1

Chapter Outline

Audit of Acquisition and Payment Cycle

» 4.1. Overview of the cycle
» 4.2. Key Internal Control
» 4.3. Tests of Controls & Substantive Tests of Transactions
» 4.4. Tests of Details of Balances of Accounts payable
» 4.5. Tests of Details of Other accounts
» Property, plant, and equipment
» Other liabilities
» Prepaid expenses
» Income and expense accounts
2
 Learning Objectives

After studying this chapter, you should be able to:

» Identify the accounts and the classes of transactions in the acquisition and payment
cycle.
» Describe the business functions and the related documents and records in the
acquisition and payment cycle.
» Understand internal control, and design and perform tests of controls and substantive
tests of transactions for the acquisition and payment cycle.
» Describe the methodology for designing tests of details of balances for accounts
payable using the audit risk model.
» Design and perform analytical procedures for accounts payable.
» Design and perform tests of details of balances for accounts payable, including out of
period liability tests.
» Distinguish the reliability of vendors’ invoices, vendors’ statements, and confirmations
of accounts payable as audit evidence
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4.1. OVERVIEW OF THE CYCLE
 4.1. Overview of the cycle

» The acquisition of goods and services includes the acquisition of such things
as raw materials, equipment, supplies, utilities, repairs and maintenance,
and research and development.
» In the first part of the chapter, we’ll examine assessing control risk and
designing tests of controls and substantive tests of transactions for the classes
of transactions in the acquisition and payment cycle.
» Then, we’ll cover performing tests of details of balances for accounts payable.
» As with the sales and collection cycle, auditors need to understand the
business functions and documents and records in a company before they
can assess control risk and design tests of controls and substantive tests of
transactions.
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 Cont.… Audit Objective

» The 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 accounting standards.

» Based on this, we will discuss two related topics:

1. The acquisition and payment cycle classes of transactions and account
balances in a typical company
2. Typical documents and records used in the acquisition and payment
cycle
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 Accounts and the Classes of Transactions in The Cycle.

» There are three classes of transactions included in the cycle:

1. Acquisitions of goods and services
2. Cash disbursements
3. Purchase returns and allowances and purchase discounts
» The following figure shows ten typical accounts involved in the acquisition and
payment cycle are shown by T accounts.
» For simplicity, we show only the control accounts for the three major categories of
expenses used by most companies.
» For each control account, examples of the subsidiary expense accounts are also
given.
» Note the large number of accounts affected by this cycle.
» It is therefore not surprising that auditing the acquisition and payment cycle often
takes more time than any other cycle.
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• The figure shows that every
transaction is either debited
or credited to accounts
payable.
• Because some companies
make acquisitions directly
by check or with cash on
hand, the figure is an
oversimplification.
• We assume that acquisitions
made for cash are processed
in the same manner as
those made by accounts
payable.

8
4.2. KEY INTERNAL CONTROL
Business Functions in the Cycle and Related Documents and Records

10
 Cont..

» There are four business functions in the cycle.

1. Processing Purchase Orders:
» The request for goods or services by the client’s personnel is the starting point
for the cycle. the request and the approval depend on the nature of the goods
and services and company policy.
» Common documents include:
i. A purchase requisition is used to request goods and services by an
authorized employee.
ii. A purchase order is a document used to order goods and services from
vendors. It includes the description, quantity, and related information for
goods and services
11
 Cont..

2. Receiving Goods and Services:

» The receipt by the company of goods or services from the vendor is a critical
point in the cycle because it is when most 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.
» Related Document:
» A receiving report is a paper or electronic document prepared at the time
goods are received.
» It includes a description of the goods, the quantity received, the date received,
and other relevant data. 12
 Cont..

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 affects the financial statements and the actual cash
disbursement; therefore, companies must take care to include all acquisition
transactions, only acquisitions that occurred, and at the correct amounts.
» Common documents and records include:
1. A vendor’s invoice is a document received from the vendor and shows the
amount owed for an acquisition.
» It indicates the description and quantity of goods and services received, price
(including freight), cash discount terms, date of the billing, and total amount.
13
 Cont..

