CHAPTER 8 Acquisition and Expenditure Cycle LEARNING OB ECTI!

E"

Review Checkpoints 1. Identif si!nificant inherent risks in the ac"uisition and expenditure c cle. %escribe the ac"uisition and expenditure c cle, includin! t pical source documents and controls. *ive examples of tests of controls for auditin! the controls over purchase of inventor and services, and disbursement of cash. Explain the importance of the completeness assertion for the audit of accounts pa able liabilities, and list some procedures for a -search for unrecorded liabilities.%iscuss audit procedures for other accounts affected b the ac"uisition and expenditure c cle. Specif some wa s fraud can be found in accounts pa able and cash disbursements. %escribe some common errors and frauds in the ac"uisition and expenditure c cle, and desi!n some audit and investi!ation procedures for detectin! them. 1

Exercises, Problems, and Simulations #1

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"OL#TION" $OR RE!IE% CHEC&POINT"

+.1 0he short2term effect on the financial statements for improperl capitali7in! expenditures is to increase net income because items that should be expensed are included as assets. 0he lon!2term effect is the same because the assets are eventuall char!ed to expense as depreciation. 4 -voucher- is a packa!e of documents, usuall with a cover pa!e. 80he packa!e can be a small envelope.9 0he packa!e2voucher contains supportin! documents for a transaction. :or example, a purchase voucher usuall contains a purchase re"uisition, purchase order, receivin! report, vendor invoice, and a ne!otiable check 8check cop when the vendor invoice has been paid9. Re"uired approvals and si!natures are on the documents. 0he voucher presents evidence of the documentation and control over a transaction. Computer s stems ma have all this documentation on disk. In a voucher s stem, each voucher is -pa able,- and the detail of the pa ables is the vouchers themselves. 4t an time, the compan ma owe a sin!le vendor more than one invoice represented on several vouchers. In a voucher s stem, there is no balance pa able to each vendor;<ust a file of different vouchers pa able. +.& 4 purchasin! mana!er can direct purchases toward vendors who provide the mana!er kick2backs or other inducements. 0his can be prevented b notif in! suppliers that the compan will not permit pa ment of kick2backs to its emplo ees. 0he compan can also rotate purchasin! mana!ers to different vendors. :inall , si!nificant purchases should be reviewed and approved b a hi!her level mana!er. 4 -blind- purchase order is one that does not show the "uantit ordered. It is !iven to the receivin! department so the will know what has been ordered, but the will have to do an independent count. =ou will find evidence about losses on purchase commitments in the open purchase order file. Evidence about unrecorded liabilities to vendors is in the 819 unmatched invoice file, and 8$9 unmatched receivin! report file. 1ana!ement reports that can be used for audit evidence, and information in them can be useful to auditors are as follows> +.) ?pen Purchase ?rders;purchase commitments, losses on purchase commitments @nmatched Receivin! Reports;!oods received but not recorded as purchases or liabilities @nmatched Aendor Invoices;unrecorded invoices, ma represent unrecorded liabilities or items in dispute 4ccounts Pa able 0rial Balance;subsidiar led!er of accounts pa able. 1a show balances b vendors, indicatin! small balances that should be lar!e. Invoice dates ma reveal failure to record invoices late in the accountin! period. Purchases Cournal;listin! of all purchases available for anal sis of purchasin! patterns and oddities. Population for sample of purchases for tests of controls. Inventor Reports 80rial Balance9 ;subsidiar led!er of inventor . Population for sample selection for ph sical observation. Scan it for oddities like ne!ative balances. :ixed 4sset Reports;fixed assets subsidiar led!er trial balance. Scan for ne!ative balances, capitali7ed repairs, and depreciation in excess of salva!e value. %epreciation recalculation.

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0he functions that should be separated to maintain internal control in a purchasin! s stem include 819 custod of the !oods 8receivin! and stores departments9, 8$9 authorit to initiate a transaction 8purchasin! department9, 8&9 bookkeepin! 8accounts pa able department, inventor record2keepin! department9 and 8#9 periodic ph sical counts 8reconciliation9 of inventor and propert assets.

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+.+

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Blank vouchers kept in secure location available onl to authori7ed personnel. Blank supportin! documents 8invoices, receivin! reports, re"uisitions, purchase orders9 kept in secure locations available onl to authori7ed personnel. Supportin! documents cancelled b Cash %isbursement function when checks are prepared. Separation of duties of preparers of supportin! documents, preparation of vouchers, check preparation, and check si!nin!. Aouchers and other supportin! documents reviewed b check si!ners. Checks mailed directl b si!ner and not returned to accounts pa able.

