CHAPTER FOUR

4. AUDIT OF ACQUISITION AND PAYMENT CYCLE

4.1 Overview of the cycle
What is the Acquisition and Payment Cycle?

The Acquisition and Payment Cycle (also referred to as the PPP Cycle for Purchases, Payables, and
Payments) consists mainly of two classes of transactions. The first class is the acquisition class. The typical
journal entry for this class of transactions is a debit to inventory or an expense and a credit to accounts
payable. The classification assertion is highly important in this scenario because there are many possible
debits that can fulfill the journal entry.

The second class of transactions in the acquisition and payment cycle is the cash disbursements class. The
typical journal entry for this class is simply a debit to accounts payable and a credit to cash. All in all, this
cycle is mainly about incurring payables and paying off those payables with cash.

4.1.1 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 IFRS.

There are three classes of transactions included in the cycle:

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

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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 Key Internal Control

Internal control pertaining to the occurrence assertion is that each purchase is accompanied by the necessary
supporting documents, such as the purchase requisition, purchase order, receiving report, and vendor’s
invoice. Without such documents, a purchase cannot “occur” and hence should not have been recorded.
Other controls include the approvals of purchase orders by higher-level staff, the cancellation of documents
once a transaction has been recorded/accounted for, and approving any changes to the vendor’s list.

In terms of the completeness assertion, purchase orders and receiving reports are typically pre-numbered and
accounted for. If a number has been recorded twice or there is a missing number from the list, it will be easy
to figure out the problem.

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Finally, in terms of the classification assertion, some controls include adequate approval from a supervisor
for journal entries, an adequate list/chart of accounts with descriptions of each, and comparing balances with
budgeted amounts. In terms of the cash disbursements, important controls are mainly the segregation of
duties and frequent bank reconciliations.

4.2.1 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
Receiving goods &
Prepaid expense
Services receiving report
Leasehold
improvements
Recognizing Acquisition transaction file
Accounts payable
the liability Acquisition journal or listing
Manufacturing expense
Vendor’s invoice Debit
Selling expense
memo voucher
Administrative expense
A/P master file A/P trial
balance
Vendor’s statements

Cash Cash in bank Processing & Check

Disbursements ( from cash recording cash Cash disbursements

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 disbursements) disbursement
transaction file Cash
Accounts payable
disbursements Journal or
Purchase discount
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

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 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.
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 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 multi-copy 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.

4.3 Methodology 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.

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

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 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
has 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:

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

Completeness: Existing acquisition Receiving reports are Accounts for a sequence of

transactions are recorded. pre-numbered and accounted for. receiving reports (a block
test).

Accuracy: Recorded acquisition Batch totals are compared with Examine file of batch totals
transactions are accurate. computer summary reports. 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 are Transaction date must be system Observe data entry
recorded on the correct dates. date (today’s date) or a reasonable process.
date.

Posting and summarization: Acquisition Comparison of accounts payable Test clerical accuracy by
transactions are properly included in the master file or trial balance totals footing the journals and
vendor and inventory master files, and are with general ledger balance. tracing postings to general
properly summarized. ledger and 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)
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 ✓ 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 Examine indication of

approval
disbursements are for goods and on supporting documents
services actually received. at 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

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

Classification: disbursement Cash Adequate chart of Examine procedures and

transactions are accounts. manual 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: Cash Comparison of vendor Test clerical accuracy by

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

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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.

4.4.1 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.

4.4.2 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.

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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 non-applicability 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.

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.

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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.

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.

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.

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.

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.

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

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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.

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 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 Supplies ➢ Prepaid rent
➢ Prepaid taxes
Property, plant, and equipment
➢ Prepaid insurance
Expenses

 Cost of goods sold • Insurance expense

 Rent expense • Professional fees
 Property taxes • Retirement benefits
 Income tax expense • Utilities

Liabilities

 Accounts payable  Accrued property taxes

 Rent payable  Other accrued expenses

 Accrued professional fees  Income taxes payable

4.5 Tests of Details 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.
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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 improvement  Leasehold improvements
 Manufacturing equipment  Construction-in-process
 Furniture and fixtures for property, plant, and
equipment

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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

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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,

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and 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

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 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

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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 ➢ Prepaid insurance

➢ Organization costs ➢ Trademarks
➢ Prepaid taxes ➢ Deferred charges
➢ Patents ➢ 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.
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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

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 (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:

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 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 years Overstatement or understatement of a balance in an
expense account
Compare individual asset and liability balances Overstatement or understatement of a balance sheet
with previous years account that would also affect an income statement
account
Compare individual expenses with budgets Misstatements 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 Misstatements of Commission expense and accrued
sales with previous years commissions
Compare individual manufacturing expenses divided Misstatement of individual manufacturing expenses
by total manufacturing expenses and related balance sheet accounts
with previous years

Tests of Controls and Substantive Tests of Transactions

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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.

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