2. A debit memo is also a document received from the vendor and indicates a
reduction in the amount owed to a vendor because of returned goods or an
allowance granted. It indicates reduction in account payables.
3. A voucher is commonly used for recording and controlling acquisitions, primarily by
enabling each acquisition transaction to be sequentially numbered.
» It includes a cover sheet or folder for containing documents and a package of relevant
documents such as the purchase order, copy of the packing slip, receiving report, and
vendor’s invoice.
4. Acquisitions Transaction File This is a computer generated file that includes all
acquisition transactions processed by the accounting system for a period, such as a
day, week, or month.
» Includes information for each transaction, such as vendor name, date, amount,
account classification or classifications, and description and quantity of goods and
services purchased. 14
 Cont..

5. The acquisitions journal or listing, often referred to as the purchases

journal, is generated from the acquisitions transaction file and typically
includes the vendor name, date, amount, and account classification or
classifications for each transaction, such as repair and maintenance,
inventory, or utilities.
» It also identifies whether the acquisition was for cash or accounts payable.
» The journal or listing can cover any time period, typically a month.
6. An accounts payable master file records acquisitions, cash
disbursements, and acquisition returns and allowances transactions for each
vendor.
7. Accounts Payable Trial Balance includes the amount owed to each
vendor or for each invoice or voucher at a point in time.
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» It is prepared directly from the accounts payable master file.
 Cont..

8. Vendor’s Statement is a document 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:
» The payment for goods and services represents a significant activity for all entities.
» This activity directly reduces balances in liability accounts, particularly accounts
payable.
» Documents include:
a) Check This document is commonly used to pay for the acquisition when
payment is due.
» Most companies use computer prepared checks based on information included
in the acquisition transactions file at the time goods and services are received.
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 Cont..

b) Cash Disbursements Transaction File This 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 discussed for the acquisitions
transaction file.
c) Cash Disbursements Journal or Listing This is a listing or 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.

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 Transaction-Related Audit Objectives & Key Internal Control

1. Recorded acquisitions are for goods and services received, consistent

with the best interests of the client (occurrence).
• Purchase requisition, purchase order, receiving report, and vendor’s invoice are
attached to the voucher.
• Acquisitions are approved at the proper level.
• Computer accepts entry of purchases only from authorized vendors in the
vendor master file
• Documents are cancelled to prevent their reuse
• Vendors’ invoices, receiving reports, purchase orders, and purchase requisitions
are internally verified

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 Cont..

2. Existing acquisition transactions are recorded (completeness)

 Purchase orders are pre-numbered and accounted for
 Receiving reports are pre-numbered and accounted for
 Vouchers are pre-numbered and accounted for
3. Recorded acquisition transactions are accurate (accuracy).
» Calculations and amounts are internally verified.
» Batch totals are compared with computer summary reports.
» Acquisitions are approved for prices and discounts
4. Acquisition transactions are recorded on the correct dates (timing).
» Procedures require recording transactions as soon as possible after the goods and
services have been received
» Dates are internally verified 19
 Cont..

5. Acquisition transactions are correctly included in the accounts payable and

inventory master files and are correctly summarized (posting and summarization).

 Accounts payable master file contents are internally verified

 Accounts payable master file or trial balance totals are compared with general
ledger balances.

6. Acquisition transactions are correctly classified (classification)

» An adequate chart of accounts is used

» Account classifications are internally verified

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4.3. Tests of Controls & Substantive
Tests of Transactions
 METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE
TESTS OF TRANSACTIONS

»Tests of controls and substantive tests of transactions for the acquisition

and payment cycle are divided into two broad areas:
1. Tests of acquisitions, which concern three of the four business
functions discussed earlier in this chapter: processing purchase
orders, receiving goods and services, and recognizing the liability
2. Tests of payments, which concern the fourth function, processing,
and recording cash disbursements
»The following figure shows methodology for designing tests of controls
and substantive tests of transactions for the acquisition and payment
cycle.
22
23
 Cont.

