Question

Managing the risk of material misstatement in the purchasing process is critical. Identify two (2) different industries and analyze how these risks differ from one industry to the other. Also, identify internal controls that could help to keep these misstatements to a minimum

Answer 1

At every step of an audit, you have to consider risks and their associated controls. Normally, purchases don’t have a lot of inherent risk because the process doesn’t involve any complicated or contentious accounting issues. For example, valuation is clear-cut; it’s the bottom line total on the invoice. Cutoff is precise as well, because the company must include only purchases that are complete by the end of the fiscal year.

Generally, you look at two inherent risk factors for purchase transactions: the supply and demand for goods and raw materials, and your previous experience with the client.

Considering industry-related factors

One inherent risk factor is potential industry-related factors. Any type of manufacturing, where the business makes the goods, or merchandising, where the business sells the goods, company depends on securing goods to sell. Should the goods become unavailable or priced beyond that which the company can reasonable resell them, you have to assess whether the company is a going concern. That is, will the company continue operations for at least the next 12 months? You can make your initial assessment by interviewing management, checking out any spikes in purchasing costs from prior years and through Internet research events affecting your client’s industry.

A very important industry-related factor is supply and demand of raw materials or goods for resale.

If your audit client uses scarce raw materials, costs can be quite volatile, and profitability from year to year can dramatically go up and down. The value of any scarce commodities your client has in inventory can fluctuate strongly as well. This information is important to know when you address balance sheet ending inventory valuation issues, which tie to the income statement presentation of purchases.

Checking for prior misstatements

When you’re auditing purchases, check out past years’ work to see what types of misstatements existed. A big issue with purchases is completeness, which is the understatement of accounts payable. If understatements existed, or if any other aspect of purchasing was problematic, you home in on these issues during the current audit. For example, maybe classification errors were high, meaning purchases showed up in incorrect financial statement accounts.

Of course, if the audit you’re performing isn’t a continuing engagement (meaning that you’re working with a new client), you have no firsthand knowledge of prior audits. That’s why it’s a good idea to always speak with the previous auditor if one exists.