+.,

4 low inherent and control risk would normall result in a strate! where the auditor relies on controls and reduces substantive tests. :irst, the auditor would confirm the low control risk evaluation b testin! controls for effectiveness. *reater reliance would also be placed on anal tical procedures. 3i!h combined inherent and control risk would result in a more substantive approach with little control testin!. 0he purpose of the auditorDs search for unrecorded liabilities is to !ather evidence as to whether the completeness assertion is true. :rom an evidence !atherin! perspective, it is much more difficult to !ather evidence on unrecorded transactions than to !ather evidence that recorded transactions 8and account balances9 are proper. 0he search for unrecorded liabilities includes procedures in other audit areas such as "uestions on bank and insurance confirmations and vouchin! the source of funds for asset additions. :ifteen specific audit procedures in the search for unrecorded liabilities are listed in Chapter +.

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:inancial statement users are most troubled b missin! overstated assets and understated liabilities. 0herefore, the need to audit for the existence of assets and the completeness of liabilities. 0 picall , when auditin! prepaids and accruals the auditor uses audit documentation that shows be!innin! balances, pa ments, expense and endin! balance. B a!reein! be!innin! balance to prior earDs audit documentation, vouchin! pa ments, and calculatin! the accurac of the endin! balance, the auditor knows that the amount char!ed to expense has to be correct Eon current assets such as propert , plant and e"uipment and intan!ibles usuall pertain to all five mana!ement assertions. 0he auditor must ensure that the exist and are owned. In addition, the valuation determined b depreciation, amorti7ation, or impairment char!es, is usuall an important issue. Complex *44P re"uirements make presentation and disclosure an area of concern. ?f the five assertions, completeness is probabl the least important, but it cannot be i!nored. 0he auditor is primaril concerned with current ear transactions in propert , plant and e"uipment accounts, assumin! that the previous earDs balances were audited. 0hus, additions, disposals and depreciation char!es warrant the most attention. 1ost expense accounts can be tested throu!h anal tical review procedures or b testin! them in con<unction with tests of related assets and liabilities 8e.!., depreciation9. Some expenses should be examined separatel because of their uni"ue nature 8e.!. le!al expenses or miscellaneous expense9. 0he followin! are possible -red fla!s- indicatin! a risk of fraud> Photocopies of invoices in the files AendorFs invoices submitted in numerical order AendorFs invoice amounts alwa s in round numbers AendorFs invoices alwa s sli!htl lower than a review threshold Aendors with onl post office box addresses Aendors with no listed telephone number 1atchin! vendor and emplo ee addresses or telephone numbers 1ultiple vendors at the same address and telephone

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+.1)

0he auditor should be!in with in"uir of the client about their knowled!e of fraud or fraud risks. 4nal tical review procedures such as vertical and hori7ontal anal ses can pinpoint accounts that appear to have unusual fluctuations. Examinin! invoices and vendor files for the red fla!s noted above will help find phon billin!s. 0he purpose is to identif fraud risk, evaluate the si!nificance of the risk and determine the amounts of an actual fraud on the financial statements. 0hese procedures are directed at misappropriation of assets b embe77lement. Emplo ees and their associates are stealin! assets from the compan b havin! it pa phon expenses. 4r!us did not have separation of duties. %ifferent people should have authori7ed the cop in! services, and approve the bills for pa ment, and codin! them to pro<ects. 4 supervisor should have been reviewin! the expenses and comparin! them to the bud!et. 0he verbal in"uir procedure mi!ht produce knowled!e of emplo eeDs responsibilities to authori7e purchases of script copies, receive them, approve pa ment, and code invoices to pro<ects. *iven Beta 1a!neticDs poor internal controls, it is possible that 1artha would never have been cau!ht. 3owever, if the compan ever contacted emplo ees about their health claims, the would have revealed the fictitious char!es. Controls should be the same as for an other vendor, except that time cards replace receivin! reports. Someone should have responsibilit for reviewin! and approvin! char!es and comparin! costs to the bud!et. Pa ments should not be made without supportin! documentation, includin! approved time cards.

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"OL#TION" $OR '#LTIPLE(CHOICE )#E"TION"

+.$& a. b. c. d. +.$# a. b. c. d. +.$' a. b. c. a. b. c. d. Incorrect Incorrect Correct Incorrect Correct Incorrect Incorrect Incorrect Incorrect Incorrect Correct Correct Incorrect Incorrect Incorrect Cash disbursements are an important part of the c cle 4lthou!h similar to sales because the are shipped out, purchase returns are considered part of the 4c"uisition and Expenditure c cle because the affect accounts pa able. 4lthou!h similar to purchases because the re"uire a receivin! report, sales returns are considered part of the Revenue and Collection c cle because the affect accounts receivable. Prepaid Insurance is one of the man accounts in the 4c"uisition and Expenditure C cle. Cost of *oods Sold should be matched with Sales b usin! inventor to record cost of !oods not et sold. Research and %evelopment is a period expense that is recorded as incurred. %epreciation is normall also a period expense, except in the unusual situation where units2of2production depreciation is used. Sales are recorded when earned. overstates net income in the period of capitali7ation overstates net income. 0his has no effect on net income. It overstates cash and pa ables. 0he completeness assertion is ver important in the audit of liabilities. 0his would restrict a compan Ds abilit to do business. 4uditors are normall not concerned with who the clientDs vendors are. Competitive bids are normall re"uired for onl lar!e purchases.

