An auditor takes a sample of purchase requisitions and traces the purchased items through the accounting information system, making sure that the requisition agrees with the purchase order, the receiving report, the vendor's invoice, the accounts payable voucher, and the canceled check.
What assertion is the auditor testing?
Typically, when an auditor starts at the source level in an accounting information system and traces various documents through the system, that auditor is making certain that nothing was lost in the actual transaction process. Thus, the auditor's primary interest is in the completeness assertion. The auditor wants to answer the question: Has this transaction been reported in the financial statements?
What departments and documents are involved when auditing inventory and accounts payable? (Assume that there is a sale of an item of stocked inventory.)
1. Requesting department.
2. Purchasing department.
3. Receiving department.
5. Accounts (or Vouchers) payable.
6. Cash disbursements.
1. Purchase requisition.
2. Purchase order.
3. Receiving report.
4. Vendor's invoice.
5. Accounts payable voucher.
Analytical procedures must be carried out early in an audit as part of the assessment of the risk of material misstatement. Analytical procedures must be carried out at the end of the audit to make certain that any unexpected fluctuations or changes in the financial statements have been noticed and addressed by the auditor. Analytical procedures are quite important at this stage of the audit process in order for the auditor to satisfy the financial statement presentation and disclosure-related objectives (i.e., occurrence and rights and obligations, completeness, accuracy and valuation, and classification and understandability).
In performing analytical procedures for inventory and accounts payable, what types of comparisons are most likely to be made?
Analytical procedures for inventory and accounts payable would include the following:
1. Comparisons of the absolute amount of inventory and accounts payable. As one example, the auditor would be especially concerned to see an unexplained reduction in accounts payable when addressing the completeness assertion.
2. Comparisons of the gross profit percentage (gross profit divided by sales).
3. Comparisons of inventory turnover (cost of goods sold divided by the average inventory) would also be looked at by the auditor.
4. Comparison of any changes in age of the average inventory balance (365 divided by the inventory turnover). This indicator can also be called the average inventory processing period.
An auditor is beginning substantive testing on inventory and accounts payable.
What are several general potential problems the auditor should anticipate when auditing inventory and accounts payable?
The following are the types of problems with inventory and accounts payable that might lead to material misstatements if not detected by the internal controls or the auditor:
1. Inventory may be damaged or obsolete, and therefore not salable.
2. Inventory may have been miscounted or misidentified.
3. Year-end cut-off of purchase, receipts and consumption of inventory are incorrect.
4. Inventory physically on hand is not owned by the client, while inventory not on hand may be on consignment at a customer's location.
An auditor is concerned that the ending inventory count was performed incorrectly.
If inventory is intentionally or unintentionally overcounted, what effect does that misstatement have on net income for that year?
If inventory is intentionally or unintentionally undercounted, what effect does that misstatement have on net income for that year?
1. If inventory is overcounted, ending inventory will be reported too high. Ending inventory is a negative component of cost of good sold. If ending inventory is too high, then cost of goods sold (an expense) will be reported as being too low. Net income will be artificially inflated, causing the company to overstate and misrepresent both its assets and net income.
2. If inventory is undercounted, ending inventory will be reported too low. Ending inventory is a negative component of cost of goods sold. If ending inventory is too low, then cost of goods sold (an expense) will be reported too high. Net income and inventory will be understated, causing the company to understate and misrepresent both its ending inventory and net income for the year.
A department needs a particular item of inventory or a new asset, such as a computer.
What document is initially generated when there is need for such items?
When an item or a new asset is needed, a requisition form is prepared by the requesting department. The requisition form for the inventory item is sometimes known as a materials requisition.
A company needs a certain item of inventory or a new asset, such as a computer. A requisition form is completed. The requisition is reviewed and authorized by the appropriate individual in the department.
What happens to this requisition form?
Once a requisition is approved, it is sent or transmitted to the purchasing department for fulfillment. If the item being requested is commonly in stock, then the physical goods are sent to the requisitioning department. If the item being requested must be ordered from an outside vendor, the purchasing department prepares a purchase order from an appropriate vendor, after perhaps securing competitive bids from several possible vendors.
