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.

P u rc h a se
and
P aym ent
C y c le

D o c u m e n ts C o n tro l R is k s S u b s ta n tiv e T e s ts o f D e ta ils R e lia b ility o f

and A sse ssm e nt P ro c e d u res o f A c c o u n ts In v o ic e s,
R e c o rd s P a y a b le S ta te m e n ts &
C o n firm a tio n

C la s se s o f A n a ly tic a l A n a ly tic a l
P u rch a s es P ro c e d u res P ro c e d u res
T ra n s a c tio n s

C la s se s o f P u rch a s es A c c o u n ts
C a s h P a y m e n ts T ra n s a c tio n s P a y a b le
T ra n s a c tio n s B a la n c e s

A c c o u n ts P a y m e n ts O u t-o f-lia b ility

P a y a b le T ra n s a c tio n s T e s ts
B a la n c e s

C re d ito rs'
C o n firm a tio n

C u t- o ff
T e s ts

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1. Documents and Records

1.1 Purchase requisition – 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 – 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 – 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 – 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.

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2. Control Risks Assessment of Purchase and Payment Cycle

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Audit risk is the risk that an auditor issues an incorrect opinion on the financial statements. Examples
of inappropriate audit opinions include the following:

 Issuing an unqualified audit report where a qualification is reasonably justified;

 Issuing a qualified audit opinion where no qualification is necessary;
 Failing to emphasize a significant matter in the audit report;
 Providing an opinion on financial statements where no such opinion may be reasonably given
due to a significant limitation of scope in the performance of the audit.
Inherent Risk is the risk of a material misstatement in the financial statements arising due to error or
omission as a result of factors other than the failure of controls.
Control Risk is the risk of a material misstatement in the financial statements arising due to absence
or failure in the operation of relevant controls of the entity.
Detection Risk is the risk that the auditors fail to detect a material misstatement in the financial
statements.
Detection risk can be reduced by auditors by increasing the number of sampled transactions for
detailed testing.

2.1 Assertions used by the auditor in purchase and payment cycle

Audit Assertions are the implicit or explicit claims and representations made by the management
responsible for the preparation of financial statements regarding the appropriateness of the
various elements of financial statements and disclosures.

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.

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Occurrence. The assertion is that recorded business transactions actually
took place.
Completeness. The assertion is that all business events to which the
company was subjected were recorded.
Accuracy. The assertion is that the full amounts of all transactions were
recorded, without error.
Cutof. The assertion is that all transactions were recorded within the
correct reporting period .
Classification. The assertion is that all transactions have been recorded
within the correct accounts in the general ledger .

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.

Occurrence. The assertion is that recorded business transactions actually

took place.
Completeness. The assertion is that all business events to which the
company was subjected were recorded.
Accuracy. The assertion is that the full amounts of all transactions were
recorded, without error.
Cutof. The assertion is that all transactions were recorded within the
correct reporting period .
Classification. The assertion is that all transactions have been recorded
within the correct accounts in the general ledger .

2.1.3 Accounts payable balances

(Jun 15)
Assertions Descriptions

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

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

Existence. The assertion is that all account balances exist for assets,
liabilities, and equity.
Rights and obligations. The assertion is that the entity has the rights to the
assets it owns and is obligated under its reported liabilities.
Completeness. The assertion is that all reported asset, liability, and equity
balances have been fully reported.
Valuation. The assertion is that all asset, liability, and equity balances
have been recorded at their proper valuations.

2.2 Internal controls and test of controls

Internal Controls
Internal control is all of the policies and procedures management uses to achieve the
following goals.
 Safeguard University assets - well designed internal controls protect assets from
accidental loss or loss from fraud.
 Ensure the reliability and integrity of financial information - Internal controls ensure
that management has accurate, timely and complete information, including
accounting records, in order to plan, monitor and report business operations.
 Ensure compliance - Internal controls help to ensure the University is in compliance
with the many federal, state and local laws and regulations affecting the operations of
our business.

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 Promote efficient and effective operations - Internal controls provide an environment
in which managers and staff can maximize the efficiency and effectiveness of their
operations.
 Accomplishment of goals and objectives - Internal controls system provide a
mechanism for management to monitor the achievement of operational goals and
objectives.

Tests of control:
 Tests of control involve the auditor testing processes or procedures carried out by
staff at the client.
 In every organisation, there will be business and accounting systems which
should have appropriate controls in place.
 There are a variety of different controls that can be broadly classified into five
categories. The categories of control activities are: Authorisation, Performance Reviews,
Information Processing, Physical, and Segregation of Duties
 Testing controls involve the auditor selecting some of these controls that the client
carried out during the year, and checking to make sure they operated effectively.
 An example of a control could be where the client had a control whereby the
monthly payroll summary had to be approved by the finance director before payment was
made.
 As a test of control, the auditor would look for evidence of that authorisation –
most commonly the signature / initials of the Finance Director on a copy of the payroll
summary.

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

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

3. Accuracy  Approved prices, terms, and  Examine proper approval

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

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purchase transactions.

