CH-12 The Purchases, Payables and Payments Process – Auditing: An International Approach : Book Guide

CHAPTER 12 The Purchases, Payables and Payments Process SOLUTIONS FOR REVIEW CHECKPOINTS 12-1 A purchase requisition is a document authorizing the purchase of the items specified. It is part of a control system and used to ensure only authorized person commit the company to purchasing goods and services. It is also the basis of approving payments for goods and services received (when matched with a receiving report or other approval by appropriate personnel) to ensure only valid payments are processed. 12-2 Duplicate payment based on the same supporting documents can be prevented by stamping or impressing "paid" on the supplier invoice and supporting documents, or by perforating (mutilating) the documents so they cannot be reprocessed unintentionally. In IT-based systems, automated controls can be used to assign unique idenitifiers and prohibit a supplier invoice already paid from being processed again. 12-3 You will find evidence about losses on purchase commitments in the open purchase order file. Evidence about unrecorded liabilities to suppliers in the (1) unmatched invoice file and (2) unmatched receiving report file. Major losses may also be discussed in minutes of board of directors meeting. 12-4 Main supporting source documents used in the purchases, payables and payments process: Purchase requisition Purchase order Receiving report Supplier's invoice Cancelled cheque or cheque copy 12-5 Management reports that can be used for audit evidence. What information in them can be useful to auditors? Open Purchase Orders--purchase commitments, losses on purchase commitments Unmatched Receiving Reports--goods received but not recorded as purchases or liabilities Unmatched Supplier Invoices--unrecorded invoices, may represent unrecorded liabilities or items in dispute Accounts Payable Trial Balance--subsidiary ledger of accounts payable. May show balances by suppliers, indicating small balances that are expected to be large. Invoice dates may reveal failure to record invoices late in the accounting period. Purchases Journal--listing of all purchases available for analysis of purchasing patterns and oddities. Population for sample of purchases for detail test 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 Reports--fixed assets subsidiary ledger trial balance. Scan for negative balances, capitalized repairs, depreciation in excess of salvage value. Depreciation recalculation. Cash Disbursements Report--cash disbursements journal. Date, cheque number, payee, amount, account debited for each cash disbursement, and a cross-reference to the supplier invoice number (or system generated identifier). This journal is a population of dash disbursement transactions available for sample selection for detail test of controls audit of supporting documents in the voucher for validity, authorization, accuracy, classification, accounting, and proper period recording. 12-6 The functions which 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) and (3) bookkeeping (accounts payable department, inventory record keeping department). 12-7 1. Clear procedures requiring use of purchase orders, receiving reports and approvals, and requirements for invoices to be marked ‘PAID’ to prevent duplicate processing are developed, communicated and understood by all personnel involved in processing payments. 2. Blank supporting documents (purchase requisitions, purchase orders, receiving reports) kept in secure locations available only to authorized personnel, or access restricted to appropriate personnel by ID and password assignment, if computerized. 3. Supporting documents cancelled by Cash Disbursement function when cheques are prepared. 4. Separation of duties of preparers of supporting documents, cheque preparation, and cheque signing. 5. All supporting documents reviewed by cheque signers. 6. Cheques mailed directly by signer and not returned to accounts payable. 12-8 An auditor could determine whether the purchasing agent had practiced "purchase order splitting" by scanning the purchases journal (or equivalent record) to spot numerous purchases near, but just less than, the limit required for bidding (or higher level approval). Could also make inquiry about major types of goods purchased in large lots or used continually, then examine purchases of those items for splitting. Bank reconciliations could also be reviewed to see if there are a large number of payments just below the limit amount. 12-9 The two characteristic parts of a test of controls procedure are: (1) description of the data population from which a sample will be drawn, and (2) expression of an action to take in terms of recalculating, vouching, tracing, etc. 12-10 From shipping department: The information is quantities and identifications of products removed from the inventory. It is used to support reductions of the detail inventory records for each product in the inventory. From receiving department: The information is quantities, identifications, and conditions of goods returned by customers. It is used to support additions to the detail inventory records. From (warehouse) (inventory stores) department: The information is quantities, identifications, and conditions of goods received on purchase orders. It is used to support additions to the detail inventory records. 12-11 Functional responsibilities that should be delegated to separate departments or management levels are: (1) capital budget planning and approval of capital expenditures, (2) data processing of documents evidencing delivery or construction and payment, (3) physical custody and operating responsibility for use of assets, (4) authority to idle, sell, or otherwise take assets out of use, and (5) periodic inspection (inventory) of fixed assets with comparison to books (recorded accountability). 12-12 The purpose of the auditor's search for unrecorded liabilities is to gather evidence as to whether the liability assertion is true. The same concern exists in the internal control objective "all valid transactions are recorded and none are omitted." 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. Generally, auditors would send confirmations to audit accounts payable if the risk of misstatement is high because controls over recording payables were weak during the period. Risk of misstatement would also be high if the auditor finds other evidence suggesting there should be significant payables balances but the recorded balances are very low. This other evidence could be a high volume of inventory receipts, or other major expenditures prior to year end that have not been paid for in cash. 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. 12-13 A continuity schedule for an accrued liability will include the opening balance, the expenses recognized/accrued during the period will be added to the balance, the cash paid out to discharge the obligations will be deducted, to arrive at the final balance that will appear on the period-end balance sheet. 12-14 Typical substantive procedures to verify the inventory valuation assertion include: Enquire about and make note of any damaged or scrap inventory, or inventory that appears slow moving or obsolete. Select a sample of inventory items from the final compilation. Vouch unit prices to vendors’ invoices or other cost records. Recalculate the multiplication of unit times price. Recalculate the extensions and totalling of the final inventory compilation for artithmetic accuracy. For selected inventory items and categories, determine the replacement cost and the applicability of lower-of-cost- or-market valuation. Determine whether obsolete or damaged goods should be written down. Enquire about obsolete, damaged, unsalable, slow-moving items.Scan the perpetual records for slow-moving items.Ensure obsolete and damaged goods observed during the physical observation have been removed from the final inventory compilation.Compare the listing of obsolete, slow-moving, damaged, or unsalable inventory from last year’s audit to the current inventory compilation. 12-15 The auditee’s final inventory compilation is tied into relevant general ledger accounts and supporting evidence the auditor obtained during the attendance at the company’s physical inventory count, as follows: a. Trace the samples of inventory items audited at the physical inventory count observation to the final inventory compilation. b. Select a further sample of items from the physical inventory listing and verify existence by finding them in the inventory. c. Trace other information (items, quantities) recorded from the inventory listing at the count date to the final compilation. For any obsolete and damaged goods observed during the physical observation the auditors will ensure they have been removed from the final inventory compilation At year-end (at physical inventory count observation) the numbers of the last shipping and receiving documents for the year are obtain. The auditor will tie these into the sales, inventory/cost of sales, and accounts payable entries to verify proper cutoff. 12-16 The FOB terms in force determine when title passes and are used to identify goods-in-transit that are not physically on hand but should be included as soon as shipped since they are FOB shipping point. Failure to record inventory purchases FOB shipping point would result in understating ending inventory and accounts payable at year end. Similarly for goods shipped out that are FOB destination, the company may still own the goods if they haven’t been delivered as of year end. If the sales were recorded prior to delivery, it result in an an overstatement of sales and accounts receivable. If the sales were not recorded early, but the inventory was not included, ending inventory and cost of sales would be understated. The FOB terms must be known to ensure goods-in-transit are correctly cut-off. 12-17 Existence and completeness. 12-18 Additions would be vouched to purchase invoices, contracts, etc. Disposals would be vouched to records of sale or scrapping of the assets, and cash receipts if any proceeds were obtained. Calculation of gain or loss would be reviewed as well. Any impairment calculations would be reviewed for reasonability. 12-19 Recalculation of amount using the policies set by management. Enquiry regarding the depreciation policies and reasons supporting them. Analysis of industry practices for similar assets to assess reasonability of method, useful lives, residual values, etc. 12-20 The search for unrecorded liabilities is a set of procedures designed to yield audit evidence of liabilities that were not recorded in the reporting period. This search should normally be performed up to the audit report date in the period following the auditee’s balance sheet date. Examples of procedures are: • Scan the open purchase order file at year-end for purchase commitments at fixed prices. From current prices, determine if any adjustments for loss and liability are needed. • List the unmatched supplier invoices and, from the unmatched receiving report file and receiving reports prepared after year-end, determine when the goods were received. Determine which invoices, if any, should be recorded. • Trace the unmatched receiving reports to accounts payable entries, and determine if any recorded in the next accounting period need to be reported in the current accounting period under audit. • Vouch a sample of cash disbursements from the accounting period following the balance sheet date against supporting documents (invoice, receiving report) to determine if the related liabilities were recorded in the proper accounting period. Select the sample from the post-year-end cutoff bank statement to audit the cash balance (see Chapter 11). • Trace liabilities reported by financial institutions to the accounts. (See the bank confirmation in Exhibit 11–8, Chapter 11.) Since a bank may not report all auditee liabilities to auditors, other corroborating evidence for possible unrecorded debts should also be obtained. • Canada Revenue Agency notices of assessment may contain evidence of income or other taxes in dispute that may need to be recorded as liabilities. • Confirm accounts payable with suppliers, especially regular suppliers showing small or zero balances in the year-end accounts payable. (Suppliers’ monthly statements controlled by the auditors also may be used.) Verify supplier addresses so confirmations will not be misdirected—perhaps deliberately. • Study the accounts payable trial balance for dates showing fewer payables than are usually recorded near the year-end, evidence that invoices aren’t being recorded. • Review responses from auditee’s lawyers to requests for information about pending or threatened litigation, and about unasserted claims and assessments. These may indicate a need for contingent liability accruals or disclosures. (As explained in Chapter 16, when the auditor assesses a risk of material misstatement due to litigation or claims, CAS 501 requires that enquiry letters prepared by the auditee be sent to the auditee’s lawyers by the auditor. These letters request the lawyer to communicate directly with the auditor.) • A checklist of accrued expenses will help determine whether the company has been conscientious in 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 warranties, and guarantee expense. • When auditing the details of sales revenue, the terms of sales will help determine if any amounts should be deferred as unearned revenue. (Initial information is gained by enquiries to management about terms of sale, such as customers’ rights of cancellation or return.) • A schedule of casualty insurance on fixed assets is used to determine the adequacy of insurance in relation to asset market values. Inadequate insurance and self--insurance create risks that should be disclosed in the notes to the financial statements. • Confirm life insurance policies with insurance companies to ask whether the company has any loans against the cash value of the insurance. Also request the names of the beneficiaries of the policies. If a party other than the company benefits from the insurance, it may be a creditor on unrecorded loans. Enquire about the business purpose of making insurance proceeds payable to other parties. • Review terms of any debt due within one year but classified long-term because the company plans to refinance it on a long-term basis. This cannot be based on management’s intent; holders of the debt or financial institutions must have shown (preferably in writing) a willingness to refinance the debt before it can be classified long-term. • Apply analytical procedures appropriate in the circumstances. In general, accounts payable volume and period- end balances should increase when the company increases physical production volume or engages in inventory stockpiling. Some liabilities may be related to other activities; for example, sales taxes are functionally related to sales dollar totals, payroll taxes to payroll totals, excise taxes to sales dollars, or volume and income taxes to income. 