After the purchasing department receives the purchase requisition, what is the next step in the purchasing process?
After the purchasing department receives the purchase requisition, it does the following:
1. Scans the request to make sure it is within the authority of the department making the request. This may necessitate checking on budget authorizations.
2. Checks the authorization signatures to make sure that appropriate approval has been received.
3. Follows a set procedure for placing an order, such as soliciting bids.
After a purchase order is generated by the purchasing department and the order is placed with a pre-approved vendor, where does the purchase order go?
A copy of the purchase order goes to the receiving department to serve as approval for accepting the merchandise when it arrives. On this copy, the quantities are generally blanked out to encourage a more accurate count of the merchandise when it is received.
Another copy of the purchase order goes to the accounts (or vouchers) payable department as documentation of the purchase.
When goods arrive at the receiving department, what are the appropriate procedures for these entity personnel?
Based on the purchase order, the receiving department should:
1. Verify the description of the physical goods with the purchase order.
2. Count the goods.
3. Check the condition of the goods.
There should be a company policy in place about rejecting goods that do not fit the description of the purchase order or handling items that are obviously damaged in shipment to the entity.
What happens to goods after they have been accepted by the receiving department?
Goods are then transferred from the receiving department to the warehouse (or supply room) or to the department that has specifically requested the item.
When the goods are conveyed, the warehouse should once again check the condition and description and quantity of the items being conveyed.
The receiving department should get a signed receipt or other sign-off for this in-house delivery.
How should the handling of an entity's merchandise be organized?
Normally, three, but quite possibly four, independent departments are involved with inventory and other merchandise received or shipped:
1. Receiving department.
2. Shipping department.
4. Requisitioning department.
What documents are generated and sent from the vendor after goods are ordered by the entity?
Both an order acknowledgement and eventually an invoice should be sent from the vendor. These documents identify the company that has placed the purchase order with the vendor, the address where the item(s) are to be shipped, and either acknowledge or invoice the company for the item(s) ordered and received:
1. Price of the item(s).
2. Quantity ordered.
3. Description of the item(s) ordered.
4. Terms of the sale (such as 2/10, n/30) and the due date of the invoice.
Which department receives the vendor's invoice, and what actions should be taken with it?
The accounts (or vouchers) payable department gets the vendor's invoice. This document is reviewed to make sure that the terms and other information on it are accurate.
The vendor's invoice is then compared to the purchase requisition, the purchase order, and the receiving report to ensure that all steps in the purchase order process have been properly authorized and that all documents are in agreement.
What documentation takes place once all purchase documents are reconciled and all authorizations are verified?
An accounts payable voucher is generated to handle the processing of the vendor's invoice for final payment. Oftentimes, the purchase documentation is attached to or combined with the voucher to form a voucher package.
After receiving the approved voucher, what roles and responsibilities does the cash disbursements department have?
The accounts payable voucher is usually filed by due date, taking into consideration any discount terms that might be available. On the voucher payment date, the cash disbursements department prepares a check. The check is compared to the documentation and then both the check and accounts payable voucher are delivered to the individual who is authorized to sign the check. Generally, a check register will be created when the check is processed that will also be delivered to the check signer. The check is then mailed under the auspices of the check signer.
An auditor takes a sample of cleared checks written for purchases and then finds individual support for them by looking at the related voucher, vendor's invoice, receiving report, purchase order, and requisition.
What assertion(s) is the auditor testing?
Whenever the auditor takes an item that is part of the accounting records and seeks to substantiate that item by looking at the supporting documentation, the auditor is primarily interested in the occurrence, completeness, classification, and accuracy assertions.
The auditor is attempting to answer: "Does this transaction pertain to the entity?", "Are all components of this transaction recorded that should have been recorded?", "Are the amounts recorded appropriately?", and "Is the item properly classified?".
An auditor is examining inventory to determine if freight-in has been properly recognized.
