What are the internal controls for the acquisition and payment cycle?

It's easy for things to go wrong in a company's acquisition and payment cycle. Companies can overstate the value of the inventory they purchase, which makes assets look bigger than they actually are. Management can omit or undervalue their accounts payable, which exaggerates financial strength. To prevent this from happening, management and auditors closely monitor internal controls and key acquisition accounts.

A business may have different threats in its acquisition cycle depending on surrounding factors. Companies in a highly competitive industry that sell low-margin products have a strong incentive to fiddle with their margins through inventory and cost-of-goods-sold valuation. Businesses that don't have strong accounting department employees with experience in operations may not be properly tracking purchasing and cash disbursement documents. Auditors will focus more attention on personalized risk factors depending on the inherent strengths and weaknesses of the company.

The stronger internal controls the company has in place, the less likely it is that there are errors or fraud in the purchasing system. Smart companies require their purchasing agents to use a list of approved vendors and review vendors on a regular basis. This reduces the risk of fraud and kickbacks for purchases. Auditors will check that there is separation of duties and approval needed in the purchasing and cash disbursement process. These controls dissuade employees from attempting to misappropriate money and help businesses catch honest errors.

Since inventory is a significant asset, auditors want to ensure it's not overstated. Auditors will observe a physical inventory count to ensure numbers add up, and they'll also perform their own sample count. They'll test inventory purchase transactions near a financial cutoff period to make sure transactions were recorded at the right time. They'll pay special attention to older inventory that the company hasn't been able to sell, since there's a high chance it may have lost value over time.

Accounts payable makes up a large amount of money that the company owes to others, so auditors will search for unrecorded accounts payable. They'll often pull transactions from a subsidiary accounts payable ledger and check that they are also recorded in the general ledger, which determines the financial statements. They may contact large vendors and suppliers and confirm they agree with what the company purports they owe them. Purchasing also affects inventory value, so they'll test transactions to see if inventory values agree with the vendor's sales price.

Chapter 10 Purchase and Payment Cycle

LEARNING OBJECTIVES

1. Describe the related documents in the purchase and payment cycle. 2. Know about the audit objectives of collecting evidence in purchases and cash payments transactions and creditors’ balances. 3. Design and perform tests of controls and assess the related control risks over the purchase and payment cycle. 4. Design and perform substantive procedures of transactions over the purchase and payment cycle. 5. Discuss the nature of accounts payable and describe the related controls over them. 6. Design and perform tests of details of balances for accounts payable including sending confirmation. 7. Know the importance of and how to carry out the out-of-period liability tests for accounts payable.

8. Discuss the relative reliability of vendors’ invoices, vendors’ statements and confirmation of accounts payable.

1. Documents and Records

1.1       Purchase requisition (請購單) – a form detailing the request for goods or services by an authorized employee of the user department and it is then passed from the user department to the purchase department. For example, order of materials by a factory/storeroom supervisor.
1.2       Purchase order (訂購單) – a document from a company to the supplier recording the description, quantity and amount of the goods or services ordered and it should be properly authorized by the company.
1.3       Goods received note (收貨單) – a document prepared by the supervisor of the storeroom/receiving department at the time the goods are received. It shows the description, quantity, condition and date of the goods received.
1.4       Purchase invoice – a document received from vendor which indicates the date, description, quantity and the total amount of goods and services the company has received.
1.5       Purchase journal and ledgers (a)        A journal (day book) for recording the purchases of goods or services. (b)        Vendors’ accounts in the purchase ledger will also be updated with the remittance advice/receipts when payments are made to vendors.

1.6 Payment voucher – an internally generated document that establishes a formal means of recording and controlling cash disbursements. It is usually accompanies with purchase invoice, goods received note and/or purchase order when approval for payment is sought.

1.7       Cheque/Electronic transfer – the means of paying the vendors when the payments are due.
1.8       Remittance advice (付款通知書) – a document sent with the cheque to a vendor detailing the amount of payment for each corresponding invoice and the total amount paid.
1.9       Cash book – it records the authorized disbursements and individual entries are supported by payment vouchers and/or presented cheques.
1.10     Vendor’s statement – a statement prepared by the vendor indicating the opening balance, purchases during the period, payments received by the vendor and closing balances.

