CHAPTER 4

Audit of the Acquisition and Payment Cycle

Chapter Objectives

After successfully completing this chapter, you should be able to:

 Identify business functions, transactions, accounts affected, and documents & records
in the acquisition and payment cycle
 Identify potential misstatements in acquisition and payment transactions
 Assess control risk and designing tests of controls & substantive tests of transactions
for acquisitions and payments
 Design and perform tests of account balances affected by acquisition and payment
cycle

ACCOUNTS AFFECTED IN THE ACQUISITION AND PAYMENT CYCLE

 Purchases  Accounts payable

 Purchase returns and allowances  Property, plant, and equipment
 Purchase discounts  Prepaid expenses
 Cash in bank  Manufacturing, administrative,
 Inventory selling expenses

CLASSES OF TRANSACTIONS IN THE ACQUISITION AND PAYMENT CYCLE

 Acquisition of goods and services

 Returns and allowance transactions
 Cash disbursements for those acquisitions

BUSINESS FUNCTIONS IN THE ACQUISITION AND PAYMENT CYCLE

 An employee recognizes a need for a purchase; completes a requisition and sends it to

purchasing. Purchasing department shops for the appropriate quality at the best price,
then prepares a purchase order (Processing purchase orders)
 When goods arrive from the vendor, the receiving dept inspects, counts, and prepares a
receiving report (Receiving goods and services)

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  When the vendor’s invoice arrives, accounts payable enters the amount in the
acquisitions journal and the accounts payable master file (Recognizing the liability)
 Before the due date, a cheque is mailed to the vendor and the payment is recorded in
the cash payments journal and accounts payable master file (Processing and
recording cash disbursements)

DOCUMENTS AND RECORDS IN THE ACQUISITION AND PAYMENT CYCLE

 Purchase requisition,
 Purchase order,
 Receiving reports,
 Vendor’s invoice,
 Debit memo, voucher,
 Acquisition transaction file,
 Acquisitions journal,
 As/P master file,
 As/P trial balance,
 Vendor’s statement,
 Cheque/electronic payment,
 Cash disbursement transaction file,
 Cash disbursements journal

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METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE
TESTS OF TRANSACTIONS FOR ACQUISITION AND PAYMENT CYCLE

Understand Internal Controls

Assess Planned Control Risk

Determine Extent of Testing controls

Design tests of Controls &

Substantive Tests of Transactions

In assessing control risk, the auditor should consider key internal controls such as adequate
segregation of duties, proper authorization, adequate documents and records, use of
prenumbered documents, internal verification procedures etc. Besides, the auditor determines
the extent of testing controls in terms of whether substantive tests will be reduced sufficiently
to justify the cost of performing tests of controls.

DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF

TRANSACTIONS - ACQUISITIONS AND PAYMENTS

In designing audit tests for acquisition and payments, the auditor should consider the specific
transaction-related audit objectives
(See the attachment containing the Summary of Transaction-Related Audit Objectives, Key
Controls, Tests of Controls, and Substantive Tests of Transactions for Acquisitions and for
Cash Disbursements)

However, before discussing the tests of controls and substantive tests of transactions for
acquisitions and for cash disbursements, proper understanding the key controls covered in the
next section is essential.

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Key Internal Controls

1. Authorization of purchases
 Proper authorization for acquisitions ensures that the goods and services acquired are
for authorized company purposes, and the acquisition of excessive or unnecessary
items are avoided.
 Different levels of authorization for different types of acquisitions or birr/dollar
amounts required.
 After the purchase requisition for an acquisition has been approved, a purchase order
to acquire the goods or services must be initiated.
 Purchasing department is responsible to ensure an adequate quality of goods and
services are acquired at a minimum price.
 The purchasing department should be separate from those who authorize the
acquisition or receive the goods.
 All purchase orders should be prenumbered to permit easier accounting for all
outstanding purchases orders and should be designed to minimize the likelihood of
unintentional omissions on the form when goods are ordered.

2. Separation of the custody of the received goods from other functions

 The receiving department initiates a receiving report as evidence of the receipt and
examination of goods.
 One copy is normally sent to the raw materials storeroom and another to the accounts
payable department for their information needs.
 To prevent theft and misuse, the goods should be physically controlled from the time
of their receipt until their use or disposal.
 The personnel in the receiving department should be independent of the storeroom
personnel and the accounting department.
 The accounting records should transfer responsibility for the goods each time they are
moved, from receiving to storage, from storage to manufacturing, etc.

