Review Questions Solutions
Chapter 12, Auditing Acquisitions and Payments Processes:
Cash Disbursements and Related Activities in the Automotive Industry
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A1 What kinds of transactions are included in the acquisition and payment cycle?
Purchases and payments for inventory, operating expenses and long-lived productive assets
Purchase returns and discounts
(In this book, payments for payroll, investments, repayment of long-term debt, and other financing transactions are included in other cycles.)
A2 What is the main activity of a retail business?
The purchase and resale of finished goods
A3 Relating to inventory, once it has arrived at a retailer, what are some internal controls that should be implemented?
Physically safeguarding the inventory that is received, preparing documents to record the receipt and movement of the inventory
A4 What types of fixed assets are common for retailers?
Major leasehold improvements that result from building out the space they lease
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B1 What is the major business function of a manufacturing company?
Manufacturing entities manufacture, create, build, assemble, or produce inventory to be sold to customers; they purchase raw materials inventory and add labor and overhead to produce the finished goods.
B2 How does encumbering funds help keep a government entity’s spending within its budget?
Encumbering funds is a process that “sets aside” the amount of money that is committed to a purchase from what is available to be spent. The encumbrance process occurs either before or at the time of the purchase – before the invoice is received.
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C1 Besides personal use vehicles, what are some other examples of products created in the automotive industry?
Commercial use vehicles, military vehicles, parts, accessories, components, services (such as: training, field support, manual preparation, financing, test support, repair services, parts delivery).
C2 Why are acquisition and payment activities very important to the success of automotive industry companies (in contrast to being considered simply back-office functions?)
These activities are tied to companies achieving their market-related goals; they have to receive raw materials on a timely basis for their scheduled manufacturing, to meet inventory needs to fulfill sales.
C3 Why might automotive industry companies choose to investigate suppliers before entering into contracts with them?
Success of the purchaser is often linked to the performance of the suppliers; companies may inspect a supplier’s quality standards and delivery performance.
C4 How is the purchasing process complicated when a manufacturer sells products in various international markets?
Political, religious and economic impacts
Labor market conditions in other country environments
Tariffs and trade barriers
Government regulations
Income and withholding taxes in other countries
Risk of governmental expropriation
Differences in business practices
C5 How are fixed price contracts used to mitigate risk?
Fixed price contracts protect the purchases from fluctuation in the costs of raw materials; this is good when the price of raw materials go up but bad when prices go down. Fixed price contracts are very useful at hedging risks for fixed price sales contracts.
C6 What does it mean when a financial instrument is used to hedge the cost of items that must be purchased for the manufacturing process?
Hedging using financial instruments means buying a financial instrument that pays a certain return that is contingent upon something else happening – for example if the price of steel goes up, the holder of the financial instrument receives a payment. (Theoretically, the entity who made the hedge would be able to spend the money received on the hedge to cover the added cost of the steel.)
C7 Why do companies in the automotive industry need extensive IT systems linked to purchasing to manage their inventory?
Automotive companies often use a large number of different parts, components and end products, both purchased and sold, as well as multiple operating locations. Having IT-based information on inventory helps the purchasing function by providing specific information about what is needed – and therefore needs to be purchased -- and when.
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D1 What objectives does management have related to purchasing, and what controls help to accomplish these objectives?
To limit items that are ordered and purchased to those the company legitimately needs for its use
D2 What are management’s objectives for cash disbursements, and what controls help to accomplish them?
To ensure that all cash disbursements are for goods and services that are actually received by the company and for correct amounts
D3 What are business objectives for recording and reporting accounting information for acquisitions and payments?
To properly post transactions
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E1 What is important regarding the organizational authority of the person who creates a purchase requisition?
The person should have knowledge that an item needs to be purchased and the authority to request the purchasing department to make the purchase. The request for the purchase should come from someone independent of the purchasing department (accomplishing segregation of duties), with the authority to approve the need for the purchase.
E2 Some businesses extend purchasing department employees the authority to perform a broader range of activities than do other businesses. What activities do all purchasing departments perform? What activities might be allowed in some businesses and not in others?
The purchasing department receives the purchase requisition and arranges with a vendor to obtained the needed goods. If management contracts with certain vendors to purchase specific items at an agreed upon price, the purchasing department may only have the authority to execute purchase transactions based on management’s contracts, using approved vendor and price lists. In other businesses, the purchasing department may shop for the best vendor to provide the item based on criteria such as price, quality and ability to deliver within a specific time frame.
E3 What function does a receiving department perform, and what are its activities?
The receiving function takes possession of the goods, counts and inspects the items, noting what was received and when as well as the condition of the delivered goods.
E4 What records does a receiving department prepare?
