CHAPTER FOUR

AUDIT OF THE ACQUISITION AND PAYMENT CYCLE

Objectives

After studying this chapter, you should be able to:

1. Identify the accounts and the classes of transactions in the acquisition and payment cycle.
2. Describe the business functions and the related documents and records in the acquisition
and payment cycle.
3. Understand internal control, and design and perform tests of controls and substantive
tests of transactions in the acquisition and payment cycle.
4. Describe the methodology for designing tests of details of balances for accounts payable
using the audit risk model.
5. Design and perform analytical procedures for accounts payable.
6. Design and perform tests of details of balances for accounts payable, including out-of-
period liability tests.
7. Distinguish the reliability of vendors’ invoices, vendors’ statements, and confirmations of
accounts payable as audit evidence.
8. Recognize the many accounts in the acquisition and payment cycle.
9. Design and perform audit tests of property, plant, and equipment and related accounts.
10. Design and perform audit tests of prepaid expenses.
11. Design and perform audit tests of accrues liabilities.
12. Design and perform tests of income and expense accounts.
 4.1 Accounts and Classes of Transactions in the Acquisition and Payment
cycle

The overall objective in the audit of the acquisition and payment cycle is to evaluate whether the
accounts affected by the acquisitions of goods and services and the cash disbursements for those
acquisitions are fairly presented in accordance with generally accepted accounting principles.

There are three classes of transactions included in the cycle:

1. Acquisition of goods and services
2. Cash disbursements
3. Purchase returns and allowances

Typical accounts included in the acquisition and payment cycle are shown by T accounts in
figure 4-1. Note the large number of accounts affected by this cycle. To keep the illustration
manageable, only the control accounts are shown for the three major categories of expenses used
by most companies. For each control account, examples of the subsidiary expense accounts are
also given.
 4.2 Business Functions in the Cycle and Related Documents

The acquisition and payment cycle involves the decisions and processes necessary for obtaining
the goods and services for operating a business. The cycle typically begins with the initiation of a
purchase requisition by an authorized employee who needs the goods or services, and it ends
with payments for the benefit received.
There are four business functions shown in the third column of Table 4-1. These functions occur
in every business in the recording of the three classes of transactions in the acquisition and
payment cycle. Observe that the first three business functions are for recording the acquisition of
goods and services on account, and the last process is for recording the cash disbursements for
payments to vendors.
Table 4-1 Classes of Transactions, Accounts, Business Functions, and Related Documents and
Records for the Acquisitions and Payment Cycle
Classes of
Transactions Accounts Business functions Documents & Records
 Acquisition Inventory
Property, plant, and Processing purchase purchase requisition
equipment Order purchase order
Prepaid expense Receiving goods &
Leasehold Services receiving report
improvements
Accounts payable Recognizing Acquisition transaction file
Manufacturing expense the liability Acquisition journal or listing
Selling expense Vendor’s invoice
Administrative expense Debit memo
voucher
A/P master file
A/P trial balance
Vendor’s statements
Cash Cash in bank
Disbursements ( from cash Processing & recording Check
disbursements) cash disbursement Cash disbursements
Accounts payable transaction file
Purchase discount Cash disbursements
Journal or listing

1. Processing Purchase Order

The request for goods and services by the client’s personnel is the starting point for the cycle. In
an effective purchasing system, a stores, or inventory control department will prepare and
approve the issuance of a purchase requisition that will be sent to the purchasing department.

The purchasing department, upon receiving the requisition, will (1) determine that the item
should be ordered and (2) select the appropriate vendor, quality, and price. Then, a serially
numbered purchase order is issued to order the goods. Copies of the purchase order should be
sent to stores, receiving and the accounts payable department.

a) Purchase requisition- is a request for goods and services by an authorized employee.

 b) Purchase order- is a document identifying the description, quantity, and related
information for goods and services the company intends to purchase. Companies often
submit purchase orders electronically to vendors who have trade arrangements for
electronic data interchange (EDI).

2. Receiving Goods and Services

The receipt by the company of goods and services from the vendor is a critical point in the cycle
because it is the point at which companies first recognize the acquisition and related liability on
their records. When goods are received, adequate control requires examination for description,
quantity, timely arrival, and condition. The receiving department should be independent of the
purchasing department. Receiving report should be prepared for all goods received. A receiving
report is a paper or electronic document prepared at the time tangible goods are received. The
receiving report includes a description of the goods, the quantity received, the date received, and
other relevant data. The receipt of goods and services in the normal course of business represents
the date companies normally recognize the liability for an acquisition.

