CHAPTER 15

Auditing the Expenditure Cycle

Spring 2007
Expenditure Cycle Transaction
Classes and Accounts: Purchases
Debit
CreditInventory
Merchandise Accounts Payable
Raw Materials Inventory
Purchases
Prepaid Expenses
Plant Assets
Other Assets

Various Expenses
 Expenditure Transaction Classes and
Accounts: Cash Disbursement &
Adjustments
Debit
Credit
Accounts Payable Cash
Purchase Discounts
Purchase Returns
 General Audit Strategy
 Assess Inherent Risk
 Use Knowledge of Business and Industry to Perform
Analytic Procedures and Assess Analytic Procedures
Risk
 Assess Control Risk
 Evidence of effectiveness gained while obtaining an
understanding of internal controls
 Evidence of effectiveness of management controls
 Evidence of effectiveness from direct tests of
programmed controls
 Design Appropriate Substantive Tests of Details
 Expenditure Cycle: Initial Audit
Procedures
 Obtain an understanding of the business
and industry.
 Significance of purchase cycle
 Economic drivers
 Industry trade terms
 Concentration of suppliers / purchase
commitments
 Expenditure Cycle: Initial Audit
Procedures cont.
Business Aspects of the Expenditure Cycle
 What does the operating cycle look like?
 Normal A/P turn
 Normal Inventory turn
 Normal A/R turn
 What do we know about costs?
 Fixed/variable
 Volatility
 Dependency on suppliers
 Expenditure Cycle: Initial Audit
Procedures cont.

Consider management incentives & pressures

 Liabilities

Understate current liabilities to meet debt covenants
 Cash Disbursements
 High volume and overall susceptible to fraud
 Expenses
 Decision to capitalize vs. expense impacts net income
 Expenditure Cycle: Initial Audit
Procedures
 Understand how key expenditure cycle issues of
economic substance are reflected in the financial
statements
 How is the transaction initiated (initiate)?
 How does receipt of good or service take place?
(movement)
 How is the transaction recorded (recording)?
 What is the standards business practice for settling
liability? (consideration)
 See flowchart 15-5 on page 698 noting where
transactions involve outside entities.
 Expenditure Cycle Audit
Objectives
Assertion Specific Audit Objective
 Completeness  Completeness
 Cutoff / Timeliness

 Existence & Occurrence  Validity

 Cutoff / Timeliness
 Valuation  Valuation at Historical Cost / GAAP
 Valuation at Net Realizable Value
 Posting and Summarization

 Rights and Obligations  Ownership

 Presentation and  Classification
Disclosure  Disclosure
 Expenditure Cycle: Initial Audit
Procedures

Assertions Specific Audit Objectives

Expected Internal Controls

Enough Comfort? Yes/No

What substantive testing do we plan on doing?

 Expenditure Cycle: Initial Audit
Procedures
Analytical Procedures
 Estimate Accounts Payable with knowledge of the
company’s historical operating cycle, creditor trade
terms, and cost of goods sold.
 Ratio of CGS / AP
 Ratio of Inventory / AP

Use results of analytical procedures to direct

attention to potentially misstated areas of f/s
 Expenditure Cycle: Understand
(and maybe test) Internal Controls
Control Environment
 Ethical Values
 Human Resource Practices
 Commitment to Competence (Hiring / Training)
 Background Checks
 Assignment of Authority and Responsibility
 Accountability
Mgmt. Risk Assessment
 Cash flow
 Supply chain
 Fraud risk
 Expenditure Cycle:
Information System
Documents
 Purchase requisition
 Purchase order
 Receiving report
 Vendor’s invoice (external)
 Voucher (internal)
 Check
 Cash disbursements journal
Files
 Approved vendor master
file
 Accounts payable master
file /or/ Voucher register
 Open P.O. file
 Receiving file
 Suspense file
 Unpaid voucher file
 Paid voucher file
 Expenditure Cycle: Obtain an
Understanding of Internal Controls
We also need to know…
 Reports:
 Reports used in decision making
 Exception reports

 Understand how reports are used to manage and

control the entity.
 Timeliness of review of reports.
 Business decisions made with reports.
 Follow-up on issues raised in reports.
 Assessing Control Activities -
Hints
 Determine first if general controls are adequate
 Ensure you are clear on what audit objective you
are assessing
 Computer Controls:
 Think about the fields and data that the computer is
comparing.
 Think about what information appears on an exception
report.
 Once you have assessed which controls you want
to place reliance on, then they can be tested
(often using sampling)
 Purchases Controls (completeness)
Completeness
 Establish initial pre-numbered control over PO, receiving,
and voucher
 Have computer:
 Ascertain that documents are pre-numbered with no missing
documents in sequence
 Identify all purchase orders without receiving reports or vouchers
Cutoff
 Computer should compare receiving date with the date
the invoice is recorded. They should be in the same
accounting period.
 Purchases Controls (existence)
Validity
 The computer should compare:
 Vendor number on purchase order and voucher with vendor on a
master vendor file (encourage use of check digits in vendor
numbers).
 Compare quantities on voucher (and vendor’s invoice) with
quantities on receiving report.
 Have managers review items charged to their budgets to
determine that items are valid.
Cutoff
 Same as w/ completeness
 Purchases Controls (valuation)
Valuation at Historical Cost
 Have the computer:
 Multiply quantity x price and add for each item on

vendor’s invoice. Compare quantity with receiving

report. Compare price with P.O.
 Batch totals if invoices are processed in batches.