A receiving report.
A receiving log may also be prepared as a way to cross reference the information.
E5 How is segregation of duties among the requisitioning, ordering, and receiving processes accomplished?
Segregation of duties is accomplished because each department makes decisions and adds the information over which it has authority. In an automated environment, each department only has access to the information it controls.
E6 What should happen when discrepancies exist among supporting documents for a purchase or when the goods received are not what was ordered or arrive damaged?
The typical process for a discrepancy is to first investigate internally. Then, if appropriate, the purchasing company notifies the vendor or shipper of any discrepancies, errors, or damage. The purchaser prepares a debit memo to document the amount that payment for a purchase should be reduced. The purchaser may receive a corrected invoice or statement. The exact process for negotiating and documenting this issues varies from company to company.
E7 What are the different ways cash disbursements can be reviewed and authorized before disbursement occurs?
Documents are accumulated into a payment support package which is reviewed before the cash disbursement is authorized. Cash disbursement is by paper check, or electronic transfer. Final approval for the payment should come from the treasury or cashier department, prior to disbursement.
If the payment is by paper check, the check signer reviews the disbursement and supporting documents before signing the check. If check signing is done automatically using a signature plate, the responsible person reviews the supporting documents and then approves the list of checks to be produced and signed. If the disbursement is by electronic transfer, the responsible person reviews the supporting documents prior to authorizing transfer of the money. Supporting documents are canceled or marked paid.
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F1 What functions of acquisition and payment should be segregated from each other?
Approving the need for the purchase
Executing the purchase
Receiving the shipment
Recording the account payable
Authorizing the cash disbursement
F2 What steps can be taken to safeguard assets?
Physical safeguarding
Keeping goods in safe locations
Storing goods in locked facilities
Documentary controls to safeguard assets
Each person who takes responsibility for the goods signs for them, accepting responsibility
Inventory records are reconciled with receiving documents
F3 How can the improper posting of the debit side of a purchase transaction cause income to be misstated?
For example, income goes up inappropriate, if a transaction that is supposed to be an increase to expenses is recorded as an increase to fixed assets
F4 Why and how is cutoff important to acquisitions and payments?
Proper cutoff ensures appropriate matching of expenses against revenues, and completeness of liabilities. Invoices received around the end of the fiscal period have to be evaluated to determine in which period they are to be recorded. Acquisitions for which invoices have not yet been received have to be estimated and recorded (accrued) so that they are shown in the proper period.
F5 What is an imprest petty cash fund, and how does it work?
An imprest petty cash fund refers to a set amount of cash that is issued to a custodian via a documented cash disbursement such as a paper check or electronic transfer. That person is responsible for disbursing the cash for the approved types of expenditures and collecting receipts or other documentation for the payments. At any time the amount of cash on hand and the receipts should add up to the total amount of the fund. When the cash on hand drops to a specified level, it is replenished by a cash distribution equal to the amount of the receipts or documentation that are used to support authorization of the replenishment.
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G1 How do audit procedures in one part of an integrated audit (ICFR or financial statement audit) relate to conclusions in the other part of the audit?
In an integrated audit, audit procedures should contribute to both audits.
G2 How can walkthroughs provide evidence about the operating effectiveness of ICFR in the audit of acquisitions and payments?
The auditor can review client procedures and observe client personnel as they perform steps.
G3 Related to purchases, what are important concerns addressed by controls? What are the control concerns that are more universal in nature, but also apply to purchase activities?
1. Purchases are for goods and services actually needed by the company
2. Purchases are with vendors the company authorizes
3. The company actually receives the goods and services before any cash disbursements are made
1. All transactions are posted
2. Transactions are posted at the correct amounts, to the proper accounts, and in the correct accounting period
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H1 How are purchase returns likely tested for the financial statement audit?
Using analytical procedures
H2 How can purchase returns be tested for the ICFR audit?
The auditor:
Observes the receiving process
Tests the return process by following goods that have been flagged for return through the system
Observe employee activities
Examine documentation of purchase returns
H3 How do auditor’s and management’s concerns differ regarding purchase discounts?
Management is concerned that no purchase discounts that are supposed to be taken in accordance with company policy are missed. The auditor is concerned that the amount paid for a purchase is properly recorded, whether or not the discount was taken.
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I1 What are the different ways that cash disbursements may be authorized in the current business environment? What important control step does the person providing the approval carry out?
By an individual or multiple check signer using paper checks
Electronic signatures on checks
Electronic funds transfers authorized by codes
The person providing the approval should review the documentation prior to providing authorization that the cash be disbursed.
I2 When cash disbursements are made through electronic funds transfer, what is an important control?
Limit authorized access and carefully safeguard authorization codes.
