Module 4 Audit of The Expendicture Cycle
Module 4 Audit of The Expendicture Cycle
MODULE 4: AUDIT OF THE EXPENDITURE CYCLE: TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS I
OVERVIEW
This module covers the explanation of the expenditure cycle and the internal control environment and objectives
pertaining thereto. Then, consideration & given to internal controls over acquisitions and cash disbursements
transactions and to the study and evaluation of controls over these two classes of transactions.
The following activities should be undertaken by the auditor in relation to the audit of the expenditure cycle:
1. Diagram the flow of transaction in a typical expenditure cycle, the specific accounts affected and the
elements of control within the cycle.
2. Relate the effect of controls on the assertions embodied in the finance statement.
3. Determine the essential features of internal control over the transactions m the expenditure cycle.
4. Prepare an audit program to gather evidence regarding compliance control procedures that reduce
control risk.
5. Evaluate effectiveness of controls and perform the substantive tests of transactions to gather evidence
to determine whether financial statement assertions are materially correct on accounts affected by the
expenditure cycle.
6. Design tests of details of account balances and analytical procedures to satisfy balance-related audit
objectives.
OBJECTIVES
LEARNING FOCUS
The expenditure cycle involves the activities associated with the acquisition and payment of goods and services,
plant assets and labor. For a trading concern, the major classes of transactions in this cycle are:
1. Acquisitions
2. Cash Disbursements
3. Payroll
For a manufacturing firm, production cycle transactions and inventory warehousing transactions are included in
the expenditure cycle in addition to the above-mentioned major classes of transactions.
This cycle does not include the acquisition of short-term or long-term securities, the redemption of long-term
debt, or the reacquisition of a company s share capital. These transactions are considered to be part of the
investing and financing cycles and are explained in Module 6.
Transactions in the expenditure cycle often affect more financial statement accounts than the other cycles
combined. On the balance sheet, the expenditure cycle impacts on all current assets, except marketable
securities and receivables, all plant and intangible assets, and many current liabilities. Transactions in this cycle
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involve major expenses reflected in the Income Statement such as salaries and wages, taxes, utilities,
advertising, repairs and other expenses.
1. Purchases
2. Accounts and notes payable - trade
3. Purchase returns and allowances
4. Cash in bank (credits for cash disbursements)
5. Purchase discount
6. Inventories (merchandise; finished goods; raw materials; goods process)
7. Manufacturing and operating expenses requiring cash payments.
the beginning balance, acquisitions, returns and transactions recorded on the statements have been
allowances, payments to the vendor, and ending recorded in the books
balance
Purchase journal
A file for recording the individual payments made by check. It contains the total cash paid, the debit to accounts
payable at the amount the transaction was recorded in the acquisition transaction file, discounts taken, and other
debits and credits.
A file for recording individual acquisitions, cash disbursements, and acquisition returns and allowances for each
vendor.
The transactions typically classified in the acquisition and cash disbursements cycle flow through these business
activities:
AUDIT OF ACQUISITIONS
Figures 1.1 and 1.2 show the flowchart of the manual system for executing purchases and purchase returns
transactions, respectively.
General Specific
1. Existence or occurrence 1. Recorded acquisitions are for items that were
acquired.
2. Completeness 2. Acquisitions that occurred are recorded.
3. Rights and obligations 3. Recorded acquisitions are the entity's
purchases and liabilities.
4. Valuation or allocation 4. Acquisitions are recorded for the proper
amounts.
5. Presentation and disclosure 5. Acquisitions are recorded to result in
presentation and disclosure in accordance
with PAS/PFRS.
In many instances, more than one control is required to ensure the validity of an assertion. Because specific
controls may vary with the client, the tests of controls discussed in this section should be viewed as illustrative
only.
The following sections present the controls an entity should have to ensure the propriety of each assertion and
the tests an auditor might perform to determine the effectiveness of the controls on acquisitions transactions.
Discussion:
A. Existence or Occurrence: Recorded acquisitions are for items that were acquired.
Controls Tests of Controls
1. Acquisitions should be approved by 1. Auditor should examine the approval
authorized personnel. Approval of acquisition signature.
is evidenced by signature on the purchase
order.