3. Recognizing the Liability

The proper recognition of the liability for the receipt of goods and services requires prompt and
accurate recording. The initial recording has a significant effect on the recorded financial
statements and the actual cash disbursements; therefore, great care must be taken to include only
existing company acquisitions at the correct amounts.

a) Acquisition transaction file- a computer generated file that include all acquisition
transactions processed by the accounting system for a period, such as a day, week, or
month. It contains all information entered in to the system and includes information for
each transaction, such as vendor name, date, amount, account classification, or
classifications, and description and quantity of inventory purchased. The information in
the acquisition transaction file is used for a variety of records, listing or reports,
depending upon the company’s need. Examples include an acquisitions journal, accounts
payable master file, and transactions for a certain account balances or division.
 b) Acquisition journal or listing- a report generated from the acquisitions transaction file
that typically includes the vendor name, date, amount, and account classifications for
each transaction, such as, repair and maintenance, inventory, or utilities.

c) Vendor’s invoice- is a document indicates such things as the description and quantity of
goods and services received, price (including freight), cash discount terms, and date of
the billings. It is an essential document because it specifies the amount of money owed to
the vendor for acquisition. For companies using EDI, the vendor invoice is transmitted
electronically rather than in paper form.

d) Debit memo- is a document indicating a reduction in the amount owed to a vendor

because of returned goods or an allowance granted. It often takes the same general form
as a vendor’s invoice, but it supports reductions in accounts payable rather than increases.

e) Voucher- this document is commonly used by organizations to establish a formal means

of recording and controlling acquisitions. Voucher include a cover sheet or folder for
containing documents and a package or relevant documents, such as the purchase order,
copy of the packing slip, receiving report, and vendor’s invoice. After payment, a copy of
the check is added to the voucher package.

f) Accounts payable master file- is used for recording individual acquisitions, cash
disbursements, and acquisition returns and allowances for each vendor.

g) Accounts payable trial balance- lists the amount owed to each vendor or for each
invoice or voucher at a point in time. It is prepared directly from the accounts payable
master file.

h) Vendor’s statement- is prepared monthly by the vendor and indicates the beginning
balance, acquisitions, returns and allowances, payments to the vendor, and ending
balance.

4. Processing and Recording Cash Disbursements

For most companies, payment is made by computer-prepared checks from information included
in the acquisition transactions file at the time goods and services are received. Checks are
typically prepared in a multicopy format, with the original going to the payee, one copy filed
with the vendor’s invoice and other supporting documents, and another filed numerically. In
most cases, individual checks are recorded in a cash disbursements transaction file.

a) Check- is the document used to pay for the acquisition when payment is due.

b) Cash disbursement transaction file- is a computer-generated file that includes all cash
disbursements transactions processed by the accounting system for a period, such as a
day, week, or month. It includes the same type of information for the acquisitions
transaction file.

c) Cash disbursements journal or listing- is a report generated from the cash

disbursements transaction file that includes all transactions for any time period. The same
transactions, including all relevant information, are included in the accounts payable
master file and general ledger.

4.3Methodology for Designing Tests of Controls and Substantive Tests of

Transactions

In a typical audit, the most time-consuming accounts to verify by substantive tests of details of
balances are accounts receivable, inventory, fixed assets, accounts payable, and expenses
accounts. Of these five, four are directly related to the acquisition and payment cycle.

Figure 4-2 Methodology for Designing Tests of Controls and Substantive Tests of
Transactions for the Acquisition and Payment Cycle

Understand internal control

Acquisitions & cash disbursements
 Asses planned control risk
Acquisitions & cash disbursements

Determine extent of
Tests of controls

Design Tests of Audit procedure

Controls and
substantive tests of
transactions for Sample size
acquisitions & each
disbursements to meet
Item to select
transaction related
audit objectives
Timing

Tests of controls and substantive tests of transactions for the acquisition and payment cycle are
divided into two broad areas: tests of acquisitions and tests of payments.

 Acquisition tests concern three of the four business functions (processing purchase orders,
receiving goods and services, and recognizing liability).

 Tests of payments concern the four functions (processing and recording cash disbursements).
Methodology for Designing Tests of Controls and Substantive Tests of Transactions are:

I. Understand Internal Control

The auditor gains understanding of internal control for the acquisition and payment cycle by
studying the client’s flow charts, preparing internal control questionnaire, performing
walkthrough tests for acquisitions and cash disbursements.

