Risk of material misstatement for accounts receivable

Meaning of Accounts receivables

Accounts receivables generally mean Trade receivables in the financial statement of large listed public companies. Accounts receivables are disclosed under the headings “Current Assets”. These are trade or non-Trade receivables that have been specified by the company or regulations and meet the criteria of being classified separately. Accounts receivables are characterized as common and significant.

Example:

The company is running an account of Accounts receivables. The company has made sales to the tune of $ 1000 to Kuman Inc. This transaction sales made on account will be recorded under Accounts receivables. Similarly, the fixed asset if sold on account, would also come under accounts receivable. However, the sales transactions on account are general and fixed assets disposal are rarely made.

Risk of material misstatement for accounts receivable

The risk for accounts receivable would be internal control risk and inherent risk. The risk of being susceptible to misstatement due to the nature of the debt is the inherent risk of the accounts receivable. Control risk occurs when the internal control system of the client fails to prevent or detect material misstatement in the accounts receivable. Some of the risks associated are unauthorized transactions, wrong recording, and non-compliance with accounting standards on assets and accounts receivables.

An unauthorized transaction is a case where someone other than a person authorized and responsible for accounts receivable deals with the related matters either within the entity or with outsiders. Such risks generally create the risk of fraud which is itself material misstatement. The audit client shall correctly record debtors as per applicable accounting standards.

The proper classification of debtors shall be done. Further, the breach of Sales terms and conditions may lead to material misstatements. Hence, the auditor needs to clearly understand the sales arrangements and check if they are complied with within time and in full.

Inherent Risk for Accounts Receivable

The inherent risk in the case of accounts receivable is high. Auditors need to perform a test of control as well for accounts receivable to get a clearer picture of the inherent risk of accounts receivables. The inherent risk for accounts receivable would relate to nature, size, and the complexity of the business of the auditee.

If the business is more inclined towards financial or special situations like hire purchase business, the inherent risks would be higher in such a scenario. The susceptibility of accounts receivable to misstatement is basically an inherent risk. Some of the scenarios that are inherent risks and procedures to be followed for accounts receivables are as follows:

  1. The non-existence of accounts receivables. For instance, fictitious invoices are generated to increase sales, and receivables are recorded on the current year when they are actually made after the year-end
  2. Accounts receivables do not reflect true economic value. This generally happens during the creation of allowance for doubtful accounts based on probabilities and aging analysis.
  3. The auditee has no control over receivables. This scenario happens when the accounts receivables notes are pledged as collateral for loans from banks are given to financial institutions on factoring arrangements.
  4. Accounts receivables are based on contingent events. This happens if the company does not follow the guidelines issued by their accounting bodies such as IFRS and GAAP or regulatory authorities.
  5. Aging analysis is not correct and does not signify the true picture of the certainty of receivables.

Control Risks for accounts receivables

The risk that internal control cannot prevent or detect material misstatement in financial statements is called control risk. Control risk for accounts receivable is related to control procedures of accounts receivable which is not able to prevent or detect a misstatement that can occur in accounts receivable. In case the inherent risk is high, the auditors carefully assess the internal control procedures in such a case. In such cases, control risks are minimized due to initial work is done.

Auditors would however need to perform tests of controls to obtain assurance of sufficient appropriate audit evidence to support their assessment if they assess that control risk is low. Further, if auditors think otherwise that control risk is high, tests of controls need not be performed.

Auditors would directly perform substantive audit procedures taking on bigger samples. Some of the scenarios that are control risks and procedures to be followed  for accounts receivables are as follows:

  1. Accounts receivable should be recorded alongside sufficient supporting documents. Supporting documents include customer purchase order, letter of lading, and sale invoice to ensure the existence of accounts receivables
  2. Reconciliation of accounts receivables by tracing supporting documents and invoices with beginning and closing balances.
  3. Ensuring that documents purchase order, bill of lading, and sales invoice are serially or prenumbered. This is useful to avoid omission.
  4. Computation of allowance for doubtful accounts is made properly.

What is the risk of material misstatement?

Meaning of Risk of Material Misstatement

The risk of material misstatement is the susceptibility of the financial statements, accounts, and assertions to material misstatement, and the risk that the client’s current internal controls would be ineffective in proactively identifying and correcting the misstatements. The inherent risk and control risk in the obligations form the risk of material misstatement. The risk of being susceptible to misstatement due to the nature of the debt is the inherent risk. Control risk occurs when the internal control system of the auditee fails to prevent or detect a material misstatement.

