CHAPTER 8 Acquisition and Expenditure Cycle LEARNING OBJECTIVES

Review Checkpoints 1. Identify significant inherent risks in the acquisition and expenditure cycle. Describe the acquisition and expenditure cycle, including typical source documents and controls. Give examples of tests of controls for auditing the controls over purchase of inventory and services, and disbursement of cash. Explain the importance of the completeness assertion for the audit of accounts payable liabilities, and list some procedures for a "search for unrecorded liabilities." Discuss audit procedures for other accounts affected by the acquisition and expenditure cycle. Specify some ways fraud can be found in accounts payable and cash disbursements. Describe some common errors and frauds in the acquisition and expenditure cycle, and design some audit and investigation procedures for detecting them. 1

Exercises, Problems, and Simulations 41

2.

2, 3, 4, 5, 6

37

3.

7, 8, 9

37

4.

10, 11

38, 39, 40, 47, 49, 50

5.

12, 13, 14, 15,

42, 44, 45, 46, 48

6.

16, 17, 18

37, 41, 42

7.

19, 20, 21, 22

37, 41, 42

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SOLUTIONS FOR REVIEW CHECKPOINTS

8.1 The short-term effect on the financial statements for improperly capitalizing expenditures is to increase net income because items that should be expensed are included as assets. The long-term effect is the same because the assets are eventually charged to expense as depreciation. A "voucher" is a package of documents, usually with a cover page. (The package can be a small envelope.) The package-voucher contains supporting documents for a transaction. For example, a purchase voucher usually contains a purchase requisition, purchase order, receiving report, vendor invoice, and a negotiable check (check copy when the vendor invoice has been paid). Required approvals and signatures are on the documents. The voucher presents evidence of the documentation and control over a transaction. Computer systems may have all this documentation on disk. In a voucher system, each voucher is "payable," and the detail of the payables is the vouchers themselves. At any time, the company may owe a single vendor more than one invoice represented on several vouchers. In a voucher system, there is no balance payable to each vendorjust a file of different vouchers payable. 8.3 A purchasing manager can direct purchases toward vendors who provide the manager kick-backs or other inducements. This can be prevented by notifying suppliers that the company will not permit payment of kick-backs to its employees. The company can also rotate purchasing managers to different vendors. Finally, significant purchases should be reviewed and approved by a higher level manager. A "blind" purchase order is one that does not show the quantity ordered. It is given to the receiving department so they will know what has been ordered, but they will have to do an independent count. You will find evidence about losses on purchase commitments in the open purchase order file. Evidence about unrecorded liabilities to vendors is in the (1) unmatched invoice file, and (2) unmatched receiving report file. Management reports that can be used for audit evidence, and information in them can be useful to auditors are as follows: 8.7 Open Purchase Orderspurchase commitments, losses on purchase commitments Unmatched Receiving Reportsgoods received but not recorded as purchases or liabilities Unmatched Vendor Invoicesunrecorded invoices, may represent unrecorded liabilities or items in dispute Accounts Payable Trial Balancesubsidiary ledger of accounts payable. May show balances by vendors, indicating small balances that should be large. Invoice dates may reveal failure to record invoices late in the accounting period. Purchases Journallisting of all purchases available for analysis of purchasing patterns and oddities. Population for sample of purchases for tests of controls. Inventory Reports (Trial Balance) subsidiary ledger of inventory. Population for sample selection for physical observation. Scan it for oddities like negative balances. Fixed Asset Reportsfixed assets subsidiary ledger trial balance. Scan for negative balances, capitalized repairs, and depreciation in excess of salvage value. Depreciation recalculation.

8.2

8.4 8.5

8.6

The functions that should be separated to maintain internal control in a purchasing system include (1) custody of the goods (receiving and stores departments), (2) authority to initiate a transaction (purchasing department), (3) bookkeeping (accounts payable department, inventory record-keeping department) and (4) periodic physical counts (reconciliation) of inventory and property assets.

