Completing the Tests in the Acquisition and Payment

Completing the Tests in the Acquisition and Payment Cycle Chapter 19 © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 1

Learning Objective 1 Recognize the many accounts in the acquisition and payment cycle. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 2

Accounts Associated with Acquisition and Payment Cycle Transactions Assets Cash Inventory Supplies Property, plant, and equipment Patents, trademarks, and copyrights Prepaid rent Prepaid taxes Prepaid insurance © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 3

Accounts Associated with Acquisition and Payment Cycle Transactions Expenses Cost of goods sold Rent expense Property taxes Income tax expense Insurance expense Professional fees Retirement benefits Utilities © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 4

Accounts Associated with Acquisition and Payment Cycle Transactions Liabilities Accounts payable Rent payable Accrued professional fees Accrued property taxes Other accrued expenses Income taxes payable © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 5

Methodology for Designing Tests of Balances – Other Accounts Identify client business risks affecting other accounts. Set tolerable misstatement and assess inherent risk for accounts. Assess control risk for accounts. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 6

Methodology for Designing Tests of Balances – Other Accounts Design and perform tests of controls and substantive tests of transactions for the acquisition and payment cycle. Design and perform analytical procedures for the acquisition and payment cycle. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 7

Methodology for Designing Tests of Balances – Other Accounts Design tests of details of account balances to satisfy balance-related audit objectives. Audit procedures Sample size Items to select Timing © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 8

Learning Objective 2 Design and perform audit tests of property, plant, and equipment related accounts. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 9

Classification of Property, Plant, and Equipment Accounts Ø Land land improvements Ø Building and building improvements Ø Manufacturing equipment Ø Furniture and fixtures Ø Autos and trucks Ø Leasehold improvements Ø Construction-in-process for property, plant, and equipment © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 10

Manufacturing Equipment and Related Accounts Manufacturing Equipment Beginning Disposals balance Acquisitions Gain or Loss on Disposals Accumulated Depreciated Disposals Beginning balance Current period depreciation Ending balance Depreciation Expense © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 11

Auditing Manufacturing Equipment and Related Accounts Analytical procedures Current year acquisitions Current year disposals Ending balance in the asset account Depreciation expense Ending balance in accumulated depreciation © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 12

Analytical Procedures for Manufacturing Equipment Analytical Procedure Possible Misstatement Compare depreciation expense divided by gross manufacturing equipment cost with previous years. Compare accumulated depreciation divided by gross manufacturing equipment cost with previous years. Misstatement in depreciation expense and accumulated depreciation Misstatement in accumulated depreciation © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 13

Analytical Procedures for Manufacturing Equipment Analytical Procedure Possible Misstatement Compare monthly or annual repairs and maintenance, supplies expense, small tools expense, and similar accounts with previous years. Expensing amounts that should be capitalized Compare gross manufacturing cost divided by some measure of production with previous years. Idle equipment or equipment that has been disposed of, but not written off. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 14

Verifying Current Year Acquisitions The proper recording of current year additions is important because of the long-term effect the assets have on the financial statements. Because of the importance of current period acquisitions, seven of the nine balance-related audit objectives are used as a frame of reference. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 15

Major Balance-Related Audit Objectives Completeness Existing acquisitions are recorded. 1. Examine vendors’ invoices of closely related accounts to uncover items that should be manufacturing equipment. 2. Review lease and rental agreements. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 16

Major Balance-Related Audit Objectives Accuracy Current year acquisitions as listed are accurate. 1. Examine vendors’ invoices. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 17

Major Balance-Related Audit Objectives Classification Current year acquisitions as listed are properly classified. Examine: 1. Vendors’ invoices in mfg. equipment account. 2. Vendors’ invoices of closely related accounts. 3. Rent and lease expense for capitalizable leases. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 18

Verifying Current Year Disposals Review whether newly acquired assets replace existing assets. Analyze gains and losses on disposal. Review documents for indications of deletion of equipment. Make inquiries about the possibility of the disposal of assets. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 19

Verifying Ending Balance of Asset Accounts 1. All equipment owned is recorded. 2. All recorded equipment physically 3. exists on the balance sheet date. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 20

Verifying Depreciation Expense The most important objective is accuracy. Consistent depreciation policy Correct calculations © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 21