To name some risks, unauthorized transactions, wrong recording of debt, and non-confirmation with accounting standards are material misstatements. An unauthorized transaction is a case where someone other than a person authorized and responsible for transaction-related affairs deals with either within an entity or with outsiders.

Such risks generally create the risk of fraud which is itself material misstatement. The audit client shall correctly record transactions as per applicable accounting standards. The proper classification shall be done. Further, the breach of policies and covenants would also lead to material misstatements.

This risk is assessed by auditors at the following two levels:

  1. At the assertion level: This is further divided into inherent risk and control risk. Inherent means the transaction already would be vulnerable to threats.
  2. At the financial statement level: This would mean risk on the company as a whole. The risk of going concerned about being impacted and not disclosed may fall under this.

Risk of Material Misstatement at the financial statement level

Such risks mean that that certain risks can affect financial statements as a whole and potentially have a major impact on several assertions. Various factors affecting the risk of material misstatement include incompetent management, Inadequate accounting systems and records, Operation in a rapidly changing industry, and poor governance by the board of managers.

The following are some of the pervasive risks at financial statement level:

  • Absence of financial reporting expertise
  • Absence of segregation of duties and safeguarding assets
  • The decision to terminate or curtail the plan
  • Absence of oversight and monitoring of plan operations and service providers
  • Absence of communication about plan events between the preparer of the financial statements
  • Changes in key personnel
  • Plan transfers (plan mergers, spin-offs, or other transfers)

Risk of material misstatement at the assertion level

The various risks related to assertion level include the following:

CompletenessThe financial transaction has been incurred and recorded up to date of reporting
Cut-offBusiness transactions have been differentiated as per the accrual system and recorded in the proper accounting period.
AccuracyEvents are recorded accurately for the amount
OccurrenceThe expenses, assets and liabilities have been actually incurred and related to the business.
ClassificationThe assets, liabilities, expenses, and income have been properly classified into their various sub-divisions. Assets need to be divided into current and non-current assets.
ExistenceOn the date of balance sheet, all the assets and obligations of the company have been reported.
ValuationThe balances of the assets and liabilities accounts correctly reflect the actual economic value.
Rights and obligationThe company owes sum of money on the date of reporting of balance sheet.
Presentation and disclosureThe applicable accounting standards are being followed to disclose all the transactions.

Let’s take a short example of how risks can be materially misstated in the case of accounts receivable. The risk for accounts receivable would be internal control risk and inherent risk. The risk of being susceptible to misstatement due to the nature of the debt is the inherent risk of the accounts receivable.

Control risk occurs when the internal control system of the client fails to prevent or detect material misstatement in the accounts receivable. Some of the risks associated are unauthorized transactions, wrong recording, and non-compliance with accounting standards on assets and accounts receivables.

An unauthorized transaction is a case where someone other than a person authorized and responsible for accounts receivable deals with the related matters either within the entity or with the outsiders. Such risks generally create the risk of fraud which is itself material misstatement. The audit client shall correctly record debtors as per applicable accounting standards. The proper classification of debtors shall be done. Further, the breach of Sales terms and conditions may lead to material misstatements.

There are two major risks of material misstatement associated with accounts receivables. The first would be the non-existence of accounts receivables. For instance, fictitious invoices are generated to increase sales, and receivables are recorded in the current year when they are actually made after the year-end. Another risk would be that accounts receivables do not reflect true economic value. This generally happens during the creation of allowance for doubtful accounts based on probabilities and aging analysis.

What is a deviation from internal control?

Meaning of internal control

Internal control refers to all of the policies and procedures management uses to achieve the objectives of the organization. Internal controls ensure to provide timely, accurate, and complete information with respect to books of accounting in order to report business operations to users of financial statements. It also helps to ensure that the company complies with all the relevant company guidelines, relevant laws, regulations, and practices. It provides the framework on how the internal activities need to be done to strengthen the control of the organization.

Deviation from internal control

Deviation from internal control occurs when the company differs from the path it designed at the beginning of the accounting period. The client also takes transactions that may be outside the regular nature of operations. Such one-off transactions should be carefully audited especially if a large amount of money is involved. These transactions do not pre-defined guidelines on who to authorize and who shall be responsible. The board minutes should be looked up to know if any sanction for such transaction is made and procedures if any has been devised. This will require separate planning and audit performance.