12-21 The main difference is in the focus of the evidence obtained, that is, which assertions each is most relevant to. The relative risk with accounts receivable is that the account balance may be overstated (existence assertion). Therefore, auditors are careful to confirm recorded balances, particularly large ones. The relative risk with accounts payable is that the account may be understated (completeness assertion). Therefore, auditors should be careful to confirm payables where understatement may exist--the small and zero balances--particularly those of suppliers with whom the company does a lot of business. 12-22 Auditors get in the most trouble by missing overstated assets and understated liabilities. This is because of the impact of these types of misstatement on financial information and ratios frequently used for making important decisions, such as current ratio, debt:equity ratio, and return on investment. Therefore, auditors need to emphasize the existence of assets and the completeness of liabilities. Overstatements of assets means there could be ficticious assets on the balance sheet, while understatements of liabilities means there could be unrecorded amounts. 12-23 The characteristics that the auditor is looking for in reviewing the auditee’s inventory-taking instructions include: 1. Names of auditee personnel responsible for the count. 2. Dates, times, and locations of inventory-taking. 3. Names of auditee personnel who will participate in the inventory-taking. 4. Detail instructions for recording accurate descriptions of inventory items, for count and double-count, and for measuring or translating physical quantities. 5. Detail instructions for making notes of obsolete or worn items. 6. Detail instructions for the use of tags, cards, count sheets, bar code readers, or other media devices, and for the collection and control of the count data. 7. Plans for shutting down plant operations or for taking inventory after store closing hours, and plans for having goods in proper places. 8. Plans for counting or controlling movement of goods in receiving and shipping areas if those operations are not shut down during the count. 9. Detail instructions for computer compilation of the count media (e.g., tags and cards) into final inventory listings or summaries. 10. Detail instructions for pricing the inventory items. 11. Detail instructions for review and approval of the inventory count, notations of obsolescence, or other matters by supervisory personnel. 12-24 Dual-direction sampling in the context of inventory test counts proceeds as follows: 1. In one direction, a sample of inventory items can be chosen from the perpetual records for test count to ascertain that recorded inventory was counted. (audit for existence) 2. In the other direction, the auditor can count a sample of items in their locations, record these, and later trace them to the perpetual records and inventory summary count sheets to ascertain whether all inventory in place was recorded and counted. (audit for completeness) 12-25 In this type of situation, the auditor will arrange to be present during one more of the test counts, and importantly, she or he will evaluate the cycle or statistical plan for validity. During the observation of the inventory-taking, the auditor will employ the usual inventory audit procedures perform test counts and be responsible for a conclusion concerning the reasonable accuracy of perpetual quantity records. 12-26 Valuation of PPE and intangible assets can be a very high risk assertion as there are many allocations and estimates involved. Due to their long lives, a number of valuation changes can occur over time. Thus, there is a high degree of complexity involved in applying GAAP for subsequent measurement, amortization, and recording impairment losses. If market conditions or production technologies change over time, an asset’s value may become impaired requiring a writedown to be recorded. Overall, the accounting choices available within GAAP, and the subjective kinds of information used, can allow management bias to affect the estimates. Also, the amounts invested in these long-lived operating assets can be quite large. These factors can often lead to the risk of material misstatement for the valuation assertion being high for PPE and intangible assets. 12-27 A continuity schedule is used to keep track of details underlying the valuation of PPE and intangible assets. They are prepared by management for its own control purposes, and the auditors can use it as a working paper on which to summarize their verification work and conclusions. 12-28 Examples of "receiving departments:" - Unloading dock where trucks park to unload (e.g. oil pumped into storage tanks) - Employees who sign for receipt of supplies and services (e.g. scripts) delivered through the "front door" - Contracts that call for regular payments, once authorized and accepted (e.g. rent and lease agreements) - Arrangements where receipt is "automatic" (e.g. electricity, water, gas) 12-29 The cases on Printing Copying Money and Retread Tires all include fictitious people, businesses, and locations. Audit them for validity by: - Find names in professional licensing directories (e.g. doctors) - Find the business address in a directory (telephone, chamber of commerce, website) and visit the location - Inquire at municipal clerk office for name of owner of real property - Inquire with government ministry of commerce for names of incorporators of corporations - Inquire with provincial or local offices for real names behind business "assumed names" 12-30 Using analytical procedures for discovery of excess costs: Compare physical quantity usage for comparable periods (fuel oil in the Receiving Missing Oil case) 12-31 Using analytical procedures for discovery of understated expenses: Compare forecast to actual results to determine the accuracy track record of personnel responsible for forecasts used in accounting calculations (Amortize the Drum Slowly Case) 12-32 Auditors need to know the physical characteristics of auditee's inventories so they can tell the difference between real and phony goods (e.g. new tires and retread tires in the Retread Tires case) 12-33 Professional skepticism is important for auditors because (1) it enables them to suspect a crook instead of being naive (e.g. documentation oddities in Retread Tires case), and (2) it could help auditors be more independent from managers optimism (e.g. revenue forecasts in Amortize the Drum Slowly case). 12-34 The verbal inquiry procedure might produce these kinds of information: - Printing (Copying) Money: Knowledge of employee's responsibilities to authorize purchases of script copies, receive them, approve payment, and code invoices to projects. - Receiving the Missing Oil: Knowledge of receiving employee’s reliance on delivery truck driver's quantity measurement. - Retread Tires: Knowledge of company's business locations (no mention of the false location). SOLUTIONS FOR EXERCISES AND PROBLEMS EP12-1 Liabilities: authorization control Authorization for accounts payable recording mainly consists of an approved purchase order, a receiving report, and an accurate supplier invoice. Auditors should look for purchase approval signatures, receiving approval signatures, and approval of the supplier invoice--checks by auditee for proper quantity, price, and discount. EP12-2 Cash disbursements: completeness control Auditors should determine if prenumbered documents are in use and whether someone has a continuing responsibility to check for intact numerical sequence. Auditors should scan and check populations for missing numbers. Computer scanning or counting can be used. EP12-3 Automated transactions: authorization control Two automatic transactions, (1) cheque printing and signature, and (2) purchase order at stock reorder point. Delay could be achieved by having the computer show a list onscreen or print a report of "proposed" transaction prior to automatic execution. An official could "approve" them by sending them from this kind of holding list forward through the processing. EP12-4 Liabilities: insurance coverage The auditor should be concerned with insurance coverage to determine that the auditee is not underinsured. If the auditee has not adequately insured the operating assets, an undue risk has been taken by management which may require disclosure. Normal business practice has not been adhered to and users of financial statements may need to be informed. EP12-5 Inventory: enquiry-based evidence As is true in other areas of a financial audit, enquiry is a valuable tool for obtaining preliminary evidence in the audit of inventory and cost of sales. For example, the auditor can gain information such as the locations of inventory, dates for the physical count, inventory held by consignees and public warehouses, the cost-flow assumption used to price cost of goods sold and inventories, and the pledging of inventory as collateral on loans. In addition to providing preliminary evidence, enquiry frequently provides information about the status and value of slow-moving inventory, apparently worn, damaged or obsolete inventory, and the existence of large inventory stockpiles. EP12-6 Specific assertions: fixed assets Some of the specific assertions related to fixed assets and related accounts are: * All recorded fixed assets are in productive use. * All asset disposals have been recorded. * All asset additions have been recorded. * Repair and maintenance expenses have not been capitalized. * Asset additions have not been improperly charged to repair and maintenance expense. * All costs of freight and installation on additions have been capitalized. * Leases have been capitalized in conformity with GAAP pronouncements. * Depreciation has been calculated accurately. * Taxes have been paid or accrued on all taxable asset property. * Casualty insurance is carried. * Assets pledged as collateral have not been improperly removed. EP12-7 Repairs and maintenance auditing The repairs and maintenance account is audited at the same time as the fixed asset accounts to determine whether items that should be classified as assets are misclassified. The same documentary files may be involved in new fixed asset acquisitions, such as work orders, cost accounting records, purchase orders and suppliers' invoices. The auditor must be alert to fixed assets misclassified as repair and maintenance expense because the auditee may be attempting to put the complete write-off in the year acquired, to avoid tax or increase income in subsequent years. EP12-8 Fixed assets: audit procedures Recalculation is used to verify cost and depreciation amounts related to the valuation of assets. Observation produces evidence about existence, use, and condition relevant to existence, valuation, and presentation assertions. Confirmation is used to get outside parties to provide external evidence about such matters as terms of leases, payment of taxes, pledge of assets as collateral, etc. This evidence can contribute to the valuation, existence, and presentation (GAAP disclosure) assertions. Enquiry produces evidence about location, status, condition, and plans for disposal relevant for the valuation and GAAP disclosure assertions. Inspection of title documents or property tax bills (for example) produces evidence about ownership rights. Scanning repairs and maintenance, taxes, insurance, and fixed asset accounts for large and unusual entries can produce leads about improperly expenses assets additions (completeness assertion), new taxes on new assets (completeness of the asset accounts assertion), failure to insure assets (GAAP disclosure assertion), and disposals (existence assertion). Physical inspection is used in an "inventory" of fixed assets to produce evidence about existence and completeness. Analysis can be used to calculate an estimate of depreciation expense based on average depreciation rates (valuation assertion). EP12-9 Payables internal control questionnaire items 1. a) Purchases and accounts payable are authorized according to company policy (proper authorization). b) For a sample of cash disbursements, vouch to approval signatures on invoices, receiving reports and purchase orders. c) Liabilities might be incurred in the company's name without the knowledge of responsible officers. 