2. A voucher should be prepared for the 2. To test this control, the auditor observes the
purchase of goods. This should be supported procedure and examines file of documents. If
by properly executed purchase requisition, the entity does not prepare vouchers, the
purchase order, receiving report, and vendor's auditor should review the entries in the
invoice. purchases journal and examine the
documents underlying them for authenticity
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and reasonableness.
3. The check signer should examine the 3. The auditor can examine cancellations on the
supporting documentation and cancel the documents to test this control. If an entity
documents, making them "paid" or writing the does not effectively cancel supporting
date and number of the check on the documents, the auditor should be concerned
document. that duplicate payment may have been made
and should scan the voucher register for
multiple entries of similar amounts.
B. Completeness: Acquisitions that occurred are recorded.
4. Prenumbered receiving reports should be 4. To test this control the auditor should observe
used and accounted for to determine that a the procedure and account for the numerical
liability is recorded for all goods received. sequence of the receiving report
5. Vouchers are prenumbered and accounted 5. The auditor should observe procedure and
for as they are entered in the voucher account for the numerical sequence of the
register. voucher.
C. Rights and Obligations: Recorded acquisitions are the entity's purchases and liabilities.
6. Receiving reports should be prepared by 6. To test this control, the auditor should observe
persons having access only to a blind copy of that the procedure is being performed
purchase order details. Requiring a purchase
order for the recording of all acquisitions will
preclude recording consigned goods as well
as goods ordered for personal use of
employees.
D. Valuation or Allocation: Acquisitions are recorded in the proper amounts.
7. Invoice amounts are verified by a clerk by 7. The auditor should examine the voucher for
reference to the purchase orders and signature indicating performance.
receiving reports. Mathematical accuracy of
the invoice is also rechecked.
E. Presentation and Disclosure: Acquisitions are recorded to result in presentation and disclosure in
accordance with PAS/PFRS.
8. Require employees to use a chart of accounts 8. Auditor should examine the chart of accounts.
that adequately describes accounts to be Also, he or she should examine the signature
debited. Account coding is assigned by one of employee performing the checking or
person and checked by another. verification.
The following audit program summarizes the audit procedures that auditors may use to test controls on
acquisitions transactions.
WP Done
Audit Procedures
Ref By Date
1. For a sample of purchases, examine the
related purchase requisition and purchase
order.
2. For a sample of purchases, trace the
transaction to the voucher register and the
perpetual inventory records maintained in
stores.
3. Check vendor invoice for mathematical
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accuracy.
4. Trace posting from the voucher register to the
general ledger.
Possible errors that may result due to control weaknesses over acquisitions transactions follow:
1. Examine underlying documents for authenticity and reasonableness. Scan voucher register for
large or unusual items. Inspect acquired property, plant, and equipment Trace inventory
purchased to perpetual records. Scan voucher register for duplicate payments.
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To test the existence of acquisitions transactions in the voucher register, an auditor should examine for selected
transactions, the underlying documents - the voucher, purchase order, receiving report, and vendor's invoice.
The auditor should also physically inspect additions to fixed assets to substantiate their existence and trace
inventory purchases to perpetual records. The auditor can scan the voucher register as well as files of check
copies to them for possible duplicate payments of invoices.
2. Trace a sequence of receiving reports to entries in the voucher register. Test cutoff. Account for
a sequence of entries in the voucher register.
The auditor may select a sequence of receiving reports and vouchers to determine that entries have been made
few them in the voucher register or purchases journal. He or she can perform a cut-off test at year-end to
ascertain that all acquisitions occurring during the year have been recorded.
3. Trace from invoices to perpetual Inventory records; Examine vendor's invoices to determine that
goods were purchased*
The auditor should examine supporting documents to ascertain that goods were not received cm consignment,
that the goods were not delivered to another location, simply that the ordered goods were received. These
supporting documents include the voucher, vendor's invoice, receiving report, purchase order, and purchase
requisition.
To ensure that acquisitions are recorded for proper amounts, auditor may select a sample of transactions and
examine the purchase requisition, trace the price to the purchase order, compare the quantity on the invoice with
the quantity on the receiving repent and recalculate the invoice total. The auditor might also choose to perform
the substantive testing of prices paid by tracing prices in published catalogs at the time of the purchase.
