CHAPTER 2

PRACTICE OF AUDITING THE PURCHASING PROCESS

 OUTLINE

2.1. CHARACTERISTICS AND MANAGEMENT ASSERTIONS OF

PURCHASING PROCESS
1.1.1. Characteristics of purchasing process
1.1.2. Management assertions of purchasing process
1.2. PERFORMING THE AUDIT OF PURCHASING PROCESS
1.2.1. Test of control
1.2.2. Analytical procedures
1.2.3. Tests of details
 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 Purchase Receiving

requisition order report and
liability Vendor
recorded
 2.1.1. CHARACTERISTICS OF PURCHASING PROCESS

• In the purchasing process, expense and liability should be

recognized in conformity with the standard.
Expenses are decreases in A liability is a present
economic benefits during the obligation of the entity arising
accounting period in the form of from past events, the
outflows or depletions of assets settlement of which is
or incurrences of liabilities that expected to result in an
result in decreases in equity, outflow from the entity of
other than those relating to resources embodying
distributions to equity participants economic benefits

EXPENSE AND LIABILITY RECOGNITION (IASB)

 2.1.1. CHARACTERISTICS OF PURCHASING PROCESS

• In purchasing process, there are three types of transactions

which are typically processed: Purchasing transaction; cash
disbursement transaction; purchase return transaction ➔
Therefore, the purchasing process affects numerous accounts
in the financial statements.
TYPES OF TRANSACTIONS AND FINANCIAL
STATEMENT ACCOUNTS AFFECTED
Three types of transactions are processed
through the purchasing process:
Type of Transaction Account Affected
Purchase Transaction Accounts payable
Inventory
Purchases or cost of goods sold
Various asset and expense accounts
Cash disbursement transaction Cash
Accounts payable
Cash discounts
Various asset and expense accounts
Purchase return transaction Purchase returns
Purchase allowances
Accounts payable
Various asset and expense accounts
 2.1.1. CHARACTERISTICS OF PURCHASING PROCESS

• In purchasing process, there are many types of Documents

and Records with many forms and different usages.
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.
 2.1.1. CHARACTERISTICS OF PURCHASING PROCESS

• In purchasing process, there are many types of Documents

and Records with many forms and different usages.

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.
 2.1.1. CHARACTERISTICS OF PURCHASING PROCESS

• The purchasing process is very complicated and has some

major functions, such as: Requisitioning; Purchasing;
Receiving; Invoice Processing; Disbursement; Accounts
payable; General ledger.
 THE MAJOR FUNCTIONS

Functions of the Purchasing Process

Initiation and approval of requests for goods and services by
Requisitioning
authorized individuals consistent with management criteria.
Approval of purchase orders and proper execution as to price,
Purchasing
quantity, quality and vendor.
Receiving Receipt of properly authorized goods and services.
Processing of vendor invoices for goods and services received;
Invoice processing also, processing of adjustments for allowances, discounts and
returns.
Disbursements Processing of payment to vendors.
Recording of all vendor invoices, cash disbursements and
Accounts payable
adjustments in individual vendor accounts.
Proper accumulation, classification, and summarization of
General ledger purchases, cash disbursements and payables in the general
ledger.
2.1.2. MANAGEMENT ASSERTIONS OF PURCHASING PROCESS
2.1.2. MANAGEMENT ASSERTIONS OF PURCHASING PROCESS
 PURCHASING PROCESS