2. a) Cash disbursements are recorded in the proper period (proper period cutoff, completeness) b) Select a sample of dated cash disbursements and vouch to cancelled cheques, comparing the dates. c) Cash disbursements could be recorded late, thus temporarily overstating cash. 3. a) Valid liabilities are recorded and none omitted (sound error checking practices). b) Observe auditee personnel making comparisons. Review correcting journal entries that result from the comparison. c) Purchases or other liabilities may fail to be recorded and the error not detected by any other means. 4. a) Recorded liabilities and cash disbursements valid and documented (sound record keeping). b) Select a sample of recorded supplier invoices, and vouch them to purchase orders and receiving reports for proper quantities and prices. c) The company might record overstated or understated liabilities. EP12-10 Inventory count, measurement The question is an exercise in applying knowledge of special business characteristics as they relate to inventory. One approach would be to identify the inherent risk of misstatements for each of the different business’s inventory assertion by assertion, and use this analysis to indicate where the key audit effort needs to be focussed to obtain sufficient, relevant evidence. Developing specific audit procedures to generate this evidence would also be a useful exercise. Some examples follow: 1. Pharmaceuticals in a drug company, - inherent risk from identifying different substances that look the same but may differ greatly in value (sugar vs. aspirin) - expert required to examine and identify substances - audit procedures should provide for the expert to provide independent competent identification evidence to auditor, under auditor’s direct control 2. Fine chemical compounds in a biotechnology company, - inherent risk from identifying different substances ( same as 1.) - also valuation of deferred development costs, patents, etc. present measurement challenges - examination of costs of research and development by examining supporting documentation, expert may be required to evaluate development viability criteria will be important audit procedures 3. Software in an information technology development company, - inherent risk from assessing the viability of the software being developed - obtaining evidence supporting the probable success of new products, probably based largely on management estimates, testing results indicating operability and feasibility - examination of costs of R&D will be a key audit procedure (similar to 2.) 4. New condominium office units in a commercial real estate developer, - inherent risk mainly from exposure to real estate market price and demand fluctuation, and cost allocations to units - effort examining process for assigning material,labour, overhead costs to units, and examining documents and records supporting the recorded amounts, and assessment of fair valuation of these assets to determine whether any writedown is required - audit procedures should include examination of supporting documents, analysis of cost calculations, and analysis of relevant real estate market data to assess fair values. 5. Fine art works in an interior design business. - inherent risk from valuation, as this is very subjective - expert appraiser may be required if this asset is material and likely to be overstated - audit procedures should examine cost data and management evidence of market values no less than costs, if appraisal values are obtained ensure the expert is providing independent competent valuation information, under auditor’s direct control EP12-11 Inventory, Analysis of Gross Margin. It is reasonable to agree with Li that the gross margin indicates an error in 2010 ending inventory. Sales have decreased yet the margin has increased. This could be due to cost reductions, but purchases appear to exceed sales (based on the ending inventory), which would be very unexpected. Most likely the ending inventory for 2010 is overstated (based on the increase in inventory and the likely error in purchases). Source: CGA-Canada AU1 Examination June, 2011. EP12-12 Inventory, Impact of Cutoff Error a) This is a cut-off error. Accounts payable will be understated as this error affects the completeness assertion Current liabilities will be understated Inventory balance is correct since these goods exist and would have been included in the total balance based on the physical count as long as the inventory was correctly costed out at FIFO to prepare final inventory valuation, valuation assertion is also okay Cost of sales will be incorrect - understated, incomplete - since it will be calculated based on perpetual records that excludes the purchase Income and equity also will be overstated b) Cut-off test involves tracing documents for last goods received and included into recording of inventory perpetual balance, and the related accounts payable recording, to ensure they are in the same period. This test will show that the A/P side was not recorded in the correct period c) Quick ratio, including error = (1500000-900000) / 450000 = 1.33 with error corrected = (1500000-900000) / (450000+65000) = 1.17 The impact of correcting the error is to lower the ratio from 1.33 to 1.17 d) The error will push quick ratio below the covenant minimum of 1.2, down to 1.17. Yes, it would be reasonable to consider this error material based on qualitative considerations, even though its impact is quantitatively small (i.e., after rounding up the ratio is still 1.2). Since the misstatement affects a key financial ratio that the bank/user is monitoring, it can have an impact on user decisions, which is the key criterion for determining materiality. It has the potential to affect the banker’s decision to continue the loan or call it back. EP12-13 PPE audit evidence and assertions a) The types of evidence and related assertions include: Inspection - physical, documents -by tracing from the evidence of the physical assets on hand to the list auditor is verifying the completeness of the listed assets -by vouching the items on the list to the actual assets, she is verifying existence Enquiry based evidence (management’s answers to her questions) this plus the inspection evidence, relates the valuation/accuracy of the recorded information - descriptions on list match actual physical items - the broken shelves should possibly be written off - evidence about additions that should appear in the cash flow statement (but not about the monetary amounts - additional procedures would be required for that) b) The physical inspection evidence about the existence of the quantities of fixtures is most reliable Reasons: It is the direct personal knowledge of auditor, not subjective The evidence about completeness is less reliable - there may be fixtures in storage that she wasn’t told about - she would need to rely on management representations. The evidence about valuation (write down) is also less reliable, since it is subjective. c) In these procedures the auditor is not checking costs of the fixtures, i.e. he not vouching recorded dollar costs of items to supporting documents (purchase invoices) so he has no evidence about valuation at cost, or the amount of additions to include in the cash flow statement He has not recalculated depreciation, so has no evidence related to that valuation aspect. SOLUTIONS FOR DISCUSSION CASES DC12-1 Purchasing control procedures Those internal control procedures Long would expect to find if Marylou's system of internal accounting control over purchases is effective are: * Purchase requisitions are prepared and/or approved only after there has been a proper determination of the need for the goods requested. * One copy of the purchase requisition is maintained on file in the stores department (computer file). * Purchase requisitions are approved by a responsible person in the store's department. Approval is given only after that person is satisfied that a need exists and that the requisition is properly prepared. Approval is clearly indicated on requisitions. * Purchase orders are issued only after they are approved by persons given the specific responsibility to make such approval. * Suppliers are requested to confirm purchase orders. This indicates acceptance and constitutes a contractual commitment. * Purchase requisitions are filed with purchase orders, and both are maintained in an orderly file in the purchase office (computer file). * Copies of purchase orders sent to the receiving department do not include the quantities of merchandise ordered (blind purchase order). * All purchase orders are numbered, and all numbers are accounted for. This allows control over purchase orders cancelled or rejected by suppliers. * Receiving department accepts only those goods for which a purchase order is on hand. DC12-2 Control tests for cash disbursements Note to Instructor: Procedure #2 below is designed to indicate that work on one sample of cash disbursements can produce evidence related to several objectives. The tasks numbered 2a through 2l all relate to the #2 sample items. AUDIT PROGRAM TEST OF CONTROLS AUDIT PROCEDURES Internal Control Objectives Test of Controls Procedures Validity Objective Recorded disbursements are valid and documented--representing payment for goods and services received. 1. Observe who has custody of signed cheques for evidence of segregation of duties from persons having cash disbursement or accounts payable record-keeping responsibilities and from persons who have cash disbursement authorization responsibilities. 2. Select a sample of cash disbursements recorded during the period, and 2a. Compare to the cancelled cheque. 2b. Examine for authorized signature and proper endorsement matching payee name. 2c. Compare recorded amount and cheque amount. 2d. Compare recorded payee name and name on cheque. 3. Scan the recorded cash disbursements for large or unusual amounts and perform the same work on these items as in the #2 sample. Authorization Objective Cash disbursements are authorized according to company policy. 2e. Examine supporting documents for a proper authorizing signature or initials approving the amount for payment. 2f. Trace authorizing signature to list of authorized approvers. 2g. Trace supplier's name to approved supplier list. Accuracy Objective Cash disbursement dollar amounts are calculated and recorded accurately. 2h. Recalculate amounts shown on supporting supplier's invoices and compare to cheque amount. 2i. Recalculate cash discount, if any. Classification Objective Cash disbursements are properly classified in the accounts. 4. Obtain a chart of accounts and the accounting manual pertaining to classification policy. 2j. For each disbursement, determine whether the debit entry is classified accurately. Accounting Objective Cash disbursements accounting is complete-- properly summarized and posted in the general ledger. 5. Foot selected summaries (daily, monthly) of cash disbursements. 6. Trace these totals to the general ledger debit and credit entries. 7. Foot the general ledger cash account. Proper Period Objective Cash disbursements are recorded in the proper period. 8. Observe cash disbursement procedures and inquire to find out whether cheques are held for time before mailing. 2k. Compare date on cheque to date of recorded disbursement. 2l. Compare dates to payee's bank clearance date for any apparent lengthy delay which indicate that cheques are held before mailing. DC12-3 Unrecorded liabilities procedures a) The fact that the auditee made a journal entry to record suppliers' invoices which were received late should simplify the PA's audit for unrecorded liabilities and reduce the possibility of a need for a further adjustment, but the PA's audit is nevertheless required. If the auditee has not journalized late invoices, the PA is compelled in his testing to substantiate what will ultimately be recorded as an adjusting entry. In this examination the PA should audit entries in the accounts payable records (e.g., trial balance) for the year being audited to ascertain that all items which according to dates of receiving reports or suppliers' invoices were applicable to that year have been included in the journal entry recorded by the auditee. b) No. The PA should obtain a letter in which responsible executives of the auditee'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 PA and it does not relieve the responsibility for doing other substantive audit work. c) Whenever a PA 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 PA 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 PA should discuss the nature and scope of the internal audit program with the internal auditor and review the working papers in order that the PA 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 PA may limit further audit work in this audit area. d) In addition to the next-year accounts payable records, the PA should consider the following sources for possible unrecorded liabilities: 1. Unentered suppliers' invoice file. 2. Status of tax returns for prior years still open. 3. Discussions with employees. 4. Representations from management. 5. Comparison of account balances with preceding year. 6. Examination of individual accounts during the audit. 7. Existing contracts and agreements. 8. Minutes. 9. Attorney's bills and letter of representation. 10. Status of renegotiable business. 11. Correspondence with principal suppliers. 