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+.$)

a. b. c. d. a. d.

Incorrect Incorrect Incorrect Correct Incorrect Correct

0hese duties should be separated. 0his would not necessaril prevent a duplicate pa ment. 0he voucher date ma be several weeks before the pa ment is due. Cancellation 8-paid-9 of vouchers prevent their use a second time. 0he re"uisition would not result in the improper deliver . Eobod at 5ake was reviewin! purchase orders to notice the deliver and pa ment b another part 8BuddDs relativeDs store9. 0his deviation caused no direct loss to 5ake, but it is a misuse of 5akeDs pricin! a!reements with its vendors and puts 5ake at risk. If the liabilit is unrecorded, it would not be on the trial balance. 4uditors ma be able to determine that cash disbursements in the subse"uent period are pa in! liabilities of the period under audit. 0his is a cut2off test. b is a more direct test 0his is onl an indirect test. b is a more direct test. 0his is often performed before the balance sheet date. 0his is often performed before the balance sheet date. 0he search for unrecorded liabilities !enerall depends upon usin! accountin! records created in the period after the ear end. 0his is often performed before the balance sheet date. Some liabilities ma be incurred but not invoiced b the vendor. Purchase orders do not normall incur liabilities. 0he receivin! reports are the population that contains the record of all !oods received for which liabilities should be recorded. If the liabilit wasnDt recorded, a check wouldnDt be issued. 4pprovals do not necessaril result in debits to the inventor . Purchase re"uisitions ma not represent the actual amount received. Invoices suppl relevant information about the "uantities purchased and the prices paid. Purchase orders ma not represent the actual amount received. 0his would have insured a proper count of the tables. 0his would insure the invoice was for the amount received. 0his would insure the check was for the amount received. 0he P. ?. and re"uisition would both show +# tables. 0he check si!ner is probabl not familiar with all the vendors. 0his is possible, but the maintenance costs ma not have been unusual 8i.e., the costs before the fraud were below bud!et9 Aendors should be approved b an independent purchasin! department. Pa roll is !enerall audited b tests of controls, anal tical procedures and substantive tests of transactions. Cost of !oods sold is !enerall audited b tests of controls, anal tical procedures and substantive tests of transactions. Supplies expense is !enerall audited in connection with supplies inventor . 0he auditor examines the specific char!es to determine potential liti!ation.

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+.&(

a. b. c. d.

Correct Incorrect Incorrect Incorrect

Propert tax expense is audited in con<unction with accrued propert taxes. Pa roll is !enerall audited b tests of controls, anal tical procedures and substantive tests of transactions. 0hereDs no asset directl related to RG%. 0he auditor examines the specific char!es to determine potential liti!ation.

"OL#TION" $OR E*ERCI"E"+ PROBLE'"+ AN, "I'#LATION"

+.&) Payable ICQ Items: Assertions, Tests of Controls, and Possible Errors or Frauds. 1. a. b. c. d. Purchases and accounts pa able are authori7ed accordin! to compan polic 8proper authori7ation9. :or a sample of cash disbursements, vouch to approval si!natures on invoices, receivin! reports and purchase orders. 5iabilities mi!ht be incurred in the compan Ds name without the knowled!e of responsible officers. Select a sample of current2 ear debits in accounts 8e.!., inventor , fixed assets, expenses9, and vouch them to supportin! documents attestin! to the compan Ds business purpose for the transaction. 5iabilities are recorded at the appropriate "uantit and description 8valuation9 Select a sample of invoices and a!ree them to the receivin! report. ?bserve receivin! department countin! receipts. Aendors could bill for "uantities !reater than the amount actuall shipped, overstatin! costs or expenses. ?bserve the clientDs inventor account and test the reconciliation of the count to the perpetual inventor . 5iabilities are recorded for actual purchases at the appropriate amounts 8sound error checkin! practices for occurrence and valuation9. ?bserve client personnel makin! comparisons. Examine initials for approval. Review correctin! <ournal entries that result from the comparison. Purchases or other liabilities ma be recorded for transactions that didnDt exist or at incorrect amounts. Reperform comparison on a test basis. Cournal entries are authori7ed and prepared in accordance with !enerall accepted accountin! principles 8presentation and disclosure9. Examine entries for approval initials. 0he compan mi!ht override controls to create fraudulent entries. Select a sample of recorded <ournal entries and reperform calculations and review for appropriate accounts.