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8.8

1. 2. 3. 4. 5. 6.

Blank vouchers kept in secure location available only to authorized personnel. Blank supporting documents (invoices, receiving reports, requisitions, purchase orders) kept in secure locations available only to authorized personnel. Supporting documents cancelled by Cash Disbursement function when checks are prepared. Separation of duties of preparers of supporting documents, preparation of vouchers, check preparation, and check signing. Vouchers and other supporting documents reviewed by check signers. Checks mailed directly by signer and not returned to accounts payable.

8.9

A low inherent and control risk would normally result in a strategy where the auditor relies on controls and reduces substantive tests. First, the auditor would confirm the low control risk evaluation by testing controls for effectiveness. Greater reliance would also be placed on analytical procedures. High combined inherent and control risk would result in a more substantive approach with little control testing. The purpose of the auditor's search for unrecorded liabilities is to gather evidence as to whether the completeness assertion is true. From an evidence gathering perspective, it is much more difficult to gather evidence on unrecorded transactions than to gather evidence that recorded transactions (and account balances) are proper. The search for unrecorded liabilities includes procedures in other audit areas such as questions on bank and insurance confirmations and vouching the source of funds for asset additions. Fifteen specific audit procedures in the search for unrecorded liabilities are listed in Chapter 8.

8.10

8.11 8.12

Financial statement users are most troubled by missing overstated assets and understated liabilities. Therefore, they need to audit for the existence of assets and the completeness of liabilities. Typically, when auditing prepaids and accruals the auditor uses audit documentation that shows beginning balances, payments, expense and ending balance. By agreeing beginning balance to prior year's audit documentation, vouching payments, and calculating the accuracy of the ending balance, the auditor knows that the amount charged to expense has to be correct Non current assets such as property, plant and equipment and intangibles usually pertain to all five management assertions. The auditor must ensure that they exist and are owned. In addition, the valuation determined by depreciation, amortization, or impairment charges, is usually an important issue. Complex GAAP requirements make presentation and disclosure an area of concern. Of the five assertions, completeness is probably the least important, but it cannot be ignored. The auditor is primarily concerned with current year transactions in property, plant and equipment accounts, assuming that the previous year's balances were audited. Thus, additions, disposals and depreciation charges warrant the most attention. Most expense accounts can be tested through analytical review procedures or by testing them in conjunction with tests of related assets and liabilities (e.g., depreciation). Some expenses should be examined separately because of their unique nature (e.g. legal expenses or miscellaneous expense). The following are possible "red flags" indicating a risk of fraud: Photocopies of invoices in the files Vendors invoices submitted in numerical order Vendors invoice amounts always in round numbers Vendors invoices always slightly lower than a review threshold Vendors with only post office box addresses Vendors with no listed telephone number Matching vendor and employee addresses or telephone numbers Multiple vendors at the same address and telephone

8.13

8.14

8.15

8.16

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8.17

The auditor should begin with inquiry of the client about their knowledge of fraud or fraud risks. Analytical review procedures such as vertical and horizontal analyses can pinpoint accounts that appear to have unusual fluctuations. Examining invoices and vendor files for the red flags noted above will help find phony billings. The purpose is to identify fraud risk, evaluate the significance of the risk and determine the amounts of any actual fraud on the financial statements. These procedures are directed at misappropriation of assets by embezzlement. Employees and their associates are stealing assets from the company by having it pay phony expenses. Argus did not have separation of duties. Different people should have authorized the copying services, and approve the bills for payment, and coding them to projects. A supervisor should have been reviewing the expenses and comparing them to the budget. The verbal inquiry procedure might produce knowledge of employee's responsibilities to authorize purchases of script copies, receive them, approve payment, and code invoices to projects. Given Beta Magnetic's poor internal controls, it is possible that Martha would never have been caught. However, if the company ever contacted employees about their health claims, they would have revealed the fictitious charges. Controls should be the same as for any other vendor, except that time cards replace receiving reports. Someone should have responsibility for reviewing and approving charges and comparing costs to the budget. Payments should not be made without supporting documentation, including approved time cards.

