Introduction to Audit procedures
Audit procedures are the primary part of the audit engagement for auditors to test the accuracy and legality of balances and transactions. Audit procedures guide the auditor to test those balances and transactions in distinct ways.
Audit procedures are exclusive for every diverse client and are based on the risks associated with the client and the accounting heads in their financial statements.
Audit procedures identify any misstatements that occur due to fraud or error. However, various procedures are applied to accomplish the desired purposes of the audit.
What are accounts receivables?
There are two types of accounts that an organization maintain in their books of accounts. A transaction assertion is a temporary account that is not transferred to next year but is closed in the current financial year such as sales, cost of sales, and expenses, etc. The others are balances accounts that are carried forward to next year by updating the balances.
Account receivables are an asset balance account in which the amounts owed by the customers are refurbished. Once supplies or services are rendered to customers, the company renews its general ledger for the invoiced amount.
Accounts receivables general ledger is updated with every non-cash transaction between the company and the customer. This means that supplies or services are rendered to the customer but are not yet paid or partially paid.
These amounts when accumulated at the year-end, give a large particular amount that is imported into the financial statements of the company.
Accounts receivables is an asset account, the balances of which will be received in the forthcoming periods from the customers. Some amounts in this total are expensed out when the company perceives that they are no longer collectable.
Accounts receivable are recorded in the current assets section of the total assets head of the balance sheet. Account receivables have a debit nature and increase the potential inflows of the organization.
Applying audit procedures on Accounts receivables:
Audit procedures are applied to the accounts receivables balances to test their assertions. Testing these assertions include verifying its existence, rights, and obligations, completeness, accuracy, classification, and presentation.
These assertions may be materially misstated due to fraud or error. It is the responsibility of the auditor to perform unique audit procedures for every assertion and reveal any misstatement if present.
However, the extent of applying audit procedures depends on the control systems implemented in the accounts receivables division and how efficiently are those controls practised to bring about the results.
Inherent risks in the accounts receivables balances:
There are some built-in risks the accounts receivables balances.
These risks may result in misstatements due to fraud or error. There may be
certain circumstances in which the accounts receivables officers may skip some
balances or insert wrong postings.
These risks are more probable when there is no connection between corresponding departments involved in the accounts receivables.
In some instances, the management may intentionally increase the accounts receivables figures to give a positive signal to stakeholders, for example by reporting next or previous year’s sales in the current year.
One important and primary risk involved in the accounts receivables balances is that the organization has not expensed out the amounts of the bad debts in the receivables balances, which they acknowledge cannot be recovered anymore.
Bad debts occur when the customers do not pay according to the terms agreed with them by the supplier. These balances should, therefore, be expensed out.
Bad debts curtail the profits made by the organization in the current year and because they will contemplate to not expense them out.
Assertions tested by audit procedures:
Testing assertions are the fundamental part of the audit that is
tested by the auditor. Every assertion has its own risk of material misstatement
involved in it. Risks present in these assertions and how they can be distilled
by the auditor are explained below:
The audit of existence in accounts receivables means to verify
the actual existence of these balances. The auditor will analyze the breakup of
accounts receivables by customer’s listings and confirming them by sending
direct confirmations to customers.
Rights and obligations:
There is not a big reason to worry about the rights of the accounts receivables of the company. However, in some major companies, the accounts receivables are transferred to a factor to collect them on behalf of the company for a discount.
This, therefore, transfers the rights to the factoring company, which will be inspected by the auditor.
It is possible that the company for the sake of reducing tax liability, intentionally missed out some receivables balances for the sales made. This compromises the completeness assertion.
The auditor can confirm these balances by sending blank confirmations to customers along with testing the cash receipts after the year-end which may relate to the sales made in the current year.
Accuracy is a simple assertion in which the auditor performs the
recalculation procedures to test the accuracy of the accounts receivables.
Misstatements may occur because of human errors by skipping or summing up extra
Presentation means disclosing the major issues in the accounts
receivables such as a large balance in the accounts receivables has gone
uncollectable which the company needs to expense out. The auditor needs to
check the extent of disclosures made in notes to the financial statements.
Unique audit procedures for testing accounts receivables:
- Matching opening balances of accounts receivables to last year’s closing balances.
- Applying analytical procedures to find any unusual differences and reasons behind them.
- Obtaining receivables ageing report from the client and matching the figures to accounts receivables general ledger.