(b) Classes of cash payment transactions

Assertions Internal Control Procedures Tests of controls

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

Segregation of duties: Safeguarding assets

One of the key concepts in placing internal controls over a company’s assets is segregation
of duties. Segregation of duties serves two key purposes:
1. It ensures that there is oversight and review to catch errors
2. It helps to prevent fraud or theft because it requires two people to collude in
order to hide a transaction
Segregation of duties involves separating three main functions and having them conducted
by different employees:
1. Having custody of assets
2. Being able to authorize the use of assets
3. Recordkeeping of assets

3. Accuracy  Regular preparation and  Review periodic bank

review of bank reconciliation reconciliation prepared by
prepared by independent person. independent person and
examine evidence for
internal verification.

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4. Cut-off  Procedure requiring recording  Examine evidence for
of cash payments after the unrecorded payments and
cheque has been signed. review of bank
reconciliation.
5. Classification  Use of adequate chart of  Trace cash payments to
accounts and have internal cash payment journal for
verification of proper codes. proper classifications and
review cash payment
journal for unusual items.

(c) Accounts payable balances

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

Confirmation-also indicates that external confirmation procedures may assist the

auditor in obtaining audit evidence with the high level of reliability that the auditor

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requires to respond to significant risks of material misstatement, whether due to fraud
or error.

Tracing refers to first selecting an accounting transaction (a source document) and then
following it into the journal or ledger. The direction of testing in this case is from the
source documents to the journals or ledgers and tests whether transactions that occurred
are recorded (completeness) in the accounting records.

Vouching refers to first selecting an item for testing from the accounting journals or
ledgers and then examining the underlying source document. Thus, the direction of
testing is from the journals or ledgers back to the source documents. Vouching provides
evidence that items included in the accounting journals or ledgers have occurred (are
valid).

3. Substantive Procedures for Purchases and Payments Transactions

3.1 Analytical procedures

3.1.1 Examples of the analytical procedures for purchases and cash payments

(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.

Analytical procedures are a type of evidence used during an audit. These

procedures can indicate possible problems with the financial records of a
client, which can then be investigated more thoroughly. Analytical
procedures involve comparisons of different sets of financial and
operational information, to see if historical relationships are continuing
forward into the period under review. In most cases, these relationships
should remain consistent over time. If not, it can imply that the financial
records are incorrect, possibly due to errors or fraudulent reporting
activity.

3.2 Substantive procedures – purchases transactions

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Substantive testing is an audit procedure that examines the financial
statements and supporting documentation to see if they contain errors.
These tests are needed as evidence to support the assertion that the
financial records of an entity are complete, valid, and accurate.
There are many substantive tests that an auditor can use. The following
list is a sampling of the available tests:
 Issue a bank confirmation to test ending cash balances
 Contact customers to confirm that accounts receivable balances are
correct
 Observe the period-end physical inventory count
 Confirm the validity of inventory valuation calculations
 Confirm with experts that the fair values assigned to assets obtained
through a business combination are reasonable
 Physically match fixed assets to fixed asset records
 Contact suppliers to confirm that accounts payable balances are
correct
 Contact lenders to confirm that loan balances are correct

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.

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N10-12
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

Tests of details are used by auditors to collect evidence that the balances,
disclosures, and underlying transactions associated with a client's financial
statements are correct. For example, an auditor could test the prepaid
expenses asset account by examining each of the prepaid expenses that
comprise the ending prepaid expenses balance.

4.1 Analytical procedures

(Jun 09, Dec 11)

4.1.1 Examples of the analytical procedures for accounts payable

(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

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balances.

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4.2 Tests of details of accounts payable balances

Audit Objectives Substantive procedures

1. Existence  Select 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  Select a sample of trade payables to confirm the balance at the
obligations 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  Obtain a list of the individual balances from the payables
allocation ledger, check the cast and agree the total to the trade
payables figure in the 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  Review the financial statements to make sure that proper
disclosures 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.

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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  The purpose is to uncover payments made in the
for payments subsequent to year subsequent accounting period that represent
end date 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  It is to find out the reasons for unpaid obligations
for invoices not paid within several to determine whether the liability should belong
weeks after year-end. to the period under audit. If not, the balance will
be overstated.
Trace goods receiving notes issued  It is a test for unrecorded obligations to make
before and after year-end to related sure that all goods received before the end of the
vendors’ invoices and accounting accounting period are included in accounts
records. payable.
Trace vendors’ statements to the  It is a form of external audit evidence to ensure
balances on the creditors’ list. 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  The purpose is to uncover any omitted liability or
with which client has done business misstated balance relating to active creditors
during the period under audit. which balance however does not appear on the
creditors list of client (i.e. zero balance with
client).

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4.4 Accounts payables’ circularization

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:
(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.

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Items Purposes
In relation to physical  The cut-off information for purchases (i.e. the last
observation of stocktaking 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  The procedures described in the above still have to
carried out before year end be performed in order to ensure the accounts
date 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/shipping point 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.

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.

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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

5.3.1 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.

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Appendix I – Purchases and Payment Cycle Flowchart

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