8.18 8.19

8.20 8.21

8.22

SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

8.23 a. b. c. d. 8.24 a. b. c. d. 8.25 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 cycle Although similar to sales because they are shipped out, purchase returns are considered part of the Acquisition and Expenditure cycle because they affect accounts payable. Although similar to purchases because they require a receiving report, sales returns are considered part of the Revenue and Collection cycle because they affect accounts receivable. Prepaid Insurance is one of the many accounts in the Acquisition and Expenditure Cycle. Cost of Goods Sold should be matched with Sales by using inventory to record cost of goods not yet sold. Research and Development is a period expense that is recorded as incurred. Depreciation is normally also a period expense, except in the unusual situation where units-of-production depreciation is used. Sales are recorded when earned. overstates net income in the period of capitalization overstates net income. This has no effect on net income. It overstates cash and payables. The completeness assertion is very important in the audit of liabilities. This would restrict a company's ability to do business. Auditors are normally not concerned with who the client's vendors are. Competitive bids are normally required for only large purchases.

8.26

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8.27

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

Incorrect Incorrect Incorrect Correct Incorrect Correct

These duties should be separated. This would not necessarily prevent a duplicate payment. The voucher date may be several weeks before the payment is due. Cancellation ("paid") of vouchers prevent their use a second time. The requisition would not result in the improper delivery. Nobody at Lake was reviewing purchase orders to notice the delivery and payment by another party (Budd's relative's store). This deviation caused no direct loss to Lake, but it is a misuse of Lake's pricing agreements with its vendors and puts Lake at risk. If the liability is unrecorded, it would not be on the trial balance. Auditors may be able to determine that cash disbursements in the subsequent period are paying liabilities of the period under audit. This is a cut-off test. b is a more direct test This is only an indirect test. b is a more direct test. This is often performed before the balance sheet date. This is often performed before the balance sheet date. The search for unrecorded liabilities generally depends upon using accounting records created in the period after the year end. This is often performed before the balance sheet date. Some liabilities may be incurred but not invoiced by the vendor. Purchase orders do not normally incur liabilities. The receiving reports are the population that contains the record of all goods received for which liabilities should be recorded. If the liability wasn't recorded, a check wouldn't be issued. Approvals do not necessarily result in debits to the inventory. Purchase requisitions may not represent the actual amount received. Invoices supply relevant information about the quantities purchased and the prices paid. Purchase orders may not represent the actual amount received. This would have insured a proper count of the tables. This would insure the invoice was for the amount received. This would insure the check was for the amount received. The P. O. and requisition would both show 84 tables. The check signer is probably not familiar with all the vendors. This is possible, but the maintenance costs may not have been unusual (i.e., the costs before the fraud were below budget) Vendors should be approved by an independent purchasing department. Payroll is generally audited by tests of controls, analytical procedures and substantive tests of transactions. Cost of goods sold is generally audited by tests of controls, analytical procedures and substantive tests of transactions. Supplies expense is generally audited in connection with supplies inventory. The auditor examines the specific charges to determine potential litigation.

8.28

8.29

a. b. c. d.

Incorrect Correct Incorrect Incorrect Incorrect Incorrect Correct Incorrect Incorrect Incorrect Correct Incorrect Incorrect Incorrect Correct Incorrect Incorrect Incorrect Incorrect Correct Incorrect Incorrect Correct Incorrect Incorrect Incorrect Correct

8.30

a. b. c. d.

8.31

a. b. c. d.

8.32

a. b. c. d.

8.33

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

8.34

8.35

a. b. c. d.

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8.36

a. b. c. d.