12. Audit testing of cutoff date for reciprocal accounts, e.g., inventory and fixed assets. DC12-4 Accounts payable confirmation 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. To determine adequacy of internal control for processing and payment of invoices. 2. To prove that amounts shown on the balance sheet are in agreement with supporting accounting records. 3. To determine that liabilities existing at the balance sheet date have been recorded. b) Clark and Kent are not required to use accounts payable confirmation procedures. For accounts payable the auditor can examine external evidence such as supplier invoices and supplier statements which substantiate the accounts payable balance. Although not required, the accounts payable confirmation is often used. The auditor might consider such use when 1. Internal controls are weak. 2. The company is in a "tight" cash position and bill-paying is slow. Debt covenants based on working capital minimums that may be violated are also a consideration in the amount of assurance required for accounts payable. 3. Physical inventories exceed general ledger inventory balances by significant amounts. 4. Certain suppliers do not send statements. 5. Supplier accounts are pledged by assets. 6. Supplier 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. Analyze the accounts payable population and stratify it into accounts with large balances, accounts with small balances, accounts with zero balances, etc. 2. 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). 3. Design a statistical sampling plan that will place more emphasis on selecting accounts with zero balances or relatively small balances, particularly when the auditee has had substantial transactions with such suppliers during the year, or a substantial balance in a previous year. 4. Select prior-year suppliers who are no longer used. 5. Select new suppliers used in the subsequent years. 6. Select suppliers that do not provide periodic statements. 7. Select accounts reflecting unusual transactions during the year. 8. Select accounts secured by pledged assets DC12-5 Inventory count observation: planning and substantive procedures a) Cindy should find in the audit working papers a planning memo describing the auditee's inventory-taking plan and notes about the auditors' first-hand observation of the instructions being given to counters, along with a memo about the auditors' observation of the counting. This memo should tell about supervision of the audit staff, and the working papers (test counts) should show the review signatures of the supervising auditors. b) Working papers should document performance of these substantive procedures for the existence and completeness assertions: . Conduct an observation of the company's physical inventory count. . Scan the inventory compilation for items added from sources other than the physical inventory count... . At year end, obtain the number of the last shipping and receiving documents...Use these to scan the sales, inventory/cost of sales, and accounts payable entries for proper cutoff. . Confirm or inspect inventories held in public warehouses. DC12-6 Sales/inventory cutoff In view of the information given, the following adjusting entries would be necessary: For the first item: Inventory Control 28,400 Inventory Variation 28,400 For the third item: Sales 21,300 Accounts Receivable 21,300 Since the goods in the first item were shipped prior to the taking of the physical inventory, the Inventory control account was reduced by the cost of these goods in the adjustment which arose from the physical inventory. Since the auditee credited Inventory Control for the cost of these goods on December 16, one of these two credits must be removed. The above entry reverses that made on December 15 with respect to these goods and leaves Cost of Sales properly charged with the $28,400 as a result of the December 16 entry. The sales entry was made properly and requires no adjustment. In the second item, the auditee has reduced the control account at the date of shipment, prior to the taking of the physical inventory. The control was in agreement with the physical count on December 15 so far as these goods were concerned, and the December 15 adjustment did not relate to these goods. Since the accounts involved are in agreement with the facts at both December 15 and December 31, no adjustment is necessary. In the third item, inventory was invoiced as sold on December 31, with the accompanying entry to cost of sales, but was still physically on hand. It can be assumed this inventory was included in the amount counted, and that the book value of inventory prior to the count was adjusted to equal the physical count value. Assuming the FOB terms transfer title at time of shipment or at time of receipt by customer, since the goods are not even shipped yet at year end the sale should not be recognized. The entry to record the sale needs to be reversed, or the sales and accounts receivable will be overstated. Since the inventory was on hand and hence counted, even though the books would have shown less due to the premature cost of sales/inventory control entry, the adjustment will bring the book balance to equal the physical balance, in effect adjusting the error already. Thus no further adjustment is required to the cost of sales or ending inventory balance. Note the following further explanation of the assumptions for the third item above: Say the book value of inventory showed $420,000 after deducting the premature cost of sales of $18,900. If this were the only error, and the physical count is done accurately, it would show the inventory on hand at year end is actually $438,900 (i.e. the $18,900 will be on hand and counted). This book-to-physical difference will have been recorded by the following entry: Inventory Variation 18,900 Cost of Sales 18,900 The ‘inventory variation’ account is essentially an account used to keep track of the book-to-physical adjustments (in a real company there may be many more of these than the one we are looking at in this example) and once the accountants are satisfied they have an accurate value they will transfer its balance into the inventory control account that will be reported in the balance sheet. So, in effect, once the accountants have processed their book- to-physical variation adjustments, this will have already corrected the impact of the premature sale entry and no further correcting entry should be made. (Note that if such an error is made at a time when the physical count value is not available, such as in the middle of the period, the inventory and cost of sales part of the error would need to be corrected.) DC12-7 Statistical sampling used to estimate inventory a) The following procedures are based upon, but not copied from, Appendix 12B: 1. Review and be satisfied with the auditee's physical inventory-taking procedures. 2. Observe the physical count 3. Make test counts where appropriate. 4. Trace selected count data to the inventory compilation 5. Select items from the compilation and trace them to original count data. 6. Select items from the warehouse at random and trace these items to the perpetual inventory record. 7. Verify footings. 8. Compare inventory compilation amounts to the subsidiary ledger control and investigate significant differences. 9. Ascertain that there was a proper purchases and sales cutoff. 10. Review the treatment of merchandise in transit and consigned merchandise. 11. Confirm merchandise in public warehouses. 12. Perform an overall analytic review of inventories. 13. Account for all auditee inventory count sheets. 14. Be sure inventory items are properly classified, in good condition, and of proper quality. b) When a company’s management uses statistical sampling to estimate inventories, the auditor should perform procedures similar to the following: 1. The auditor should review the auditee's procedures and methods for determining inventories to ascertain that they are sufficiently reliable to produce results substantially the same as those that would be obtained by a 100 percent inventory count. 2. The auditor should be satisfied that the statistical sampling plan to be used by the auditee has statistical validity, that it will be properly applied, and the planned tolerable misstatement and sampling risk as defined statistically, will be reasonable in the circumstances. 3. The auditor should ascertain that proper steps have been taken to ensure that all parts and supplies in the warehouse are included in the perpetual inventory record. This would normally be checked in advance of the physical count. 4. The auditor should be present when the sample is drawn to make sure that the requirements for random selection are properly observed and that all items in the inventory have an equal or determinable probability of selection. 5. The auditor must be present to observe counts and must be satisfied with the auditee's counting procedures. The inventory observation can be made either during or after the year end of the period under audit if well-kept perpetual records are maintained and the auditee makes periodic comparisons of physical counts with such records. 6. The auditor should review the statistical evaluation and be satisfied that the estimated value of the tolerable misstatement at a given level of sampling risk meets the materiality requirements set for the audit. DC12-8 Inventory procedures using GAS Basic Inventory Audit Procedures How General Purpose Computer Software Package and Type of Inventory File Data Might Be Helpful 1. Observe the physical count, making and recording test counts where applicable. Determining which items are to be test counted by making a random sample of a representative number of items from the inventory file as of the date of the physical count. 2. Test the mathematical accuracy of the inventory compilation (summary) Mathematically computing the dollar value of each inventory item counted by multiplying the quantity on hand by the cost per unit and verifying the addition of the extended dollar values. 3. Compare the auditor's test counts to the inventory records. Arranging test counts in a tape-format identical to the inventory file and matching the tapes. 4. Compare physical count data to inventory records. Comparing the total extended values of all inventory items counted and the extended values of each inventory item counted to the inventory records. 5. Test the pricing of the inventory by obtaining a list of costs per item from buyers, suppliers, or other sources. Preparing a tape in a format identical to the tape of the inventory file and matching the tapes. 6. Examine purchase and sale cutoff. Listing a sample of items on the inventory file for which the date of last purchase and date of the last sale are on or immediately prior to the date of the physical count. 7. Ascertain the propriety of items of inventory located in public warehouses. Listing items located in public warehouses. 8. Analyze inventory for evidence of possible obsolescence. Listing items on the inventory file for which the date of the last sale indicates a lack of recent transactions. 9. Analyze inventory for evidence of possible overstocking or slow-moving items. Listing items on the inventory file for which the quantity on hand is excessive in relation to the quantity sold during the year. 10. Perform overall test for accuracy of inventory master file. Listing items, if any, with negative quantities or costs. DC12-9 Manufacturing equipment and accumulated depreciation a) Major objectives of the audit of Manufacturing Equipment, Manufacturing Equipment--Accumulated Depreciation, and Repairs to Manufacturing Equipment are to determine that: 1. The Manufacturing Equipment account represents the cost of manufacturing equipment in use at December 31 (Valuation). 2. The company owns the property and to ascertain the nature of any liens or other obligations against the property (Existence, Disclosure, Ownership/Rights). 3. The property is in existence, adequately insured, and recoverable through service potential or liquidation (Existence, Valuation). 4. Additions for the year have been accurately recorded and there has been a proper differentiation between capital and maintenance charges (Existence). 5. Retirements of property during the year, together with the associated salvage and cost of removal, have been properly recognized (Existence, Valuation). 6. A proper amount of depreciation expense has been allocated to the period, based on the asset cost, estimated life, and salvage (Valuation). 7. Accumulated depreciation is adequate but not excessive (Valuation). 8. Repairs represent an expense of the current period and necessary maintenance has not been deferred to later periods (Valuation). b. Auditing procedures for the current year additions to Manufacturing Equipment include the following: 1. Obtain a list of cash disbursements charged to Manufacturing Equipment and cross-reference to the analysis of the Manufacturing Equipment account. (Limits may be used in making this list.) 2. Review the list for reasonableness and the propriety of the account charged. 3. For major disbursements and a sample of other disbursements, perform the following steps: a. Examine supporting documentation. b. Determine that required budgetary approvals and explanations of variances from the budget have been made. c. For equipment requiring installation, determine that a capital work order for the installation was established. d. For equipment replacements, determine that the appropriate retirement has been made. e. Trace property additions into the subsidiary ledger. 