1. Understand Internal Control

»The auditor gains an understanding of internal control for the acquisition
and payment cycle as part of performing risk assessment procedures by:
» studying the client’s flowcharts,
» reviewing internal control questionnaires, and
» performing walkthrough tests for acquisition and cash disbursement
transactions.
2. Assess Planned Control Risk
»These are authorization of purchases, separation of the custody of the
received goods from other functions, timely recording and independent
review of transactions, and authorization of payments to vendors.
24
 Cont.

» During Authorization of Payments, 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 pre-numbered 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 should take care to provide physical control over blank, voided,
and signed checks. 25
 Cont.

3. Determine Extent of Testing of Controls

»After auditors identify key internal controls and deficiencies, they
assess control risk.
»When auditors intend to rely on controls to support a preliminary control
risk assessment below maximum, the auditor performs tests of controls
to obtain evidence that controls are operating effectively.
»As the operating effectiveness of controls improves and is supported by
additional tests of controls, the auditor is able to reduce substantive
testing

26
 Cont.

4. Design Tests of Controls and Substantive Tests of Transactions

for Acquisitions and Cash Dispersments
»In designing tests of Controls and Substantive Tests of Transactions for
Acquisitions and payment cycle you should:
»Relate each of the internal controls to transaction related audit
objectives
»Relate tests of controls to internal controls
»Relate substantive tests of transactions to transaction related audit
objectives after considering controls and deficiencies in the system

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 Design Tests of Controls and Substantive Tests of Transactions for
Acquisitions
1. Recorded Acquisitions Are for Goods and Services Received, Consistent with
the Best Interests of the Client (Occurrence)

Test of Controls Substantive Tests of Transactions

» Examine documents in voucher package » Review the acquisitions journal, general ledger,
and accounts payable master file for large or
for existence. unusual amounts.
» Examine indication of approval. » Examine underlying documents for
» Attempt to input transactions with valid reasonableness and authenticity (vendors’
invoices, receiving reports, purchase orders,
and invalid vendors. and purchase requisitions)
» Examine indication of cancellation. » Examine vendor master file for unusual
vendors.
» Examine indication of internal verification
» Trace inventory acquisitions to inventory
master file.
» Examine fixed assets acquired. 28
 Cont.
2. Existing acquisition transactions 3. Acquisition transactions are
are recorded (completeness). correctly classified (classification)
Test of Controls Test of Controls
» Account for a sequence of purchase » Examine procedures manual and chart
orders. of accounts
» Account for a sequence of receiving » Examine indication of internal
reports verification
» Account for a sequence of vouchers. Substantive Tests of Transactions
Substantive Tests of Transactions » Compare classification with chart of
accounts by referring to vendors’
» Trace from a file of receiving reports to
invoices
the acquisitions journal.
» Trace from a file of vendors’ invoices to
the acquisitions journal
29
 Cont.
4. Recorded acquisition transactions are accurate (accuracy).

Test of Controls Substantive test of Transactions

» Examine indication of internal verification. » Compare recorded transactions in the
acquisitions journal with the vendor’s
» Examine file of batch totals for initials of
invoice, receiving report, and other
data control clerk; compare totals to
supporting documentation.
summary reports
» Recompute the clerical accuracy on the
» Examine indication of approval.
vendor’s invoice, including discounts and
freight

30
 Cont.
5. Acquisition transactions are correctly included in the accounts payable
and inventory master files and are correctly summarized (posting and
summarization)

Test of Controls Substantive test of transactions

»Examine indication of internal » Test clerical accuracy by footing the
verification journals and tracing postings to
general ledger and accounts payable
»Examine initials on general ledger and inventory master files
accounts indicating comparison.

31
 Cont.

6. Acquisition transactions are recorded on the correct dates

(timing)

Test of Controls Substantive test of Transactions

»Examine procedures manual and »Compare dates of receiving reports
observe whether unrecorded and vendors’ invoices with dates in
vendors’ invoices exist the acquisition journal
»Examine indication of internal
verification.
32
 Cont..

