SULTHAN HAKIM/ 145020308121003

International Undergraduate Program in Accounting of Brawijaya University

Course: Auditing Laboratory

AUDITING CASES: 6. AUDIT PROCEDURES AND AUDIT DOCUMENTATION:

TESTING THE INVENTORY PURCHASING SYSTEM

DISCUSSION QUESTIONS

1. In the brief description presented of Lakeside's inventory procurement system,

several specific control activities can be seen:

the company maintains a perpetual inventory which provides significantly

greater control than does a periodic system;
the case implies that the company uses preprinted forms so that
adequate information is captured whenever a document is prepared;
all purchase requisitions are reviewed and authorized before
merchandise is ordered;
incoming inventory is inspected for damage upon receipt;
all invoices are matched with the appropriate purchase requisition
and receiving report before payment is approved;
prices of every invoice are verified; and

2. Canceled checks are the last document in this system, while receiving reports
are one of the first. Whenever auditors select a final document such as a
canceled check and search for its documentation, they are seeking to
substantiate the validity of the balance being reported. All forms and documents
must be present to prove that the amount and the company's reporting were both
correct. Such testing also seeks to discover whether false transactions have
been entered into the system. For example, if a canceled check is found without
a corresponding receiving report or purchase requisition, the possibility exists
that money has been stolen from the company; a payment was made for
merchandise that was not ordered nor received.

Taking a beginning document such as a receiving report and tracing the impact
of the transaction through an entire system is intended to provide evidence of
completeness and that the system and its controls are working as designed.
Obviously, such testing will also provide evidence as to the validity of the account
balance, but this particular procedure is more often associated with the
completeness assertion and internal control evaluation.

3. How might Lakeside pay for goods that were received? The company could, as
an example, receive an invoice and not properly match it with the corresponding
 receiving report. The receiving report might state that 10 items were actually
acquired while the invoice was for 20 or 100. The individual doing the review
may not notice the discrepancy and erroneously approve the invoice. As another
possibility, this individual might authorize an incorrect invoice in order to receive
a kickback from the vendor.

How might Lakeside fail to pay for goods that were not received? If either the
receiving report or the invoice is lost, the documents will not match and payment
cannot be made. Thus, the company may wait indefinitely for the other (lost)
form before approving the cash disbursement.

4. Audit documentation, also called a working paper, is designed to demonstrate

that the auditor has obtained sufficient, competent evidence on which to base an
opinion as to the fair presentation of the client's financial statements. Given that
overall objective, the working paper indicates the testing that was performed and
the evidence that was accumulated. The working paper should also specify any
problems that were encountered and their resolution. The working paper must
demonstrate that this portion of the examination was properly planned and that
all assistants were adequately supervised. In addition, the audit documents as a
whole must indicate that internal control was studied and evaluated. All audit
documents are the property of the auditor and are maintained by the auditor in
order to support the opinion rendered by the auditor.

5. A CPA firm must establish policies and procedures for the supervision of work at
all organizational levels to provide reasonable assurance that the examination
conforms to generally accepted auditing standards. Procedures for supervision
are necessary to ensure that appropriate judgments and conclusions have been
drawn from the work performed. Not every member of an audit team will have
the expertise necessary to evaluate the handling of each accounting and auditing
problem that arises. Furthermore, some of the audit staff may lack an in-depth
knowledge of the client or the client's industry, thus increasing the possibility of
incorrect judgments. Supervision by auditors having the necessary experience
and expertise provides reasonable assurance that sufficient evidence and proper
conclusions were obtained.

Auditing literature places emphasis on the existence of appropriate supervisory

policies and anticipates that practices will be used by a firm in each audit
engagement to verify proper supervision. One such procedure is to have staff
members leave their initials to indicate the completion of a test or later review.
Thus, the working paper shown in Exhibit 6-1 was originally produced by Art
Heyman (AH) and subsequently reviewed by Carole Mitchell (CM), and Wallace
Andrews (WA). From the location of the initials, this auditing firm must require
acknowledgment at every point of audit judgment to indicate that the supervisors
concur with the actions taken. This policy enables the firm to monitor the degree
of supervision in each area of the audit as well as to ensure that no critical
problem will escape the attention of supervising auditors.