3. Timely recording and independent review of transactions

 The accounts payable department has responsibility for verifying the appropriateness
of acquisitions.
 Depending on the policy of the client, the recording of the liability for acquisitions is
made on the basis of the receipt of goods and services or recording is deferred until the
vendor’s invoice is received.
 The accounts payable personnel compare the details on the purchase order, the
receiving report, and the vendor’s invoice to determine that the descriptions, prices,
quantities, terms, and freight on the vendor’s invoice are correct.
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  The accounts payable department also verifies extensions, footings, and account
distributions.
 The accounts payable department should also account for all receiving reports to
assure that the completeness objective is satisfied.
 An important control in the accounts payable and information technology departments
is the requirement that personnel who record acquisitions do not have access to cash,
marketable securities, and other assets.
 Adequate documents and records, proper procedures for record keeping, and
independent checks on performance are also necessary controls in the accounts
payable function.

4. Authorization of payments to vendors

 The most important controls over cash disbursements include:
 The signing of checks by an individual with proper authority
 Separation of responsibilities for signing checks and performing the accounts
payable function
 Careful examination of supporting documents by the check signer at the time the
check is signed
 The checks should be prenumbered to make it easier to account for all checks and
printed on special paper that makes it difficult to alter the payee or amount. Companies
 Physical control over blank, voided, and signed checks is required.
 There must be a method of canceling supporting documents to prevent their reuse as
support for another check at a later time. A common method is to document the check
number on the supporting documents.

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 TEST OF DETAILS OF BALANCE FOR ACCOUNTS PAYABLE

In addition to testing controls and transactions for acquisitions and payments, it is necessary
to audit accounts payable balance shown in the client’s draft balance sheet. This involves
performing analytical procedures and test of details of balances. The following analytical
procedures may be performed for As/P:

Analytical procedures Possible misstatement

Review list of Accounts payable for unusual, Classification misstatement for

non-vendor, & interest-bearing payables nontrade liabilities

Compare acquisition-related expense account Misstatement of As/P & expenses

balances with prior years

Compare individual As/P with previous years Unrecorded or nonexistent accounts or

misstatements

Calculate ratios (e.g. Average paying period, Unrecorded or nonexistent accounts or

As/P to current liabilities ratio misstatements

What audit procedures should be performed by the auditor to test accounts payable balance?
The following table shows the most common audit procedures for As/P balance:

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 Balance-Related Audit Objectives and Tests of Details of Balances for Accounts Payable

Audit Objective Audit Procedures

Detail tie-in  Re-add the accounts payable list

 Trace the total to the general ledger
 Trace individual vendors’ invoice to master file for names and
amounts
Existence  Trace from accounts payable list to vendors’ invoices and statements
 Confirmation with creditors, emphasize large & unusual amounts
Completeness  Perform out-of-period liability tests (search for unrecorded liability)
 Examine the unpaid vendors’ invoices file on the balance sheet
date & trace them to related receiving report (to test for
inclusion)
 Examine subsequent cash disbursements (to test for inclusion)
 Trace Receiving Reports Issued Before Year-End to Related
Vendors’ Invoices (to test for inclusion)
 Trace Vendors’ Statements That Show a Balance Due to the
Accounts Payable Trial Balance (to test for inclusion)
 Send Confirmations to Vendors with Which the Client Does
Business (also called zero balance confirmation)
Because of the emphasis on understatements in liability accounts, out-of-
period liability tests are important for accounts payable.
Accuracy  Trace from accounts payable list to vendors’ invoices and statements
 Confirmation with creditors, emphasize large & unusual amounts
 Perform out-of-period liability tests
Classification  Review the list and master file for related parties, interest-bearing
debts, long-term payables, debit balances in accounts payable
Cutoff  Perform out-of-period liability tests
 Perform detailed tests as part of physical observation of inventory
(i.e. coordinate the cutoff test with the observation of inventory)
 Test for inventory in transits by examining vendor’s invoice
(consider shipping terms i.e. F.O.B. shipping point or F.O.B.
Destination)
Obligations  Examine vendors’ statements
 Confirmation with creditors

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Vendors’ Statement Reconciliation

The main thrust of the testing of accounts payable is usually to test for completeness i.e. to
gain assurance that all liabilities which should be included, are included.