Ordering Goods inward and Payment

recording of
invoicing

• Risks and control • Risks and control • Risks and control

objectives objectives objectives
• Controls • Controls • Controls
• Test of controls • Test of controls • Test of controls
 ORDERING
1.1. RISKS AND CONTROL OBJECTIVES
- Risks
+ Unauthorised purchases may be made for personal use.
+ Goods and services might not be obtained on the most
advantageous terms.
- Control objects:
+ All orders for goods and services are properly authorized and
duly processed. All orders are for goods and services actually required
by the company.
+ Orders are only made with authorized suppliers.
+ Orders are made at competitive prices.
 ORDERING
1.2. CONTROL
- Segregation of duties; requisition and ordering
- Central policy for choice of suppliers
- Evidence required of requirements for purchase before purchase authorized (pre-
set re-order quantities and re-order levels)
- Orders forms prepared only when a pre-numbered purchase requisition has been
received
- Authorisation of order forms
- Pre-number order forms
- Safeguarding of blank order forms
- Review for outstanding orders
- Monitoring of supplier terms and taking advantage of favourable conditions (bulk
order and prompt payment discounts)
 ORDERING
1.2. CONTROL
Example:
Truman Limited buys “Drox” frequently. Drox is highly marketable and
easily portable and the company has a history of theft of inventories of
Drox.
What controls should Truman Limited apply to mitigate this risk?
 ORDERING
1.2. CONTROL
Example:
- The company should have a stores manager who will be in charge of purchase
requisitions, which will be made when inventories of Drox have fallen to a pre-set
level.
- Orders will only be raised in respect of purchase requisitions made by the stores
manager, except in periods of his absence, when requisitions may be made by his
deputy.
- Orders will be authorized by the purchases director.
- Random, occasional spot checks will be carried out by the purchases director on the
level of Drox when the requisition is raised
- Purchase orders will be kept in a locked office in the purchase department
In addition, in order to control inventories, Drox will only be kept in a locked cupboard
in the warehouse.
 ORDERING
1.3. TESTS OF CONTROL
- Review list of suppliers and check a sample to orders made
- Check sequence of pre-numbered order forms
- Check orders are supported by a purchase requisition
- Review security arrangements over blank orders
 ORDERING
1.3. TEST OF CONTROL
Example:
The auditors has been asked review the controls over the
purchases of Drox operating effectively.
What tests of control should the auditors take?
 ORDERING
1.3. TEST OF CONTROL
Example:
Tests of control:
- Perform a spot check on security arrangements over purchase orders
- Request that the purchases director notifies the audit team of requisitions
for Drox during the audit and perform spot check on re-order level
- Observe the premises for evidence of Drox being stored elsewhere than the
locked cupboard
- Review sample of orders for Drox to ensure that purchase requisition exists
and orders were made only by the store manager.
- If sampled requisitions were made by the deputy of the store manager,
check absence records for the store manager.
 INTERACTIVE QUESTION 1
The directors of Lyton Limited (LL) have just uncovered a fraud being
perpetrated by the stores manager. He was in charge of ordering, had raised a
number of false orders to non-existent suppliers, raised goods received
records in respect of non-existent deliveries and forwarded an invoice to the
accounts department, which has then paid.
Requirement:
Which two of the following controls could have prevented this fraud?
a. Approved list of suppliers.
b. Check of goods inward by person other than orderer.
c. Pre-numbered order forms.
d. Blank order forms locked in a safe.
 GOODS INWARD AND RECORDING OF
INVOICING
2.1. RISKS AND CONTROL OBJECTIVES
- Risks:
+ Goods may be misappropriated for private use.
+ Goods may be accepted that have not been ordered.
+ Invoices may not be recorded resulting in non-payment.
+ The company may not record credit notes resulting in paying invoices
unnecessarily.
 GOODS INWARD AND RECORDING OF
INVOICING
2.1. RISKS AND CONTROL OBJECTIVES
- Control objectives:
+ All goods and services are used for the company’s purposes, and not
private purposes.
+ Goods and services are only accepted if they have been ordered, and
the order has been authorised.
+ All goods and services received are accurately recorded.
+ Liabilities are recognized for all goods and services that have been
received.
+ All credits to which the company is entitled are claimed and received.
+ Receipt of goods and services is necessary in order for a liability to be
recorded.
+ All credit notes that are received are recorded in the nominal ledger.
+ Cut-off is applied correctly to the payables account.
 GOODS INWARD AND RECORDING OF
INVOICING
2.2. CONTROLS
- Examination of goods inwards: quality, quantity, condition
- Recording arrival and acceptance of goods (pre-numbered goods received
records)
- Comparison of goods received records with purchase orders
- Referencing of supplier invoices: numerical sequence and supplier
reference.