4. Obtain a list of machinery repair work orders in process and completed during the year. The list should show a description of the work done, the account charged, and the budgeted and actual expenditures. (Limits may be used in making this list.) a. Cross-reference the list to the analysis of Manufacturing Equipment. b. Review the list for reasonableness of expenditures and the propriety of the account charged. Investigate abnormalities. 5. Examine machinery rebuilding work orders in detail on a test basis: a. Cross-reference charges to the list of work orders and trace the amount of asset additions into the subsidiary ledger. b. Trace time and material charges to supporting payroll and material usage records. (The extent of this check will depend on what work has been done on the detail tests of payroll and material.) Review the reasonableness of the hours worked, the work description, and the material used in terms of the work order description. c. Evaluate the policy and procedures for allocating overhead to the work order and check their application. d. Examine support for and evaluate propriety of other charges to the work order. e. Determine that proper budgetary approval has been given. Compare budgeted amounts with actual expenditures and ascertain that required explanations for variances have been made. f. Determine that corresponding retirements of manufacturing equipment have been made and properly accounted for. 6. Review the propriety of other charges to Manufacturing Equipment and check to supporting documentations (on a test basis, if appropriate). 7. Physically inspect any major additions for the year and a random sample of other additions. 8. Discuss plant operations with responsible operating personnel. Inquire about capitalization policies, obsolete or unused machinery, major additions and retirements, and any questions arising during the examination. 9. Vouch a sample of charges in the Repairs account and determine that they are proper repairs and not capital items. 10. Review the useful lives, depreciation methods, and salvage values for reasonableness. Recalculate depreciation as a test of mathematical accuracy. DC12-10 Peacock Company: Incomplete flowchart of inventory and purchasing control procedures a) The following steps have been omitted from the flowchart of Peacock Co.'s inventory and purchase order system: General Omissions: 1. All key entry should be verified (daily procedure and key entry prior to Run 4). 2. The disposition of all paper documents and reports should be indicated. These documents or reports occur at each step of the system. 3. Exception reports should be prepared for each computer run; such reports were not prepared for Runs 1, 4 and 5. Procedures for handling any exceptions should be indicated. Specific Omissions: 4. Purchases and purchase returns and allowances of inventory items have been omitted. There should be a daily activity for purchasing and filing these activities as there is for sales. 5. No provision is made for additions, deletions, and changes to the inventory file. These would be prepared daily so that they could be processed during Run 2. 6. The conversion of input data to magnetic tape (Run 1) should include an edit run; a procedure to correct any errors discovered during this edit run should be indicated. 7. The files used in Run 2 have not been sorted properly. a) The weekly transactions (sales and returns, the omitted purchases and returns) should be sorted into the same sequence as the Master Inventory File. b) The Items Ordered Previous Week should be sorted in the same sequence as the Master Inventory File (this sort could be done after Run 5). 8. The Updated Master Inventory File has not been shown as an output to Run 2; this file should also be shown as an input for the next week by a broken line and arrows. 9. The Exception Report prepared and run on Monday in a supplementary run to update the Master Inventory file. 10. The Items to Order This Week should be sorted into the same sequence as the Master Supplier File prior to Run 3. 11. The changes that are input prior to Run 4 have to be sorted by supplier number in order to be processed in Run 4. 12. Output tape from Run 5 (Items Ordered This Week) should be shown as being an input to Run 2 (Items Ordered Previous Week) by broken line and arrow. b) Listed below are control procedures Peacock Co. could employ to assure proper functioning of its system. 1. All conversion of key input to magnetic tape should include an edit routine. 2. Transmittal tapes should accompany each batch (i.e., batch totals) or source documents from the Sales Department and the Receiving Department. 3. Other control totals should be employed throughout the system where applicable. For example: a) Record counts: Daily transactions should be counted to guard against lost transactions. b) Hash totals: Identification numbers (e.g., inventory codes, supplier codes) can be added as a check to determine if all items have been processed (all runs). c) Financial totals: Totals of financial items can be accumulated to determine if all items have been processed (all runs). These control totals would be compared against the appropriate transmittal tapes and other control totals prepared prior to processing. 4. A control report should be prepared at Run 2. This report would include such items as records input, new records added, old records deleted, and updated inventory counts. The control reports are used to assure that all records are accounted for and are used in conjunction with the control totals discussed above (items 3 and 4). Similar control reports should be prepared for Runs 3, 4, and 5. DC12-11 Inventory evidence and long-term purchase contracts a) Gathering evidence about the contract would involve reading the contract, discussing the terms with management, asking if any attempt would be made to renegotiate the price, and confirming the terms of the contract with All-Purpose. b) Facts cited that the auditor would have to discover consist of the current market price information and the informed expectations about the duration of the price level. A general awareness of economic conditions, newspaper reports, aluminum industry trade sources, and consultation with metals commodity experts are sources and means of confirming these "facts." c) By all indications, there should be a write-down of inventory to market and a current recognition of loss on the firm purchase commitment. Current inventory write-down: Inventory per books______________ $ 240,000 Inventory at market 400 tons @ $.20/lb._____________________ 160,000 Write-down to market__________ $ 80,000 Loss on purchase contracts: Contract purchases 500 tons_______________________ $300,000 700 tons_______________________ 420,000 1,000 tons_____________________ 500,000 $1,220,000 2,200 tons @ $400/ton market___ 880,000 Loss on purchase contract___ $ 340,000 The loss on the current net realizable value of the inventory will be recorded as a write-down of the inventory balance. The loss on the future contract purchases will be recorded as a provision (per IAS 37). DC12-12 Deake Corporation: Property Accounting System a) Four major objectives which Deake Corporation's automated property system should possess include: * Completeness. Records for all fixed assets owned by Deake Corporation need to be included in the system. Completeness is important because the users of the information derived from the system will assume the data in the system are complete and all fixed assets are recorded. If all fixed assets are recorded in the system, a reconciliation of the physical inventory of all fixed assets with the records will reveal any disappearances or losses. In order to assure complete records, controls must be established so that all fixed assets are recorded as acquired, records of fixed assets are updated, and records cannot be deleted without proper authorization. * Accuracy. Accuracy in establishing records and updating them based upon current transactions (improvements, maintenance, depreciation, additions, disposal) are very important if users are going to rely on the information generated from the system for decisions. * Timeliness. Transactions affecting the fixed assets records should be processed as quickly as possible. Users of the information will assume that all events pertaining to the fixed asset records are reflected in the records. In addition, requests for information from the system should be handled as expeditiously as possible. Information has to be provided on a timely basis to users if the information is to be useful for decision-making purposes. * Flexibility. The property accounting system should be designed to permit additions, revisions and changes to be made without the system needing to be redesigned and redeveloped completely. This flexibility is needed should the company's needs change in the future. b) The data items which should be included in the computer record for each fixed asset owned by Deake include: * Descriptive data * Name of asset * Manufacturer * Model and serial number * Asset class code * Company assigned asset number * General ledger account number * Location data (plant, department, building) * Acquisition date * Original cost * Data for book depreciation * Data for Tax depreciation * Maintenance record * Cycle * Date * Amount DC12-13 Grover Manufacturing - Purchasing defalcation a) 1. The following audit procedures may be applied to company records and documents to discover evidence of defalcations being committed by the buyer. a) Make a detailed review of the internal controls relating to purchasing to ascertain whether there are any weaknesses that might permit the buyer to commit an irregularity. The review should include the determination that the controls are actually being observed and that approvals and countersignatures are not being given perfunctorily. The auditor's tests should then be concentrated in the areas of weakness. b) Examine a representative sample of purchase orders issued by the buyer to determine that they have been prepared and issued in accordance with established company policy, particularly with respect to the countersignature of purchase orders over $200. Determine whether any orders for amounts in excess of $200 were split into two or more orders to evade the $200 limitations. c) Compare the representative sample of purchase orders with their related approved requisitions to ascertain that the purchase orders issued were for goods and services required by the business and are supported by an authorized document originated outside of the purchasing department. d) Test the authenticity of the suppliers by reference to telephone directors, purchasing directories, credit-rating publications, etc. This step will disclose any dummy or fictitious suppliers through which the buyer might later obtain funds. e) Review the disbursing procedures and examine paid cheques, giving particular attention to the payee and the endorsement. This step will indicate whether the buyer has access to cheques and might reveal any irregularity in their negotiation. 2. To discover evidence indicating possible collusion between the buyer' and authentic suppliers, the following audit steps might be applied: a) Note whether one supplier appears to be heavily favored over others for goods available from many suppliers. b) Compare the prices on suppliers' invoices for like items. c) Compare prices on purchase orders and invoices with suppliers' catalogs, price lists, etc. d) Examine competitive bids received by the purchasing department. If necessary, arrange to have bids obtained directly from suppliers, including some not dealt with by the auditee. e) If the review of pricing data reveals that certain suppliers offer quantity discounts, rebates, etc., ascertain that the company receives all such allowances to which it is entitled. f) Inspect suppliers' invoices and receiving reports, and trace receipts to perpetual inventory records for assurance that the material was received. g) Compare the perpetual inventory records and the materials on hand for agreement. Also review the results of the taking of the physical inventory. Determine if any shortages discovered resulted from nonreceipt of materials. h) As an overall check on the purchasing function, compare the activity in the accounts recording the buyer's purchases with activity in prior periods and account for any unusual fluctuations. In addition, review the perpetual inventory records for evidence of unbalanced inventory or unnecessary accumulation of material. DC12-14 Inventory assertions, risk assessment and audit procedures a. and b. Inventory Quantity For the first time, BSL has been stockpiling scrap metal inventory. This is because the price of scrap metal is expected to increase. However, BSL does not have a good inventory tracking system in place based on the information Jack provided. Instead, BSL did its best to track the additions to the stockpile throughout the year. They tried to “count” the inventory at year-end using some sort of formula, but management wasn’t able to confirm the amount they had logged. They ended up using their initial estimate, as logged by them, to estimate the amount of scrap metal inventory. Last year’s inventory balance of $10,000 was immaterial, so we likely did not attend the count. We did not attend the “count” again this year, which is a concern from an audit perspective since the inventory amount is now quite significant ($500,000). The amount of inventory recorded on the balance sheet, and the cost of goods sold amount on the income