Internal control helps to minimize risk and achieve the goals of the entity. It segregates the tasks into various responsibilities and affixes these tasks with authorization procedures. Hence, the designing of internal control would need special attention. The deviation from internal control includes the following:

  1. business transaction that occurred that was not expected to occur
  2. business transaction that was expected to happen did not happen
  3. a control exists but did not operated effectively. It means internal control has not prevented or detected or made the necessary correction
  4. absence of internal controls

Let’s take an elaborate example of deviation from internal control:

Sinra Inc supplies raw materials within the borders of the country. It has not dealt with any transaction beyond borders and does not plan to do so. With the increase in scale and popularity of quality of raw materials of Sinra Inc, a foreign company Kuman Inc held talks with officials of Sinra Inc.

In this scenario, the management of Sinra Inc does not have an established plan or internal control guidelines on how to proceed with transactions. So, they have to prepare new guidelines, report it under board minutes, authorize the personnel to handle the deal, and proceed.

The auditor would also need to look upon this carefully as new transactions previously out of the scope of client business have occurred. The auditor would need to prepare new planning and determine the extent of nature and timing of the transaction. Further details on auditing aspects are shown below.

Impact of deviations to the auditor

In the initial auditing stage, the auditor would require to understand the complications of the business operations of the client. They need to validate the process, understand it, and devise how internal control shall work and the way management has done and found out deficiencies that may happen. The auditor would test the controls to obtain sufficient and appropriate audit evidence to minimize substantive audit procedures as much as possible.

The auditor needs to assess the impact of such transactions on business and the amount of money involved. As the internal control may not be effective, the probability of misstatement impacting financial statements goes high. Auditors need to gather evidence to support his opinion on financial statements. The auditor would also need to test further the likelihood of similar transactions in the future so that when it happens, internal controls are in place and working effectively.

Talking about the above example, the auditor has to scrutinize any instances the company has faced in the past and what actions were taken. The auditor shall also determine the internal controls to be devised based on its professional experience and judgment. The auditor shall start checking major components of the transaction as authorization, recording, safeguards, and verification. The auditor shall study the board minutes to know who is responsible for the business transactions and the supporting documents aiding it.

They also need to know what authority is recording in the books of account and how they are being ratified later on. In case of assets deal related to physical nature, the auditor shall check if the proper safeguards have been employed by the management. The auditor may also need to physically verify the asset in case it is tangible in nature. If any issues exist, the auditor may raise this matter in a management letter to show the internal control weakness and provide proper recommendations.

How to assess materiality in an audit?

Meaning of materiality

There is no specific definition of materiality under U.S. Generally Accepted Accounting Principles (GAAP). However, the gist as per the Conceptual Framework for Financial Reporting under International Financial Reporting Standards states that information is to be considered material if it influences decisions of stakeholders who are depending on the financial information of the reporting entity. Materiality varies on nature or magnitude, or both, of which information relates to.

The materiality in the context of audit shall include:

  1. Misstatements that can influence the decision of users of balance sheet
  2. Professional judgement based on the nature and size of misstatement.

Determining the benchmark for materiality

The benchmark for materiality shall be based primarily on professional judgment. Some auditing bodies have prescribed recommendations for setting up benchmarks related to materiality. Then the general benchmark is basically an amount exceeding 5% of profit before tax from continuing operations for profit-oriented manufacturing business and 1% of total income or expenses in case of a not-for-profit entity. It does stress that higher or lower.

Auditors tend to use various ranges based on their personal experience. However, these ranges are more or less the same in the industry. Auditors base their decisions on the basis of the economic value of transactions.

Specific levels of materiality for individual balances, classes of transactions, or disclosures

Under select cases, balance, class of transaction or disclosure in the financial statements would warrant a lower level of materiality as based on the amount, the users can be persuaded to make a different decision, one that may not be rational or without complete knowledge. The following factors need to be considered in order to assess materiality in audit:

  1. If all the relevant laws affect the expectations of users
  2. Disclosure requirement in certain industries like research and development in pharmaceutical industries
  3. Disclosure requirements in case of business combinations

Example:

The total value of investments in Equity scheme offered by the government is $ 100m and the total contributions receivable from active members is only $ 50,000.

In this case, applying any kind of percentage won’t be useful for such an investment company. Auditors shall determine materiality by setting a lower amount for such member contributions and similar debtors and creditors.

Determining performance materiality

“Performance materiality as the amount set by auditors at below overall materiality to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality.” – Standards on Auditing 320

It serves two basis purposes as to reduce aggregation risk and providing some security against risk of internal control not detecting irregularities. The audit techniques require performance materiality to be as a percentage of overall materiality. The higher would be the level of assessed risk and lower the percentage. Performance materiality is used by auditors in two ways.