- Checking of supplier’s invoices:
+ Prices, quantities, accuracy of calculation;
+ Comparison with order and goods received record
- Recording return of goods (pre-numbered goods returned notes)
- Procedures for obtaining credit notes from suppliers
 GOODS INWARD AND RECORDING OF
INVOICING
2.2. CONTROLS
- Segregation of duties: accounting and checking functions
- Prompt recording of purchases and purchase returns ledger
- Regular maintenance of payables ledger
- Comparison of monthly statements of account balance from suppliers
with payables balances.
- Review of classification of expenditure
- Matching of goods received records and invoices along with the creation
of an accrual for any goods received but not matched to invoices at the
year-end.
 GOODS INWARD AND RECORDING OF
INVOICING
2.2. CONTROLS
- Example
The production department at Manufacturing Company Limited (MCL)
works on a just-in-time basis. Orders for necessary materials are
dispatched by a computer according to pre-set re-order levels.
Deliveries are made within 12 hours by the suppliers, who invoice
eclectronically when goods are dispatched. Items are put into
production within hours of arriving at MCL’ premises.
How can the MCL operate this system effectively?
 GOODS INWARD AND RECORDING OF
INVOICING
2.2. CONTROLS
- Example
• In this example, it is crucial that controls over goods inward operate effectively. In the first case, it is
necessary that the quality of goods being put into production immediately are of appropriate quality or
production will be held up. Therefore it is vital that goods inward are checked for quality and quantity on
arrival at mcl’s premises.
• It is also important that goods inwards are recorded, as with the goods being used so quickly it would be
more difficult to verify purchase invoices to goods being held in a warehouse.
• Therefore mcl have a pre-printed, numbered goods received record (grr) which contains a number of
checks in respect of quality and quantity and on which the warehouse staff note the relevant order number,
the time of delivery, and the quantity of goods delivered. A copy of this GRR is forwarded to the accounts
department to be matched with the supplier’s electronic invoice.
 GOODS INWARD AND RECORDING OF
INVOICING
2.2. CONTROLS
- Example
Stibbe Limited have recently discovered that they have been paying
invoices that had been credited because the goods had been returned by
the production quality controller due to poor quality.
What controls should SL have put to prevent this occurring?
 GOODS INWARD AND RECORDING OF
INVOICING
2.2. CONTROLS
- Example
In order to prevent this occurring, SL should have put the following
controls in place:
- Raising purchase return notes
- Copy purchase return notes sent to accounts department by production
department
- Review of credit notes before payment run authorized
- Regular comparision of supplier statements with payable ledger accounts
 GOODS INWARD AND RECORDING OF
INVOICING
2.3. TEST OF CONTROLS
- Check invoices for goods are:
+ Supported by goods received records
+ Entered in inventory records
+ Priced correctly by checking to quotations, price lists to see the price
in order
+ Properly referenced with a number and supplier code
+ Correctly coded by type of expenditure
+ Trace entry in record of goods returned … and see credit note duly
received from the supplier, for invoices not passed due to defects or
discrepancy
 GOODS INWARD AND RECORDING OF
INVOICING
2.3. TEST OF CONTROLS
- For invoices of all types:
+ Check calculations and additions
+ Check entries in payables ledger and verify that they are correctly
analysed
- For credit notes:
+ Verify the correctness of credit received with correspondence
+ Check entries in inventory records
+ Check entries in record of returns
+ Check entries in payables ledger and verify that they are correctly
analysed
 GOODS INWARD AND RECORDING OF
INVOICING
2.3. TEST OF CONTROLS
- Checked for returns that credit notes are duly received from the suppliers
- Test numerical sequence and enquire into missing numbers of:
+ Purchase requisitions
+ Goods received records
+ Suppliers’ invoices
+ Purchase orders
+ Goods returned notes
- Obtain explanations for items which have been outstanding for a long time:
+ Unmatched purchase requisitions
+ Unmatched purchase orders
+ Unmatched goods received records
+ Unrecorded invoices
 GOODS INWARD AND RECORDING OF
INVOICING
2.3. TEST OF CONTROLS
- Verify that invoices and credit notes recorded in the purchases account
are:
+ Initialed for prices, calculations and extensions
+ Cross-referenced to purchase orders, goods received records…
+ Authorised for payment
- Check additions
- Check postings to nominal ledger accounts
- Examine nominal ledger account for unusual entries
- For a sample of supplier accounts
+ Test check additions and carried forward balances
+ Note and enquire into all contra entries
 GOODS INWARD AND RECORDING OF
INVOICING
2.3. TEST OF CONTROLS
- Example:
What should the auditor do to vefify the control over goods inward at MCL?
 GOODS INWARD AND RECORDING OF
INVOICING
2.3. TEST OF CONTROLS
- Example:
What should the auditor do to vefify the control over goods inward at MCL?
- Selects a sample of goods received records and checks that they are in