statement, are therefore not certain. Also, since we did not attend the count and we likely cannot rely on the accuracy of the log (we can’t test its accuracy), we may have to qualify our audit report on the consolidated financial statements (scope limitation). Before doing so, though, we should explore alternative ways of gaining assurance about the inventory, if possible. Since it is only 13 days after year-end, a count and rollback might be possible. However, since there is no inventory system in place, we may only have the log as a “system” to rely upon to do the rollback. The log could be used to trace back the amounts that were put in the pile after year-end, but we are not certain it is reliable. In order to substantiate the amounts in the log, we can agree the amounts added to the pile by looking at the receipts issued when the scrap metal was purchased. To determine the amounts coming out of the log, we can look at the sales invoices Alternatively, BSL could work with a specialist to get a better estimate of the year-end inventory amount. A specialist might be able to calculate a reliable amount for BSL to use instead of depending on the log, or might be able to help better apply the formula that BSL used so that the differences found between the log and the pile are explained or eliminated. Note that if BSL uses a specialist, we may be able to rely on that work for our audit. However, we may need to get our own specialist to help us explain how BSL’s specialist measured the inventory, depending on the circumstances. We will need to perform the necessary procedures to be able to rely on the work performed by the specialist; for example, ensure he or she has the expertise, assess the independence of the specialist, agree on what can and cannot be communicated, etc. (CAS 620 of CICA Handbook — Assurance). Price The valuation of the scrap metal inventory is also a potential issue. The market rates are volatile for the different metals. However, there appears to be a “market” for scrap metal, so BSL can likely determine prices for the various metals it has stockpiled. We will need to determine what price BSL used to value its inventory and assess whether the inventory was valued at the lower of cost and net realizable value. c. (CAS Guidance: CAS 501 (audit evidence — specific considerations for selected items) addresses how to obtain sufficient and appropriate evidence when auditing inventory, particularly around existence and condition of inventory (see paragraphs 4 to 7, which describe the need to count or to perform alternate procedures, or, if unable to do either, to modify the auditor’s opinion).) (The same discussions would be had with respect to the specialist under CAS, but might be broken down further based on the fact that CASs separate external specialists from those internal to the firm. Note, though, that the case facts do not require a discussion of management’s specialist since there isn’t one.) (A key difference when compared with Canadian standards is that the work of a specialist used by a client could be relied upon for audit purposes under Canadian standards if the specialist is judged to meet reliance criteria of independence, etc. Under CASs, this specialist is part of normal audit evidence: CAS 620 (using the work of an auditor's expert) — An individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist the auditor in obtaining sufficient appropriate audit evidence. An auditor's expert may be either an auditor's internal expert (who is a partner or staff, including temporary staff, of the auditor's firm or a network firm), or an auditor's external expert. CAS 500 (audit evidence) — Management’s expert is defined as an individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the entity to assist the entity in preparing the financial statements.) simulation facts, often recognizing the audit concerns as a result of stockpiling inventory and the issues with respect to the determination of the quantity of inventory held at year-end and verifying its value. Useful procedures to mitigate the level of risk were suggested by most students, such as the rollback of inventory and substantiating amounts to supporting documentation. Some students automatically jumped to the conclusion that a qualification was necessary, rather than consider the alternative ways assurance could be obtained over the inventory balance. It is important for students to think through the issues rather than jumping to the obvious, but not necessarily correct, recommendation.) DC12-15 Repairs expense, error adjustment a) Incorrect capitalization of costs as capital assets results in 100% understatement of expenses (overstatement of income) in the period the error occurs, but the error reverses as an overstatement of expense (understatement of income) over the years that the related capital assets are amortized. In this case the current income is overstated by $400,000, and the error will reverse over the next 8 years. If straight-line amortization and no residual value are assumed, the error will be understatement of $50,000 in each of the next 8 years. Other assumptions and interpretations are possible. b) The prior year’s error would be about $11,000 ($100,000/9) understatement of income, assuming last year there were 9 years of estimated remaining life at that time, straight-line amortization and no residual value. c) and d) The error is close to materiality, and the prior year may not have been audited to as high a degree of precision since this higher risk of misstatement (i.e. the aging equipment and increasingly costly repairs vis a vis the capitalization policy) appears to have been assessed in the current year for the first time. Thus it seems reasonable to require an adjustment in the current year of at least a portion of the error. The auditor may also recommend a revision of the capitalization policy in light of the current situation, as a management letter point. DC12-16 Mining properties, using the work of experts The case requires reading the CAS 620 requirement for using the work of an auditor’s expert in an assurance engagement, and applying them to the case scenario. One possible approach to the case is outlined below. a) First consideration is what expert will be used. Choices are audit staff member, auditor hired, auditee hired, or auditee staff member. In this case, given the risk and independence concerns in the case, the auditor hiring a expert seems appropriate (assuming there is not one on staff of the audit firm, if there were this would be a good choice). The auditee has already provided a specialist (assumed to be a White Ice employee) but that was determined by the auditor to be insufficiently independent in the public company risk setting. Another option is to have the independent expert review the employee expert’s work. The audit plan would include consideration of the expert's expertise and competence in the appraising diamonds, and his or her integrity, objectivity and independence obtained, for example, by enquiry of the expert's professional body whether he or she is a member in good standing, or examining his or her licence. The auditor also should have or obtain reasonable assurance concerning the expert's objectivity and appropriate degree of independence in relation to the auditor’s requirements. Other considerations include the need for confidentiality and for the expert to understand the objectives and nature of the assurance engagement sufficiently to understand his or her role and responsibilities. Auditor’s planned procedures include enquiry, discussion and analytical procedures: i) assessing the appropriateness and reliability of the expert's source data; and ii) obtaining a general understanding of the expert's assumptions and methods, the internal consistency of the assumptions and, when applicable, the consistency of the methods and assumptions with those used in prior periods; and reviewing and evaluating the expert's findings, including any written report (see paragraph 5049.60), and relating the findings or report to the audit objectives. Since the case suggests the audit risk is high, the auditor may plan to obtain further assurance that the source data the expert uses is appropriate and free from error by performing tests of source data and, if the expert performs the tests, the auditor would supervise or review them to obtain reasonable assurance that they are appropriate, taking into account significance and risk. When control risk is assessed at less than the maximum in determining the extent of tests, tests of the controls would be performed. The source of the data and its significance and appropriateness to the engagement need to be considered in concluding on the adequacy of tests of the data. b) In considering this suggestion the auditor would consider that the evidence from related party expert is less independent, similar to the considerations of using auditee-employed specialists. Also, as a related party, any transactions with White Ice are not necessarily at market value and so are not useful as evidence of the valuation of the diamond inventory. Other relevant issues can be discussed. DC12-17 Audit issues in Internet business The case presents several accounting issues related to accounting for Internet based businesses. Consideration needs to be given to the setting (new business, planned IPO) and potential management objectives that can influence their accounting choices, the needs and sophistication of potential financial statement users, and other facts set out in the case. Generally, the accounting choices suggest an aggressive attitude and a desire by management to report high revenues and gross profit, and growth in these two measures, possibly to influence share prices and enhance their own returns from the stock options they hold. The various issues can be analyzed, with the key concern of accounting for ‘substance over form’ as the guiding principle. The auditor’s position should reflect the analysis and the context of the case. The accounting/auditing issues that should be addressed include - revenue recognition on the on-line shopping system development contract, recognizing TSM never completed this type of system before - the measurement of revenues and costs, gross vs. net, for the on-line auction service and the on-line travel agency - accounting for the bartered advertising - presentation of the promotional discounts, warehousing, packaging and shipping goods to customers as marketing expenses rather than as costs of goods sold - adequacy of accounting policy note on revenue recognition DC12-18 On the Road Inc. - Comprehensive audit engagement case This is a comprehensive case that could be used for group work in class or as a major assignment, or as a class discussion to pull together the “big picture” and the details of planning an audit. The following is one approach to meeting the requirements of the case. There are other valid approaches that can be taken. a) Main users of OTR’s financial statements and the kinds of decisions/evaluations that each user will make based on these financial statements- • Joy, the owner, will use the financial statements mainly to evaluate the performance of her investment in this business and also the performance of the managers. The performance of the business will allow her to make decisions on whether she should stay invested this business, expand it, contract it, or otherwise change its direction. The managers’ performance will help her make decisions about promoting them, rewarding them, motivating and firing them, etc. If Joy is satisfied not to monitor the business very closely, she may only required the financial statements for more general stewardship reasons, to comply with legal requirements that corporations prepare annual financial statements. Since Joy is providing quite a generous bonus based on pre-tax net income, this suggests financial information useful for motivating and rewarding the managers is more important to her than for postponing tax (but other assumptions are possible) • Managers will use the financial statements to assess the business performance so they can make changes if needed to improve profitability, and their bonuses will be determined by the reported profits. • Bank is mainly going to use the financial statements to assess the financial health of the company and for cash flow prediction - before it will advance a loan to OTR the bank will want to see if the company will likely be able to generate enough cash to cover interest and repay the loan principal. • Other valid points b) What are the main objectives of OTR’s management that may affect the financial statements? • the managers receive a bonus of 30% of net income, their main objective can be expected to be to report the highest possible net income, as soon as possible. They would be also interested in internal control and measuring the performance of the business for the purposes of managing it more effectively. c) Four or more possible revenue and expense recognition points for OTR’s tour business and a recommendation (one possible analysis) are as follows: • Four possible revenue recognition points are at the time of booking, at the time of receiving final payment which is 14 days before the tour if on-line sale or when the payment forwarded by the travel agent is received, when the tour starts, and after the tour is finished. • The expenses of these tours can be assumed to include items like tour guides’ and drivers’ wages, gas, insurance, campsite fees, meals. To achieve the GAAP concept of ‘matching’ these would need to be treated as ‘product’ costs by recognizing them in the same period as the revenues they generate. If revenue were recognized before the tours actually run, a lot of estimates would need to be made to accrue the expenses, however this may be feasible since the costs are fairly predictable. • It appears that the largest ‘cost’ will be depreciation of the camper vans, which is always an estimate regardless of what revenue and expense recognition timing is used. However it can be matched to the tours on the basis of mileage, making it more like a product cost. It could also be expensed on the basis of expected months or years of use, more like a period cost. Analysis • Since the bank is asking for three years of GAAP statements, GAAP compliance is a constraint. In particular, consistency will be required over the three years. • the facts are that ‘earning’ the revenue requires them to actually run the tour, so that seems to suggest the all revenue recognition criteria are met when the tours are completed. At this point all the costs would be reasonably determinable, and the amount of revenue has been collected. So all the revenue recognition criteria are met at this time. • however, the non-refundability of the fees means that they have the money regardless of whether the customer takes the tour or not. This may support an analysis that the main critical event is getting the final payment. there seems to be little uncertainty regarding whether OTR will provide the tour, as their history shows they never have had to cancel a tour except for one extremely rare event. There may be an argument that some portion of the revenue is earned when the tour payment is received. For example, if the profit margin on a tour is typically 20%, there may be an argument for recognizing the ‘profit’ part of the revenue when the final payment is received and the balance after the tour is completed. • In any case, there is a need to provide for bad debts on the portion of sales made through travel agents at the time the revenue is recognized, and, assuming there is a credit card payment fee (often 2 or 3% is charged by the credit card company) this would also be part of the ‘costs’ that need to be recognized in the same period as revenues (or as a reduction in sales revenues, bottom line impact is the same). • As a practical matter by the end of the tour season, all the revenue and costs will be known. However, the payment of monthly bonuses on profits means that managers incentive are to front load the profits in earlier months (we assume that if there is a loss the bonus is zero, so this would work in the managers favour) • Objectives of managers would be to maximize their bonuses. We can see they took an aggressive stance in expecting the van to last 9.4 years, when we now know they only last 3 or 4 years at most. This will have overstated the profits in the early years of the business. This may have resulted in the managers receiving higher bonuses, and Joy also taking more profits out of the business (as dividends) than are sustainable. Based on history the depreciation policy should be revisited to use a more reasonable expected life for these assets. Recommendations (must flow logically from the analysis above) - Recognize a portion of revenues when the tours start. This meets the management bonus objective as a major part of the activities, selling the tours and organizing them, are completed. The portion, which can be viewed as ‘non-refundable deposit’, could be based on the expected profit percentage, it should not exceed the expected profit on each tour or more profit may be recognized, and bonuses paid, than ultimately materialize. Costs of organizing and selling the tours, including bad debt estimate and travel agents commissions, should be recognized as well at the time the tour starts, to match the revenue. the balance of the revenue, and the ‘product costs’ of touring should be recognized at the completion of the tour. This reflects managers’ performance in selling and organizing the tours but holds back some profit that may have to be refunded if some catastrophe occurs that prevent the tour from being completed. It provides a reasonable measure of the business performance since there is a matching of revenues and costs. As business management points, some of the company’s risks might be insured against, e.g. natural disasters. Also the company might sell travel insurance that would cover customers who have to cancel after the refund period for personal reasons. This could increase profitability - OTR may want to self-insure this part of the business so these insurance proceeds would accrue to it. Other valid points and approaches to the analysis are possible d. Outline the key issues that would need to be addressed by a prospective auditor in order to decide whether to accept the engagement. - Is the PA firm independent? - Does the PA firm have the expertise to conduct the audit? - Will the auditee be able to pay the audit fee? - Is the auditee a going concern? - Is management integrity in question? - Why do they need an audit? - Who are the main financial statement users? - Will the audit fee justify the auditor’s liability risk? - Other valid points e) Prepare a report to Joy describing a preliminary audit plan for OTR in detail. Include explanations for each component you include in the preliminary plan that will help Joy to understand the audit objectives and procedures. The Preliminary Plan should include the following steps, adapted to the context of the OTR business. It should be addressed to Joy in wording that is appropriate for her to understand the planned audit work. PRELIMINARY AUDIT PLAN This memo set out the main steps we are planning to take to perform the audit of OTR. We may expand and refine these steps based on what we learn as a result of performing the audit work. Understanding Your Business and Its Risks We will: • Interview management with regard to business and accounting policies. • Determine the extent of significant computer applications in the company’s accounting system. • Obtain draft financial statements and identify the main business processes in place • Perform preliminary analytical procedures to identify risk areas in the financial statement accounts. • Assess the risks inherent in your business in general, and more specifically in terms of the risks that there are misstatements in particular amounts in the draft financial statements. • Obtain an understanding of the company’s internal control through interviews, observations and determine whether to perform tests of controls, identify any weaknesses and inform OTR management of any significant problems. • Perform detailed test of control procedures, if required, and make an assessment of the risk that control will not have prevented a material misstatement in the OTR financial statements. • Based on control risk assessment design the nature, timing and extent of substantive audit procedures on the year end financial statement balances and summarize in the Balance Audit Program The Preliminary Balance Audit Program The program covers each accounting processes in OTR’s business processes and provides a program of audit procedures for each related cycle and the specific accounts in that cycle, tailored to the nature of OTR’s business The procedures in these audit programs are designed to obtain evidence about the existence or occurrence, completeness, valuation, ownership (rights and obligations), and presentation and disclosure assertions implicit in each account title and balance and apply evidence gathering techniques such as confirmation, computation, enquiry, and physical inspection and inspection of documents Revenue process Accounts: Sales, receivables, receipts Purchases process Accounts: Expenses for purchasing goods and services, payables, payments, capital assets, depreciation Payroll Salaries expense, bonuses expense, payables, payments Financing and Investing Debt, share capital, interest, dividends Etc. DC12-19 Real Cash Paid to Phony Doctors” - Cash Payments Fraud - Medical Benefit Claims - Comprehensive audit engagement case This case would be suitable for an in-class discussion. Test of Controls The processing and control work in the claims processing department can be audited for deviations from controls. Procedure: Select a sample of paid claims and reperform the claims processing procedures to verify the employee status, coverage of treatment, proper guideline charges, cumulative amount less than $50,000 and accurate calculation. However, this procedure would not help answer the question: “Does Martha Lee steal the money to pay for the limousines?” “Thinking like a crook” points out the holes in the controls. Nobody tried to verify data with external sources. However, an auditor must be careful in an investigation not to create suspicions about a manager’s integrity that may turn out to be untrue, for example by letting rumours start by interviewing employees to find out whether they actually had the medical claim paid on their behalf. If money is being taken, the company cheque must be intercepted in some manner. Audit of Balance The balance under audit is the sum of the charges in the employee medical benefits expense account, and the objective relates to the valid existence of the payments. Procedure: The first procedure can be: Obtain a list of practitioners paid by the company and look them up in their provincial professional association directories. Look up their addresses and determine whether they are valid business addresses. You might try comparing claims processors’ signatures on various forms but this is hard to do and requires training. An extended procedure would be: Compare the practitioners’ addresses to addresses known to be associated with Martha Lee and other claims processing employees. Tests most likely to detect Martha’s theft The comparison of practitioners to the association directories could show an unusual number of “practitioners” who were not licensed in the current period. Also noting those with post office box addresses, or suspicious mailing addresses, may reveal phony payments. Further enquiries and surveillance could show them to related to Martha Lee, her husband, or other claims processing employees. DC12-20 Analysis of Purchasing Process and Controls. The case involves an engagement to review the control effectiveness of the purchasing process in a manufacturing company, IMS. The case asks for a report to the engagement partner, addressing the three points the IMS CEO, Ted Pollock, has asked the firm to report on. A further requirement is identifying any additional issues and making any observations that would be relevant to the engagement to note for the partner. The case requires a detailed analysis of controls and would be useful as an in-class exercise, perhaps in small break- out groups. Instructors can assist the students in applying the control concepts to the case facts and developing an appropriate report format. This is an engagement of the type that may be done for a public company where management is required by securities regulations to provide a certification of the company’s internal control effectiveness. The response assumes the PA firm would not be acting as the financial statement auditor in this engagement,. The following report uses a format that would be appropriate for this purpose. Other reporting formats are also acceptable, but should be written in the role of the staff member, and addressed to the control review engagement partner using appropriate language and level of detail. While it is assumed this is a report to management rather than to outside parties, the casealso provides insights into auditors’ assessment of internal control effectiveness for either a stand- alone report or as part of an integrated audit approach where the financial statement audit report gives opinions on both control effectiveness and fair presentation (e.g., the ‘integrated audit’ approach set out in the U.S. in PCAOB AS5, or as a voluntary audit report in Canada following the CICA standard OCS 5925 on the management certification required by CSA NI 52-109). MEMORANDUM To: Engagement Partner From: Staff Member Subject: Analysis of Integrated Measurement Systems (IMS) purchasing process Here is the analysis of the IMS purchasing process as you have requested. It covers the three questions the IMS CEO has asked us to address in our analysis: 1. Identification of the existing key internal controls 2. Description of the procedures IMS could use to test the controls 3. Identification of control weaknesses with recommendations for improvements to overcome the weaknesses The report also contains additional issues and observations that would be relevant for us in relation to this control review engagement. Key Internal Controls in the Purchasing Process Many controls are incorporated in the IMS purchasing process. The table below lists the key controls we identified and explains why they are important to meeting the stated control objectives of IMS. Control Procedure Control objectives it meets 1. The Purchase Request (PR) approved by being signed by personnel with appropriate level of authority. Purchasing activities result in purchases that are authorized. Levels of authority ensure that personnel with an appropriate level of seniority review and approve significant expenditures. 2. PRs reviewed and approved by the purchasing manager. All requests are approved by senior independent manager before a purchase order is issued. Any unusual purchase requests can be questioned through the review process. 