Correct Incorrect Incorrect Incorrect

Property tax expense is audited in conjunction with accrued property taxes. Payroll is generally audited by tests of controls, analytical procedures and substantive tests of transactions. There's no asset directly related to R&D. The auditor examines the specific charges to determine potential litigation.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

8.37 Payable ICQ Items: Assertions, Tests of Controls, and Possible Errors or Frauds. 1. a. b. c. d. Purchases and accounts payable are authorized according to company policy (proper authorization). For a sample of cash disbursements, vouch to approval signatures on invoices, receiving reports and purchase orders. Liabilities might be incurred in the company's name without the knowledge of responsible officers. Select a sample of current-year debits in accounts (e.g., inventory, fixed assets, expenses), and vouch them to supporting documents attesting to the company's business purpose for the transaction. Liabilities are recorded at the appropriate quantity and description (valuation) Select a sample of invoices and agree them to the receiving report. Observe receiving department counting receipts. Vendors could bill for quantities greater than the amount actually shipped, overstating costs or expenses. Observe the client's inventory account and test the reconciliation of the count to the perpetual inventory. Liabilities are recorded for actual purchases at the appropriate amounts (sound error checking practices for occurrence and valuation). Observe client personnel making comparisons. Examine initials for approval. Review correcting journal entries that result from the comparison. Purchases or other liabilities may be recorded for transactions that didn't exist or at incorrect amounts. Reperform comparison on a test basis. Journal entries are authorized and prepared in accordance with generally accepted accounting principles (presentation and disclosure). Examine entries for approval initials. The company might override controls to create fraudulent entries. Select a sample of recorded journal entries and reperform calculations and review for appropriate accounts.

2.

a. b. c. d.

3.

a. b. c. d.

4.

a. b. c. d.

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8.38

Unrecorded Liabilities Procedures a. The fact that the client made a journal entry to record vendors' invoices which were received late should simplify the CPA's audit for unrecorded liabilities and reduce the possibility of a need for a further adjustment, but the CPA's audit is nevertheless required. If the client has not journalized late invoices, the CPA is compelled in his testing to substantiate what will ultimately be recorded as an adjusting entry. In this examination the CPA should audit entries in the voucher register for the year being audited to ascertain that all items which according to dates of receiving reports or vendors' invoices were applicable to that year have been included in the journal entry recorded by the client. No. The CPA should obtain a letter in which responsible executives of the client's organization represent that to the best of their knowledge all liabilities have been recognized. However, this is done as a normal audit procedure to afford additional assurance to the CPA and it does not relieve the responsibility for doing other substantive audit work. Whenever a CPA is justified in relying on work done by an internal auditor, he or she should curtail (but not eliminate) his or her own audit work. In this case, the CPA should have ascertained early in the examination that Ozine's internal auditor is qualified by being both technically competent and reasonably independent. Once satisfied as to these points, the CPA should discuss the nature and scope of the internal audit program with the internal auditor and review the working papers in order that the CPA may properly coordinate the audit program with that of the internal auditor. If the Ozine internal auditor is qualified and has made tests for unrecorded liabilities, the CPA may reduce further audit work in this audit area. In addition to the next-year voucher register, the CPA should consider the following sources for possible unrecorded liabilities: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Unentered vendors' invoice file. Status of tax returns for prior years still open. Discussions with employees. Representations from management. Comparison of account balances with preceding year. Examination of individual accounts during the audit. Existing contracts and agreements. Minutes. Attorney's bills and letter of representation. Status of renegotiable business. Correspondence with principal suppliers. Audit testing of cutoff date for reciprocal accounts, e.g., inventory and fixed assets.

b.

c.

d.

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8.39

Accounts Payable Confirmations a. The accounts payable audit procedures should be directed toward searching for proper inclusion of all accounts payable and ascertaining that recorded amounts are reasonably stated because the primary audit purpose is to reveal any possible material understatements. The principal objectives of the accounts payable examination are 1. 2. 3. b. To determine adequacy of internal control for processing and payment of invoices. To prove that amounts shown on the balance sheet are in agreement with supporting accounting records. To determine that liabilities existing at the balance sheet date have been recorded.