sequence, enquiring into any missing numbers (spoilt copies should be
retained) and seeking evidence (initials of relevant staff) that the quality
checks have been carried out.
- These goods received records would then be checked to purchase
invoices to ensure that all invoices had an associated goods received
record and also to purchase orders to ensure that the goods were
ordered properly.
 INTERACTIVE QUESTION 2
Weezy plc is a company that has a large number of deliveries
daily
Requirement
Which one of the following internal controls is most likely to
prevent Weezy plc paying for goods that have not been
received?
a. Locked stores
b. Matching of purchase invoices with goods received records
c. Authorisation of invoice payment
d. Safeguarding of blank order documents
 INTERACTIVE QUESTION 3
Rhonda posts the invoices to the payables account
Requirement
Which one of the following would help prevent suppliers
from being overpaid?
a. Posting invoices to the receivables account
b. Examining nominal ledger account for unsual entries
c. Authorisation of payments
d. Bank reconciliations
 PAYMENT
3.1. RISKS AND CONTROL OBJECTIVES
- Risks:
+ False invoices are paid in error
+ Invoices are paid too soon
+ Payments is not correctly recorded
+ Credits are not correctly recorded
+ Payments are not recorded in the correct period
- Control objectives:
+ All expenditure is for goods that are received
+ All expenditure is authorized
+ All expenditure that is made is recorded correctly in the norminal
ledger
+ Payments are not made twice for the same liability
 PAYMENT
3.2. CONTROLS
Cheque and cash The cashier should generally not concerned with
payments generally keeping or writing-up books of account other than
those recording payments, nor should he have access to,
or be responsible for the custody of, securities or title
deeds belonging to the company
The person responsible for preparing cheques should
not himself be a cheque signatory. Cheque signatories
in turn should not be responsible for recording
payments
 PAYMENT
3.2. CONTROLS
Cheque and - Cheque and bank transfer requisitions
bank transfer + Appropriate supporting documentation (invoices)
payments + Approval by appropriate staff
+ Presentation to cheque signatories (in case of cheque)
+ Instigation of bank transfer by appropriate staff
- Authority to sign cheques
+ Signatories should not also approve cheque requisitions
+ Limitations on authority to specific amounts
+ At least 2 signatories should be required
+ Prohibitions over signing of blank cheques
 PAYMENT
3.2. CONTROLS
Cheque and - Prompt dispatch of signed cheques
bank transfer - Obtaining of paid cheques from banks
payments - Payments recorded promptly in nominal ledger
Cash payments - Authorisation of expenditure
- Cancellation of vouchers to ensure they cannot be paid
twice
- Limits on payments
- Rules on cash advance to employees, IOUs and cheque
cashing
 PAYMENT
3.3. TESTS OF CONTROLS
Payments in - For a sample of payments:
cash at bank + Compare with paid cheques to ensure payee agree
account + Check that cheques are signed by the persons authorized to do so within
(authorization) their authority limits
+ Check that bank transfer was authorized and initiated by appropriate
person
+ Check to suppliers’ invoices for goods and services. Verify that supporting
documents are signed as having been checked and passed for payment and
have been stamped “paid”
+ Check to suppliers’ statements
+ Check to other documentary evidence, as appropriate (agreements,
authorised expense vouchers, petty cash books…)
 PAYMENT
3.3. TESTS OF CONTROLS
Payments - For a sample of weeks:
in cash at + Check the sequence of cheque numbers and enquire
bank into missing numbers.
account + Trace transfers to other bank accounts, petty cash
(recording) account or other records, as appropriate.
+ Check additions, including extensions, and balances
forward at the beginning and end of the months covering
the periods chosen.
+ Check postings to the nominal ledger
 PAYMENT
3.3. TESTS OF CONTROLS
Bank - For a period which includes a reconciliation date reperform
reconciliations reconciliation
- Verify that reconciliations have been prepared at regular
intervals throughout the year
- Scrutinise reconciliations for unsual items
Petty cash - For a sample of payments:
payment + Check to supporting vouchers
+ Check whether they are properly approved
+ See that vouchers have been marked and initialled by the
cashier to prevent their re-use
 INTERACTIVE QUESTION 4
Which two of the following control activities are most likely
to reduce the risk of payments being made twice for the
same liability?
a. Stamping “Paid” on invoices that have been paid
b. Prompt dispatch of cheques
c. Authorisation of payments
d. Checking supplier statements before payments are made
 INTERACTIVE QUESTION 5
The auditor of Sunny plc has identified that there is no
procedure to track purchase invoice due dates
Which one of the following is the most likely consequence
which might arise as a result of that deficiency?
a. Prompt payment discounts may not be obtained
b. Goods not actually received may be paid for
c. Inferior goods may be purchased
d. Payments may be made to fictitious suppliers