- Recalculating the figures of accounts receivables general ledger to confirm the accuracy.
- Verification of invoices against the supporting documentation to verify that correct postings are carried out in the general ledger.
- Verifying the sales period by inspecting the shipment documents of those sales.
- Verifying completeness and existence by sending direct confirmations to debtors.
- Reviewing the company’s policy for allowance for doubtful debts and applying it to the receivables balances.
- Comparing general ledger balances to actual receivables listings and checking their accuracy.
- Analyze that the necessary disclosures for bad debts and other significant events are correctly presented in the notes to the financial statements.
- Applying cut off procedures to verify that amounts recorded in the current year do not relate to other periods.
What is Auditing?
Auditing refers to the examination and assessment of accounting records and other related statements by an independence examination auditor. This financial certainty would assist the stakeholders to know clearly about the assertion of financial statements that they are using.
Auditing will be carried out in both the public and corporate sectors. It acknowledges all the possible parts of evidence that formulates and evaluates the opinion on the basis of communication which is carried out.
There are many steps in the audit processes and many procedures are carrying out by auditors in order to assess the assertions.
Advantages of audit procedures:
Auditing is one of the best practice which ensures public companies growth and development. Auditing is known to be the place of strict substantive testing. It is expected to adhere to certain rules, and procedures.
It list out the maximum of every costs so that business people can achieve prior intimation about the audit. Below are some of the merits or advantages of an audit procedure or benefits of audit procedures.
- The main advantage of audit procedures is that they could be applied at every single stage of the audit to explore the absolute amounts which need to be reflected in the financial statements, as well as into the relationships existing between those amounts.
- These audit procedures are a very good test for the general reasonableness of any amount. They could be used on a universal basis, and they could also be broken down into their singular and individual elements.
- Audit procedures assist the auditor to carry out trustworthy comparisons on a day to day basis, taking into consideration of financial reports from other years, and giving the auditors a better and proper understanding of individual financial accounts area and the business as a whole.
- This contained reduced information which is associated with the company’s financial statements which have lower returns and interest rates on their investments. Most times this procedure provides facilitated claims and settlements related to a partner. By carrying out the auditing procedures, errors and frauds can be quickly rectified and taken care of.
- Audit procedures that have been conducted have to be within those claimed accounts department. In the case of a loss or losses, the property which will maintain a fund can be transferred. In a scenario where the public has separated ownership plan then these claims have to be settled from those insurance claims, using a good audit procedure.
Disadvantages of audit procedure:
- Since audit procedures normally have to be carried out on incomplete accounts or draft prior to when the final financial statements or records had been prepared, significant and relevant adjustments, which are normally made at a later stage, are usually not taken into consideration.
- Without a proper and good knowledge of the business or organization, the auditor might be tempted and may accept the results of an audit procedures which show no or little unusual variations, which might not have been the case if there have been relevant changes in the organization or company of which the auditor does not have any knowledge about and which the management may attempt to conceal from these auditors.
Audit procedure is one of the most importance thing that auditors need to make sure that they are well and correctly prepare and tailor to minimize audit works and risks. Revenues are one of the sensitive areas that auditors need to place their great attention on.
This is because it is mater so much on the users of financial statements. Revenues are also the sensitive areas where the risks of manipulation, risks or errors are likely to happen on most of entity.
Before we talk about the audit procedure for testing revenues, it is benefit to start from understanding the nature of revenues in the financial statements, the key internal control over financial reporting, financial assertion, and common risks that usually happen to the revenues.
Understanding Internal Control:
Having obtained an understanding about how entity set up internal control over revenues is very importance for auditors to tailor the practical audit procedures to address all possible risks that might happen. The key internal control that auditors should look into are mainly related to prices authorization, goods or services delivery process, revenues recording process, billing and correction process.
These processes are mater for management to address the financial statements assertion related to revenues.
Financial Assertion Related to Revenues:
The following are the key financial statements assertion related to revenues:
- Completeness: This assertion concern the completeness of recording in the financial statements. The incomplete record of revenues might be happen because of many difference reasons including entity’s process and procedure could not capture all the revenues, errors and sometime fraud.
- Cut off: cut off assertion concerning that revenues are recording in the different period that they are belonging to. This could cause the understated and overstate of revenues that being show in the income statement.