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+.&+

Unrecorded Liabilities Procedures a. 0he fact that the client made a <ournal entr to record vendorsD invoices which were received late should simplif the CP4Ds audit for unrecorded liabilities and reduce the possibilit of a need for a further ad<ustment, but the CP4Ds audit is nevertheless re"uired. If the client has not <ournali7ed late invoices, the CP4 is compelled in his testin! to substantiate what will ultimatel be recorded as an ad<ustin! entr . In this examination the CP4 should audit entries in the voucher re!ister for the ear bein! audited to ascertain that all items which accordin! to dates of receivin! reports or vendorsD invoices were applicable to that ear have been included in the <ournal entr recorded b the client. Eo. 0he CP4 should obtain a letter in which responsible executives of the clientDs or!ani7ation represent that to the best of their knowled!e all liabilities have been reco!ni7ed. 3owever, this is done as a normal audit procedure to afford additional assurance to the CP4 and it does not relieve the responsibilit for doin! other substantive audit work. Hhenever a CP4 is <ustified in rel in! on work done b an internal auditor, he or she should curtail 8but not eliminate9 his or her own audit work. In this case, the CP4 should have ascertained earl in the examination that ?7ineDs internal auditor is "ualified b bein! both technicall competent and reasonabl independent. ?nce satisfied as to these points, the CP4 should discuss the nature and scope of the internal audit pro!ram with the internal auditor and review the workin! papers in order that the CP4 ma properl coordinate the audit pro!ram with that of the internal auditor. If the ?7ine internal auditor is "ualified and has made tests for unrecorded liabilities, the CP4 ma reduce further audit work in this audit area. In addition to the next2 ear voucher re!ister, the CP4 should consider the followin! sources for possible unrecorded liabilities> 1. $. &. #. '. (. ). +. ,. 1.. 11. 1$. @nentered vendorsD invoice file. Status of tax returns for prior ears still open. %iscussions with emplo ees. Representations from mana!ement. Comparison of account balances with precedin! ear. Examination of individual accounts durin! the audit. Existin! contracts and a!reements. 1inutes. 4ttorne Ds bills and letter of representation. Status of rene!otiable business. Correspondence with principal suppliers. 4udit testin! of cutoff date for reciprocal accounts, e.!., inventor and fixed assets.

b.

c.

d.

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Accounts Payable Confirmations a. 0he accounts pa able audit procedures should be directed toward searchin! for proper inclusion of all accounts pa able and ascertainin! that recorded amounts are reasonabl stated because the primar audit purpose is to reveal an possible material understatements. 0he principal ob<ectives of the accounts pa able examination are 1. $. &. b. 0o determine ade"uac of internal control for processin! and pa ment of invoices. 0o prove that amounts shown on the balance sheet are in a!reement with supportin! accountin! records. 0o determine that liabilities existin! at the balance sheet date have been recorded.

Clark and Ient are not re"uired to use accounts pa able confirmation procedures. :or accounts pa able the auditor can examine external evidence such as vendor invoices and vendor statements that substantiate the accounts pa able balance. 4lthou!h not re"uired, the accounts pa able confirmation is often used. 0he auditor mi!ht consider such use when 1. $. &. #. '. (. Internal controls are weak. 0he compan is in a -ti!ht- cash position and bill2pa in! is slow. Ph sical inventories exceed !eneral led!er inventor balances b si!nificant amounts. Certain vendors do not send statements. Aendor accounts are pled!ed b assets. Aendor accounts include unusual transactions.

c.

Hhen auditin! accounts pa able the auditor is primaril concerned with the possibilit of unrecorded pa ables or understatement of recorded pa ables. Selection of accounts with relativel small or no balances for confirmation is the more efficient direction of testin! since understatements are more likel to be detected when examinin! such accounts. Hhen selectin! accounts pa able for confirmation, the followin! procedures could be followed> 1. $. &. #. '. (. ). +. 4nal 7e the accounts pa able population and stratif it into accounts with lar!e balances, accounts with small balances, accounts with 7ero balances, etc. @se a samplin! techni"ue that selects items based on criteria other than the dollar amount of the items 8e.!., select based on terminal di!its, select ever nth item based on predetermined interval, etc9. %esi!n a statistical samplin! plan that will place more emphasis on selectin! accounts with 7ero balances or relativel small balances, particularl when the client has had substantial transactions with such vendors durin! the ear. Select prior2 ear vendors who are no lon!er used. Select new vendors used in the subse"uent ears. Select vendors that do not provide periodic statements. Select accounts reflectin! unusual transactions durin! the ear. Select accounts secured b pled!ed assets.