Auditors are interested in the effect of controls in the financial statements assertions embodied in the cash
disbursements. Auditors address the following assertions when testing cash disbursements:
General Specific
1. Existence or occurrence 1. Recorded cash disbursements occurred.
2. Completeness 2. All cash disbursements made are recorded.
3. Rights and obligations 3. All cash disbursements made are for
obligations of the entity.
4. Valuation or allocation 4. Debits to various accounts and credits to cash
are valued at proper amounts.
5. Presentation and disclosure 5. Cash disbursements are recorded to result in
presentation and disclosure in accordance
with PAS/PFRS.
The following sections present the controls an entity should have to ensure the propriety of each assertion and
the tests an auditor might perform to determine the effectiveness of the controls on cash disbursement
transactions.
Discussion:
An employee who does not handle cash The auditor observes that the employee who prepares
disbursements and cash receipts prepares the bank the reconciliation does not handle cash receipts or
reconciliation. disbursements. In addition, the auditor inspects the
reconciliation.
C. Rights and Obligations: All cash disbursements made are for obligations of the entity.
Check signer who is independent of voucher 5. The auditor tests this control by inquiring about the
preparation should examine the supporting segregation of duties and observing whether
documentation before signing checks to determine that separation really exists. He or she can also inquire
the payment is for an obligation of the entity. about the check signer's procedures for reviewing
documents in support of cash disbursement and may
observe the check signer performing these
procedures.
D. Valuation or Allocation: Debits to various accounts and credits to cash are valued at proper amounts.
Amounts (including discounts taken) and calculations To test this control, the auditor should observe the
on vendors' invoices are independently verified. procedure. He or she can examine signatures on paid
Employee signs the voucher after verification is done. invoices.
E. Presentation and Disclosure: Cash disbursements are recorded to result in presentation and disclosure in
accordance with PAS/PFRS.
Chart of accounts adequately describes accounts to be The auditor can test this control by observing the
used, and account coding is assigned by one person procedure. He can also examine the signatures of the
and checked by another. employees performing the review account coding.
In summary, typical audit procedures employed by the auditor in testing disbursement for the period under
consideration include the following:
WP Done
Audit Procedures
Ref By Date
1. Prove the arithmetical accuracy of the cash
disbursements record and trace postings to
the general ledger.
2. Compare paid bank checks with the cash
disbursement records.
3. Account for ail checks.
4. Reconcile recorded disbursements with the
bank statement.
5. Examine supporting documents.
6. Review cash disbursements records for
unusual items.
Possible errors that may result due to control weaknesses over payments to vendors follow:
Auditors examine the documents underlying cash disbursements such as receiving reports, purchase order,
purchase requisitions, and vendors' invoice for consistency with each other and with the entry in the cash
disbursements journal. Approvals on these documents provide evidence that the transaction occurred and that
the payment was the entity's debt. Checks with appropriate endorsements and which have been paid by the
bank provide evidence about the existence of the transactions. The auditor likewise recomputes the discount
taken to verify proper valuation of cash disbursement transactions. Accuracy of accounts charged may also be
verified by the auditor by reference to the chart of accounts.
The auditors may prepare a proof of cash which reconciles cash disbursements as recorded on the bank with
cash disbursement recorded by the bank.
The auditors can prepare bank reconciliation or test a bank reconciliation prepared by the client for an interim
period. When preparing the bank reconciliation, the auditor should receive the bank sentence directly from the
bank. If the bank statement has been opened by the client's employees, the auditor generally compares the
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individual entries on it with the documents returned by the bank and looks for erasures, changes or other
irregularities on the statement.
Posttest
4. When an entity's controls are ineffective for payments, what potential misstatements could arise in the
financial statements?