II. Assess Planned Control Risk

The key controls for acquisition and payment cycle are:

 Authorization of purchases- proper authorization for acquisition is essential because it

ensures that goods and services acquired are for authorized company purposes and it avoids
the acquisition of excessive or unnecessary items.

 The separation of custody of the received goods from other functions- most companies
have the receiving department initiate a receiving report as evidence of the receipt and
examination of goods.

 The timely recording and independent review of transactions- in some companies, the
recording of the liability for acquisitions made on the basis of the receipt of goods and
services, and in other companies, it is deferred until the vendor’s invoice is received.

 The 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 the checks and performing the accounts payable
function, and careful examination of the supporting documents by the check signer at the
time the check is signed.

III. Determine Extent of Testing of Controls

After the auditor identifies the key internal controls and weaknesses and assesses control
risk, it is appropriate to decide whether substantive tests will be reduced sufficiently to
justify the cost of performing tests of controls.

IV. Design Tests of Controls and Substantive Tests of Transactions

 For Acquisitions

Key internal controls and common tests of controls for each transaction-related audit objectives
are summarized below as follows:

Table 4-2 Summary of Transaction-Related Audit Objectives, Key Controls and Tests of
Controls

Transaction-related audit objective Key internal control Common tests of control

Occurrence: Recorded acquisitions Existence of purchase Examine underlying

are for goods and services received, requisition, purchase order, documents for
consistent with the best interests of receiving report, and vendor’s reasonableness and
the client. invoice attached to the authenticity.
voucher/cheque.

Completeness: Existing acquisition Receiving reports are Accounts for a sequence

transactions are recorded. prenumbered and accounted for. of receiving reports (a
block test).

Accuracy: Recorded acquisition Batch totals are compared with Examine file of batch
transactions are accurate. computer summary reports. totals for initials of data
entry clerk; compare
totals to summary
reports.

Classification: Acquisition Automatic updates and postings. Enter test transactions or

transactions are properly classified. observe entry, and trace
to correct file.

Timing: Acquisition transactions Transaction date must be system Observe data entry
are recorded on the correct dates. date (today’s date) or a process.
 reasonable date.

Posting and summarization: Comparison of accounts payable Test clerical accuracy by

Acquisition transactions are properly master file or trial balance totals footing the journals and
included in the vendor and inventory with general ledger balance. tracing postings to
master files, and are properly general ledger and
summarized. accounts payable and
inventory master files.

Four of the six transaction related audit objectives for acquisitions deserve special attention
are:

 Recorded acquisitions are for goods and services received, consistence with best interest of
client (Existence)

 Existing acquisitions are recorded (completeness)

 Acquisitions are accurately recorded (accuracy)

 Acquisitions are correctly classified (classification)

V. Design Tests of Controls and Substantive Tests of Transactions for Cash Disbursements

The same format used in Table 2-2 for acquisitions is also used for cash disbursements.

Table 4-3 Summary of Transaction-related Audit Objectives, Key Controls, and Tests of
Controls for Cash Disbursements

Transaction-related audit objective Key internal control Common tests of control

Occurrence: Recorded cash Approvals of payment on Examine indication of

 disbursements are for goods and supporting documents at approval.
services actually received. the time cheques are
signed.

Completeness: Existing cash Cheques are Account for a sequence

disbursement transactions are prenumbered and of cheques (block test).
recorded. accounted for.

Accuracy: Recorded cash Monthly preparation of a Examine bank

disbursement transactions are bank reconciliation by an reconciliations and
accurate. independent person. observe their preparation.

Classification: Cash Adequate chart of Examine procedures

disbursement transactions are accounts. manual and chart of
properly classified. accounts.

Timing: Cash disbursement Transaction date must be Observe data entry

transactions are recorded on the system date. process.
correct dates.

Posting and summarization: Comparison of vendor Test clerical accuracy by

Cash disbursement transactions master file or trial footing journals and
are properly included in the balance totals with tracing postings to
vendor master file and properly general ledger balance. general ledger and
summarized. vendor master file.

Attributes Sampling

Because of the importance of tests of controls and substantive tests of transactions for
acquisitions and cash disbursements, the use of attributes sampling is common in this audit
area.

4.4 Methodology for Designing Tests of Details of Balances of Accounts Payable

 Because all acquisitions and payments cycle transactions typically follow through accounts
payable, this account is critical to any audit of the acquisition and payment cycle.

