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Overview
Overview
The risk of material misstatement (RMM) in the acquisition and expenditure cycle arises from errors or fraud that could cause financial statements to be materially misstated. The document highlights that this cycle is prone to issues such as unrecorded liabilities, improper expense recognition, and fraudulent schemes, which auditors assess using the "what could go wrong?" (WCGW) approach tied to financial statement assertions. Audit Analytics data from 2020 indicates that expense-related restatements accounted for 11% of all restatements, ranking fifth among reasons, though such errors have declined over time due to improved oversight (e.g., PCAOB inspections).
Key Risks of Material Misstatement
Key Risks of Material Misstatement
The text identifies several specific risks within the acquisition and expenditure cycle:
Unrecorded Liabilities:
Unrecorded Liabilities:
Cause: In many accounting systems, liabilities are recorded only after a "three-way match" of purchase orders, receiving reports, and vendor invoices. Delays or failures in matching can result in unrecorded liabilities, understating costs and overstating profits.
Example: Goods received but not yet invoiced may be omitted if the process stalls.
Assertion Impact: Primarily affects completeness, as liabilities may not be recorded.
Improper Cutoff:
Improper Cutoff:
Cause: Management may intentionally delay recording expenses and liabilities until after the fiscal year-end to enhance financial statement appearance.
Example: Closing records early (e.g., December 22 for a December 31 year-end) shifts expenses to the next period.
Assertion Impact: Affects cutoff, as expenses and liabilities are recorded in the wrong period.
Noncancelable Purchase Agreements:
Noncancelable Purchase Agreements:
Cause: Long-term purchase commitments (e.g., blanket purchase orders) may not reflect current market values, requiring immediate loss recognition if goods’ value declines permanently before delivery.
Example: A company commits to buy aluminum at 40 cents per pound, but the market price drops to 32 cents, necessitating a loss for the excess commitment.
Assertion Impact: Affects valuation, as losses must be recognized, and completeness, if not recorded.
Fraudulent Activities:
Fraudulent Activities:
Cause: Employees or management may perpetrate fraud, such as submitting fictitious invoices or misclassifying expenses, to misstate financial results or for personal gain.
Example: WorldCom capitalized ordinary expenses, inflating assets and income by billions, while smaller frauds (e.g., $100,000) can be critical for smaller firms.
Assertion Impact: Impacts existence (fictitious liabilities), classification (misallocated expenses), and valuation (incorrect amounts).
WCGW Analysis
WCGW Analysis
The document uses the WCGW approach to assess RMM across five primary concerns, summarized in Exhibit 8.4 on Page 10 (330):
Completeness: A key focus due to unrecorded liabilities or expenses, often linked to delays in the three-way match or intentional omission.
Cutoff: Risk increases with manipulation to defer costs, affecting period-end accuracy.
Existence/Occurrence: Fictitious liabilities or expenses (e.g., personal expenses via accounts payable) pose risks.
Valuation/Accuracy: Incorrect amounts from errors or fraud (e.g., inflated invoices) can misstate accounts.
Classification: Misstating expense types (e.g., capitalizing operating costs) distorts financial statements.
Additional Insights
Additional Insights
Historical Context: The text notes high-profile cases like WorldCom ($11 billion restatement) and Kraft Heinz ($208 million restatement) to illustrate the scale of potential misstatements, emphasizing that even smaller frauds can be material for smaller entities.
Planning Implications: Auditors must identify misstatement sources during planning, focusing on where controls fail (e.g., lack of external verification) or where incentives exist to manipulate results (e.g., management bias).
Trends: While expense recognition errors have decreased (236 in 2007 to 42 in 2020), they remain a significant audit concern, necessitating robust procedures.
Key Takeaways
Key Takeaways
The acquisition and expenditure cycle’s RMM stems from unrecorded liabilities, cutoff manipulation, valuation issues in purchase commitments, and fraud, impacting multiple assertions.
Completeness and cutoff are particularly critical due to systemic and intentional risks, while existence, valuation, and classification are vulnerable to fraud.
Auditors use the WCGW framework to pinpoint risks, tailoring procedures to detect both errors and intentional misstatements, as supported by examples and data.
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