One of the audit procedures to be performed for testing accounts payable is to reconcile
vendors’ statements with creditors’ ledger. Although the two must generally agree, the
following are the possible reasons for the difference:

a. Timing differences
 Invoices not yet received by the client
 Payments not received by the vendor
 Returns and credit memos not yet appearing on the vendor’s statement
b. Errors
 Supplier errors that will remain as part of the reconciliation of until the supplier
corrects them
 Client errors, which the client needs to adjust
c. Administrative reasons
 Goods received accrual (invoices received but not processed-perhaps awaiting
authorization or posting)
 Goods received not invoiced (the client accrues for all goods received but does
not record in the journal and post to the creditors’ ledger until the invoice is
received)
 Cheques in the drawer (delay in sending out the cheques although not a good
idea to keep signed cheques for longer time)

The auditor may use the following form to reconcile vendors’ statements with creditors’
ledger:

Balance per supplier statement XXX Balance per creditors’ ledger XXX
Less: Add:
Returns/credit memos not yet XXX Invoices not yet posted XXX
credited
Payments not yet received by the XXX Goods received not invoiced XXX
supplier
Reconciled balance XXX Reconciled balance XXX

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 AUDIT OF PROPERTY, PLANT AND EQUIPMENT (PPE)
1. Characteristics of Property, Plant, and Equipment
 Have expected lives of more than one year
 Used in the business
 Not acquired for resale
2. Classification of Property, Plant, and Equipment
 Land and land improvements  Furniture and fixtures
 Buildings and buildings  Autos and trucks
improvements  Leasehold improvements
 Equipment  Construction-in- progress
3. Property, Plant, and Equipment Accounts
 PPE account  Gain/loss on disposal
 Accumulated depreciation  Repair and maintenance account
 Depreciation expense
4. Property, Plant, and Equipment Transactions
 Acquisitions  Disposals
 Periodic Depreciation
5. Property, Plant, and Equipment records
Fixed asset master file is the primary accounting record for Property, Plant, and
Equipment. It shows detailed records for each asset containing such information as:
 Description of the asset  Current year depreciation
 Date of acquisition  Accumulated depreciation
 Original cost  Disposals etc
The total for all records in the master file equals the general ledger balances for the related
accounts i.e. PPE account, depreciation, and accumulated depreciation.

6. Audit Tests for Property, Plant, and Equipment

a. Perform analytical procedures

Most of the typical analytical procedures assess the likelihood of material
misstatements in depreciation expense and accumulated depreciation as shown below:

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 Analytical procedure Possible misstatement
Compare depreciation expense divided Misstatement in depreciation expense
by gross fixed asset cost with previous and accumulated depreciation
years
Compare accumulated depreciation Misstatement in accumulated
divided by gross fixed asset cost with depreciation
previous years
Compare monthly or annual repairs and Expensing amounts that should be
maintenance, supplies expense, small capitalized
tools expense, or similar accounts with
previous years
Compare gross manufacturing cost Idle equipment or equipment that was
divided by some measure of production disposed of but not written off
with previous years

b. Verify current period acquisitions

Current year acquisitions must be recorded correctly because failure to capitalize them
or recording at incorrect amounts affects the balance sheet as well as the income
statement until the asset is disposed of or fully depreciated (see the attachment)

c. Verify current period disposals

The most important internal control over disposals is the existence of a formal method
to inform management and record the results of sale, trade-in, abandonment or theft.
The most important audit procedures are those for searching for unrecorded disposals
such as:
 Review whether newly acquired assets replace existing assets
 Analyze gains and losses on disposals
 Review plant modifications and changes in product line
 Review insurance coverage for indications of deletion of fixed assets
 Make inquiries of management for possible disposals

d. Verify the ending balance in the asset account

 Test for agreement between property (fixed assets) master file and general
ledger
 Conduct physical inventory of fixed assets
 Test for presentation and disclosures (e.g. separately presenting each fixed asset;
fixed assets collaterized for loans)
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 e. Verify depreciation expense

Recorded amounts of depreciation are internal allocations rather than exchange

transactions with outside parties. Primary audit objectives involve determining whether
the client is:
 Following a consistent depreciation policy from period to period and whether
 Making calculations accurately

f. Verify the ending balance in accumulated depreciation

Debits to accumulated depreciation account are normally tested as a part of the audit of
the disposals of assets. Credits are verified as part of the audit of depreciation expense.