If tests of controls and related substantive tests of transactions show that controls are operating
effectively, the auditor may be able to reduce analytical procedures and tests of details of
balances of accounts payable. However, because accounts payable tend to be material for many
companies, auditors almost always perform extensive analytical procedures and some tests of
details of balances of that account.

Phase I

- Identify client business risks affecting accounts payable.

- Set tolerable misstatement and assess inherent risk for accounts payable.
- Assess control risk for accounts payable.

Phase II

- Design and perform tests of controls and substantive tests of transactions for the
acquisition and payment cycle.

Phase III

- Design and perform analytical procedures for the acquisition and payment cycle.
- Design tests of details of accounts payable balance to satisfy balance related audit
objectives.

Design and Perform Analytical Procedures for Accounts Payable

The use of analytical procedures is as important in the acquisition and payment cycle as it is in
every other cycle, especially for uncovering misstatements in accounts payable. Of the most
important analytical procedures for uncovering misstatements of accounts payable is comparing
current year expense totals with prior years. For example, by comparing utilities expense with
the prior year, the auditor may determine that the last utilities bill for the year was not recorded.
Comparing expenses with prior years is an effective analytical procedure for accounts payable
when expenses from year to year are expected to be relatively stable. Typical examples include
rent, utilities, and other expenses billed on a regular basis.

Design and Perform Tests of Details of Accounts Payable, including out-of-period Liability
Tests

The overall objective in the audit of accounts payable is to determine whether the accounts
payable balance is fairly stated and properly disclosed. Eight of the nine balance-related audit
objectives are applicable to accounts payable. Realizable value is not applicable to liabilities.

The auditor should recognize the difference in emphasis between the audit of liabilities and the
audit of assets. When assets are being verified, attention is focused on making certain that the
balance in the account is not overstated. The existence of recorded assets is constantly
questioned and verified by confirmation, and examination of supporting documents. The auditor
should not ignore the possibility of assets being understated but should be more concerned about
the possibility of overstatement than understatement. The opposite approach is taken in verifying
liability balances; that is the main focus is on understated or omitted liabilities.

The same balance-related audit objectives that are used as a frame of reference for verifying
accounts receivable are also applicable to liabilities, with three minor modifications. The most
obvious difference in verifying liabilities is the nonapplicability of the realizable value objective.
The second difference is in the rights and obligations objective. For assets, the auditor is
concerned with the client’s rights to the use and disposal of assets. For liabilities, the auditor is
concerned with the client’s obligations for the payment of the liability. If the client has no
obligation to pay a liability, it should not be included as a liability. The third difference is
discussed earlier: In auditing liabilities, the emphasis is on the search for understatements other
than for overstatements.

The actual audit procedures will vary considerably depending on the nature of the entity, the
materiality of accounts payable, the nature and effectiveness of internal controls, and inherent
risk.

Out-of-Period Liability Tests

Because of the emphasis on understatements in liability accounts, out-of-period liability tests are
important for accounts payable. The extent of tests to uncover unrecorded accounts payable,
often called the search for unrecorded accounts payable, depends heavily on assessed control risk
and the materiality of the potential balance in the account. The same audit procedures used to
uncover unrecorded payables are applicable to the accuracy objective. The audit procedures that
follow are typical tests.

1. Examine Underlying Documentation for Subsequent Cash Disbursements- The

purpose of this audit procedure is to uncover cash disbursements made in the
subsequent accounting period that represent liabilities at the balance sheet date.
Supporting documentation is examined to determine whether a cash disbursement
was for a current period obligation. The receiving report indicates the date inventory
was received and is therefore an especially useful document. Similarly, the vendor’s
invoice often indicates the date services were provided.

2. Examine Underlying Documentation for Bills Not Paid Several Weeks After the
Year-End- This procedure is carried out in the same manner as the preceding one and
serves the same purpose. The only difference is that it is done for unpaid obligations
near the end of the audit field work rather than for obligations that have already been
paid.

3. Trace Receiving Reports Issued Before Year-End to Related Vendor’s Invoice-

All merchandise received before the year-end of the accounting period, indicated by
the issuance of a receiving report, should be included as accounts payable. By tracing
receiving reports issued at and before year-end to vendor’s invoices and making sure
that they are included in accounts payable, the auditor is testing for unrecorded
obligations.