6. Because of the great volume of audit documentation accumulated during an

 engagement, most firms use an indexing system to organize all materials.
Indexing allows the auditor easier access to the various documents and
expedites the review process. The "N-2" designation on this document is
apparently part of an indexing system, although no indication is given in the case
as to the actual derivation of the symbols. Abernethy and Chapman may be
using a code in which the letter N refers to the inventory account, and this
particular document presents the results of the second testing procedure
performed on that account.

7. One of the purposes of audit documentation is to serve as an historical record of

all audit testing performed by the CPA firm. This documentation provides a
guideline for future audits but, more importantly, serves as evidence should the
auditor's work ever come under question. To assure that the audit documents
clearly reflect the procedures that were carried out and the evidence gathered,
many auditing firms require that the objective, the scope, and the conclusions
reached be included in the documentation of each test. Furthermore, by having
to furnish this information, the staff auditor is more likely to understand the
purpose of the procedures being applied.

8. Audit procedures are the steps that are required to test a particular control,
transaction, or account. Some firms write procedures specifically designed for a
particular audit client. Also, some firms have standardized audit procedures for
use on all audits. For quality control standards, standardized procedures are
preferable to ensure that all audits are performed in a like fashion. However,
these standardized procedures should be supplemented with procedures
designed to meet the particular circumstances of each client.
EXERCISES

1. The audit procedures seem generally clear, although they do contain some
problems. For example, the fifth procedure states that the auditor "examined
canceled checks for amounts, dates, signatures, endorsements, and payee."
Obviously, the auditor is not just physically examining this information but is
confirming the data against some other document (the invoice). This
reconciliation is not clearly stated. Also, in the seventh procedure, no indication
is given as to the purpose of verifying the account code.

Exception (A) is poorly written. The staff auditor does not indicate whether the
$200 and the $360 amounts are over or under the current list price. Additionally,
the explanation for the discrepancies is vague. Stating that "the difference
represents monthly purchases from Cypress at different prices than shown in
current price list" indicates nothing about the reason for the change. The major
problem, though, with this explanation (and the actual testing procedure) is that
Thomas' word is accepted as an adequate explanation for the discrepancy. The
auditor provides no information that any further testing has been carried out to
verify these amounts. The assumption has apparently been made through the
comment "Pass Further Work" that the differences are immaterial and, thus, do
not require additional testing. Since all of the supervisors have added their
initials, concurrence appears to exist with this evaluation. Students may want to
discuss whether these two discrepancies warrant further examination and, if so,
what testing could be performed.

Exception (B) is also vague and poorly written. Once again, Thomas' explanation
is apparently accepted without further question or testing. The comment does
not indicate the amount of the differences that are involved in this replacement.
Therefore, judging the materiality of the items will be quite difficult for the audit
supervisors.

Exception (C) seems relatively clear. An auditor would prefer to see this policy in
an official Lakeside manual rather than accepting oral evidence, but in a small
company such as Lakeside, that may not be possible. The auditor should adjust
the flowchart and memorandum for this system to include this discovery.

On the whole, other than comments A and B, this working paper appears to be
clear and comprehensive. By reviewing the steps of the audit program listed in
this case, students can see that Heyman has performed the audit procedures
designed by Mitchell.

2. Attached is one example of an audit document that could be produced by

carrying out the prescribed auditing procedures. A great amount of variety exists
in format, and students ought to be evaluated on the clarity and understandability
of their approach rather than on the development of a particular structure.

In reviewing this audit document with students, the instructor should be aware
that this question was developed with several educational objectives in mind:
 To introduce students to the types of testing procedures performed by
auditors in verifying the operating efficiency of a company's control
policies and procedures.