» Four of the six transaction related audit objectives for acquisitions deserve
special attention and are therefore examined more closely.
» The correctness of many asset, liability, and expense accounts depends on
the correct recording of transactions in the acquisitions journal, especially
related to these four objectives.
» These are:
1. Recorded Acquisitions Are for Goods and Services Received, Consistent
with the Best Interests of the Client (Occurrence)
2. Existing Acquisitions Are Recorded (Completeness)
3. Acquisitions Are Accurately Recorded (Accuracy)
4. Acquisitions Are Correctly Classified (Classification)
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 Design Tests of Controls and Substantive Tests of Transactions for
Cash Disbursements
1. Recorded cash disbursements are for goods and services actually
received (occurrence).

Test of Controls Substantive Tests of Transactions

» Discuss with personnel and observe » Review the cash disbursements journal,
activities general ledger, and accounts payable master
» Discuss with personnel and observe file for large or unusual amounts.
activities. » Trace the cancelled check or electronic bank
» Examine indication of approval records of disbursements to the related
acquisitions journal entry and examine for
payee name and amount
» Examine supporting documents as part of
the tests of acquisitions 34
 Cont..
2. Existing cash disbursement transactions are recorded (completeness)

Test of Controls Substantive test of Transactions

»Account for a sequence of checks. »Reconcile recorded cash
»Examine bank reconciliations and disbursements with the cash
observe their preparation disbursements on the bank statement
(proof of cash disbursements).

35
 Cont..
3. Recorded cash disbursement transactions are accurate (accuracy).

Test of Controls Substantive test of Transactions

»Examine indication of internal » Compare cancelled checks and electronic
verification bank records of disbursements with the
related acquisitions journal and cash
»Examine bank reconciliations disbursements journal entries.
and observe their preparation
» Recompute cash discounts.
» Prepare a proof of cash disbursements.

36
 Cont..

4. Cash disbursement transactions are correctly included in the accounts

payable master file and are correctly summarized (posting and
summarization).

Test of Controls Substantive Test of Transactions

»Examine indication of internal » Test clerical accuracy by footing
verification. journals and tracing postings to
»Examine initials on general ledger general ledger and accounts payable
accounts indicating comparison. master file

37
 Cont..

5. Cash disbursement transactions are correctly classified (classification)

Test of Controls Substantive test of Transactions

»Examine procedures manual and »Compare classification with chart of
chart of accounts. accounts by referring to vendors’
»Examine indication of internal invoices and acquisitions journal
verification

38
 Cont..
6. Cash disbursement transactions are recorded on the correct dates
(timing).

Test of Controls Substantive Test of Transactions

» Examine procedures manual and »Compare dates on cancelled
observe whether unrecorded checks or electronic bank records
checks exist with the cash disbursements
»Examine indication of internal journal
verification »Compare dates on cancelled
checks or electronic bank records
with the bank cancellation date

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4.4. Tests of Details of
Balances of Accounts payable
 Account Payables

»Accounts payable are unpaid obligations for goods and services

received in the ordinary course of business.

»Accounts payable includes obligations for the acquisition of raw

materials, equipment, utilities, repairs, and many other types of goods
and services that were received before the end of the year.

»Most accounts payable can also be identified by the existence of

vendors’ invoices for the obligation.
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 Cont.

»Accounts payable should be distinguished from accrued liabilities

and interest bearing obligations. Why?

»A liability is an account payable only if the total amount of the

obligation is known and owed at the balance sheet date.

»If the obligation includes the payment of interest, it should be recorded

as a note payable, contract payable, mortgage payable, or bond
payable. 42
 Methodology for designing tests of details for accounts
payable

PHASE I
• Identify client business risks affecting accounts payable

PHASE I
• Set performance materiality and assess inherent risk for accounts payable

PHASE I
• Assess control risk for the acquisition an payment cycle

• Design and perform tests of controls and substantive tests of transactions for the
PHASE
II acquisition and payment cycle

PHASE • Design and perform analytical procedures for accounts payable

III

• Design tests of details of accounts payable to satisfy balance-related audit

PHASE
III objectives
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 Cont..