4. Trace Vendor’s Statements That Show a Balance Due to the Accounts Payable
Trial Balance- If the client maintains a file of vendors’ statements, any statement
indicating a balance due at the balance sheet date can be traced to the listing to make
sure that it is included as an accounts payable.
 5. Send Confirmations to Vendors with Which the Client Does Business- Although
the use of confirmations for accounts payable is less common than for accounts
payable, it is sometimes used to test for vendors omitted from the accounts payable
list, omitted transactions and misstated account balances.

6. Cutoff Tests- Cutoff tests for accounts payable are intended to determine whether
transactions recorded a few days before and after the balance sheet date are included
in the correct period. The five out-of-period liability audit tests just discussed are
directly related to cutoff for acquisitions, but they emphasize understatements.

Reliability of Evidence

In deciding thee appropriate evidence for verifying accounts payable, it is essential that the
auditor understand the relative reliability of the three primary types of evidence ordinarily used:
vendors’ invoices, vendors’ statements, and confirmations.

Distinction Between Vendors’ Invoices and Vendors’ Statements: - In verifying the amount
due to a vendor, the auditor should make a distinction between vendors’ invoices and vendors’
statements. In examining vendors’ invoices and related supporting documents, such as receiving
reports and purchase orders, the auditor gets highly reliable evidence about individual
transactions. A vendor’s statement is not as desirable as invoices for verifying individual
transactions because a statement includes only the total amount of transaction. The units
acquired, price, freight, and other data are not included. However, a statement has the advantage
of including the ending balance according to the vendor’s records.

Which of these two documents is better for verifying the correct balance in accounts payable?
The vendor’s statement is superior for verifying accounts payable because it includes the ending
balance.

Which of these two documents is better for testing acquisitions in tests of controls and
substantive tests of transactions? The vendor’s invoice is superior for verifying transactions
because the auditor is verifying individual transactions and the invoice shows the details of the
acquisitions.
Difference between Vendors’ Statements and Confirmations- The most important distinction
between a vendor’s statement and a confirmation of accounts payable is the source of the
information. A vendor’s statement has been prepared by an independent third party but is in the
hands of the client at the time the auditor examines it. This provides the client with an
opportunity to alter a vendor’s statement or to not make certain statements available to the
auditor. A confirmation of accounts payable, which normally is a request for an itemized
statement sent directly to the CPA’s office, provides the same information but can be regarded as
more reliable. In addition, confirmations of accounts payable often include a request for
information about notes and acceptances payable as well as consigned inventory owned by the
vendor but stored on the client’s premises.

Completing the Tests in the Acquisition and Payment Cycle: Verification of Selected
Accounts

Acquisitions of assets affect supplies, property, plant and equipment, and prepaid expenses
accounts, to name a few. This section continues the discussion of the acquisition and payment
cycle by highlighting unique audit issues related to other accounts commonly found in the
acquisition and payment cycle of most businesses.

Types of Other Accounts in the Acquisition and Payment Cycle

Many of the typical accounts associated with transactions in the acquisition and payment cycle
are listed below. These accounts are common in many types of businesses. As the nature of the
industry or the client’s business becomes more specialized, however, the types of assets,
expenses, and liabilities change.

Assets Cash Patents, trademarks, and copyrights

Inventory Prepaid rent
Supplies Prepaid taxes
Property, plant, and equipment Prepaid insurance

Expenses

Cost of goods sold Property taxes

Rent expense Income tax expense
Insurance expense Retirement benefits
Professional fees Utilities

Liabilities

Accounts payable Accrued property taxes

Rent payable Other accrued expenses
Accrued professional fees Income taxes payable

Audit of Property, Plant, and Equipment

The term property, plant, and equipment: includes all tangible assets with a service life of more
than one year that are used in the operation of the business and are not acquired for the purpose
of resale. Three major subgroups of such assets are generally recognized:

1. Land, such as acres of property used in the operation of the business, has the significant
characteristic of not being subject to depreciation.

2. Buildings, machinery, equipment, and land improvements, such as fences and

parking lots, have limited service lives and are subject to depreciation.

3. Natural resources (wasting assets), such as oil wells, coal mines, and tracts of timber,
are subject to depletion as the natural resources are extracted or removed.

Acquisitions and disposals of property, plant, and equipment are usually large in dollar amount,
but concentrated in only a few transactions. Individual items of plant and equipment may remain
unchanged in the accounts for many years.