- Occurrence: Auditor should consider assess the whether the revenues recorded in the period were really occurred. There is a risks that revenues recorded might not occurred.
- Right and Obligation: Right and obligation is very importance and it is concerning about entity right and obligation over the goods that sold to customers. This is link to the risks and reward then auditors performing cut off testing.
Common Risks Related to Revenues:
- Factitious sales amount at end of or during the year that recording in the financial statements to reach to certain amount that could let top management to get certain reward like bonus or incentive.
- Factitious of sales amount might also committed by sales team or sales manager to get bonus as well inventive like top management.
- Goods or services that sold are not collectable. These might be the poor customer’s creditability assessment that perform by sales managers or the poor internal control over sales process.
- Fraud over cash collection from selling of goods or services.
- Review the sales occurrence: This is performing by obtaining the sales transactions that recorded in the financial statements during the period as well as sales report that link to the financial statements. Then perform an audit sampling to total population of those sales transactions to review against quotation, sales orders, invoices, contracts and goods delivery noted. Ensure that the sampling items are represent the total population, otherwise the conclusion might go wrong.
- Perform Sales Revenues Analysis could help auditor to identify the unusual event or transactions related to sales. For example, comparing the sales trend again the goods of goods sold or inventories. This analysis could help auditors to perform additional review if they found that the trend go in different direction. There are many different method to perform an analysis over the revenues that auditors could use such as seasonal sales revenues, trend analysis of revenues compare with related non-financial data.
- Review the sales price authorization. The fraud over this area is likely to happen. Of cause management is the one who handle to manage and make sure that fraud risk is protected and minimize. But, auditor should also review the control over this area. Focus on unauthorized sales, and unauthorized sales commission that link to performance inventive of sales team and sales manager.
- Review the collectability: Sales increase is good but collectability of those sales amount is importance. Account receivable analysis should be performed, and credit policy should be review. Review the written off amount of account receivable during the year and then assess its reasonableness.
- Review the sales recognition whether the recognition of sales during the period are respecting the IAS 18 or not. It is importance to assess that the future economic related to sales will be inflow into the company and the sales amount is measurable.
- Review the completeness of revenues recording in the financial statements. Revenues might be understated if they are under recording.
Depreciation expenses are one of the major expenses that reporting in the income statement. Those expenses are the costs that the entity charged to fixed assets used for operation during the periods.
This is because accounting standard allows the entity not to records the expenses that they incurred for purchasing capital assets at the time of purchasing.
But they could allocate those expenses systematically over the period that they are using.
During the audit of financial statements, auditors should make sure that the audit procedures that they prepare are addressing the risks of material misstatements that cause by depreciation expenses and other related items such as fixed assets.
Understanding about depreciation:
Before performing detail testing on the depreciation expenses, auditors should consider reviewing and assessing the control over the fixed assets and depreciation. This will help auditors test the depreciation expenses more efficiently.
The key control that auditors should look into including fixed assets purchasing, fixed assets physical control, depreciation calculation and recording of those expenses into financial statements.
The following are the key procedures that auditor should perform during their testing on depreciation expenses:
- Review Depreciation Rate: Auditors should assess the reasonableness of depreciation that the entity provided to the group or class of assets. The rate should be consistent to the capacity that fixed assets could contribute to the inflow of economic. Audits should also assess the deprecation rate against the rate provided by the tax authority as well as their understanding. Professional skepticism should also be applied during this testing by considering whether the depreciation rate could help management could get the expenses that they want. In some situationss, management may want to larges expenses or else.
- Recalculate the depreciation expenses: This is normally done by auditors to recalculate the depreciation expenses prepared by accountants in their depreciation schedule. Once auditors completed their calculations, then auditors should compare their results to client results. The difference should clearly investigate.
- Review the accumulated depreciation: The auditor should also review the accumulated depreciation that reports in the balance sheet. These amounts are mater to the net book value of fixed assets. If they are not included the expenses incurred during the period correctly, then the net book value of fixed assets will also incorrectly stated.
- Reconcile the depreciation expenses: Depreciation expenses that recording the income statements should be reconciled with the expenses calculated in the depreciation schedule. The auditor should reconcile this, and if they are not reconciled, the explanation should be obtained from management.
- Test the reasonableness: This procedure is linked to the recalculation procedure. For example, auditors perform depreciation expenses recalculation for a few months and then they project the expenses into the whole years based on their own figure. Once auditors did the whole year projection, then auditors could compare their own calculation with accountant figures. This comparison is expected to have different. But, the auditor could set the acceptable threshold.