Verifying Ending Balance in Accumulated Depreciation 1. Accumulated depreciation as stated in the property master file agrees with the general ledger. 2. Accumulated depreciation in the master file is accurate. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 22

Learning Objective 3 Design and perform audit tests of prepaid expenses. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 23

Audit of Prepaid Expenses • Prepaid rent • Organization cost • Prepaid taxes • Patents • Prepaid insurance • Trademarks • Deferred charges • Copyrights © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 24

Prepaid Insurance and Related Accounts Prepaid Insurance Beginning balance Current period insurance expense Acquisitions Ending balance Insurance Expense © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 25

Prepaid Insurance Internal Controls 1. Controls over the acquisition and recording of insurance 2. Controls over the insurance register 3. Controls over the charge-off of insurance expense © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 26

Prepaid Insurance Audit Tests Compare total prepaid insurance and insurance expense with previous years. Compute the ratio of prepaid insurance to insurance expense and compare it with previous years. Compare the individual insurance policy coverage on the schedule of insurance obtained with the preceding year’s schedule. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 27

Prepaid Insurance Audit Tests Compare the computed prepaid insurance balance for the current year on a policy-by-policy basis with that of the preceding year. Review the insurance coverage listed on the prepaid insurance schedule with an appropriate client official or insurance broker. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 28

Balance-Related Audit Objectives Existence and Completeness Rights Insurance policies in the prepaid insurance schedule exist and existing policies are listed. The client has rights to all insurance policies in the prepaid insurance schedule. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 29

Balance-Related Audit Objectives Accuracy and Detail tie-in Classification Prepaid amounts are accurate and the total is correctly added and agrees with the general ledger. Insurance expense is properly classified. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 30

Balance-Related Audit Objectives Cutoff Presentation and Disclosure Insurance transactions are recorded in the proper period. Prepaid insurance is properly presented and disclosed. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 31

Learning Objective 4 Design and perform audit tests of accrued liabilities. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 32

Audit of Accrued Liabilities • Accrued income taxes • Accrued interest • Accrued pension costs • Accrued professional fees • Accrued rent • Accrued warranty costs © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 33

Accrued Property Taxes and Related Accounts Accrued Property Taxes Beginning balance Payments (property taxes) Current period property tax expense Ending balance Property Tax Expense © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 34

Learning Objective 5 Design and perform audit tests of income and expense accounts. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 35

Approach to Auditing Income and Expense Accounts Analytical procedures Tests of controls and substantive tests of transactions Tests of details of account balances © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 36

Analytical Procedures for Income and Expense Accounts Analytical Procedure Possible Misstatement Compare individual expenses with previous year. Overstatement or understatement of a balance in an expense sheet. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 37

Analytical Procedures for Income and Expense Accounts Analytical Procedure Possible Misstatement Compare individual asset and liability balances with previous years. Overstatement or understatement of a balance sheet account that would also affect an income statement account © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 38

Analytical Procedures for Income and Expense Accounts Analytical Procedure Possible Misstatement Compare individual expenses with budgets. Misstatement of expenses and related balance sheet accounts Compare gross margin percentage with previous years. Misstatement of cost of goods sold and inventory © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 39

Analytical Procedures for Income and Expense Accounts Analytical Procedure Possible Misstatement Compare inventory turnover ratio with previous years. Compare prepaid insurance expense with previous years. Misstatement of cost of goods sold and inventory Misstatement of insurance expense and prepaid insurance © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 40

Analytical Procedures for Income and Expense Accounts Analytical Procedure Possible Misstatement Compare commission expense divided by sales with previous years. Compare individual manufacturing expenses divided by total mfg. expenses with previous years. Misstatement of commission expense, accrued commissions Misstatement of individual mfg. expenses and related balance sheet accounts © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 41

Tests of Controls and Substantive Test of Transactions Understanding internal control and the related tests of controls and substantive tests of transactions to determine the appropriate assessed control risk are the most important means of verifying many of the income statement accounts in each of the transaction cycles. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 42

Tests of Details of Account Balances and Expense Analysis Expense account analysis Tests of details of account balances – allocation © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 43

Allocation Several expense accounts result from the allocation of accounting data rather than discrete transactions. These include depreciation, depletion, and the amortization of copyrights and catalog cost. The allocation of manufacturing overhead between inventory and cost of goods sold is an example of a different type of allocation that affects expenses. © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 44

End of Chapter 19 © 2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley 19 - 45