Because the audits of these property, plant, and equipment accounts are similar, this section
focuses on auditing manufacturing equipment to illustrate an approach to auditing all types of
property, plant, and equipment accounts. When there are significant differences in the
verification of other types of property, plant, and equipment accounts, the differences are briefly
discussed.

Overview of Equipment Related Accounts

The accounts commonly used for manufacturing are:

Land and land improvements Autos and trucks
Buildings and building improvements Leasehold improvements
Manufacturing equipment Construction-in-process for property, plant,
Furniture and fixtures and equipment

The primary accounting record for manufacturing equipment and other property, plant, and
equipment accounts is generally a fixed asset master file. The contents of the fixed asset master
file must be understood for a meaningful study of the audit of manufacturing equipment. The
master file is composed of a set of records, one for each piece of equipment and other types of
property owned. In turn, each record includes descriptive information, date of acquisition,
original cost, current year depreciation, and accumulated depreciation for the property. The totals
for all records in the master file equal the general ledger balances for the related accounts. The
master file will also contain information about property acquired and disposed of during the year.
For disposals, proceeds, gains, and losses will be included.

Contrast with Audit of Current Assets

Manufacturing equipment is normally audited differently from current asset accounts for three
reasons:

1. There are usually fewer current period acquisitions of manufacturing equipment,

2. The amount of any given acquisition is often material, and
3. The equipment is likely to be kept and maintained in the accounting records for several
years.

Because of these differences, the emphasis in auditing manufacturing equipment is on the

verification of current period acquisitions rather than on the balance carried forward from the
preceding year.

Although the approach to verifying manufacturing equipment is dissimilar from that used for
current assets, several other asset accounts are verified in much the same manner. These include
patents, copyrights, catalog costs, and all property, plant, and equipment accounts.
Internal Control over Manufacturing Equipment

The principal purpose of internal controls relating to manufacturing equipment is to obtain

maximum efficiency from the dollars invested in plant assets.

The amounts invested in manufacturing equipment represent a large portion of the total assets of
many industrial concerns. The expenses of maintenance, rearrangement, and depreciation of
these assets are a major factor in the income statement. The large size of the amounts involved
makes strong internal control essential to the production of reliable financial statements. Errors
in measurement of income will be material if assets are scraped without their cost being removed
from the accounts or if the distinction between capital and revenue expenditures is not
maintained consistently. The losses that arise from uncontrolled methods of acquiring,
maintaining, and retiring manufacturing equipment are often greater than the losses from fraud in
cash handling.

In an audit of manufacturing equipment and related accounts, it is helpful to separate the tests in
to the following categories:

 Analytical procedures
 Verification of :
 Current-year acquisitions
 Current-year disposals
 The ending balance in the asset account
 Depreciation expense
 The ending balance in accumulated depreciation

The following sections highlight the use of these categories of tests in the audit of manufacturing
equipment, depreciation expense, accumulated depreciation, and gain or loss on disposal
accounts.

Analytical procedures- As in all audit areas, the nature of analytical procedures depends on the
nature of the client’s operations. Most of the typical analytical procedures performed relate to
assessing the likelihood of material misstatements in the depreciation expense and accumulated
depreciation accounts.

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. The failure
to capitalize a fixed asset, or the recording of an acquisition at the improper amount, affects the
balance sheet until the company disposes of the asset. The income statement is affected until the
asset is fully depreciated.

The starting point for the verification of current year acquisitions is normally a schedule
obtaining from the client of all acquisitions recorded in the general ledger during the year. A
typical schedule lists each addition separately and includes the date of the acquisition, vendor,
description, notion of new or used, life of the asset for depreciation purposes, depreciation
methods, and cost. The client obtains this information from the property master file.

Testing current period additions should also include reviewing recorded transactions for proper
classifications. In some cases, amounts recorded as manufacturing equipment should be
classified as office equipment or as a part of the building. There is also the possibility that the
client has improperly capitalized repairs, rents, or similar expenses.

The inclusion of transactions that should properly be recorded as assets in repairs and
maintenance expense, lease expense, supplies, small tools, and similar accounts is a common
client error. The error results from lack of understanding of IFRS and some clients’ desire to
avoid income taxes. If the auditor concludes that this type of misstatement is likely, it may be
necessary to vouch the larger amounts debited to the expense accounts. It is a common practice
to do so as part of the audit of the property, pant, and equipment accounts.