I3 What are important detective controls for cash disbursements?
Reconciliation and monitoring:
1. Bank statements must be reconciled on a timely basis by a person independent of handling or recording cash receipts and disbursements
2. Vendors invoices and statements should be reconciled to accounts payable records by a person independent of ordering and recording transactions
I4 What control purposes and management assertions are supported by bank reconciliations?
1. To ensure that all cash disbursements that (1) occurred are recorded, and (2) are recorded actually occurred.
(existence or occurrence, completeness, valuation or allocation)
2. To ensure that cash disbursements are recorded in the same accounting period in which they are made.
(cutoff)
3. To ensure that cash disbursements are properly posted to the correct cash account and correct vendor record in the accounts payable subsidiary ledger, and to the general ledger.
(existence or occurrence, completeness, valuation or allocation, presentation and disclosure)
I5 What control purposes and management assertions are supported by reconciling vendor invoices and statements to accounts payable subsidiary ledger records?
1. To ensure that all cash disbursements that (1) occurred are recorded, and (2) are recorded actually occurred.
(Existence or occurrence, completeness, valuation or allocation)
2. To ensure that cash disbursements are properly posted to the correct cash account and correct vendor record in the accounts payable subsidiary ledger, and to the general ledger.
(existence or occurrence, completeness, valuation or allocation, presentation and disclosure)
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J1 What is the advantage of performing dual purpose tests?
Dual purpose tests provide the auditor with the opportunity to collect audit evidence about ICFR and the account balances in the financial statement using the same evidence items.
J2 How is underlying information (used for substantive analytical procedures) tested, and why?
To be able to rely on the results of analytical procedures the auditor must test whether the underlying information is complete and accurate. ICFR of the accounting system must function for the underlying information to be relied on. Additional evidence of reliability comes from dual purpose tests and tests of details of balances.
J3 How are analytical procedures used for acquisitions and payments?
They are used to confirm or dispute other audit evidence and to provide evidence on expense accounts for which less direct examination is performed.
J4 Why do analytical procedures help whether they confirm or dispute other findings?
If analytical procedures confirm other audit evidence they corroborate that the other audit evidence is reliable. If analytical procedures results are inconsistent with the results of other audit procedures, the auditor performs more audit work and will be able to assess whether the other evidence is appropriate.
J5 What is involved in most common analytical procedures? What is compared?
Compare a current year account balance with the account balance in prior years, a budget or an industry benchmark
Calculate a ratio or statistic and compare the outcome to other relevant information
Analytical procedures consider the relationships of company information, in light of changes within the company and external influences. The goal is to determine whether the observed relationships make sense in light of the business activities and economic environment.
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K1 What other audit evidence besides confirmations are used to support the auditor’s conclusions about accounts payable?
In addition to confirmations, the auditor uses examination of documents and the search for unrecorded liabilities.
K2 What is the important management assertion for accounts payable about which confirmation can provide audit evidence?
Completeness; unrecorded or under-recorded liabilities (understatement)
K3 What is the purpose of sending confirmations to vendors with small or zero balances?
The amount by which a liability can be understated is “infinite” – in other words, if a liability is simply not recorded, the balance is shown as zero, but the actually liability could be any amount. If the auditor only selected large accounts payable balances to confirm the process would miss the liabilities that are actually large but are shown as being small or zero amounts in the company’s records.
K4 What is a “blank” confirmation? Why is this format often used for accounts payable?
A blank confirmation is one in which the amounts are not filled in and are to be added by the recipient of the confirmation. Blank confirmations are used when the auditor wants to reduce the risk that the recipient will just “sign off” on the amount, without actually checking it.
K5 What are common sources of discrepancies between responses on blank accounts payable confirmations and the audit client’s accounts payable subsidiary ledger?
The most common cause of discrepancies is timing differences. The auditor is looking for evidence that supports the balance at the fiscal year end. Transactions may have occurred after the fiscal year end – both purchases and payments – and before the confirmation information is provided. If the creditor confirms that balance at the date of the confirmation, rather than at the date of the fiscal year end, then the auditor must reconcile the difference.
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L1 What audit procedures fall under the label Search for Unrecorded Liabilities? What management assertion do these audit procedures address?
1. Ask the client about the procedures it established and followed to be sure that all liabilities are recorded.
2. Review cash disbursements and related supporting documents in the subsequent accounting period. All cash disbursements should be for transactions of the current period, or items shown as payables at the prior fiscal year end.
3. Review invoices and statements and relating supporting documents for liabilities not paid at the time the audit work at the client’s location is completed. Trace the unpaid bills to either a liability of the period being audited or a payable that has been recorded in the subsequent accounting period.