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Searc for Unrecorded Liabilities !List of substanti"e #rocedures$ 1. Scan the open purchase order file at ear2end for indications of material purchase commitments at fixed prices. ?btain current prices and determine whether an ad<ustments for loss and liabilit for purchase commitments are needed. 5ist the unmatched vendor invoices and determine when the !oods were received, lookin! to the unmatched receivin! report file and receivin! reports prepared after the ear2end. %etermine which invoices, if an , should be recorded. 0race the ear2end unmatched receivin! reports to accounts pa able entries, and determine whether ones recorded in the next accountin! period need to be ad<usted to report them in the current accountin! period under audit. Select a sample of cash disbursements from the accountin! period followin! the balance sheet date. Aouch them to supportin! documents 8invoice, receivin! report9 to determine whether the related liabilities were recorded in the proper accountin! period. Stud IRS examination reports for evidence of income or other taxes in dispute, and decide whether actual or estimated liabilities need to be recorded. Confirm accounts pa able with vendors, especiall re!ular suppliers showin! small or 7ero balances in the ear2end accounts pa able. 0hese are the ones most likel to be understated. 8AendorsD monthl statements controlled b the auditors also ma be used for this procedure.9 Be sure to verif the vendorsD addresses so confirmations will not be misdirected, perhaps to conspirators in a scheme to understate liabilities. Stud the accounts pa able trial balance for indications of dates showin! fewer pa ables than usual recorded near the ear2end. 84 financial officer ma be dela in! the recordin! of vendor invoices.9 @se a checklist of accrued expenses to determine whether the compan has been conscientious about expense and liabilit accrualsJ includin! accruals for wa!es, interest, utilities, sales and excise taxes, pa roll taxes, income taxes, real propert taxes, rent, sales commissions, ro alties, and warrant and !uarantee expense. Hhen auditin! the details of sales revenue, pa attention to the terms of sales to determine whether an amounts should be deferred as unearned revenue. In"uiries directed to mana!ement about terms of sales can be used to obtain initial information, such as in"uiries about customersD ri!hts of cancellation or return. 0he terms ma si!nal the need for deferred revenue accountin!. 4ppl anal tical procedures appropriate in the circumstances. Calculate and compare the !ross mar!in percent of the current ear to prior ear8s9, and compare important expense account balances to prior ears to notice an that this ear appear to be too low.

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PU%C&ASI'( STA%S: Purc asin) *ic+bac+s In this case, let our initial ob<ective be to select one vendor for investi!ation. Instead of a -tests of controls- section, name the one vendor ou would select from those in Exhibit +.#121 and tell our reasons. In the -test of balances- section, tell how ou would investi!ate the situation. In the -discover summar section, speculate about how our investi!ation mi!ht reveal the culprit. AU,IT APP%-AC& ?b<ective> Select one vendor for investi!ation, and tr to obtain evidence of purchasin! at inflated prices. Control> Purchasin! operations should be performed under rules and procedures desi!ned to motivate purchasin! a!ents to bu at the best prices available from competin! vendors. Competitive biddin! should be re"uired unless conditions make the best prices available without bid. 3owever, purchasin! a!ents should have flexibilit within operatin! procedures to move "uickl to obtain the best balance of "uantities, deliver terms, and prices as events dictate. 0hus the ma not alwa s obtain competitive bids. 4 hi!her mana!er level should supervise and review the results of purchasin! activit on a re!ular basis, perhaps reperformin! some price2obtainin! actions occasionall to determine whether the a!ents are achievin! efficienc . Such review mi!ht also involve selectin! odd situations for extensive review. 0ests of Controls> 0he one vendor selected is ?rion Corp. Ie reasons for this selection are> Aolume is hi!h and has increased almost 1...K, more than an 5ast bid was obtained last ear, older than other vendorsD bids. 0he percent purchased on bid is lowest amon! those bid. Collins, the mana!er, is in char!e. Collins purchases from several vendors without bids. other vendor

4udit of Balance> Investi!ation of purchases from ?rion> a. b. c. d. e. f. !. h. Review purchase invoices to determine unit prices for paper. Compare unit prices with other suppliers. Interview other suppliers and their salespersons to tr to determine whether Collins solicited kickbacks. Review bid records to determine the dates of submitted bids and bid prices. Examine CollinsD personnel file. Investi!ate references if the were not consulted earlier. 1i!ht investi!ate a!ain with more determination to notice telltale si!ns. Conduct interviews with Collins and other purchasin! a!ents under a front of learnin! about purchasin! procedures. Carefull seek information or impressions about Collins relations with ?rion. In"uire at secretar of state office for names of ?rion incorporators to see if Collins is connected. 5ook up officers in national executives director to see if she is listed as an officer of ?rion. Covertl observe CollinsD lifest le and spendin! habits. 4 ruse mi!ht be used to !et information about CollinsD bank balance and activit . 8?vert action such as subpoena should not be used until clear evidence of !uilt is available.9

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PU%C&ASI'( STA%S: Purc asin) *ic+bac+s !Continued$ ,ISC-.E%/ SU00A%/ If Collins is takin! kickbacks in return for causin! Baile to pa hi!her prices, the price comparison information should show evidence. If this is the case, the other procedures should also bear fruit;past emplo ment histor problems, police record, dero!ator !ossip from coworkers, more wealth than <ustified b salar , ma be even a direct connection with ?rion. Collins has plent of -room- to cause Baile a si!nificant financial drain. Purchases from ?rion were L1,$$.,... over the last two ears, and about L'..,... of supplies and sundries without bid from other suppliers. If the overpricin! to Baile were 1.K on all these purchases, it could amount to L1)$,... for two earsD -work.P.S. 0he title of the case -Purchasin! Stars- is a clue to the solution 8?rion9

