Auditing purchases, payables, inventory and payroll

Lesson 9 followed the money in: revenue, receivables and cash. This lesson follows it out: purchases of goods and services, the payables they create, the inventory they become, and the payroll that pays the people who make and sell it. The risks change direction. For revenue and assets, overstatement is the main worry; for expenses and liabilities, it is understatement, because management that wants to look profitable has every reason to leave costs out. Inventory sits in between, with existence and valuation risks of its own. For Fairhaven, inventory is the largest current asset, its valuation is a significant risk, and its count on December 31 is one of the most important days of the audit.

The purchases and payables cycle

The purchases cycle runs from a requisition through a purchase order, receipt of goods, a vendor invoice, approval for payment, and the disbursement. Key controls include approval of purchase orders within authority limits, a three-way match of purchase order, receiving report and invoice before payment, control over the vendor master file (especially changes to vendor bank details, a favorite target of payment fraud), segregation of purchasing, receiving, recording and payment, and monthly reconciliation of vendor statements to the payables ledger.

Searching for unrecorded liabilities

Because the main risk for payables is understatement, sampling the recorded payables balance gives little comfort: a liability that was never recorded cannot be selected from the list. Instead, the auditor looks outside the recorded balance. The search for unrecorded liabilities examines payments made after year end, and unpaid invoices received after year end, to see whether any relate to goods or services received before year end. The auditor also reviews receiving reports near year end, reconciles statements from major vendors to the ledger, reads board minutes and contracts for commitments, and asks management about accruals.

# Search for unrecorded liabilities: payments in January and February 2027 (thousands of dollars)
payments = [  # vendor, amount, date paid, date goods or services received, recorded in 2026 payables?
    ("Pacific Freight", 142, "2027-01-08", "2026-12-20", True),
    ("Summit Textiles", 318, "2027-01-15", "2026-12-28", False),
    ("Kelvin Utilities", 41, "2027-01-20", "2026-12-31", False),
    ("Northern Sign Co.", 22, "2027-01-22", "2027-01-10", False),
    ("Bramble Shaw LLP", 120, "2027-02-10", "2027-01-31", False),
    ("Orca Packaging", 64, "2027-02-03", "2026-12-15", True),
]
unrecorded = 0
for v, amt, paid, received, booked in payments:
    belongs = received <= "2026-12-31"
    if belongs and not booked:
        unrecorded += amt
        note = "UNRECORDED 2026 liability"
    elif belongs:
        note = "properly accrued"
    else:
        note = "2027 expense"
    print(f"{v:<20}{amt:>6}  received {received}: {note}")
print(f"Total unrecorded liabilities found: {unrecorded}")

Pacific Freight        142  received 2026-12-20: properly accrued
Summit Textiles        318  received 2026-12-28: UNRECORDED 2026 liability
Kelvin Utilities        41  received 2026-12-31: UNRECORDED 2026 liability
Northern Sign Co.       22  received 2027-01-10: 2027 expense
Bramble Shaw LLP       120  received 2027-01-31: 2027 expense
Orca Packaging          64  received 2026-12-15: properly accrued
Total unrecorded liabilities found: 359

Two of the January payments relate to goods and services received in December but not recorded: a shipment of fabric from Summit Textiles and the December utilities bill, totaling 359 thousand. Both are misstatements for the summary of misstatements, and the auditor asks why the receiving clerk's report on December 28 did not trigger an accrual. The new warehouse system may be part of the answer, which links back to the IT risk identified in planning.

Inventory: existence and the physical count

When inventory is material, the auditor must attend the physical inventory count, unless impracticable, to observe the client's procedures, inspect the inventory and perform test counts. This is the main evidence of existence. Before the count, the auditor reviews the client's count instructions: whether count areas are clearly defined, whether teams of two count and recount, whether count tags are prenumbered and controlled, whether movements of goods are stopped or controlled during the count, and whether damaged or obsolete items are identified.

AS 2510 for issuers and AU-C 501 for non-issuers require the auditor to observe the physical count when inventory is material, and to test the final inventory records.

During the count, the auditor makes test counts in two directions: from the floor to the count sheets (completeness) and from the count sheets to the floor (existence). The auditor records a sample of count tag numbers and quantities to trace into the final inventory listing later, and obtains cut-off information: the last receiving report and the last shipping document before the count. Goods in transit, consigned goods held for others and goods held at third-party warehouses need separate procedures, such as confirmations with the warehouse operator.

Because Fairhaven replaced its warehouse system in July, the auditor also tests the system's perpetual records. Before the year-end count, the team compares a sample of system quantities with floor counts at a mid-year roll-forward point and evaluates the data conversion. If the count reveals large differences between perpetual records and floor quantities, management must investigate and adjust, and the auditor considers whether controls over inventory movements are ineffective.