Verifying Current Year Disposals- transactions involving the disposal of manufacturing

equipment are often misstated when company internal controls lack a formal method to inform
management of the sale, trade-in, abandonment, or theft of recorded machinery and equipment.
There should be adequate internal verification of recorded disposals to make sure that assets are
correctly removed from the accounting records. The most important audit procedures are those
for searching for unrecorded disposals.
The starting point for verifying disposals is the client’s schedule of recorded disposals. The
schedule typically includes the date when the asset was disposed of, the name of the person or
firm acquiring the asset, the selling price, the original cost of the asset, the acquisition date, and
the accumulated depreciation of the asset.

The following procedures are often used for verifying disposals:

 Review whether newly acquired assets replace existing assets.
 Analyze gains and losses on the disposal of assets and miscellaneous income for receipts
from the disposal of assets.
 Review plant modifications and changes in product line, property taxes, or insurance
coverage for indication of deletions of equipment.
 Make inquiries of management and production personnel about the possibility of the
disposal of assets.

Verifying Ending Balance of Asset Account- the nature of the internal controls over existing
assets determines whether it is necessary to verify manufacturing equipment acquired in prior
years. Relevant controls include periodic count and formal method of informing the accounting
department of disposals. The proper presentation and disclosure of manufacturing equipment in
the financial statements must be evaluated carefully to make sure that IFRS is followed.
Manufacturing equipment should include the gross cost and should ordinarily be separated from
other fixed assets.

Verifying Depreciation Expense- the recorded amounts are determined by internal allocations
rather than by exchange transactions with outside parties. The most important objective for
depreciation expense is accuracy. Two major concerns are involved in the accuracy objective:

1) Determining whether the client is following a consistent depreciation policy from period
to period and
2) Determine whether the client’s calculations are correct.

Verifying Ending Balance in Accumulated Depreciation- the debits to accumulated

depreciation are normally tested as part of the audit of disposals of assets, whereas the credits are
verified as a part of depreciation expense.
Two objectives are usually emphasized in the audit of the ending balance in accumulated
depreciation:

1. Accumulated depreciation as stated in the property master file agrees with the general
ledger. This objective can be satisfied by test-footing the accumulated depreciation in the
property master file and tracing the total to the general ledger.
2. Accumulated depreciation in the master file is accurate.

Audit of Natural Resources

In the examination of companies operating properties subject to depletion (mines, oil, and gas
deposits, timberlands, and other natural resources), the auditors follow a pattern similar to that
used in evaluating the provision for depreciation expense and accumulated depreciation. They
determine whether depletion has been recorded consistently and in accordance with IFRS, and
they test the mathematical accuracy of the client’s computations.

Audit of Intangible Assets

Intangible assets include a variety of assets. All intangible assets are characterized by a lack of
physical substance. Furthermore, they do not qualify as current assets, and they are non-
monetary – that is, they do not represent fixed claims to cash.

Among the more prominent intangible assets are goodwill, copyrights, trademarks, patents,
franchises, and others. Because of their intangible nature, these assets may be more difficult to
identify than units of plant and equipment. In addition, 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 in an independent expert to value material intangible
assets.

Audit of Prepaid Expenses

Prepaid expenses arise from the concept of matching expenses with revenues than from their
resale or liquidation value. The following are examples:

 Prepaid rent
 Organization costs
 Prepaid taxes
 Patents
 Prepaid insurance
 Trademarks
 Deferred charges
 copyrights
In this section, the audit of prepaid insurance is discussed as an account representative of this
group because it is found in almost every audit, it is a common expense, and the auditor is
responsible for reviewing the adequacy of insurance coverage.

Audit of Prepaid 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 acquisition and recording of insurance are part of the acquisition and payment cycle. These
include proper authorization for new insurance policies and payment of insurance premiums
consistent with the procedures discussed in that cycle.

The organization may have an insurance register or spreadsheet, or it may simply have a file of
insurance policies in force. Use of an insurance register is an essential control to ensure that the
company has adequate insurance. The control should include a provision for periodic review of
the adequacy of the insurance coverage by an independent qualified person.

Prepaid Insurance Expense: Audit Tests

Throughout the audit of prepaid insurance and insurance expense, the auditor should keep in
mind that the amount in insurance expense is a residual based on the beginning balance in
prepaid insurance, the payment of premiums during the year, and the ending balance. The only
verification of the balance in the expense account that is ordinarily necessary is analytical
procedures and a brief test to be sure that the charges to insurance expense arose from credits to
prepaid insurance.