1. Identify Client Business Risks Affecting Accounts Payable (Phase I)

» The auditor needs to understand the nature of changes to these systems to
identify whether client business risks and related management controls affect the
likelihood of material misstatements in accounts payable.
2. Set Performance Materiality and Assess Inherent Risk (Phase I)
» Auditors typically set performance materiality for accounts payable relatively high.
» For the same reasons, auditors often assess inherent risk as medium or high.
» They are especially concerned about the completeness and cutoff balance related
audit objectives because of the potential for understatements in the account
balance.

44
 Cont..

3&4. Assess Control Risk and Design and Perform Tests of Controls and
Substantive Tests of Transactions (Phases I and II)
» The auditor’s ultimate substantive tests depend on the relative effectiveness of
internal controls related to accounts payable.
» Therefore, auditors must have a thorough understanding of how these controls
relate to accounts payable.
5. Design and Perform Analytical Procedures (Phase III)
» Auditors should compare current year expense totals with prior years to uncover
misstatements of accounts payable as well as in the expense accounts.
» Because of double-entry accounting, a misstatement of an expense account usually
also results in an equal misstatement of accounts payable.
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Cont..

46
 Cont..

6. Design and Perform Tests of Details of Accounts Payable Balance (Phase III)
» The overall objective in the audit of accounts payable is to determine whether the
accounts payable balance is fairly stated and properly disclosed.
» Seven of the eight balance related audit objectives are applicable to accounts payable:
1. existence,
2. completeness,
3. accuracy,
4. classification,
5. cutoff,
6. detail tie in, and
7. rights and obligations.
» Realizable value is not applicable to liabilities. 47
Cont.…

48
Cont..

49
 Cont..

» 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

50
 Cont..

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) 51
4.5. TESTS OF DETAILS OF OTHER ACCOUNTS

»Tests of Details of Other accounts includes:

1. Property, plant, and equipment
2. Other/Accrued liabilities
3. Prepaid expenses
4. Income and expense accounts

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 1. PROPERTY, PLANT, AND EQUIPMENT (PPE)

» Characteristics of Property, Plant, and Equipment

» Have expected lives of more than one year
» Used in the business
» Not acquired for resale
» Classification of Property, Plant, and Equipment
» Land and land improvements
» Buildings and buildings improvements
» Equipment
» Furniture and fixtures
» Autos and trucks
» Leasehold improvements
» Construction-in- progress
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 Cont..

» Property, Plant, and Equipment Accounts

» PPE account
» Accumulated depreciation
» Depreciation expense
» Gain/loss on disposal
» Repair and maintenance account
» Property, Plant, and Equipment Transactions
» Acquisitions
» Periodic Depreciation
» Disposals

54
 Cont..

» 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
» Date of acquisition
» Original cost
» Current year depreciation
» Accumulated depreciation
» Disposals etc..

55
 Cont..

» 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.

» Auditors verify equipment differently from current asset accounts for three reasons:

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

large equipment used in manufacturing.

2. The amount of any given acquisition is often material.

3. The equipment is likely to be kept and maintained in the accounting records for
several years.
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 Audit Tests for Property, Plant, and Equipment

1. Perform analytical procedures

» Most of the typical analytical procedures assess the likelihood of material misstatements in
depreciation expense and accumulated depreciation.

57
 Cont..

2. 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.
3. 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
58
 Cont..

4. 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)
5. Verify depreciation expense
» Recorded amounts of depreciation are internal allocations rather than
exchange transactions with outside parties.

59
 Cont..

» Primary audit objectives involve determining whether the client is:

» Following a consistent depreciation policy from period to period and
» Making calculations accurately

6. 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.

60
 Balance-Related Audit Objectives and Tests of Details of Balances for
Equipment Additions

1. Current year acquisitions in the acquisitions schedule agree with related master
file amounts, and the total agrees with the general ledger (detail tie-in).
» Foot the acquisitions schedule.
» Trace the individual acquisitions to the master file for amounts and descriptions.
» Trace the total to the general ledger.
2. Current year acquisitions as listed exist (existence)
» Examine vendors’ invoices and receiving reports
» Physically examine assets
3. Existing acquisitions are recorded (completeness).
» Examine vendors’ invoices of closely related accounts such as repairs and
maintenance to uncover items that should be recorded as equipment.
» Review lease and rental agreements 61
 Cont..