Tailor the correct audit procedures to the testing of fixed assets is not only helps auditors to minimize the detection risks but also helps the auditor to works more efficiently. That means the auditor could spend less time and effort on reviewing the fixed assets but still get the required result.
The auditor could tailor the right auditor procedure only if the controls related to fixed assets are obtained and the risks are properly assessed.
Now, before we go to the detail on audit procedures of fixed assets, it is good to start with the overview of fixed assets including the relevance standard with deal with, the control, assertion, and the risks that might be happened to fixed assets.
Fixed assets are the long term assets that record in the balance sheet and showing balance at the end of the reporting date. Fixed assets are non-current assets that have a useful life for more than one year.
Fixed assets are not recognized as expenses in the income statement at the time of purchasing but it is recognized as expenses when the entity uses them.
Fixed assets are normally large if we compare to other assets like current assets. And they are generally considered as sensitive areas from the audit perspective.
The auditor in charge of these areas should be the one that has experiences and knowledge enough otherwise the detection or audit risks might be increasing.
Auditors should obtain the key control on how the entity manages and control its fixed assets. The better auditors understand internal control over fixed assets, the better the auditor tailors the procedures and implement the procedures.
There are many key areas that they should consider reviewing. Those including CAPEX budget preparation, and authorization.
The procurement procedures from suppliers finding process into receiving assets as well as making payments. These controls are critical for auditors. If the controls here are not strong, then the quality of financial reporting related to fixed assets is also questionable.
One auditor obtains and updates their understanding of the key internal control, then they should validate the control by testing the key process and control that mater to financial statements. The procedure should be tailor after validation of the control.
Fixed assets are the accounting balance that reports and present in the balance sheet and the assertion used to prepare and report these items are not much different from other balance sheet items. The audit procedures should sufficient enough to address all of these assertions.
- Existence: There are the risks that fixed assets that report in the balance sheet might not exist. To ensure this, the auditor should consider performing the physical observation as well as joining the physical observation.
- Completeness: this assertion concern the completeness of fixed assets that record in the balance sheet, as well as fixed assets listing. If the fixed assets are not completely records, understatement is likely to happen.
- Valuation assertion concern about the net present value of the reported fixed assets. These including the cost that entity include or exclude from the cost of capitalization as well as recoverability of fixed assets compared to its net book value. There are the risks of overstatement of fixed assets for certain assets that significantly affected by technology.
- Cuff off is the income statement assertion, but it is like the balance sheet assertion. For example, if the fixed assets that purchase before and after the reporting date are not correctly cut off then the fixed asset amount that reports in financial statements also not correct.
- Classification: This assertion concerning the classification between fixed assets and current assets as well as the items among the fixed assets. For example, repair and maintenance might be included in the capital expenditure.
- Disclosure: This assertion concern the disclosure of important information that matters to the users of financial statements. Those include the accounting policy, significant purchase, as well as disposal.
Common Risks Related to Fixed Assets:
The audit risks related to fixed assets are vary based on the nature of fixed assets, control that entity has, and auditor limitation. The following are the risks that normally attach to an audit of fixed assets:
- Incorrect Depreciation rate and calculation: Depreciation rate is normally decided by management. In some cases, management might intend to manipulate the depreciation rate to get the depreciation expenses based on what they want. The auditor needs to ensure that the assessment of the depreciation rate is performed. The rate should be based on the expected useful life, as well as the capacity of assets.
- The reported fixed assets are not existing: The assets that report in the financial statements are normally material compare to other assets and the existence of those assets is normally the concern of auditors. To address this, the audit might need to check between book value in the financial statements to fixed assets listing. And then check the listing to the fixed assets count sheet.
- Overstatement of fixed assets: It is important to assess the recoverable amount of fixed assets. For example, the business units of the entity have their revenues down over that last twelve months. This indicates that book values of fixed assets that use in these business units are lower than the reported amount.
- Reconcile the book value of assets to GL and TB: Auditors should have entity’s financial statements, general ledger as well as Trial Balance for the period that they are auditing as well as relevance period. Before working on TB and GL of fixed assets, it is important for the auditor to check whether the GL and TB are linked to fixed assets book value, depreciation, as well as accumulate depreciation, which is tight to financial statements.