AUDIT TESTS FOR ACCRUALS

 Review relevant invoices when received after the balance sheet date. If none are
received, compare with previous periods.
 Obtain the list of accruals from the client, recalculate it to confirm arithmetical
accuracy.
 Agree the figure per schedule to the general ledger and financial statements
 Agree the calculation of the accruals by reference to supporting documentation e.g.
previous period invoice

AUDITING INTANGIBLE ASSETS

Intangible assets include goodwill, copyrights, trademarks, deferred expenses, capitalized
charges for brand names, and others. It may be extremely difficult to value as they do not
have a ready value, and can rapidly drop in value. Audit expertise in the area is required, or
the auditor may need to engage an independent expert to value material intangible assets.

AUDIT OF PREPAID EXPENSES

[

Prepaid expenses arise from the concept of matching expenses with revenues. These types of
accounts are found in almost every audit. Prepaid insurance is used as an example because it
is a common expense and the auditor is responsible for reviewing the adequacy of insurance
coverage. Regarding audit of insurance expense, the auditor considers internal controls in the
following categories: Controls over the acquisition and recording of insurance, insurance
coverage, and charge-off of insurance expense. The organization may have an insurance

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 register or spreadsheet, or it may simply have a file of insurance policies in force. Audit tests
for insurance expense include:
 Analytical procedures
 Verification that charges to the insurance expense arose from credits to prepaid
insurance (based upon a schedule of insurance charges and prepaid expenses prepared
by the client)

AUDIT OF INCOME AND EXPENSES (OPERATIONS)

The purpose of audit of operations is to determine whether the income and expense accounts
are fairly presented. The auditor needs to be aware of the importance of the income statement
to users. Matching and consistent application of accounting principles are evaluated. This
part of the audit is closely linked to the audit of all of the other transaction cycles. All tests
conducted during the audit need to be considered to evaluate their impact upon the audit of
operations. Analytical review is an important audit step for the audit of operations. The most
common analytical procedures are presented in the below table:

Analytical procedure Possible misstatement

Compare individual expenses with previous Overstatement or understatement of a balance in
years an expense account
Compare individual asset and liability Overstatement or understatement of a balance
balances with previous years sheet account that would also affect an income
statement account
Compare individual expenses with budgets Misstatement of expenses and related balance
sheet accounts
Compare gross margin percentage with Misstatement of cost of goods sold and inventory
previous years
Compare inventory turnover ratio with Misstatement of cost of goods sold and inventory
previous years
Compare prepaid insurance and insurance Misstatement of insurance expense and prepaid
expense with previous years insurance

Compare commission expense divided by Misstatement of commission expense and accrued

sales with previous years commissions
Compare individual manufacturing Misstatement of individual manufacturing
expenses divided by total manufacturing expenses and related balance sheet accounts
expenses with previous years
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 Review Questions

1. What four basic business operations are executed in the acquisition and payment cycle?
2. Mention the two main classes of transactions in the acquisition and payment cycle.
3. Identify the appropriate records and documents in relation to the following functions:
a. Purchasing c. Recognizing the liability
b. Receiving
d. Processing and recording cash disbursements
4. List one possible internal control for each of the six transaction-related audit objectives
for cash disbursements. For each control, list a test of control to test its effectiveness.
5. List one possible control for each of the six transaction-related audit objectives for
acquisitions. For each control, list a test of control to test its effectiveness.
6. What are the similarities and differences in the objectives of the following two procedures?
(1) Select a random sample of receiving reports and trace them to related vendors’ invoices
and acquisitions journal entries, comparing the vendor’s name, type of material and
quantity acquired, and total amount of the acquisition. (2) Select a random sample of
acquisitions journal entries and trace them to related vendors’ invoices and receiving
reports, comparing the vendor’s name, type of material and quantity acquired, and total
amount of the acquisition.
7. What is meant by a voucher? Explain how its use can improve an organization’s internal
controls.
8. How would you verify that all unpresented cheques (cheques not cleared the bank) are
included on a client’s bank reconciliation?
9. What is the relationship between the audit of property, plant, and equipment accounts and
the audit of repair and maintenance accounts? Explain how the auditor organizes the audit
to take this relationship into consideration.
10.In auditing depreciation expense, what major considerations should the auditor keep in
mind? Explain how each can be verified.
11.Explain the conditions under which the external auditors rely on the work of others such
as valuers, surveyors, internal auditors etc.
12.Assume that you are auditing the accounts payable of A Company and have found that the
balance according to A Company’s creditors’ ledger does not agree to the statement from
its supplier B Company. You extracted the following data in your attempt to search for the
difference (all figures are in Birr):