Clark and Kent are not required to use accounts payable confirmation procedures. For accounts payable the auditor can examine external evidence such as vendor invoices and vendor statements that substantiate the accounts payable balance. Although not required, the accounts payable confirmation is often used. The auditor might consider such use when 1. 2. 3. 4. 5. 6. Internal controls are weak. The company is in a "tight" cash position and bill-paying is slow. Physical inventories exceed general ledger inventory balances by significant amounts. Certain vendors do not send statements. Vendor accounts are pledged by assets. Vendor accounts include unusual transactions.

c.

When auditing accounts payable the auditor is primarily concerned with the possibility of unrecorded payables or understatement of recorded payables. Selection of accounts with relatively small or no balances for confirmation is the more efficient direction of testing since understatements are more likely to be detected when examining such accounts. When selecting accounts payable for confirmation, the following procedures could be followed: 1. 2. 3. 4. 5. 6. 7. 8. Analyze the accounts payable population and stratify it into accounts with large balances, accounts with small balances, accounts with zero balances, etc. Use a sampling technique that selects items based on criteria other than the dollar amount of the items (e.g., select based on terminal digits, select every nth item based on predetermined interval, etc). Design a statistical sampling plan that will place more emphasis on selecting accounts with zero balances or relatively small balances, particularly when the client has had substantial transactions with such vendors during the year. Select prior-year vendors who are no longer used. Select new vendors used in the subsequent years. Select vendors that do not provide periodic statements. Select accounts reflecting unusual transactions during the year. Select accounts secured by pledged assets.

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8.40

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

2.

3.

4.

5. 6.

7.

8.

9.

10.

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8.41

PURCHASING STARS: Purchasing Kickbacks In this case, let your initial objective be to select one vendor for investigation. Instead of a "tests of controls" section, name the one vendor you would select from those in Exhibit 8.41-1 and tell your reasons. In the "test of balances" section, tell how you would investigate the situation. In the "discovery summary" section, speculate about how your investigation might reveal the culprit. AUDIT APPROACH Objective: Select one vendor for investigation, and try to obtain evidence of purchasing at inflated prices. Control: Purchasing operations should be performed under rules and procedures designed to motivate purchasing agents to buy at the best prices available from competing vendors. Competitive bidding should be required unless conditions make the best prices available without bid. However, purchasing agents should have flexibility within operating procedures to move quickly to obtain the best balance of quantities, delivery terms, and prices as events dictate. Thus they may not always obtain competitive bids. A higher manager level should supervise and review the results of purchasing activity on a regular basis, perhaps reperforming some price-obtaining actions occasionally to determine whether the agents are achieving efficiency. Such review might also involve selecting odd situations for extensive review. Tests of Controls: The one vendor selected is Orion Corp. Key reasons for this selection are: Volume is high and has increased almost 1000%, more than any other vendor Last bid was obtained last year, older than other vendors' bids. The percent purchased on bid is lowest among those bid. Collins, the manager, is in charge. Collins purchases from several vendors without bids.

Audit of Balance: Investigation of purchases from Orion: a. b. c. d. e. f. g. h. Review purchase invoices to determine unit prices for paper. Compare unit prices with other suppliers. Interview other suppliers and their salespersons to try to determine whether Collins solicited kickbacks. Review bid records to determine the dates of submitted bids and bid prices. Examine Collins' personnel file. Investigate references if they were not consulted earlier. Might investigate again with more determination to notice telltale signs. Conduct interviews with Collins and other purchasing agents under a front of learning about purchasing procedures. Carefully seek information or impressions about Collins relations with Orion. Inquire at secretary of state office for names of Orion incorporators to see if Collins is connected. Look up officers in national executives directory to see if she is listed as an officer of Orion. Covertly observe Collins' lifestyle and spending habits. A ruse might be used to get information about Collins' bank balance and activity. (Overt action such as subpoena should not be used until clear evidence of guilt is available.)

