Meaning of expenses
Expenses depict a decrease in economic benefits for the accounting period. Expenses are in the form of outflows of assets or payments of operating liabilities which results in a decrease in equity. This is other than those relating to distributions to equity shareholders.
Expenses are reduced from the revenues in order to arrive at the net profit for the accounting period. Expenses include utilities, office supplies, transportation, professional fees, consulting fees, and insurance.
In financial statements, expenses are sometimes called general and administrative expenses or operating expenses. They are recorded only in the income statement (or called statement of comprehensive income) in the expenses section. They are not shown in other statements like balance sheets (or called statement of financial position), statement of change in equity, or statement of cash flow.
Here, we will discuss the overall audit procedures for expenses that are normally performed by auditors, key audit assertions used by management to record the expenses, and tests by the auditor.
Audit Assertions for Expenses
Audit of expenses can be done by testing various audit assertions of completeness, accuracy, occurrence, and cut-off. Audit procedures are relevant to gathering appropriate audit evidence in order to make a conclusion with regard to expenses.
The understatement of expenses will make look financial statements better than it is. Therefore, the auditors shall primarily look at such cases of an understatement. In the case of auditing expenses, the most important aspect is the completeness of records in the income statement.
The lack of strong internal controls will lead to an understatement of expenses. This usually happens due to fraud committed by the internal staff. Near the end of the reporting date, the management may try to delay incurring expenses in order to avoid getting the expenses being reported. Hence, they might do this by recording in the next accounting period and avoiding the current. This is simply understating the profits and needs to be checked by the auditors.
Here are the key audit assertions to test the assertions:
|Completeness||The expenses that have been incurred are complete records and timely recorded up to date of reporting|
|Cut-off||The expenses have been differentiated as per the accrual system and recorded in the proper accounting period.|
|Accuracy||The expenses are recorded accurately for the amount|
|Occurrence||The expenses have been actually incurred and related to the business.|
|Classification||The expenses have been properly classified as factory, administration, and selling expenses if necessary.|
Risk of Material Misstatement for Expenses
The primary risk of material misstatement is the risk that internal control may not able to detect or prevent the issues related to procedures that are inherent. It is the combination of both inherent risk and control risk.
The risk of being susceptible to misstatement due to the nature of the debt is the inherent risk of the debt. Control risk occurs when the internal control system of the auditee fails to prevent or detect material misstatement in the debt.
The primary inherent risk would be the understatement of expenses. This would lead to over-reporting the profits in the current accounting period. This happens when incentives are linked to profit or as a result of intense pressure from within the company.
Take, for instance, branch managers are given a 5% incentive bonus as a percentage of profit if a certain business is achieved. In this case, the branch manager would try to overstate profit by underreporting the profits due to the inherent structure of the incentive.
The varieties of inherent risks that may occur in the audit of expenses are as follows:
- The expenses have been accrued, not recorded and not yet paid.
- The expenses are recorded as asset to understate the expenses and overstate the asset. Take for an instance, installation of newly purchased machinery.
- The general repairs and maintenance expenses are added to the cost of fixed assets.
- Changing the accounting period to close books early. This has although happened very rarely.
- Breaking down the large expenses into smaller ones to avoid checks and cut-off procedures employed by the auditors.
The varieties of control risks that may occur in the audit of expenses are as follows:
- Dividing duties among various staffs to make purchases, receive goods and proper accounting in the system.
- Proper authorization on all expenses and payment
- Matching the purchase invoice with amount of goods received along with transportation invoice.
Take for example, in case no authorization control is employed, the risk that expenses have been incurred for fictitious or personal purposes increases.
Substantive Audit Procedures for Expenses
In the case of expenses, substantive audit procedures would include substantive analytical procedures and tests of details. Analytical procedures mean gathering the audit evidence with respect to audit assertions. The accounting trends, financial ratios, and relationships among data are analyzed in such a procedure. Following are some substantive audit procedures to be followed while auditing expenses:
- Obtain all the supporting documents such as invoices, voucher slips, etc for the expense being incurred
- Perform further audit procedures when expenses reach the amount above the budget threshold significantly (by more than 10%)
- Check whether proper authorization has been done with regard to expenses.
- Verify that vendors exist through third party confirmation and making surprise visits when goods are received and auditing goods received a note with the physical purchase being received.
- Ensure that proper classification has been made for expenses with respect to revenue expenditure and capital expenditure.
- Verify the related party expenses and ensure they are being reported with notes to financial statements where necessary.