Balance per A Company …………………………............................. 700

Balance per B Company………………………….............................. 3,000
Invoices in file of creditors’ ledger clerk’s desk awaiting posting …. 300

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 Goods returned by A Company to B Company in last week of the year, not yet reflected
on B Company ……………. ................................................................. 400
Value of goods from B Company received by A Company’s receiving department and
invoiced by B Company on the very last day of the year (invoices are sent by mail)
…………………........................................................................... 100
Payment by cheque sent by mail by A Company to B Company on the very last day of the
year ……………………........................................................................ 1,500

Required: What is the correct figure for the balance between A Company and B
Company that should form part of A company’s payable figure in its financial statements?

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 ADDIS ABABA UNIVERSITY
COLLEGE OF BUSINESS & ECONOMICS
DEPARTMENT OF ACCOUNTING & FINANCE
COURSE NAME: AUDITING PRINCIPLES & PRACTICES II
INSTRUCTOR: - TEWODROS HAILU

Illustration on Creditors’ Reconciliation

NATIONWIDE CO.LTD.
CREDITORS LEDGER CARD FOR WHOLESALE SUPPLIES LTD.
Date Description Reference Amount Balance

30 Sep 2022 Balance forward $ 14,350.00

15 Oct 2022 Invoice WS86554 8,346.44 22,696.44

26 Oct 2022 Invoice WS86973 3,947.47 26,643.91

27 Oct 2022 Cheque 2665 -14,063.00 12,580.91

27 Oct 2022 Discount taken -287.00 12,293.91

15 Nov 2022 Invoice WS87124 6,437.80 18,731.71

26 Nov 2022 Invoice WS87199 3,492.21 22,223.92

30 Nov 2022 Cheque 2738 -12,048.03 10,175.89

30 Nov 2022 Discount taken -245.88 9,930.01

09 Dec 2022 Invoice WS87395 16,322.68 26,252.69

28 Dec 2022 Invoice WS87706 2,318.12 28,570.81

30 Dec 2022 Cheque 2841 -9,731.41 18,839.40

30 Dec 2022 Discount taken -198.60 18,640.80

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 STATEMENT FROM WHOLESALE SUPPLIERS LIMITED
AMOUNT DUE BY NATIONWIDE CO. LTD AT 31 DECEMBER 2022
Reference Debit Credit Date Balance

Balance 30/09/2022 26,727.55

WS86554 8,346.44 0 2/10/2022 35,073.99

Payment 0 12,130.00 3/10/2022 22,943.99

Disc 1814 0 247.55 3/10/2022 22,696.44

WS86973 3,947.47 0 16/10/2022 26,643.91

Payment 0.00 14,063.00 29/10/2022 12.580.91

Disc 1827 0.00 287 29/10/2022 12,293.91

WS87124 6,437.80 0 6/11/2022 18,731.71

Disc 1831 0.00 47.33 6/11/2022 18,684.38

WS87199 3,942.21 0 15/11/2022 22,626.59

WS87395 16,322.68 0 5/12/2022 38,949.27

Payment 0.00 12,048.03 5/12/2022 26,901.24

WS87706 2,318.12 0 14/12/2022 29,219.36

WS88043 4,321.15 0 30/12/2022 33,540.51

Balance Due to Wholesale Suppliers 33,540.51

*Remember if you pay within 30 days of invoice date, we allow 2% discount.

Note to the student: For any differences in invoice balances and discount, assume that it is Nationwide
who has made the mistake.

REQUIRED: Establish/determine the balance owed by Nationwide to wholesale supplier’s Limited at the
beginning of January 2023.

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