 It can be used in the early auditing schedule to identify areas of special focus and how much time needs to be allocated thereon. The other would be to use it midway through the audit where necessary based on the judgment of the auditor. This would include sampling and how many items to include in the sampling. If lower materiality is set for some accounts and balances, auditors would also need to lower performance materiality in such cases.

Assessing materiality of misstatements

The auditor shall assess every misstatement and their impact on relevant classes of transactions, accounts balances or disclosures. This shall also include if materiality level that has been set has been included by such transaction.

The auditors need to assess if misstatements are material according to their size and nature. Auditors need to consider qualitative assessment, balance sheet classifications, disclosure of misstatements, and impact on prior period financial statements while assessing the materiality of misstatements.

Reassessing materiality during the audit

Auditors need to be proactive as well as reactive. They need to set the benchmarks at the beginning and when circumstances arise where it would be necessary to change the benchmark, they need to be reactive as well. Auditors should revise overall materiality during audit if they are aware during the audit procedures that is being carried on.

This may happen when they realize they have set a different benchmark with respect to the amount. This happens if the materiality is determined prior to year-end information. If the auditors realize that lower materiality is set than required in the present scenario, they have to reassess the materiality. Auditors would then revise performance materiality considering the impact on nature, time, and extent of audit procedures.

Auditing Retained Earnings and Dividend

Meaning of retained earnings

The company operates in a business environment and strives to obtain higher and higher profits each year. The net profit is obtained by deducting the expenses from the revenues. These net profits are appropriated to reserves and surplus.

Such profits when transferred to reserves and surplus after paying off the dividend to equity and preference shareholders. Retained earnings are shown under reserves and surplus under the equity side of the balance sheet. It is also reported in the statement of changes in equity of the entity at the end of the reporting period.

Meaning of dividends

Dividend depicts the payment of earnings as a distribution of its earnings. Preference shareholders have coupons attached to them and they are paid dividends firstly before equity shareholders. Common shareholders are paid the dividend and then all the earnings after equity dividends are transferred to retained earnings.

The relation between dividends and retained earnings

Dividends and retained earnings are closely related to each other through net profit as :

ParticularsAmount ($)
Net ProfitXXX
Less: DividendXX
Earnings transferred to retained earningsXXX

The earnings that are retained are transferred to Retained Earnings. The proportion dividend paid to net profit is called dividend payout ration. The proportion of earnings retained to net profit is the retention ratio.

Both dividend and retained earnings form part of the same coin. Hence, these items should be audited in tandem and not separately.

Audit assertions for retained earnings and dividends

The audit workings regarding the retained earnings and dividends would be about the review and analysis of the statement of changes in retained earnings.

These come from two transactions as when net income is transferred from profit and loss statement to the retained earnings after payment of dividend if any. Hence, dividends should be audited as part of the bigger picture that would be auditing the retained earnings. The audit assertions would be completeness, existence and presentation, and disclosure.

AssertionDescription
CompletenessThe transactions that are related to retained earnings such as dividends paid to equity shareholders or preference shareholders and all other prior year adjustment items should be recorded.
ExistenceThe dividends that arise out of deduction of retained earnings shall be approved and declared in the board meetings.
Presentation and disclosureThe appropriate disclosures should be made with respect to restrictions on retained earnings, dividend preference, dividend rate, dividends in arrears in the notes to financial statements.

Risks for retained earnings and dividends

The inherent risk and control risk occur in presentation and disclosure which forms the risk of material misstatement. The risk of being susceptible to misstatement due to the nature of the dividend payout is the inherent risk related to dividends.

Control risk occurs when the internal control system of the client fails to prevent or detect material misstatement in the statement of changes in retained earnings.

To name some risks, unauthorized transactions without approval by board meetings, wrong recording of retained earnings, and non-confirmation with accounting standards and company regulations in case of buybacks and other corporate announcements are some material misstatements.

Unauthorized transaction rarely happens in case of retained earnings. Since retained earnings are reserve which can be manipulated carefully in order to carry out corporate announcements such as dividends and buybacks and rights issue, the auditor needs to carefully check if all the items related to retained earnings are properly approved in board minutes.