5. Compare a vendor's statement to a vendor's invoice and describe how an auditor might use each.
6. The following questions relate to auditing the expenditure cycle. Choose the best response.
a. Select and examine canceled checks, and ascertain that the related receiving reports are
dated no earlier than the checks.
b. Select and examine canceled checks, and ascertain that the related receiving reports are
dated no later than the checks,
c. Select and examine receiving reports, and ascertain that the related canceled checks are
dated no earlier than the receiving reports.
d. Select and examine receiving reports, and ascertain that the related canceled checks are
dated no later than the receiving reports.
C. The accounts payable department receives the purchase order to accomplish all the following
except:
AICPA Adapted
7. The following questions relate to internal control for acquisitions and disbursements. Choose the best
response.
A. For effective internal control, which of the following individuals should be responsible for mailing
signed checks?
a. Receptionist
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b. Treasurer
c. Accounts payable clerk
d. Payroll clerk
B. If internal control is properly designed, the same employee should not be permitted to:
C. In a properly designed accounts payable system, a voucher is prepared after the invoice, purchase
order, requisition, and receiving report have been verified. The next step in the system is to
AICPA Adapted
8. The following questions relate to the expenditure cycle. Choose the best response.
A. You are auditing the December 31, 2005, accounts payable balance of one of your firm's divisions. The
division controller's office has provided you with a schedule listing the creditors and the amount owed to
each at December 31, 2005. Which of the following audit procedures would be your best choice for
determining that no individual account payable has been omitted from the schedule?
a. Send confirmation requests to a randomly selected sample of creditors listed on the schedule.
b. Send confirmation requests to creditors that are listed on the schedule but not listed on the
corresponding December 31, 2004, schedule.
c. Examine support for selected January 2006 payments to creditors, ascertaining that those
relating to 2006 are not on the schedule.
d. Examine support for selected January 2006 payments to creditors, ascertaining that those
relating to 2005 are on this schedule.
B. A company uses an automated accounts payable system to process its disbursements. An internal
auditor wants to reconcile the accounts payable balance listed in the firm's month-end trial balance
report to the master accounts payable file, which is stored on magnetic tape. Which of the following
application audit techniques would be most appropriate to this task?
a. purchases can be made at prices higher than normal from a vendor controlled by a buyer.
b. unnecessary supplies can be purchased by department managers.
c. payment can be made for supplies not received.
d. payment can be made for supplies received but not ordered by the purchasing department.
D. Which of the following controls could be used to detect bank deposits that are recorded but never
made?
E. The treasurer makes disbursements by check and reconciles the monthly bank statements to
accounting records. Which of the following best describes the control impact of this arrangement?
a. Internal control will be enhanced because these are duties a treasurer should perform.
b. The treasurer will be in a position to make and conceal unauthorized payments.
c. The treasurer will be able to make unauthorized adjustments to the cash account.
d. Controls will be enhanced because the treasurer will have two opportunities to discover
inappropriate disbursements.
F. To minimize the risk that agents in the purchasing department will use their positions for personal gain,
the organization should:
G. In an audit of a purchasing department, which of the following would ordinarily be considered a risk
factor?
IIA Adapted
9. These questions pertain to basic features of internal control over acquisitions and cash disbursements
transactions. Choose the best response.
A. A client erroneously recorded a large purchase twice. Which of the following internal accounting control
measures would be most likely to detect this error in a timely and efficient manner?
B. For effective internal control purposes, which of the following individuals should be responsible for
mailing signed checks?
a. Receptionist
b. Treasurer
c. Accounts payable clerk
d. Payroll clerk
C. The accounts payable department receives the purchase order form to accomplish all of the following
except:
AICPA Adapted
10. These questions involve the study and evaluation of internal control over acquisitions and cash
disbursements transactions. Choose the best response.
A. In examining cash disbursements, an auditor plans to choose a sample using systematic selection with
a random start The primary advantage of such a systematic selection is that population items.
a. Which include irregularities will not be overlooked when the auditor exercises compatible
reciprocal options.
b. May occur in a systematic pattern, thus making the sample more representative.
c. May occur more than once in a sample.
d. Do not have to be prenumbered in order for the auditor to use the technique.
B. A client's materials-purchasing cycle begins with requisitions from user departments and end with the
receipt of materials and the recognition of a liability. An auditor's primary objective in reviewing this cycle
is to:
11. An auditor discovered the following matters while performing tests of controls.
An invoice for goods received from PJ Supply Company for P400 was paid, but the client had never
ordered the goods.