2. Control Risks Assessment of Purchase and Payment Cycle

2.1 Assertions used by the auditor in purchase and payment cycle

2.1.1 Classes of purchases transactions

Assertions	Descriptions
1. Occurrence	Recorded purchases are for goods and services received/provided.
2. Completeness	All existing purchase transactions are recorded.
3. Accuracy	Recorded purchases are correctly recorded for the amount of goods/services received.
4. Cut-off	Purchases are recorded at the correct dates/periods.
5. Classification	Purchases transactions are properly classified.

2.1.2 Classes of cash payments transactions

Assertions	Descriptions
1. Occurrence	Recorded cash payments are for goods/services actually received.
2. Completeness	All existing cash payments are recorded
3. Accuracy	Cash payments to suppliers are recorded at the amount paid.
4. Cut-off	Cash payments are recorded at the correct dates/periods.
5. Classification	Cash payments transactions are properly classified.

2.1.3 Accounts payable balances
(Jun 15)

Assertions	Descriptions
1. Existence	Recorded accounts payable in the accounts payable ledger exist.
2. Rights and obligations	The company has an obligation to pay the liability included in accounts payable.
3. Completeness	Existing accounts payable are included in the accounts payable list.
4. Valuation and allocation	Accounts payable are included in the financial statements at appropriate amounts.

5. Presentation and disclosures

All disclosed events, transactions, and other matters relating to accounts payable have occurred and pertain to the entity are properly disclosed and presented in the financial statements.

2.2 Internal controls and test of controls

2.2.1    Internal controls for purchase and payment cycle is mainly concerned about the following aspects:
(a)        Proper authorization of purchases.
(b)        Separation of asset custody from other functions.
(c)        Timely recording and independent checking of purchase and payment transactions.
(d)        Proper authority of payments.
2.2.2    Examples of internal control procedures and test of control for purchase and payment cycle are as follows:

(a) Classes of purchase transactions

Assertions	Internal Control Procedures	Test of control
1. Occurrence	Purchases are approved at the appropriate level. Internal verification of relevant documents such as purchase requisitions, purchase orders, suppliers’ invoices, and goods received notes.	Examine proper approvals for purchase requisitions, purchase order, and goods received notes. Examine the indications of internal verification for these documents.
2. Completeness	Purchase requisition, purchase order, receiving report and vouchers are prenumbered and accounted for.	Account for the numerical sequence purchase order and goods received notes. Trace samples of goods received notes to the related suppliers’ invoices and entries in the purchase journal.

3. Accuracy	Approved prices, terms, and discounts. Internal verification of calculations and amount of suppliers’ invoices.	Examine proper approval for purchase requisition and purchase order. Examine indications of internal verification for recording purchase transactions.
4. Cut-off	Policies and procedures requiring the recording transactions as soon as possible after goods and services have been received.	Compare the dates on goods received notes and entries on purchase journal. Review documents for unrecorded suppliers’ invoices exist.
5. Classification	Use of an appropriate chart of accounts and have internal verification of classification.	Examine procedure manual, chart of accounts and internal verification for proper classification of purchase transactions.

(b) Classes of cash payment transactions

Assertions	Internal Control Procedures	Tests of controls
1. Occurrence	Adequate segregation of duties between handling cash and maintaining accounts payable record. Examination and approval of supporting documents before cheque signing.	Observe segregation of duties and independent reconciliation of bank balances.
2. Completeness	Cheques are prenumbered and accounted for. Bank reconciliation is prepared by staff not involved in recording cash payments and custody of assets.	Account for sequence of cheques and examine bank reconciliation.

3. Accuracy	Regular preparation and review of bank reconciliation prepared by independent person.	Review periodic bank reconciliation prepared by independent person and examine evidence for internal verification.
4. Cut-off	Procedure requiring recording of cash payments after the cheque has been signed.	Examine evidence for unrecorded payments and review of bank reconciliation.
5. Classification	Use of adequate chart of accounts and have internal verification of proper codes.	Trace cash payments to cash payment journal for proper classifications and review cash payment journal for unusual items.

Assertions	Internal Control Procedures	Tests of controls
1. Existence	Recorded accounts payable is supported by suppliers’ invoices and goods received notes.	Select samples from creditors list and send creditors’ confirmation.
2. Rights and obligations	Recorded accounts payable is supported by suppliers’ invoices and goods received notes.	Review bank statements for any unrecorded cheques payments.
3. Completeness	Purchase orders, receiving reports and vouchers are prenumbered and accounted for.	Trace samples of goods received notes to the related suppliers’ invoices and entries in the purchase journal and in creditors’ ledger.
4. Valuation and allocation	Proper policies and procedures to ensure accounts payable are recorded at fair value.	Examine evidence of approval of unusual trade terms and discounts.
5. Presentation and disclosures	The accounts payable balance is disclosed and presented fairly at appropriate amounts.	Review evidence of internal review for proper disclosure of those related party transactions.