+.#$

(rounds for ,ismissal AU,IT APP%-AC& ?b<ective> 0o detect fraudulent hirin! of consultin! firm. Control> 0he control should have been approval b someone above %oeDs level. Pa ments should not have been made without such approval. 4fter bein! si!ned, checks should be mailed directl from the treasurerDs office. 0est of Controls> Examine disbursements for indication of authori7ation. Endorsements on checks can be examined for double si!natures. 4udit of Balance> 0ests of char!es to the capital account should reveal the lar!e amount of expenses bein! capitali7ed. In addition to vouchin! these char!es, auditors should in"uire about whether the are properl capitali7ed as lon!2term assets. ,ISC-.E%/ SU00A%/ Compan emplo ees in char!e of capital pro<ects be!an noticin! the lar!e char!es. In 1arch $..1 %oe and her husband were named in a L$.# million civil <ud!ment, the lar!est fraud in the histor of Iin! Count , Hashin!ton. 0he settlement re"uired a list of possession the %oes had ac"uired. 0he 1,2pa!e list contained #+, items. Cars, pianos, and other items were sold at auction and netted 0he Coffee Co. about L1.+ million. %oe was a compulsive shopper. 0he police reported there was onl a small path throu!h the rooms of her house, with boxes of her purchases stacked to the ceilin!. Red fla!s that should have tipped off her supervisor and co2workers included> %oe was evasive and never satisfactoril answered "uestions about :CC. Hhen the supervisor asked to meet with :CC he was told the were workin! out of the office. :CC was not re!istered in the State of Hashin!ton or listed in telephone directories. :CCDs mailin! address was a P.?. box. 0he ph sical address was %oeDs residence. %oe re"uested special handlin! for :CC checks whereb , she picked them up personall .

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+.#&

Audit Simulation11Audit t e Fi2ed Asset and ,e#reciation Sc edule 8a9 0he Computer B s stem is depreciated for a full ear 8L'+&,...9, but depreciation should be calculated for onl + months. Correct amount is L&+,,.... 0he depreciation on the Press should be L)',... instead of L1'.,.... Somebod doubled the depreciation expense for this ear. 4ccumulated %epreciation Cost of *oods Sold Inventor *eneral and 4dmit Expense 8b9 5ist two audit procedures for auditin! the fixed asset additions. 0he best wa to approach this re"uirement is to write a procedure for each assertion. Buildin! $> Existence> Inspect the buildin! to determine that it is -in productive use- 8evidence of existence9. Ri!hts 8?wnership9> Aouch the le!al title papers and recorded deed for evidence of ownership. Aaluation> Aouch the contractorDs billin!s and the pa ments for evidence of appropriate cost valuation. Presentation and %isclosure> Stud an related loan a!reements for pled!e as securit for loans in relation to necessar disclosure. Inspect insurance policies for evidence of ade"uate insurance 8inade"uate insurance ma re"uire disclosure9. Completeness> Inspect Buildin! 1 and make in"uiries about whether an part of it has been sold or leased since the new buildin! was occupied 8evidence of completeness of recordin! of dispositions, if an 9. Computer B s stem. Existence> Inspect the computer and observe it in operation 8existence9 Ri!hts 8?wnership9 and Aaluation> Aouch purchase and title documents 8ownership and cost valuation9. Presentation and %isclosure> Stud an related loan a!reements for pled!e as securit for loans in relation to necessar disclosure. Inspect insurance policies for evidence of ade"uate insurance 8inade"uate insurance ma re"uire disclosure9. Completeness> Aouch expenses in the repairs and maintenance accounts 8or similar accounts9 for installation and testin! costs that should be capitali7ed 8evidence of completeness of recordin! asset cost9. 4uto $ Existence> Inspect the auto and observe it in operation 8existence9. Ri!hts 8?wnership9 and Aaluation> Aouch purchase and title documents 8ownership and cost valuation9. $(,,... (),'.. ),'.. 1,#,...

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+.#&

Audit Simulation11Audit t e Fi2ed Asset and ,e#reciation Sc edule !#art b, Continued$ Presentation and %isclosure> Stud an related loan a!reements for pled!e as securit for loans in relation to necessar disclosure. Inspect insurance policies for evidence of ade"uate insurance 8inade"uate insurance ma re"uire disclosure9. Insurance ma be re"uired for lawful operation. In"uire about its useJ if b executive officers, it ma need to be reported as compensation in the prox statement 8public companies9. Completeness> Aouch expenses in the repairs and maintenance accounts 8or similar accounts9 for t pical additional costs 8e.!. tax, title, and license9 that should be capitali7ed 8evidence of completeness of recordin! asset cost9. 8c9 0he loss on the sale of the Computer 4 s stem should be L'#$,... 8L',...,... 2 L&,,'+,... 2 L'..,...9. 0he !ain on the sale of 4uto 1 8full depreciated9 should be L1,.... 0he cash flow from investin! activities should show cash inflow from sale of assets in the amount of L'.1,.... 0here should be cash outflow for purchase of assets in the amount of L L#','$$,....

