coordinated with the client’s physical inventory count. Proper cut-off should also be determined for purchase return transactions.



Rights and Obligations

There is little risk related to this assertion because clients seldom have an incentive to record liabilities that are not obligations of the

entity.



ValuationAccounts payable are recorded at either the gross amount of the invoice or net of cash discount amount. The valuation of accruals depends upon the type and nature of the

accrued expense. Most accruals are relatively easy to value.



Classification, Presentation and Disclosure

Major classification issues include . . .

1. Identifying and reclassifying any material debits contained in accounts payable.

2. Segregating short-term and long-term payables.

3. Ensuring that different types of payables are properly classified.

Major classification issues include . . .

1. Identifying and reclassifying any material debits contained in accounts payable.

2. Segregating short-term and long-term payables.

3. Ensuring that different types of payables are properly classified.



Disclosure Items for the Purchasing Process

Payables by type (trade, employees, etc.).

Payables by type (trade, employees, etc.).

Short- and long-term payables.Short- and long-term payables.

Long-term purchase contracts, including any unusual purchase commitments.

Long-term purchase contracts, including any unusual purchase commitments.

Purchases from and payables to related parties.

Purchases from and payables to related parties.

Dependence on a single vendor or a small number of vendors.

Dependence on a single vendor or a small number of vendors.

Costs by reportable segment of the business.Costs by reportable segment of the business.


Accounts Payable Confirmation

Accounts payable confirmations are used less often than accounts receivable confirmations.

The auditor is able to examine externally created source documents relating to accounts

payable. When confirmations are used they are usually positive and referred to as blank confirmations. The vendor is asked to supply

the balance owed by the client.

Accounts payable confirmations are used less often than accounts receivable confirmations.

The auditor is able to examine externally created source documents relating to accounts

payable. When confirmations are used they are usually positive and referred to as blank confirmations. The vendor is asked to supply

the balance owed by the client.


Evaluating the Audit Findings

The auditor compares the aggregated identified misstatement to materiality to determine if the identified

misstatement would affect the audit. The auditor requests the client to correct the identified

misstatements and then compares the uncorrected misstatements with materiality to conclude whether the

financial statements are fairly stated.

If uncorrected misstatements in accounts payable, when considered together with other uncorrected misstatements,

are less than materiality, the auditor may accept that the financial statements are fairly presented. Conversely, if the

uncorrected misstatement exceeds the materiality, the auditor should conclude that the financial statements are not

fairly presented.


End of Chapter 11