What assertion is being tested?
In this case, the auditor is concerned with the cost that is being reported for the inventory value. Therefore, the valuation assertion is being tested.
1. If the question is "Did the transaction get recorded?", then the completeness assertion is being tested.
2. If the question is "Did too many transactions get recorded?", then, the existence or occurrence assertion is being tested.
3. If the question is "Did the right number get recorded for the transaction?", then, the accuracy assertion is being tested.
An auditor usually confirms accounts receivable.
Does the auditor also typically confirm accounts payable?
Accounts payable can be confirmed and is confirmed on infrequent occasions. However, with accounts payable, the auditor is concerned more with the completeness assertion, rather than the existence assertion. Confirmation is not a traditional test when reported balances might be subject to either underreporting or no reporting at all.
An auditor takes a sample of accounts payable transactions recorded during the three to five days prior to the end of Year 1 and verifies that they were not supposed to be reported in Year 2.
What assertion is being tested?
The auditor is investigating whether or not these transactions actually occurred and should be recognized in the reporting period. Thus, this test is made to substantiate the existence, the occurrence, and the cutoff assertions.
When a check is prepared to pay an account payable voucher, what takes place within the accounting records?
The check should be supported by the check register or cash disbursements journal. The total of the check register or cash disbursements journal becomes a credit item for cash and a debit item for accounts payable in the general ledger.
An auditor takes a sample of accounts payable transactions recorded during the three to five days immediately after the end of Year 1 and verifies that they were not supposed to be reported in Year 1.
What assertion(s) is being tested?
The auditor is investigating whether these transactions should be included in Year 1 or Year 2. Whenever an auditor is investigating whether transactions were left out of a reporting period, the auditor is testing the completeness and cutoff assertions.
The subsequent period is the time period between the end of the reporting company's fiscal year and the last day of the auditor's field work. The auditor looks for audit evidence during this period of time.
What types of evidence might an auditor examine during this time period in substantiating inventory and accounts payable amounts?
In the subsequent period, the auditor should look at each of the following:
1. Cash payments that might indicate year-end liabilities that were not recorded.
2. Receipt of inventory that might have belonged to the company at year-end, but was not recorded as such at year-end.
3. Invoices received by the company that might indicate year-end liabilities.
4. Perishable and other inventory that fails to sell, which might indicate that it should have been written down at year-end.
An auditor is concerned that the reporting entity might have inventory out on consignment at year-end.
How might the auditor gather evidence in this matter?
In searching for consigned inventory, the auditor:
1. Reviews the contracts file for any documentation of such an arrangement. The auditor could also check the prior year's audit file for any information on consigned inventory and how it was investigated in that audit.
2. Watches for suspicious receivable transactions where cash payments were made in periodic or random intervals. the consignee company may be making payments to the client as the items are sold.
3. Reviews all returned accounts receivable confirmations to determine if there is any mention of goods being held on consignment.
When should a company take its physical inventory count?
If a company is using a periodic inventory system such that there are no records to indicate the account balance in inventory, the physical inventory count must be taken at or near the end of the reporting period.
If a company is using a perpetual inventory system such that there are records of inventory items continually available, the physical count can be taken at virtually any time during the year. However, if the auditor's assessment of either inherent risk or control risk is relatively high, the auditor will probably demand that the physical count be accomplished on the last day of the reporting period.
What is the independent auditor's role in connection with the physical inventory count?
The auditor should be present to observe the inventory count in order to ensure that the company has performed this task accurately. The auditor would remain available throughout the process to answer questions from or concerns of those individuals who are engaged in the count.
In observing the inventory count, the auditor expects to see all obsolete and damaged inventory separated from the salable inventory.
Why is this important? What assertion is being tested?
Obsolete and damaged inventory (as well as any other inventory that might be unsalable) should be valued at its net realizable value (expected sales price less any cost to sell). the auditor is testing the valuation assertion when he considers what items of inventory might be obsolete, damaged, or otherwise unsalable.