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8.41

PURCHASING STARS: Purchasing Kickbacks (Continued) DISCOVERY SUMMARY If Collins is taking kickbacks in return for causing Bailey to pay higher prices, the price comparison information should show evidence. If this is the case, the other procedures should also bear fruitpast employment history problems, police record, derogatory gossip from coworkers, more wealth than justified by salary, maybe even a direct connection with Orion. Collins has plenty of "room" to cause Bailey a significant financial drain. Purchases from Orion were $1,220,000 over the last two years, and about $500,000 of supplies and sundries without bid from other suppliers. If the overpricing to Bailey were 10% on all these purchases, it could amount to $172,000 for two years' "work." P.S. The title of the case "Purchasing Stars" is a clue to the solution (Orion)

8.42

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

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8.43

Audit Simulation--Audit the Fixed Asset and Depreciation Schedule (a) The Computer B system is depreciated for a full year ($583,000), but depreciation should be calculated for only 8 months. Correct amount is $389,000. The depreciation on the Press should be $75,000 instead of $150,000. Somebody doubled the depreciation expense for this year. Accumulated Depreciation Cost of Goods Sold Inventory General and Admit Expense (b) List two audit procedures for auditing the fixed asset additions. The best way to approach this requirement is to write a procedure for each assertion. Building 2: Existence: Inspect the building to determine that it is "in productive use" (evidence of existence). Rights (Ownership): Vouch the legal title papers and recorded deed for evidence of ownership. Valuation: Vouch the contractor's billings and the payments for evidence of appropriate cost valuation. Presentation and Disclosure: Study any related loan agreements for pledge as security for loans in relation to necessary disclosure. Inspect insurance policies for evidence of adequate insurance (inadequate insurance may require disclosure). Completeness: Inspect Building 1 and make inquiries about whether any part of it has been sold or leased since the new building was occupied (evidence of completeness of recording of dispositions, if any). Computer B system. Existence: Inspect the computer and observe it in operation (existence) Rights (Ownership) and Valuation: Vouch purchase and title documents (ownership and cost valuation). Presentation and Disclosure: Study any related loan agreements for pledge as security for loans in relation to necessary disclosure. Inspect insurance policies for evidence of adequate insurance (inadequate insurance may require disclosure). Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for installation and testing costs that should be capitalized (evidence of completeness of recording asset cost). Auto 2 Existence: Inspect the auto and observe it in operation (existence). Rights (Ownership) and Valuation: Vouch purchase and title documents (ownership and cost valuation). 269,000 67,500 7,500 194,000

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Audit Simulation--Audit the Fixed Asset and Depreciation Schedule (part b, Continued) Presentation and Disclosure: Study any related loan agreements for pledge as security for loans in relation to necessary disclosure. Inspect insurance policies for evidence of adequate insurance (inadequate insurance may require disclosure). Insurance may be required for lawful operation. Inquire about its use; if by executive officers, it may need to be reported as compensation in the proxy statement (public companies). Completeness: Vouch expenses in the repairs and maintenance accounts (or similar accounts) for typical additional costs (e.g. tax, title, and license) that should be capitalized (evidence of completeness of recording asset cost). (c) The loss on the sale of the Computer A system should be $542,000 ($5,000,000 - $3,958,000 $500,000). The gain on the sale of Auto 1 (fully depreciated) should be $1,000. The cash flow from investing activities should show cash inflow from sale of assets in the amount of $501,000. There should be cash outflow for purchase of assets in the amount of $ $45,522,000.

8.44

Property and Equipment Assertions and Substantive Audit Procedures 1. Legal right evidence: D. 2. Examine deeds and title insurance certificates.

Existence evidence: G. Physically examine all major property and equipment additions.

3.

Valuation evidence: B. Review the provision for depreciation expense and determine whether depreciable lives and methods used in the current year are consistent with those used in the prior year.