3. Substantive Procedures for Purchases and Payments Transactions

3.1 Analytical procedures

3.1.1
	(a) Compare purchases expenses with budgeted amount. (b) Compare purchases expenses with prior year. (c) Compare individual accounts payable with previous year. (d) Calculate ratios of purchases to account payable and compare with last year.

3.2 Substantive procedures – purchases transactions

3.2.1 Examples of substantive tests for purchases transactions are as follows:

Assertions	Substantive procedures
1. Occurrence	Select samples from purchases journal and trace to purchases requisitions, purchases orders, suppliers’ invoices and goods received notes.
2. Completeness	Trace good received note/suppliers’ invoices to entries in purchases journal and accounts payable ledger.
3. Accuracy	Vouch details of suppliers’ invoices to related purchase requisition, purchase orders, and goods received notes; and Trace suppliers’ invoice to recorded purchases.
4. Cut-off	Compare dates of recorded purchases transactions with dates on goods received notes.
5. Classification	Examine supporting documents for purchases transactions and evaluate whether the transactions are properly classified.

3.3 Substantive procedures – payments transactions

3.3.1 Examples of substantive tests for payments transactions are as follows:

Assertions	Substantive procedures
1. Occurrence	Trace from cash payment journal to bank statement.
2. Completeness	Trace goods received notes/ suppliers’ invoices to entries in purchases journal and accounts payable ledger.
3. Accuracy	Trace from cash payment journal to suppliers’ invoices and to bank statement.
4. Timing	Compare dates of cheque stubs listing and related entries in cash payment journal.
5. Classification	Examine documents supporting cash payments for proper classification.

4. Tests of Details of Accounts Payable

4.1 Analytical procedures
(Jun 09, Dec 11)

4.1.1

(a)        Scrutinize list of accounts payable for unusual items.
(b)        Calculate the trade payables payment period and compare with that of last year.
(c)        Calculate ratio of accounts payable to current liabilities and compare with that of last year.
(d)        Compare amounts owed to individual suppliers per current year’s list with that of last year.
(e)        Compare current year’s balances in accounts payable with last year’s balances.

4.2 Tests of details of accounts payable balances
(Jun 09)

Audit Objectives	Substantive procedures
1. Existence	Circularise a sample of trade payables to confirm the balance at the end of the year. Compare the balances with suppliers’ statements. Check suppliers’ invoices and goods received notes.
2. Rights and obligations	Circularise a sample of trade payables to confirm the balance at the end of the year. Compare the balances with suppliers’ statements. Check suppliers’ invoices and goods received notes.
3. Completeness	Investigate any supplier names that were shown on last year’s payables listing but do not have a balance showing in this year’s list of balances. Review after date invoices and payments and ensure they have been provided for at the year-end as appropriate. Select a sample of goods received notes immediately prior to the year end and included in year-end payables, and ensure that the goods are included in year-end inventories.
4. Valuation and allocation	Obtain a list of the individual balances from the payables ledger, check the cast and agree the total to the trade payables figure in the draft financial statements. Ensure that balances have been correctly extracted from the payables ledger. Obtain a list of debit balances in the payables ledger and obtain explanations from management. Agree brought forward figures to last year’s audit file.
5. Presentation and disclosures	Review the financial statements to make sure that proper segregation has been done for interest bearing liabilities, current or long-term liabilities, and whether additional information has to be disclosed as note to the accounts, e.g. related party disclosures.

4.3 Out-of-liability tests for accounts payable

4.3.1 The following table shows the audit procedures to uncover unrecorded accounts payable in the financial statements.

Procedures	Purposes
Examine underlying documentation for payments subsequent to year end date	The purpose is to uncover payments made in the subsequent accounting period that represent liabilities at the balance sheet date. Select some payments made during the first few weeks after the year end and, for example, trace them to the accounts payable list to make sure that they have been included as a liability if they are of current period obligations.
Examine underlying documentation for invoices not paid within several weeks after year-end.	It is to find out the reasons for unpaid obligations to determine whether the liability should belong to the period under audit. If not, the balance will be overstated.
Trace goods receiving notes issued before and after year-end to related vendors’ invoices and accounting records.	It is a test for unrecorded obligations to make sure that all goods received before the end of the accounting period are included in accounts payable.
Trace vendors’ statements to the balances on the creditors’ list.	It is a form of external audit evidence to ensure any balance indicated on the vendor’s statement dated after balance sheet date has been included as a liability in the financial statements of the period under audit.
Send confirmation to trade creditor with which client has done business during the period under audit.	The purpose is to uncover any omitted liability or misstated balance relating to active creditors which balance however does not appear on the creditors list of client (i.e. zero balance with client).