Inventory: valuation

Inventory is measured at the lower of cost and net realizable value. The auditor tests cost by examining supplier invoices for a sample of purchased items, testing the allocation of freight, duties and overheads, and checking the cost formula (first-in, first-out or weighted average). It tests net realizable value by comparing cost with estimated selling prices less costs to sell, using sales after year end where possible, because actual selling prices in January and February are strong evidence of what inventory on hand at December 31 was worth.

# Net realizable value test on slow-moving inventory styles (thousands of dollars)
styles = [  # style, units on hand, unit cost, average selling price Jan-Feb 2027, selling cost per unit
    ("Ridgeline 2-person tent", 4_200, 0.118, 0.199, 0.020),
    ("Alpine shell jacket (2024 season)", 9_800, 0.074, 0.069, 0.012),
    ("Trail runner shoe v3", 6_500, 0.052, 0.041, 0.009),
    ("Down vest (discontinued)", 3_100, 0.061, 0.038, 0.008),
    ("Camp stove", 2_900, 0.044, 0.079, 0.006),
]
total_writedown = 0
print(f"{'Style':<38}{'Cost':>8}{'NRV':>8}{'Write-down':>12}")
for name, units, cost, price, sell in styles:
    nrv_unit = price - sell
    c, n = units * cost, units * max(nrv_unit, 0)
    wd = max(c - n, 0)
    total_writedown += wd
    print(f"{name:<38}{c:>8.0f}{n:>8.0f}{wd:>12.0f}")
recorded = 260
print(f"Auditor's estimate of required write-down: {total_writedown:.0f}")
print(f"Write-down recorded by management: {recorded}")
print(f"Possible overstatement of inventory: {total_writedown - recorded:.0f}")

Style                                     Cost     NRV  Write-down
Ridgeline 2-person tent                    496     752           0
Alpine shell jacket (2024 season)          725     559         167
Trail runner shoe v3                       338     208         130
Down vest (discontinued)                   189      93          96
Camp stove                                 128     212           0
Auditor's estimate of required write-down: 393
Write-down recorded by management: 260
Possible overstatement of inventory: 133

Three of the slow-moving styles are selling below cost after year end. The auditor's estimate of the required write-down is about 0.39 million against the 0.26 million management recorded, a difference of about 0.13 million. The difference is a judgmental misstatement. Because inventory valuation is a significant risk, the auditor also evaluates management's process: how it identifies slow-moving styles, whether its assumptions about markdowns are consistent with experience, and whether the write-down was reduced from the prior year in a way that suggests bias toward the bonus target.

Payroll

Payroll is usually a large expense and a low-risk area for misstatement, because it is routine, well controlled and easy to predict. The main risks are fictitious ("ghost") employees, unauthorized changes to pay rates, and incorrect accruals for wages, vacation, bonuses and payroll taxes at year end. Controls include segregation of human resources (which hires and sets pay rates) from payroll processing and payment, approval of time records by supervisors, and review of payroll registers and reports of master file changes.

Because payroll is predictable, substantive analytics often provide much of the evidence, as lesson 7 showed: Fairhaven's payroll was within about 0.1 million of the expectation built from headcount and the wage increase. The auditor adds tests of details for the year-end accruals: the bonus accrual against the bonus plan and the board's approval, vacation pay against policy and records, and payroll tax remittances. Data analytics can test the whole employee master file for duplicate bank accounts, employees without tax numbers, employees paid after their termination date, or employees with the same address as a payroll clerk.

Fairhaven outsources payroll processing to a service organization. Bramble Shaw uses the service auditor's SOC 1 Type 2 report under SSAE 18 (AT-C 320), which covers the design and operating effectiveness of controls at the service organization over a period, and tests the complementary user entity controls at Fairhaven, such as review of the payroll register.

Property, plant and equipment and other balances

The remaining balances are covered more briefly. For property, plant and equipment, the auditor focuses on additions and disposals during the year, because the opening balance was audited last year. It vouches significant additions to invoices and contracts, checks whether repairs were wrongly capitalized (or, in a company trying to look profitable, whether capital items were properly capitalized), recalculates depreciation analytically, and considers impairment indicators, such as underperforming stores. For debt, the auditor confirms balances and terms with lenders, reads loan agreements for covenants, and recalculates interest. For equity, it confirms share capital with the transfer agent and examines board approval of dividends and share issues. For leases, it tests the completeness of the lease population, because unrecorded store leases understate both right-of-use assets and liabilities.

Fairhaven's bank loan includes a covenant that debt must not exceed 0.75 times equity. On the draft figures, debt to equity is 46,000 / 64,400, or about 0.71. The misstatements found so far in this lesson and lesson 9 would reduce equity (through lower profit), so the auditor tracks how close the corrected ratio comes to the covenant. A breach could make the debt repayable on demand, require reclassification as current, and raise going concern questions, as lesson 11 discusses.