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8.45

Assertions and Substantive Balance-Audit Procedures for Property, Plant, and Equipment (P, P&E) Valuation Existence Valuation Valuation Valuation and Allocation Valuation Existence Existence Rights Presentation and Disclosure Completeness Valuation and Allocation Valuation and Allocation Presentation and Disclosure Presentation and Disclosure Rights and Obligations Presentation and Disclosure Rights Presentation and Disclosure Valuation Presentation and Disclosure 1. 2. 3. 4. For major amounts charged to P,P&E and a sample of smaller charges examine, supporting documentation for expenditure amounts, budgetary approvals, and capital work orders. For a sample of capitalized P, P&E examine construction work orders in detail. For the sample of construction work orders, vouch time and material charges to supporting payroll and material usage records. Review the reasonableness of the hours worked, the work description, and the material used. Evaluate the policy and procedures for allocating overhead to the work orders and recalculate their application. Determine that corresponding retirements of replaced P,P&E have been made and properly accounted entered in the detail records. Select major additions for the year and a random sample of other additions, and inspect the physical assets. Discuss plant operations with responsible operating personnel. Inquire about capitalization policies and the use of leased assets. Vouch a sample of charges in the Repairs account and determine whether they are proper repairs and not capital items. Review the useful lives, depreciation methods, and salvage values for reasonableness. Recalculate depreciation. Obtain written management representations about assets pledged as security for loans. Study loan documents for terms and security of loans obtained for purchase of P,P&E. Study lease agreements to determine proper GAAP accounting for lease obligations. Inspect title documents for automotive and real estate assets. Study insurance policies to determine whether P, P&E is adequately insured for casualty loss. Analyze the productive economic use of P,P&E to determine whether any other-than-temporary impairment is evident.

5. 6. 7. 8. 9. 10. 11.

12. 13. 14. 15.

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8.46

CAATTS ApplicationP, P&E a. The information needed to reconcile subsidiary detail records to general ledger balances: Asset type Location code Cost Accumulated depreciation, end of year The task of footing the subsidiary ledger and comparing the recalculation to the general ledger balance(s) does not complete the audit of fixed assets. Additional evidence is needed to be persuaded of existence of the assets (observation), valuation (vouching invoices, recalculating depreciation), completeness (vouching and tracing transactions dated around the year-end), presentation and disclosure (in-use-status, inquiries about hypothecation, liens). b. The assistant will also need to know the asset number, description, as well as Asset Type and Location Code mentioned in (a) above.

8.47

Search for Unrecorded Liabilities A. Audit Program 1 2 3 4 5 6 Obtain a trial balance of recorded accounts payable as of year-end. Send confirmations to creditors with small or zero balances and those with whom the company has done significant business. Ask client personnel about their procedures for ensuring that all liabilities are recorded. Obtain a list of unmatched vendor invoices and determine when the goods were received. Trace the unmatched receiving reports to accounts payable, and determine whether items recorded in the next accounting period need to be adjusted. Select a sample of cash disbursements from the accounting period following the balance sheet date. Vouch them to supporting documents (invoice, receiving report) to determine whether the related liabilities were recorded in the proper accounting period.

B.

Adjusting Journal Entry Vouchers Payable Rent Expense $53,000 $53,0001

To reverse January rent expense recorded in December Miscellaneous expense Cost of Goods Sold Office expense Vouchers Payable To record unrecorded liabilities.
1 2

$6,300.00 12,889.66 8,644.862 $27,834.52

May omit if students assume the charge was made to prepaid rent. Includes unbilled amount for December

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8.48 Kaplan CPA Exam SimulationObtaining EvidenceSales and Expense