In observing the physical inventory at year-end, the auditor takes and records test counts.
What is the purpose of this audit step?
The test counts of inventory items are taken to verify the accuracy of the client's count.
The test counts are recorded so they can be reconciled with the costing figures later documented by the client. For example, if the client asserts that the 20 sofas on hand at year-end have a cost of $198 each, the auditor wants to make sure that 20 was the number of sofas on hand at year-end.
The client's inventory valuation (and, hence, the cost of goods sold and net income) can be manipulated simply by increasing or decreasing the number of units that were supposedly on hand and counted at year-end.
Which management assertion is affected when the number of units of inventory is understated?
Which management assertion is affected when the number of units of inventory is overstated?
Understated inventory means that certain transactions have been left off the financial statements at year-end, which affects the completeness assertion. This situation could involve the underreporting of inventory that is physically present at year-end.
Overstated inventory means that extra transactions were included in the financial statements, which affects the existence and perhaps the cutoff assertions.
The inventory turnover rate has decreased rather significantly during the current reporting year.
What types of problems might this indicate?
If the inventory rate has declined during the current reporting period, either the cost of goods sold amount has declined or the average inventory amount has increased, which might indicate the following problems:
1. Obsolete or damaged inventory or just excess inventory is being held, which is inflating the inventory figure.
2. Year-end inventory cut-off transactions were perhaps handled incorrectly, and some of the ending inventory items should not have been included.
3. The application of FIFO or LIFO inventory valuation is computed incorrectly, causing inventory and cost of goods sold to be incorrectly stated.
After a check is written, signed, and mailed, what happens to the accounts payable voucher?
Because an accounts payable voucher is an approval to disburse a payment, the company is concerned that a voucher could be reused to trigger the processing of additional checks. Therefore, immediately after the check is signed, the voucher should be defaced or marked in some way so as to prevent its reuse. "Paid" can be stamped on the voucher in obvious places, or the voucher could be perforated mechanically with the date paid clearly indicated.
What management assertion is most important when an auditor examines accounts payable?
Companies often understate their liabilities because this understatement improves net income, current ratio, and net worth. Recording of accounts payable is predicated upon the receipt of a document that comes form outside the company.
Whenever the auditor is concerned that transactions have been left off of the financial statements, the auditor is testing the completeness assertion.
When placing an order, the purchasing department must prepare a purchase order.
What information should be found on a purchase order?
The purchase order should contain the following:
1. Vendor's name.
2. Quantity and price of the item ordered.
3. Description of item ordered.
4. Proposed terms of the invoice document.
5. Destination and timing as to where and when the goods are to be shipped.
The requisitioning department produces a purchase requisition to indicate that an item (such as a computer or certain type of inventory) is needed.
What department gets this document?
The purchase requisition is sent to the purchasing department, the department that is in charge of orchestrating the company's purchase transactions.
What is an approved vendor list and its purpose?
An approved vendor list is an authorized list or file of vendors that the purchasing department can buy from without additional approval.
By limiting the authorized vendors that the purchasing department can use in its day-to-day purchasing decisions, the company can ensure that each vendor is legitimate and of good quality and reputation, which helps prevent items of poor quality, perhaps higher prices, and perhaps kickbacks from unauthorized or unscrupulous vendors.
What document is prepared by the receiving department when goods are received?
Who gets a copy of this document?
The receiving department prepares a receiving report, which lists the item's quantity, description, and condition as it was received. Copies of the receiving report are sent to a number of departments within a company, including:
1. Accounts (or vouchers) payable, as documentation for the receipt of the merchandise.
2. Inventory, to update its current records of the on-hand item quantity.
3. The purchasing department.
What happens after the accounts payable voucher has been prepared, reviewed, and approved?
The accounts payable voucher should be recorded in a voucher register, which documents the date and the amount of the liability and what was acquired. The voucher register is usually totaled on a daily basis, with the appropriate records being transmitted to the general ledger. The accounts payable voucher is then physically sent to the cash disbursements department.