Auditing Payables and Expenses
The expenditure cycle covers the acquisition of goods and services, from the initial purchase request through payment. Because the primary audit risk for payables is understatement (unrecorded liabilities), auditors focus heavily on completeness rather than existence.
Expenditure Cycle Overview
Departments and Responsibilities
| Department | Key Responsibilities |
|---|---|
| Purchasing | Receives approved purchase requisitions, selects vendors, and issues purchase orders (POs) |
| Receiving | Inspects incoming goods, counts quantities, and prepares a receiving report |
| Accounts Payable | Matches documents, records liabilities, and approves invoices for payment |
| Treasurer | Signs checks and authorizes disbursements; maintains custody of funds |
Proper segregation requires that the person who authorizes purchases (purchasing), the person who has custody of goods (receiving/warehouse), and the person who records the liability (accounts payable) are all different individuals. The treasurer, who disburses cash, should also be independent of the recording function.
Example: Purchase Transaction at Kingfisher Industries
- A department manager at Kingfisher Industries submits a purchase requisition for raw materials.
- The purchasing department reviews the requisition, selects a vendor, and issues a purchase order.
- When goods arrive, the receiving department counts and inspects them, preparing a receiving report.
- The accounts payable department performs a three-way match and records the liability.
- The treasurer reviews the approved voucher package and signs the check for payment.
The Three-Way Match
Before an invoice is approved for payment, the accounts payable department performs a three-way match by comparing:
- Purchase Order (PO) – Confirms the goods were authorized and specifies agreed-upon prices and quantities
- Receiving Report – Confirms the goods were actually received and in what quantities
- Vendor Invoice – The bill from the supplier requesting payment
The three-way match is a critical internal control over the expenditure cycle. All three documents must agree on item descriptions, quantities, and prices before payment is authorized. Any discrepancies must be investigated and resolved before the invoice is approved.
Example: Three-Way Match at Gies Co.
Gies Co. orders 500 units from a supplier at $10 each. The receiving report shows 480 units received. The vendor invoice bills for 500 units at $10 each. The accounts payable clerk identifies the 20-unit discrepancy and contacts the vendor before approving payment—only paying for 480 units actually received.
Accounts Payable Confirmations
Unlike AR confirmations (which are almost always performed), AP confirmations are not required but are used in specific circumstances.
When AP Confirmations Are Used
AP confirmations are most useful when sent to vendors with small or zero balances per the client's records. The goal is to detect unrecorded liabilities—invoices the client received but never recorded.
- AR confirmations target large balances to test existence (overstatement risk)
- AP confirmations target small or zero balances to test completeness (understatement risk)
This is because the primary risk for payables is that liabilities are understated, not overstated.
Example: AP Confirmations at MAS Inc.
The auditor of MAS Inc. identifies vendors the company regularly does business with but that show unusually low or zero balances at year-end. The auditor sends confirmations to these vendors asking them to report the amount MAS Inc. owes. If a vendor reports a balance that MAS Inc. has not recorded, the auditor has identified an unrecorded liability.
Search for Unrecorded Accounts Payable
This is one of the most important expenditure cycle procedures and directly addresses the completeness assertion.
Procedure Steps
- Examine cash disbursements after year-end – Review checks written and payments made in the period following the balance sheet date to identify invoices that relate to the audit period but were not recorded as liabilities at year-end.
- Review unmatched receiving reports – Identify receiving reports near year-end that have no corresponding recorded payable (goods received but liability not yet booked).
- Review unmatched purchase orders – Examine open POs for goods that may have been received but not yet invoiced.
- Examine vendor statements – Compare vendor statements received after year-end to recorded payable balances.
- Inquire of management – Ask about any known unrecorded obligations.
The search for unrecorded payables starts with documentation outside the accounting records (such as subsequent cash disbursements or receiving reports) and traces into the records. This approach is effective because if the liability was never recorded, it will not appear in the accounting records themselves.
Example: Search at BIF Partners
While auditing BIF Partners, the auditor reviews January disbursements and finds a $150,000 payment to Illini Security for consulting services performed in December. The auditor traces this payment back to the invoice and confirms the services were rendered before year-end. Since BIF Partners had not accrued this amount, the auditor proposes an adjusting entry to record the unrecorded liability.
Common Expenditure Cycle Audit Procedures
| Procedure | Assertion Tested | Description |
|---|---|---|
| Search for unrecorded payables | Completeness | Examine subsequent disbursements, unmatched receiving reports, and vendor statements |
| AP confirmations (small/zero balances) | Completeness | Confirm with vendors showing low balances to detect unrecorded liabilities |
| Vouch recorded payables | Existence/Occurrence | Select recorded payables and trace to supporting POs, receiving reports, and invoices |
| Cutoff testing | Cutoff | Examine transactions near period-end to ensure proper recording in the correct period |
| Recalculate accrued liabilities | Valuation/Accuracy | Independently compute accruals for items like utilities, wages, and interest |
| Review expense accounts | Classification | Analyze large or unusual expense entries for proper classification |
| Disclosure review | Presentation | Verify completeness of payable and commitment disclosures |
Cutoff Testing for Purchases
The auditor examines the last receiving reports issued before year-end and the first receiving reports issued after year-end to verify that:
- Goods received before year-end are recorded as purchases and payables in the current period
- Goods received after year-end are recorded in the subsequent period
Example: Cutoff Testing at Illini Entertainment
Illini Entertainment's last receiving report before December 31 is #4872, and the first receiving report after year-end is #4873. The auditor verifies that all purchases through receiving report #4872 are recorded in the current year and that receiving report #4873 and subsequent reports are recorded in the following year.
Remember: for accounts payable, the auditor is primarily concerned with completeness (understatement). This is the opposite of accounts receivable, where the primary concern is existence (overstatement). The direction of testing and the nature of procedures reflect this difference.