 Limit tests where limits vary based on account

numbers.
 Have managers review items charged to their budgets
to determine that amounts are reasonable.
 Purchases Controls (valuation)
Valuation at N.R.V.
 Not applicable at transaction level.
 Generally not applicable for liability.
Posting and Summarization
 Have the computer compare:
 Run to run totals: Running balance in voucher register
+ transactions = new balance.
 Sum of accounts payable subsidiary ledger with general
ledger control account.
 Purchases Controls (R & O)
Ownership
 like net realizable value, generally applies to balances, not
transactions.
 Purchases Controls (P & D)
Classification
 Have the computer:
 Compare account numbers on purchase order with account
numbers on voucher.
 Have managers review items charged to their budgets to
determine that items are properly charged to their
accounts
Disclosure
 Related party?
 The auditor rarely finds controls over disclosure and must
test substantively
 Cash Disb Controls (completeness)

Completeness
 The AP master file is the report of all unpaid vouchers.
 Have the computer generate an exception report of all
items past their due date and not paid.
 Account for pre-numbered checks. Print exception
report with any missing sequences.
Cutoff
 Independent Bank Reconciliation on a monthly basis.
 Cash Disb Controls (existence)
Validity
 Computer will automatically check for duplicate
payments of specific voucher/vendor’s invoice so it is
not paid twice.
 Controls over access to cash
 Computer will not process payment without recording of the
voucher. Key control is over validity of voucher.
 Pay only vendor’s on authorized vendor list. Control ability to
put vendor on list.
 Segregation of duties between making changes in
approved vendor list, recording payable and disbursing
cash.
 Cash Disb Controls (valuation)
Valuation at historical cost
 Issue: The check is written in the proper amount.
 Computer compares check amount, plus purchase discount, to voucher
amount. Requires additional authorization for paying different amount.
 Authorization procedures for signing checks of certain sizes.
Valuation at NRV
 Not applicable to transactions.
Posting and Summarization
 Run to run totals on disbursement’s journal.
 Compare sum of A/P subsidiary ledgers with control account
in the general ledger
 Cash Disb Controls (R & O)
Ownership

Controlled by controlling voucher.
 Cash Disb Controls (P & D)
Classification
 Exception report where controller reviews all transactions
not charged to accounts payable and cash.
 Have managers review items charged to their budgets to
determine that items are properly charged to their
accounts.
Disclosure
 Do not expect control here.
Accounts Payable:
Determining Detection Risk
 Inherent Risk
 Major concern is understatement.
 Analytic Procedures Risk
 Control Risk
 Control risk over purchases
 Control risk over disbursements
 Use audit risk model to solve for test of
details risk – How much more comfort
do we need?
 Accounts Payable:
Standard Substantive Tests
 Initial substantive procedures
 Agree beginning balance to prior year
workpapers
 Agree subsidiary ledger to general ledger
 Computer scan of all transactions and balances
for unusual items.
 Rank order payables by size or aging
 Computer analysis of voucher register (consider
fraud assessment procedures here)
 Accounts Payable:
Standard Substantive Tests
Analytical Procedures
 Liquidity ratios look too good

 Significant change in accounts payable turn

days
 Understand the company’s ability to

generate cash flow from operations

 Is accounts payable growing at about the

same pace as inventory growth?

 Accounts Payable (completeness)
Substantive Tests
Completeness
 Search for unrecorded liabilities (primary test)
 Subsequent cash disbursements (checks & wires)
 Unpaid invoices
Cutoff
 Obtain listing of last receipts at inventory

observation and trace to recording of payable

 Search for unrecorded liabilities

 This also ties in with cash disbursements cut-off

 Accounts Payable (existence)
Substantive Tests
Validity
 Consider confirmation based on risk of misstatement: This
is a costly procedure
 Significant number of purchase returns (returns to
vendor?)
 Review vendor’s statements
 Accounts Payable (valuation)
Substantive Tests
Valuation at historical cost
 Subsequent payment of Accounts Payable
 Confirmation of Accounts Payable
 Review of Vendor’s Statements
Valuation at N.R.V.
 Not an issue with liability
Posting and Summarization
 See initial procedure where this is tested substantively.
 Accounts Payable (R & O)
Substantive Tests

Ownership
 Ownership tests are risk based. Key is internal controls
that ensure that only the transactions of the entity are
recorded in books.
 Ties with cut-off procedures. Do they have title of
purchases they have not recorded as liabilities?
 Accounts Payable (P & D)
Substantive Tests
Presentation
 Review A/P for debit balances that should be reclassified
 Review proper classification of trade payables, related
party payables, etc.
Disclosure
 Review financial statement disclosures against disclosure
check list
 How this all fits together:
The Audit Risk Model
AR = IR x CR x AP x TD

AR = IR x AP x CR x TD

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