4.4 Accounts payables’ circularization (發函詢證)

4.4.1    The samples of balances selected for sending confirmation might include:
(a)        significant suppliers with credit balances;
(b)        suppliers with debit balances;
(c)        significant suppliers with ‘nil’ balances;
(d)        a variety of large, small and medium balances selected from the purchase ledger; and
(e)        any accounts known to be in dispute. 4.4.2    When the replies have been received from creditors, examine and compare with the balances in the books.

(a) Differences will arise as a result of cash in transit, goods in transit or unusual adjustments like discounts claimed by one party and disallowed by another.

(b) Significant differences must be followed up with the client as they may indicate attempts to suppress (隱瞞) liabilities or reveal deficiencies in the system of controls.
4.4.3 Possible reasons for discrepancies between the amounts confirmed by the suppliers and the reported amounts: (Jun 09, Dec 12) (a) Invoice issued by the supplier not yet received or processed by the client. (b) Payment not yet received by the supplier or not yet processed by the supplier. (c) Errors made by the client or by the supplier. (d) Goods returned not yet recorded by the supplier.

(e) Cheques sent to suppliers are in transit at year end date.

4.5 Cut-off tests

4.5.1 These test are intended to determine whether transactions recorded a few days before and after the balance sheet date are included in the correct period.
4.5.2 The audit tests performed on out-of-period liability described above are actually related directly to cut-off tests for purchases but they emphasize on understatement. Here, to test for overstatement, the following procedures will be carried out.

Items	Purposes
In relation to physical observation of stocktaking	The cut-off information for purchases (i.e. the last of current year and the first of following accounting year purchase order and goods receipt note) should be obtained during the physical observation of the stocktaking. Record in the working papers the last purchase order, and goods received note number included in the physical count and the number of first purchase order, and GRN of the following accounting period. Trace these numbers to the accounts payable records to verify that the liabilities concerned are correctly included or excluded from the appropriate period.
If physical count of stock is carried out before year end date	The procedures described in the above still have to be performed in order to ensure the accounts payable cut-off is accurate on the date the stocktaking takes place.
Goods in transit	FOB destination means that the title of goods passes to the buyer when the goods are received for inventory. FOB origin means that the title passes to the buyer when the goods are shipped. Review suppliers’ invoices received shortly after year-end to ensure that the inventory and related accounts payable must be recorded in the current period if goods are on a FOB origin basis and if the amounts are material.

Question 1
The firm of WK & Co., your employer, is the external auditor of East West Limited (“EWL”) which is a company that carries out a trading business.

You have worked on this audit assignment for a few years and this year you are the senior in charge of the audit. A newly recruited accounting graduate who has no practical experience is assigned as your assistant. You have already conducted tests of controls for the transaction cycles, and control risks are assessed as medium for these cycles. You decide to let the assistant carry out some substantive procedures for the accounts payable section.

Required:

(a) What are the analytical procedures for accounts payable? (3 marks)
(b) Besides presentation and disclosures, what are the other four assertions for accounts payable? For each of the assertions, provide one test of details procedure. (8 marks) (c) “The tests of transactions procedures for cash payment that address the completeness assertion also address the completeness assertion for accounts payable,” said the assistant. Do you agree? Explain. (3 marks) (d) “If there are minor discrepancies between the amounts confirmed by the suppliers and the reported amounts, then we can say that the result is satisfactory and no further audit procedures needed to be performed,” said the assistant. Do you agree? Explain. (6 marks)

(HKIAAT PBE Paper III Auditing and Information Systems June 2009 Q3)

5. Relative Reliability of Invoices, Statements and Confirmation

5.1 When assessing whether sufficient appropriate audit evidence has been collected for verifying accounts payable, it is essential that the auditor understand the relative reliability of the primary types of evidence including suppliers’ invoices, suppliers’ statements, and creditors’ confirmation.
5.2 To compare the relative reliability of invoices, statements and confirmations; the following aspects should be considered.