+.##

Pro#erty and E3ui#ment Assertions and Substanti"e Audit Procedures 1. 5e!al ri!ht evidence> %. $. Examine deeds and title insurance certificates.

Existence evidence> *. Ph sicall examine all ma<or propert and e"uipment additions.

&.

Aaluation evidence> B. Review the provision for depreciation expense and determine whether depreciable lives and methods used in the current ear are consistent with those used in the prior ear.

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+.#'

Assertions and Substanti"e 4alance1Audit Procedures for Pro#erty, Plant, and E3ui#ment !P, P5E 9 Aaluation Existence Aaluation Aaluation Aaluation and 4llocation Aaluation Existence Existence Ri!hts Presentation and %isclosure Completeness Aaluation and 4llocation Aaluation and 4llocation Presentation and %isclosure Presentation and %isclosure Ri!hts and ?bli!ations Presentation and %isclosure Ri!hts Presentation and %isclosure Aaluation Presentation and %isclosure 1. $. &. #. :or ma<or amounts char!ed to P,PGE and a sample of smaller char!es examine, supportin! documentation for expenditure amounts, bud!etar approvals, and capital work orders. :or a sample of capitali7ed P, PGE examine construction work orders in detail. :or the sample of construction work orders, vouch time and material char!es to supportin! pa roll and material usa!e records. Review the reasonableness of the hours worked, the work description, and the material used. Evaluate the polic and procedures for allocatin! overhead to the work orders and recalculate their application. %etermine that correspondin! retirements of replaced P,PGE have been made and properl accounted entered in the detail records. Select ma<or additions for the ear and a random sample of other additions, and inspect the ph sical assets. %iscuss plant operations with responsible operatin! personnel. In"uire about capitali7ation policies and the use of leased assets. Aouch a sample of char!es in the Repairs account and determine whether the are proper repairs and not capital items. Review the useful lives, depreciation methods, and salva!e values for reasonableness. Recalculate depreciation. ?btain written mana!ement representations about assets pled!ed as securit for loans. Stud loan documents for terms and securit of loans obtained for purchase of P,PGE. Stud lease a!reements to determine proper *44P accountin! for lease obli!ations. Inspect title documents for automotive and real estate assets. Stud insurance policies to determine whether P, PGE is ade"uatel insured for casualt loss. 4nal 7e the productive economic use of P,PGE to determine whether an other2than2temporar impairment is evident.

'. (. ). +. ,. 1.. 11.

1$. 1&. 1#. 1'.

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+.#(

CAATTS A##lication6P, P5E a. 0he information needed to reconcile subsidiar detail records to !eneral led!er balances> 4sset t pe 5ocation code Cost 4ccumulated depreciation, end of ear 0he task of footin! the subsidiar led!er and comparin! the recalculation to the !eneral led!er balance8s9 does not complete the audit of fixed assets. 4dditional evidence is needed to be persuaded of existence of the assets 8observation9, valuation 8vouchin! invoices, recalculatin! depreciation9, completeness 8vouchin! and tracin! transactions dated around the ear2end9, presentation and disclosure 8in2use2status, in"uiries about h pothecation, liens9. b. 0he assistant will also need to know the asset number, description, as well as 4sset 0 pe and 5ocation Code mentioned in 8a9 above.

+.#)

Searc for Unrecorded Liabilities 4. 4udit Pro!ram 1 $ & # ' ( ?btain a trial balance of recorded accounts pa able as of ear2end. Send confirmations to creditors with small or 7ero balances and those with whom the compan has done si!nificant business. 4sk client personnel about their procedures for ensurin! that all liabilities are recorded. ?btain a list of unmatched vendor invoices and determine when the !oods were received. 0race the unmatched receivin! reports to accounts pa able, and determine whether items recorded in the next accountin! period need to be ad<usted. Select a sample of cash disbursements from the accountin! period followin! the balance sheet date. Aouch them to supportin! documents 8invoice, receivin! report9 to determine whether the related liabilities were recorded in the proper accountin! period.

B.