4. Current year acquisitions as listed are accurate (accuracy).

» Examine vendors’ invoices
5. Current year acquisitions as listed are correctly classified (classification).
» Examine vendors’ invoices in various equipment accounts to uncover items that should
be classified as manufacturing or office equipment, part of the buildings, or repairs.
» Examine vendors’ invoices of closely related accounts such as repairs to uncover items
that should be recorded as equipment.
» Examine rent and lease expense for capitalizable leases.
6. Current year acquisitions are recorded in the correct period (cutoff).
» Review transactions near the balance
» sheet date for correct period
7. The client has rights to current year acquisitions (rights).
» Examine vendors’ invoices.
62
 2. AUDIT OF ACCRUED LIABILITIES

» Accrued liabilities are the estimated unpaid obligations for services or benefits that
have been received before the balance sheet date.
» Many accrued liabilities represent future obligations for unpaid services resulting
from the passage of time but are not payable at the balance sheet date
» Includes:
» Accrued payroll
» Accrued professional fees
» Accrued payroll taxes
» Accrued rent
» Accrued officers’ bonuses
» Accrued interest
» Accrued commissions 63
Cont..

64
 Cont..

» Auditing Accrued Property Taxes

» When auditors verify accrued property taxes, all eight balance-related audit
objectives except realizable value are relevant.
» Two are especially significant:
1. Existing properties for which accrual of taxes is appropriate are on the
accrual schedule.
» The failure to include properties for which taxes should be accrued will
understate the property tax liability (completeness).
2. Accrued property taxes are accurately recorded. The auditor’s concern is
the consistent treatment of the accrual from year to year (accuracy).
65
 3. AUDIT OF PREPAID EXPENSES

» Prepaid expenses, deferred charges, and intangibles are assets that vary in
life from several months to several years.
» These include:
» • Prepaid rent • Patents • Deferred charges • Organization costs • Prepaid
insurance • Copyrights • Prepaid taxes • Trademarks • Goodwill
» In some cases, these accounts are highly material.
» Analytical procedures are often sufficient for prepaid expenses, deferred
charges, and intangibles.
» In certain audits, some of these assets can be significant and involve
complex judgment.
66
 Overview of Prepaid Insurance…..cont.

» Prepaid insurance is payments made to insurers in advance for insurance coverage.

» Internal controls for prepaid insurance and insurance expense can be conveniently
divided into three categories:
» controls over the acquisition and recording of insurance,
» controls over the insurance register, and
» controls over the charge-off of insurance expense.
» Controls over the acquisition and recording of insurance are a part of the acquisition
and payment cycle.
» An insurance register is a record of insurance policies in force and the expiration
date of each policy.
» Auditors use insurance registers to identify policies in force related to prepaid
insurance accounts.
67
 Audit Test for Prepaid Insurances: Analytical procedure and Verifications

» Auditors commonly perform the following analytical procedures for prepaid insurance
and insurance expense:
1. Compare total prepaid insurance and insurance expense with previous years.
2. Compute the ratio of prepaid insurance to insurance expense and compare it
with previous years.
3. Compare the individual current insurance policy coverage with the preceding
year’s schedule
4. Compare the computed prepaid insurance balance for the current year with
that of the preceding year
5. Review the insurance coverage listed on the prepaid insurance schedule with
an appropriate client official or insurance broker for adequacy of coverage.
» When auditors verify prepaid insurances, all eight balance-related audit
objectives are going to be tested except realizable value are relevant.
68
 4. AUDIT OF INCOME AND EXPENSE ACCOUNTS

»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.
»Analytical review is an important audit step for the audit of operations.
»The most common analytical procedures are presented in the below
table:
69
Cont..

70
Cont..

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END OF CHAPTER FOUR
THANKS!