To assist students in developing the ability to discover and evaluate

control problems. In this case, a number of problems exist; some are
meaningless, while some are quite significant. If this question is
approached, at least partially, as a discussion question, student ideas as
to the meaning and importance of each problem can be quite interesting.

To aid students in developing audit document construction techniques.

As in a previous case, one or more of the students' efforts can be chosen
and presented to the class as a whole or in small groups for a technical
critique.

3. If Art Heyman found inconsistencies in this part of the audit his primary
responsibility is to document the items. He should do only enough work
at this point to fully understand the nature of the inconsistency, so that
his documentation is adequate. In conversations with Mitchell further
work may be developed.
 Lakeside Company W.P. No. N-3
Tests of Receiving Reports and Cash Disbursements 1

12/31/09 Accountant: AH

Date: 12/3/09

Audit Procedures Date Receiving Invoice Check

Report Number Number Number
t G 8/20/09 3918 711 3091

t G 8/21/09 3919 802 3121

t GC 8/24/09 3920 991 3164

t EF 8/27/09 3921 1261 3203

t GBD 8/28/09 3922 1313 3251

t G 9/2/09 3923 1406 3310

t E 9/3/09 3924 1510 3345

t A 9/7/09 3925 1616 3397

t GB 9/7/09 3926 1691 3425

t GC 9/14/09 3927 1812 3451

t G E 9/16/09 3928 2072 3471

t GC 9/21/09 3929 2149 3510

Audit Objective:
To verify that items received were properly ordered, received, and paid.

Scope:
Population: All receiving reports prepared during the period under audit.
Sample: Judgmentally selected 12 receiving reports from inventory department file. Pulled
reports sequentially, randomly starting with #3918.

Audit Procedures:

Review receiving reports. All complete and signed by inspectors, except A.

Compared receiving report with purchase invoice for quantity and description. All agreed
except B.

Compared receiving report to purchase requisition for quantity and description. All agreed
except B and C. All requisitions approved by Rogers or Miller.

Invoices reviewed for compliance to see if they were checked, extended, and footed by
Lakeside employees. All were except D.

Compared invoice prices with Cypress Master Price List. All agreed except E.

t Inspected canceled checks and compared them to invoice amounts, recomputing 3% discount.
All agreed except E.
Comments: See W/P N-3 page 2.
Audit Conclusion:
Further testing necessary because of exceptions noted.
 Lakeside Company W.P. No. N-3

Tests of Receiving Reports and Cash Disbursement (cont.) 2

12/31/09 Accountant: AH
Date: 12/3/09

Comments

A Receiving report not in file. Client should be asked to find it or provide a reason for its absence.
Unless it is accounted for, the scope of testing may need to be expanded.

B On two invoices Cypress billed Lakeside for items different from those received. In both cases the bill
was for the items ordered, not those received. R.R. #3923 shows an item that is more expensive than
the one billed, while R.R. #3927 has an item that is less expensive than the one billed. The purchase
requisition for R.R. #2923 indicates Lakeside's acceptance of a replacement but no indication in
connection with R.R. #3927. Lakeside has paid for goods ordered, not goods received. This reflects a
serious problem with both the Lakeside and Cypress systems.

C Some receiving reports indicate receiving a different amount of goods than ordered. Requisitions indicate
that goods have been backordered in both cases. Lakeside, however, paid only for goods received. System is
functioning properly.

D No indication on this invoice that pricing, footing, or extensions were verified. Other invoices show
initials and tick marks. Failure to comply with the system in this one case.

E In a number of cases, invoice prices were less than the Master Price List. There seems to be a
discount on special items, but more evidence is needed.

F One invoice was reduced by a 4% discount, instead of 3%. Further inquiry required to determine
reason.

G In virtually all cases, checks were issued 2 or 3 days after the 20-day deadline for taking discounts,
but Lakeside took the discount in every case. Further inquiry is required to determine if
Lakeside still has a liability for these amounts.