4d<ustin! Cournal Entr Aouchers Pa able Rent Expense L'&,... L'&,...1

0o reverse Canuar rent expense recorded in %ecember 1iscellaneous expense Cost of *oods Sold ?ffice expense Aouchers Pa able 0o record unrecorded liabilities.
1 $

L(,&..... 1$,++,.(( +,(##.+($ L$),+&#.'$

1a omit if students assume the char!e was made to prepaid rent. Includes unbilled amount for %ecember

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+.#+ *a#lan CPA E2am Simulation6-btainin) E"idence6Sales and E2#ense

-#tion 0rue

Procedure Evidence supportin! the valuation of sales returns will be !ained via the audit procedures for accounts receivable. Specificall , audit procedures for the allowance for doubtful accounts should reveal an material misstatements of sales and6or sales returns. Aouchin! expenses performed as part of the search for unrecorded liabilities will onl uncover an material misclassifications of expenses that occurred durin! the ear and were paid subse"uent to ear end. 0o !ain assurance that expenses were not misclassified for the entire ear, the auditor must vouch a sample of expenses based on materialit levels. 4n unexplained increase in the !ross profit ratio ma su!!est the presence of unrecorded expenses in C?*S since unrecorded expenses would understate total expenses and falsel increase the profitabilit ratios 8i.e., net income9. 4mberl Fs bill and hold transactions ma increase audit risk because such transactions ma result in sales bein! overstated at ear end. Bill and hold transactions usuall involve sellin! products for lar!e discounts to retailers and holdin! them 8perhaps in third2part warehouses9 to be delivered at a later date. Clearl the risk is of prematurel recorded or uncollectible sales.

:alse

0rue

:alse

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+.#,

*a#lan CPA E2am Simulation6Accounts Payable Confirmations 1. :alse Confirmations should be sent to all vendors re!ardless of whether a pa able is recorded since the ob<ective is to search for unrecorded items that ma have resulted in an understatement of accounts pa able. *iven the (.2da pa ment terms, Southland will probabl not pa some of its vendor balances relatin! to the end of =ear 1 b the completion of fieldwork on :ebruar 1' of =ear $. 0herefore, sendin! vendor confirmations earl ma provide timel evidence to corroborate the accounts pa able balance. Since the emphasis is on detectin! understated pa ables, materialit is a less important or even irrelevant factor when determinin! which vendor accounts should be confirmed. %isputed accounts are !enerall included in the auditorFs confirmation sample. Hhether le!al action has been taken a!ainst the client is irrelevant to the confirmation procedure. Because of the 1#2da pa ment terms, Eorth River will have likel paid their invoices open at %ecember &1, =ear 1 prior to the start of the audit field work in :ebruar , =ear $. 0herefore, the review of subse"uent pa ments is the most effective procedure to !ather evidence for the accounts pa able assertions, includin! completeness. Since the control risk was assessed as low, it ma be appropriate to confirm the Southland accounts pa able at an interim date. 0his is to ensure that control risk was appropriatel assessed as low and that the internal controls are operatin! effectivel . Confirmations provide evidence supportin! the obli!ation and ri!hts assertion since all accounts pa able are considered obli!ationsJ the are liabilities. 0o substantiate both the completeness and the existence assertions, vendor balances to be confirmed should be selected from SouthlandFs list of vendors. Selectin! vendors from the ear2end pa ables listin! onl addresses the existence assertion.

$.

0rue

&.

0rue

#.

:alse

'.

:alse

(.

0rue

). +.

0rue :alse

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+.'.

*a#lan CPA E2am Simulation6-btainin) E"idence6Accounts Payable 1. ). &. E E 4 Eo ad<ustment is necessar since the item is properl included in accounts pa able at the end of =ear 1. 0he telephone service period was for =ear 1. Eo ad<ustment is necessar since the electrical supplies were received in =ear 1 and properl included in accounts pa able at the end of =ear 1. 4n ad<ustment is necessar since no liabilit for the insurance premium is recorded at the end of =ear 1. 4n ad<ustment should be made to record the one2month 81$616=1 M 1$6&16=19 insurance expense included in the service period. Eo ad<ustment is necessar since the item is properl excluded from accounts pa able at the end of =ear 1. 0he feed inventor was not received until =ear $ and because it was also a one2time deal, there is no !uidin! precedent in terms of determinin! when the liabilit was actuall incurred. 0hus, based on the facts, Southland has E?0 likel incurred a le!al obli!ation to pa until =ear $ when the inventor was received. In this case, the invoice date of 1$6$,6=1 is not relevant to Southland in terms of determinin! when the liabilit was incurred. 4n ad<ustment is necessar since no liabilit for the inventor is recorded at the end of =ear 1. It was noted that the inventor was received b Southland prior to the end of =ear 1 on 1$6&.6=1, so a liabilit should have been recorded at that time. Expenses are overstated since the item should have been capitali7ed. Eo ad<ustment is needed to accounts pa able since it is properl included at the end of =ear 1. 4s it is currentl recorded b Southland, accounts pa able and inventor are overstated b L,,&.., the amount of the second shipment that was not received until after the end of =ear 1. Eo ad<ustment is necessar since the item is properl included in accounts pa able at the end of =ear 1. 0he water service period was for =ear 1.

#.

E.

+.

(.

C.

$.

B.

'.

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