A vendor's invoice was not paid within the discount period because the receiving report was lost.
A vendor's invoice for hollow steel casing windows was paid. The goods were received, but vinyl
insulated windows had been ordered.
A vendor was overpaid because the invoice was incorrectly footed.
A purchase of raw materials was recorded as a purchase of supplies.
An obligation for insurance was not paid because the voucher that was prepared was never recorded.
Required:
12. The following questions deal with internal control over acquisitions and cash disbursements. Choose the
best response.
A. To avoid potential errors and irregularities, a well-designed internal control structure in the accounts
payable area should include a separation of which of the following functions?
a. Checks should be signed by the controller and at least one other employee of the company.
b. Checks should be sequentially numbered and the numerical sequence should be accounted
for by the person preparing bank reconciliations.
c. Checks and supporting documents should be marked "paid" immediately after the check is
returned with the bank statement.
d. Checks should be sent directly to the payee by the employee who prepares documents that
authorize check preparation.
13. The following are errors or irregularities that have occurred in Fresh Foods Grocery Store, a retail and
wholesale grocery company.
The incorrect price was used on sales invoices for billing shipments to customers because the wrong
price was entered into the computer file.
A vendor's invoice was paid twice for the same shipment. The second payment arose because the
vendor sent a duplicate copy of the original two weeks after the payment was due.
Employees in the receiving department took sides of beef for their personal use. When a shipment of
meat was received, the receiving department filled out a receiving report and forwarded it to the
accounting department for the amount of goods actually received. At that time, two sides of beef were
put in an employee's pickup truck rather than in the storage freezer.
During the physical count of inventory of the retail grocery, one counter wrote down the wrong
description of several products and miscounted the quantity.
A salesperson sold an entire carload of lamb at a price below cost because she did not know the cost of
lamb had increased in the past week.
On the last day of the year, a truckload of beef was set aside for shipment but was not shipped.
Because it was still on hand the inventory was counted. The shipping document was dated the last day
of the year so it was also included as a current-year sale.
Required:
a. For each error or irregularity, identify one or more types of controls that were absent.
b. For each or irregularity, identify the internal control objectives that have not been met.
c. For each error or irregularity, suggest a control procedure to correct the deficiency.
14. The following control procedures over purchases and cash disbursements transactions are prescribed
by the Love Company:
Required:
15. Long, CPA, has been engaged to examine and report on the financial statements of Maybelle
Corporation, During the review phase of the study of Maybelle's system of internal accounting control
over purchases, Long was given the document flowchart below for purchases.
Required:
a. Identify the procedures, relating to purchase requisitions and purchases orders, that Long would expect
to find if Maybelle's system of internal accounting control over purchases is effective. For example,
purchase orders are prepared only after giving proper consideration to the time to order and quantity to
order. Do not comment on the effectiveness of the flow of documents as presented in the flowchart or
on separation of duties.
b. What are the factors to consider in determining
1. The time to order?
2. The quantity to order?
AICPA Adapted
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16. The following questions related to cash disbursements are included on the internal control questionnaire for
Summer Company.
Required:
The company has no formal rules on conflicts of interest. Your analysis produced evidence that one of
the thirty buyers in the department owns a substantial interest in a major supplier and procures supplies
averaging P50, 000 a year from that supplier. The prices charged by the supplier are competitive.
Buyers select proposed sources without submitting the lists of bidders for review. Your tests disclosed
no evidence that higher costs were incurred as a result of that practice.
Buyers who originate written requests for quotations from suppliers receive the suppliers' bids directly
from the mailroom. In your test of one hundred purchases based on competitive bids, you found that in
seventy-five cases the low bidders were awarded the purchase orders.
4> Purchase requisitions received in the purchasing department from other departments in the company
must be signed by persons authorized to do so. Your examination of 200 requests disclosed that three,
all for small amounts, were not properly signed. The buyer who had issued all three orders honored the
requests because he misunderstood the applicable procedure. The clerical personnel charged with
reviewing such requests had given them to the buyer in error.
Required:
AICPA Adapted