3. Prequalification of suppliers and bidding process for larger purchases. Ensures suppliers meet IMS prequalification criteria before being given an order. (Prequalification criteria should ensure suppliers are of sufficient size to meet orders, have met performance standards for delivery times and quality, and include a reference check.) Bidding process ensures all qualified suppliers have opportunity to bid, so that competitive prices are obtained for major purchases, and collusion between suppliers and buyers is prevented. 4. Purchasing manager reviews the Purchase Orders (PO) Purchasing manager review prevents buyers from trying to get around the control system. Approved POs ensures all purchases are authorized. 5. Receiver matches the quantities received against the Bill of Lading (BL) and signs BL Ensures company will not pay for goods not received, that missed items or overshipments will be documented for follow-up. Receiver’s signature indicates this control has been performed. 6. All goods are received in warehouse. Central receiving allows for better safeguarding of goods, and better record keeping through application of control 5. by receiver in warehouse. 7. Signed copy of BL matched to PR and PO authorization. Ensures goods received were ordered. The PO commits IMS to the purchase transaction. Records goods received that is all that should be paid for, and records proper amounts/price that should be paid . Matching BL, PO and PR provides control over existence, completeness and accuracy of transactions to be entered into the accounting system (Accounts Payable, Inventory, etc.) 8. Copy of BL goes to user department with goods, and user agrees quantity received to BL copy Person placing order can verify accuracy and completeness of what was received, compared to what was received in warehouse 9. Purchasing clerk forwards BLs with no matching source documentation to buyer for investigation Buyer can catch errors in goods received, such as over - shipments by supplier, or goods shipped that were not ordered. Ensures existence and accuracy of goods received and payments recorded. 10. Purchasing clerk forwards PRs and POs unmatched for over 90 days to user group for investigation. User group follow up can identify errors where goods were received by users but no BL was processed to ensure accurate recording. This control can also ensure safeguarding of asset by indentifying potential unauthorized or fraudulent transactions where goods received have been removed without proper authorization. Internal Control Weaknesses and Recommendations to Strengthen Control My review and analysis of the purchasing process revealed the following significant control weaknesses, as well as some inefficiencies that are listed in the final section of this report. I provide recommended changes to the process that would strengthen the control and overall cost-effectiveness of IMS controls. Control Weakness and Potential Impact Recommended action to improve control 1. PR authorizing signatures are not verified by purchasing clerk or manager. There is no check that the person signing has a high enough level of authority. Unauthorized purchase commitments may arise for IMS Provide purchasing clerk with list of authorized individuals and levels of authority, which should be updated regularly. Clerk should check PRs are properly authorized by appropriate individuals. 2. PRs are not prenumbered. Clerk could assign same number, allowing a false order to be processed. Prenumbered PRs should be used across the company. The purchasing clerk should log the numbers of the PRs received and processed into POs so that all orders can be tracked through the purchasing process and accounting system. 3. Buyers have discretion to select suppliers for purchases of up to $25,000, or over if buyer claims bidding process is too costly. Buyers could split up orders to come in less that $5,000 to allow discretion not to choose from prequalified supplier list. Buyers could collude with one supplier, favour them over other suppliers, and receive kickbacks from this arrangement. Introduce additional procedures to automatically rotate through preapproved supplier list, and for manager to review and approve when supplier for large purchases has been selected by buyer discretion. Manager should review purchases by supplier to look for evidence of order splitting or favouring a single supplier. 4. Purchasing manager sends PO back to buyer who delivers it to supplier. Buyer can alter PO before it is delivered, and arrange for extra goods to be ordered that the buyer would keep when they arrive. The buyer could cover up by telling the user group the extras over what they put on their PR were an overshipment that the buyer has agreed to “ship back” to supplier. The BL and PO will match and get recorded into accounts payable and ultimately IMS will pay too much for the goods it actually needed and received. This weakness can also facilitate collusion as the buyer is delivering the PO to the supplier. Once approved by the purchasing manager, the PO should be sent directly to the supplier. The buyer would not have the opportunity to alter the PO or collude with the supplier. 5. All employees have access to the warehouse. Employees could steal some inventory from the warehouse. Access to warehouse should be physically restricted or monitored so only those employees who require access to do their jobs are permitted access, through use of access cards or keys. 6. BL not matched to PO by receiver. Receiver only checks goods on BL match what was received but does not check that these goods were ordered. Goods could be received and paid for that were not ordered. The receiver should have a copy of the PO so the authorization and details of the order can be checked before the goods are accepted. 7. Receiver sends BL to user group where it is filed and to the payables group for payment. The receiver could steal goods and report them as short shipments to user group, while payables group will pay for the full amount. There is evidence this may be happening now, as users are noticing a lot of manual adjustments on BLs. The user group should sign off on the BLs to verify the goods were received as shown, then send the signed BLs to the payables group so the information can be matched prior to payment. User groups can keep another copy of the BL if they require it for their own records. 8. Discrepancies between BL and PR are resolved by buyer. When purchasing clerk matches the PR, PO and BL, any differences are forwarded to buyer for resolution. The buyer can alter the documents to cover up collusion with a supplier, possibly altering prices or quantities to increase payment by IMS. This weakness overrides any control that IMS can achieve by using POs and can provide an opportunity for fraud to occur. The purchasing manager should be the only person allowed to approve discrepancies, to segregate initiation of the purchases from approving differences. The buyer should provide supporting documentation to the purchasing manager explaining all differences. 9. The buyers is asked to explain BLs that have no matching PO and PR (It is difficult to see how this could happen as all orders should result from a PR and PO being created - but this may arise if a supplier splits a shipment and the documents are only matched to the first BL, so the second has nothing to match to) If users groups are circumventing controls by ordering goods without approving a PR and getting a PO, the buyer may not have any reason to report this, especially if the buyer is colluding with someone in a user group to obtain goods improperly. The purchasing clerk should not send the BL to the payables group until the manager of the user group and the purchasing manager approve it 10. Unmatched BL is sent to payables group for payment. Items could be purchased and paid for that have not been approved. Purchasing clerk should ensure all BLs are approved before sending to payables group. 11. Unmatched PRs and POs are sent back to the user group after 90 days for follow up, on the assumption the goods must have been received. Errors in recording cancelled orders, or missing paperwork, will not be detected on a timely basis. Purchasing clerk should follow up on outstanding orders weekly. Tests of Controls IMS can use the following procedures to test the controls identified above. Control Test Authorization of PR by user department Select a sample of PRs (either from file in purchasing department or in account payable department) Review PRs for evidence of approval by a person with proper level of authority Review of PR and PO by purchasing manager (Assuming the manager signs as evidence of review) Select a sample of PRs and POs (from accounts payable) Review for evidence of manager review Verify the information on the PR and PO match in terms of quantities and descriptions, appropriate supplier selection, etc.) Vendor selected from prequalified list Select a sample of POs Review supplier selection and trace to prequalification list for purchases $5000- $25000, and to evidence of bidding process if > $25000 If bidding process waived, investigate with buyer and assess validity of reasons supporting the waiver. To address potential circumvention of process by a buyer, these additional tests could be done: 1. Generate a list of purchases sorted by buyer and by supplier to see whether a buyer is favouring only one or a few suppliers. 2. Generate a list of purchases sorted by buyer and by amount, to see if an unusual proportion of the purchases is under $5,000 which may indicate order splitting to circumvent supplier selection control policies. 3. For any suppliers not on the prequalified list, enquire of buyer responsible and assess validity of explanation for not following the policy. 4. Select purchases close to the $5000 and $25000 cutoff levels to see whether they tend to be placed by one buyer with one supplier, which may indicate possible collusion between the buyer and the supplier. Goods received in the warehouse by the receiver, who signs off on BL Periodically observe the receiver performing his/her duties in the warehouse. Select a sample of BL (from purchasing or accounts payable) and examine for receiver’s signature Signed BLs are matched to PR and PO Select a sample of POs Verify there are matching PRs and BLs are signed by receiver Trace to copied POs and PRs kept by purchasing manager to verify authorization A copy of BL is sent to user group (Assuming the user group signs the BL as evidence of approval) Select a sample of BLs from user groups Examine for evidence of approval Vouch to BL used in accounts payable to ensure not altered by receiver (to address weakness of 2 copies of BL being sent to users and to purchasing ) Unmatched documents are investigated. Select a sample of unmatched BLs and unmatched PR/POs from accounts payable Review for evidence that discrepancies are followed up and resolved Ensure unmatched documents have not been processed for payment Other observations relevant to this engagement The IMS CEO has adopted a corporate governance framework that can be expected to strengthen its control environment and other company level controls as set out in the COSO framework. We have been engaged to support the adoption of its main elements, by documenting its purchasing process and identifying key controls, evaluating control strengths and weaknesses in regards to IMS’s main control objectives (authorization of transactions, safeguarding assets, prevention of error and fraud, accuracy and completeness of records, and appropriate use of information) and advising on how IMS could test its controls for effectiveness. My analysis and recommendations above should meet these requirements of the engagement. As a further help to the CEO in this exercise, I have also identified the following potential inefficiencies, and recommended solutions. More efficient procedures can save time that IMS can devote to implementing stronger control procedures. Potential Inefficiencies Recommended solution 1. Review of both PR and PO by purchasing manager is redundant since purchasing clerk has already reviewed them and they contain the same information. Consider having purchasing manager review only the POs, since these commit IMS to purchasing the goods. The purchasing manager can use this review as an opportunity also to monitor selection of suppliers, to further increase efficiency. 2. The buyer creation of PO by re-entering data from PRs is redundant, and the second entry introduces more chance of input errors. Allow the user group to generate a PO, which the buyer can add the supplier information to. Then submit this PO to the review and approvals as required. It may be a further efficiency to generate a PO only for purchases over a certain dollar amount, such as $500. 3. As described the system requires a lot of photocopies of documents, which is inefficient and may also allow documents to be altered prior to copying so the changes are hard to detect The company could benefit from using multipart forms with the number of copies required, to reduce need for photocopying. IMS could also consider whether automating the purchasing process would be cost effective. I hope this report will be useful to you in completing the engagement. Please contact me if you require any other work for this engagement, or if any questions arise. I would be happy to accompany you to your next meeting with Ted Pollock if that will be helpful. Best regards, Staff member (CICA Adapted) Solution Manual for Auditing: An International Approach Wally J. Smieliauskas, Kathryn Kate Bewley 9780071051415