Audit of Accrued Liabilities

A third major category of accounts in the acquisition and payment cycle is accrued liabilities.
Accrued liabilities are estimated unpaid obligations for services or benefits that have been
received before the balance sheet date.
Examples include accrued property taxes, accrued payrolls and payroll taxes, accrued
commissions and bonuses, accrued income taxes, accrued interest, accrued professional fees,
accrued rent, and amounts accrued under service guarantees.

The basic auditing steps for accrued liabilities are:

1. Examine any contracts or other documents on hand that provide the basis for the accrual.
2. Appraise the accuracy of the detailed accounting records maintained for this category of
liability.
3. Identify and evaluate the reasonableness of the assumptions made that underlie the
computation of the liability.
4. Test the computations made by the client in setting up the accrual.
5. Determine that accrued liabilities have been treated consistently at the beginning and end
of the period.
6. Consider the need for accrual of other accrued liabilities not presently considered (that is,
test completeness).

The verification of accrued expenses varies depending on the nature of the accrual and the
circumstances of the client. For most audits, accruals take little audit time, but in some instances,
accounts such as accrued income taxes, warranty costs, and pension costs are material and
require considerable audit effort. To illustrate, the audit of accrued property taxes is discussed in
this section.

Accrued Property Taxes

Property tax payments are usually few in number and substantial in amount. It is, therefore,
feasible for the audit working papers to include an analysis showing all of the year’s property tax
transactions. Tax payments should be verified by inspection of the property tax bills issued by
local government units and by reference to the related paid checks. If the tax accruals at the
balance sheet date differ significantly from those of prior years, an explanation of the variation
should be obtained. The auditors should verify that property tax bills have been received on all
taxable property or that an estimated tax has been accrued.
Audit of Income and Expense Accounts

The final look at key accounts in the acquisition and payment cycle includes an overview of
procedures auditors typically use to determine whether the income and expense accounts in the
financial statements are fairly presented in accordance with IFRS. The auditor must be satisfied
that each of the income and expense totals included in the income statements as well as net
earnings are not materially misstated.

In conducting audit tests of the financial statements, the auditor must be aware of the importance
of the income statement to users of the statements. Many users rely more heavily on the income
statement than on the balance sheet for making decisions. Equity investors, long-term creditors,
union representatives, and often even short-term creditors are more interested in the ability of a
firm to generate profit than in the historical cost or book value of the individual assets.

Considering the purposes of the income statement, the following are two essential concepts in
the audit of income and expense accounts:

1. The matching of periodic income and expense is necessary for a proper determination of
operating results.
2. The consistent application of accounting principles for different periods is necessary for
comparability.

The parts of the audit directly affecting these accounts are as follows:

 Analytical procedures
 Tests of controls and substantive tests of transaction
 Tests of details of account balances

Analytical procedures should be thought of as part of the test of the fairness of the presentation
of both balance sheet and income statement. A few analytical procedures and the possible
misstatements they may uncover in the audit of income and expense accounts are shown below.
 Analytical Procedures for Income and Expense Accounts

Analytical procedure Possible misstatement

Compare individual expenses with previous Overstatement or understatement of a balance in an
years expense account
Compare individual asset and liability Overstatement or understatement of a balance sheet
balances with previous years 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 insurance
expense with previous years
Compare commission expense divided by Misstatement of commission expense and accrued
sales with previous years commissions
Compare individual manufacturing expenses Misstatement of individual manufacturing expenses and
divided by total manufacturing expenses related balance sheet accounts
with previous years

Tests of Controls and Substantive Tests of Transactions

Tests of controls and substantive tests of transactions both have the effect of simultaneously
verifying balance sheet and income statement accounts. For example, when an auditor concludes
that internal controls are adequate to provide reasonable assurance that transactions in the
acquisitions journal exist, are accurately recorded, correctly classified, and recorded in a timely
manner, evidence exists as to the correctness of individual balance sheet accounts such as
accounts payable and fixed assets and income statement accounts such as advertising and repairs.
Tests of Details of Account Balances- Expense Analysis

The amounts included in certain income statement accounts must be analyzed even though the
previously mentioned tests have been performed. Expense account analysis is the examination of
underlying documentation of the individual transactions and amounts making up the detail of the
total of an expense account. The underlying documents are of the same nature as those used for
examining transactions as part of tests of acquisition transactions and include invoices, receiving
reports, purchase orders, and contracts.