False Purchases Camouflage Overstated Profits
Comptronix Corporation announced that senior members of its manage -
ment team overstated profits, and there would be material adjustments to
the prior years’ audited financial state ments. Central to the fraud was the
use of fictitious purchases of large equipment items to overstate fixed
assets and hide fictitious sales.
The senior executives circumvented Comptronix’s existing internal controls
by bypassing the purchasing and receiving departments so that no one at
Comptronix could discover the scheme. Comptronix employees usually
created a fairly extensive paper trail for equipment purchases. Company
internal controls over acquisition and cash disbursement transactions
typically required a purchase order, receiving report, and vendor invoice
before payment could be authorized by the Chief Operating Officer or the
controller/treasurer, who were both participants in the fraud. As a result,
the executives were able to bypass controls over cash disbursements and
authorize payment for nonexistent purchases without creating any docu -
ments for the fictitious transactions.
The company also created fictitious sales and related receivables. The company issued checks to pay for the false
purchase transactions. The checks were then redeposited into the company’s bank account and recorded as
collections on the fictitious receivables. As a result, it appeared that the fictitious sales were collected, and that
payments were made to support the false fixed asset purchases.
The fraud scheme grossly exaggerated the company’s performance by reporting profits when the company was
actually incurring losses. On the day that the public announcement of the fraud was made, Comptronix’s common
stock price declined abruptly by 72 percent! The SEC ultimately charged the executives with violating the antifraud
provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC permanently barred the
executives from serving as officers or directors of any public company, ordered them to repay bonuses and trading
losses avoided, and imposed civil monetary penalties against them.
Source:Accounting and Auditing Enforcement Release No. 543, Commerce Clearing House, Inc., Chicago.
AUDIT OF THE ACQUISITION
AND PAYMENT CYCLE:
TESTS OF CONTROLS,
SUBSTANTIVE TESTS
OF TRANSACTIONS,
AND ACCOUNTS PAYABLE
CHAPTER18
After studying this chapter,
you should be able to
18-1
Identify the accounts and the
classes of transactions in the
acquisition and payment cycle.
18-2
Describe the business functions
and the related documents and
records in the acquisition and
payment cycle.
18-3
Understand internal control,
and design and perform tests of
controls and substantive tests of
transactions for the acquisition
and payment cycle.
18-4
Describe the methodology for
designing tests of details of
balances for accounts payable
using the audit risk model.
18-5
Design and perform analytical
procedures for accounts payable.
18-6
Design and perform tests of
details of balances for accounts
payable, including out-of-period
liability tests.
18-7
Distinguish the reliability of
vendors’ invoices, vendors’
statements, and confirmations
of accounts payable as audit
evidence.
LEARNING OBJECTIVES
Also known as Purchases, Payables, and Payments (PPP) 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.
Typical Business Functions and Important Documents
Although many companies follow different internal processes and use electronic-based methods, the following flowchart is a typical business process in the acquisition and payment cycle.
The process generally starts with a purchase requisition that an employee of the company generates. The purchase requisition is a document that describes the product needed and the quantity required. The document is then sent to the purchasing department that generates a purchase order. The purchase order lists the product to purchase, the quantity to order, and the price the company is willing to pay.
Typically, employees are only permitted to buy from an approved vendor’s list. Once the ordered goods have been received by the next department, the company issues a receiving report. The report should reconcile with the purchase order and is sent to the accounts payable team in the accounting department. Here, the employee reconciles the received goods with the vendor invoice, and the journal entry to accounts payable is recorded. Finally, the payment is processed by treasury, and the cash is actually paid out.
General Methodology for Auditing Cycles
When auditing cycles for different companies, the typical approach is to:
- Understand the entity and its environment
- For each cycle, identify internal controls that exist
- Assess control risk and the risk of material misstatement
- Evaluate the cost-benefit analysis of testing controls and following a combined audit approach vs. a purely substantive audit approach
Important Internal Controls For Acquisitions and Disbursements
Remember that for classes of transactions, there are five applicable assertions: cut-off, classification, completeness, occurrence, and accuracy.
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.
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.
The Auditor’s Role
Substantive analytical procedures are typically trend and ratio analysis against industry data, prior year data, and expected results. Substantive analytical procedures are usually sufficient and appropriate as audit evidence because the amounts are not significant and very often involve relatively trivial balances such as general and administrative expenses.
However, for more judgmental and more complex accounting issues with regards to legal expenses, repairs, maintenance expense, and lease expense, for example, auditors will want to obtain more assurance and perform tests of details of balances.
Related Readings
Thank you for reading CFI’s guide to the acquisition and payment cycle. We offer the following free resources for more information.
- Accounts Receivables
- Retained Earnings
- Income Statement
- Financial Modeling Certification