5.3 Determinants of reliability of audit evidence
(Jun 10) 5.3.1 HKSA 500 states that audit evidence is more reliable when it is: (a) obtained from independent sources outside the entity. (b) in documentary form. (c) original documents rather than photocopies or facsimiles. (d) obtained directly by the auditor rather than audit evidence obtained indirectly or by inference. 5.3.2 Suppliers’ invoices, suppliers’ statements and creditors’ confirmation meet the first three criteria listed above.

5.3.3 Only creditors’ confirmation can meet the fourth criteria. Creditors’ confirmation can be viewed as more reliable than the other two.

Appendix I – Purchases and Payment Cycle Flowchart

Additional Examination Style Questions

Question 2
In the audit of Quadrant Manufacturing Co. Ltd.’s account for the year ended 31 December 2007, the following data are extracted from the accounting records.

GRN No.	Date of GRN	Date of Supplier’s invoice	Invoice amount	Term of invoice	Date of shipment
	Year 2007		$	(Note)
882	29 Dec.	3 Jan 2008	1,000,000	I	18 Dec 2007
883	29 Dec.	27 Dec 2007	1,200,000	II	27 Dec 2007
884	30 Dec.	29 Dec 2007	1,000,000	I	29 Dec 2007
885	31 Dec.	31 Dec 2007	2,000,000	I	30 Dec 2007
886	31 Dec.	8 Jan 2008	1,500,000	II	28 Dec 2007
	Year 2008
887	2 January	8 Jan 2008	1,200,000	I	28 Dec 2007
888	2 January	27 Dec 2007	1,000,000	II	31 Dec 2007
889	3 January	27 Dec 2007	1,100,000	I	3 Jan 2008
890	3 January	6 Jan 2008	1,800,000	II	29 Dec 2007
891	4 January	31 Dec 2007	1,700,000	I	3 Jan 2008

Note I: All the suppliers are on FOB origin terms, i.e. the title of goods passes to the buyer when the goods are shipped.
Note II: All the suppliers are on FOB destination terms, i.e. the title of goods passes to the buyer when the goods are received for inventory.

Only goods received on or before 31 December 2007 have been taken up as purchases of Quadran Manufacturing Co. Ltd. For the year ended 31 December 2007.

Required:

(a) Why do the auditors have to obtain the number of the last GRN on or before the year-end, and why do they have to obtain the number of the first GRN after the year-end? When should this be performed? (3 marks)
(b) Based on the given information, identify the date that Quadrant Manufacturing Co. Ltd. Should take up the purchases relating to the goods received under GRN No. 882 to 891. (10 marks)

(c) For cut-off error identified in (b), prepare the necessary journal. (4 marks) (d) In addition to the review of GRN, suggest three audit procedures for testing the understatement of trade creditors. (3 marks) (Total 20 marks)

(Adapted HKAAT Paper 8 Auditing December 1999)

Question 3
Panda Limited has established the following policies and procedures on the ordering of materials for production.

Policies on raising purchase orders

The purchasing department is responsible for placing purchase orders with the vendors.
In normal circumstances, purchase orders have to be placed with vendors 20 weeks before the production date and the goods are expected to arrive ten weeks before the production date. Shipment of goods usually takes about one week.
Each week the materials department raises purchase requests to the purchasing department based on the weekly production schedule planned for 20 weeks later. The weekly production schedule is budgeted 40 weeks in advance.
If there is a significant change in the production schedule, the production department can raise a purchase request directly with the purchasing department.
Stocks ordered for cancelled productions are received as usual and are stored in the warehouse for future use.

Procedures on placing purchase orders

Vendors are invited to bid for each order in accordance with the specifications provided by the purchasing department.
The purchasing department places orders with the vendor with the lowest bid without considering other criteria.
The purchasing department cannot access the stock ledger maintained by the materials department.
The materials department examines the quality o the goods received to ensure that the goods meet the firm’s specifications.

Observations during the course of audit

In order to fulfil rush orders, the production department goes direct to the purchasing department and makes purchase requests to the purchasing department without complying with the requirements of 20-week ordering in advance and the bidding procedures.
In the past year, Panda purchased over 95% of its consumption of material VM from Vendor A. Material VM is an essential material for the production of Panda’s major products.
The accounting department settles all vendor invoices according to the terms of credit stated in the invoice without checking the status of stocks delivery with the materials department.
Some vendors sent invoices to Panda Limited before the stocks were delivered. These invoices were settled within one week.

Required:

Identify TEN weaknesses and make recommendations for improvement. (20 marks)

(Adapted HKAAT Paper 8 Auditing December 2002)

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