Option True

Procedure Evidence supporting the valuation of sales returns will be gained via the audit procedures for accounts receivable. Specifically, audit procedures for the allowance for doubtful accounts should reveal any material misstatements of sales and/or sales returns. Vouching expenses performed as part of the search for unrecorded liabilities will only uncover any material misclassifications of expenses that occurred during the year and were paid subsequent to year end. To gain assurance that expenses were not misclassified for the entire year, the auditor must vouch a sample of expenses based on materiality levels. An unexplained increase in the gross profit ratio may suggest the presence of unrecorded expenses in COGS since unrecorded expenses would understate total expenses and falsely increase the profitability ratios (i.e., net income). Amberlys bill and hold transactions may increase audit risk because such transactions may result in sales being overstated at year end. Bill and hold transactions usually involve selling products for large discounts to retailers and holding them (perhaps in third-party warehouses) to be delivered at a later date. Clearly the risk is of prematurely recorded or uncollectible sales.

False

True

False

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8.49

Kaplan CPA Exam SimulationAccounts Payable Confirmations 1. False Confirmations should be sent to all vendors regardless of whether a payable is recorded since the objective is to search for unrecorded items that may have resulted in an understatement of accounts payable. Given the 60-day payment terms, Southland will probably not pay some of its vendor balances relating to the end of Year 1 by the completion of fieldwork on February 15 of Year 2. Therefore, sending vendor confirmations early may provide timely evidence to corroborate the accounts payable balance. Since the emphasis is on detecting understated payables, materiality is a less important or even irrelevant factor when determining which vendor accounts should be confirmed. Disputed accounts are generally included in the auditors confirmation sample. Whether legal action has been taken against the client is irrelevant to the confirmation procedure. Because of the 14-day payment terms, North River will have likely paid their invoices open at December 31, Year 1 prior to the start of the audit field work in February, Year 2. Therefore, the review of subsequent payments is the most effective procedure to gather evidence for the accounts payable assertions, including completeness. Since the control risk was assessed as low, it may be appropriate to confirm the Southland accounts payable at an interim date. This is to ensure that control risk was appropriately assessed as low and that the internal controls are operating effectively. Confirmations provide evidence supporting the obligation and rights assertion since all accounts payable are considered obligations; they are liabilities. To substantiate both the completeness and the existence assertions, vendor balances to be confirmed should be selected from Southlands list of vendors. Selecting vendors from the year-end payables listing only addresses the existence assertion.

2.

True

3.

True

4.

False

5.

False

6.

True

7. 8.

True False

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8.50

Kaplan CPA Exam SimulationObtaining EvidenceAccounts Payable 1. 7. 3. E E A No adjustment is necessary since the item is properly included in accounts payable at the end of Year 1. The telephone service period was for Year 1. No adjustment is necessary since the electrical supplies were received in Year 1 and properly included in accounts payable at the end of Year 1. An adjustment is necessary since no liability for the insurance premium is recorded at the end of Year 1. An adjustment should be made to record the one-month (12/1/Y1 12/31/Y1) insurance expense included in the service period. No adjustment is necessary since the item is properly excluded from accounts payable at the end of Year 1. The feed inventory was not received until Year 2 and because it was also a one-time deal, there is no guiding precedent in terms of determining when the liability was actually incurred. Thus, based on the facts, Southland has NOT likely incurred a legal obligation to pay until Year 2 when the inventory was received. In this case, the invoice date of 12/29/Y1 is not relevant to Southland in terms of determining when the liability was incurred. An adjustment is necessary since no liability for the inventory is recorded at the end of Year 1. It was noted that the inventory was received by Southland prior to the end of Year 1 on 12/30/Y1, so a liability should have been recorded at that time. Expenses are overstated since the item should have been capitalized. No adjustment is needed to accounts payable since it is properly included at the end of Year 1. As it is currently recorded by Southland, accounts payable and inventory are overstated by $9,300, the amount of the second shipment that was not received until after the end of Year 1. No adjustment is necessary since the item is properly included in accounts payable at the end of Year 1. The water service period was for Year 1.

4.

E.

8.

6.

C.

2.

B.

5.

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