Audit procedures for retained earnings and dividends

The audit procedures with respect to audit assertions are explained briefly below:

AssertionsAudit Procedures
CompletenessTaking note of each of the board minutes of the client. Inspecting the supporting documents for declaration of dividend Tracing the dividend declaration to the general ledger. Tracing back all the prior period items with supporting documents with respect to retained earnings. Verifying that dividends are recorded in the current accounting period
ExistenceVerifying all the dividend transactions declared and paid through bank accounts that occur in the accounting period. Vouch for all those dividend transactions to board minutes for the evidence of approval and declaration. Verifying that dividends are recorded in the current accounting period
Presentation and disclosureEnsuring that retained earnings are disclosed under the headings reserves and surplus under liabilities side of the balance sheet. The disclosures with respect to various restrictions placed on retained earnings by the client’s bank, bondholders, or creditors shall be made in the notes as an integral part of the financial statements. Examine the restrictions placed and the nature of the restrictions on retained earnings. The disclosures with respect to dividend rate, preference dividend, and arrears of dividend shall also be made in the financial statements.

Auditing Share Capital

Meaning of share capital

Share capital is the amount invested by a company’s shareholders for use in the business. After the creation of the company, the shareholders bring in the contribution through cash which is shown on the balance sheet on the liability side as an equity account. Share capital is also called shareholders’ capital, equity capital, contributed capital, or paid-in capital.

Share capital is the primary item of interest in the balance sheet. It is further divided into various kinds as common stock and preferred stock. The paid value is represented on the balance sheet.

Audit Assertions for Share capital

If the company shows equity on the balance sheet, it asserts that it exists on the balance sheet date and that related transactions with equity have been made. Take, for example, if equity is issued, then certain cash would be received at the other end. The double entry system of bookkeeping keeps both cash and equity share capital in check over here.

The share capital has certain rights and obligations. Take, for example, common share capital has rights over retained earnings while preferred share capital has a preference to be paid a dividend before the dividend is paid to equity shareholders. Preference shareholders enjoy priority over equity shareholders.

Both these equity share capital and preference share capital are different classifications of share capital, which again is a separate assertion. Further, preference share capital is further divided into contributing, participating, non-participating, non-contributing, and further sub-classifications.

As of the date of reporting, the firm’s management and shareholders are subject to share capital assertions as per applicable auditing and accounting standards. This would include disclosures of the existence, rights, and obligations of the company and maintenance of the records of share capital. The following are major audit assertions related to shares capital.

ExistenceEnsuring that reported capital actually exists on the date of reporting
CompletenessThe nature and types of share capital transactions that have been issued should be recorded.
ValuationShare capital is recorded in line with applicable accounting standards.
Present and disclosureAn appropriate level of information about share capital is disclosed in accordance with applicable accounting standards.

Primary risks of share capital

The risks associated with share capital have decreased with the advent of the digital mechanism of the share issues and other related aspects. Hardly, the big public listed companies have share related issues. However, the risk of error in a presentation in the balance sheet may happen as a result of accounting mistakes.

When equity share capital is overstated, it means that the balance sheet is strong. Hence, primary risks for equity share capital would be misrepresentation in the balance as a result of error and intentional overstatement that does happen in the case of entities other than corporate forms.

Substantive audit procedures for Share capital

These are the extensive audit procedures needed to perform when a large sum of money is involved in the accounts. The number of transactions in share capital is minimal and the amount involved is major in comparison to the balance sheet. Hence, auditors shall apply substantive procedures as:

AssertionsSubstantive audit procedures
ExistenceVerification with a certificate of incorporation, articles of association, and Memorandum of association. Matching the balances with SEC/relevant authority filings.
CompletenessVerification of authorized and issued share capital with supporting documents like bylaws, AOA, and others.Reconciliation of share capital balances with SEC and other filings and general ledger prepared by the company.
ValuationMatching those share capital transactions has occurred in line with board meetings. Reconciliation of share capital receipts with escrow account along with paid-up capital portion, treasury portion, and amount of refunds share capital has been issued in lieu of fixed asset or for some other arrangement, ensuring that exchanged assets are properly valued and take professional experts to help if necessary.
Presentation and disclosureEnsuring the following items are disclosed in the financial statements as Classes of share capital rights related to each class of share capital authorized share capital and issued share capital. Share capital with conversion rights or options adjustment required in comprehensive income.

In a nutshell, substantive audit procedures for share capital would include summarizing and reviewing all the equity-related transactions, their proper classifications, reconciliation of the opening balances to the balance as on the reporting date and further reviewing disclosure for compliance in accordance with the applicable financial framework.