- Reconcile book value of assets to fixed assets register or mater file to ensure that the register that uses for the physical count is completed and accurate.
- Review the depreciation schedule: Accountant use depreciation schedule to calculate and control the depreciation expenses as well as accumulated depreciation. Auditor review the reasonableness of depreciation rate, useful life, depreciation calculation, as well as accumulate depreciation calculation.
- Review the working paper of reconciling fixed asset per listing to actual count to ensure that the result after count reflects fixed assets in the financial statements.
- Review repair and maintenance costs whether it is currently correctly classified. Repair and maintenance is the cost that spends for bringing assets to current and earlier condition. If the cost that spends on assets is to extend the capacity of assets, then those costs should not be included in the repair and maintenance. Those costs should be capitalized.
- Review the acquisition of fixed assets and related capitalization cost whether all necessary costs that should be capitalized as per IAS 16 had been included in the capitalization costs.
- Disposing of fixed assets during the years are also important for certain cases. For example, based on the pre-analytical review, auditors found that there are material amounts of fixed assets that were disposed of. If this is the case, the auditor should review not only the procedures of disposal, accounting recognition but also the main reason for disposal which might affect the others recoverable of fixed assets.
- Maintaining a fixed asset register and/or master file is only important for the accuracy, completeness, and existence of fixed assets. The auditor should consider reviewing the reliability of fixed assets listing as well as mater file.
- Review fixed assets impairment assessment: Based on IAS 36 Impairment, the entity needs to assess the impairment every year. The auditor should consider reviewing the procedures and processes that managers use to assess the impairments.
- De-recognition of fixed assets is agreed to the de recognition procedure and policy. Make sure that assets that had been disposed of and written off are removed from the list and financial statements.
Written by Sinra
There are many audit procedures and approach that auditors could use to perform during their detail testing the inventories that report by management in the financial statements. Before to go to detail on the procedure, it is good to start with the overview of inventories first.
Inventories are the current assets that reporting in the entity balance sheet at the end of the reporting period. These inventories could ranks from trade inventories to non-inventories.
Non-trading inventories are the inventories that entity make or purchases for their own use and normally have a useful life for less than one year.
Trading inventories are the inventories that make or purchase for trading. These include raw material that entity purchases from suppliers, work in progress and finish goods that are ready for sales or delivery.
Inventories are normally considered as significant accounts per audit perspective. This is because inventory normally has large amounts at the reporting date as well as nature is sensitive compared to other assets. The fraud over inventories is likely to happen by staff or managements due to this sensitivity.
In this article, we will write about the auditor procedure for testing inventories in the entity’s financial statements. We will also explain the assertion that auditors should confirm, common risks related to inventories, and the procedures to address the assertion and risks.
As the best audit practice and as required by the standard, the auditor should performance an understanding of key control over financial reporting. And if we want to perform an audit of inventories in entity’s financial statements, we should start by trying to obtain as much as information related to the control of over inventories.
It could be rank from understanding the system that the entity uses to control its inventories, key people who managing, and how inventories are physically controlled.
Others key control including reviewing and delivering inventories should also clearly confirm. Key authorization over inventories also importance for auditors and it is subject for review.
Once auditor understood these key controls, auditors will be able to tailor the audit procedure effetely for them to address the risks at less effort.
- Existing: Auditor should confirm this assertion whether the inventories that recording in the entity balance sheet really exists.
- Valuation: Value of inventory is really important especially the slow-moving and high tech inventories.
- Ownership: It is important to review the ownership of inventories that records in the financial statements and store in the entity’s warehouse.
- Accuracy: Check whether inventories amount and value are correctly calculated in the financial statements.
- Cut off: Whether inventories records are properly cut off. Example, inventories that should be recorded in 2016 were recorded in 2016 and the inventories that should be recorded in 2017 were recorded in 2017.
- Occurrence: Auditor might want to test whether inventories that purchases and sold during the year have really occurred.
- Completeness: Test whether inventories are completely recording in the list as well as financial statements.
- Right and Obligation: Check whether the entity has the right to manage the inventories.
Common Risks Related Inventories:
Fraud over the inventories that committed by entity staff frequently happens to most of the entity’s inventories, based on my experiences.
It was sometime committed by normal staff and sometimes it is committed by the management of the entity and sometimes the collusion among the key players. Auditors should also consider the review and assess the fraud risks related to this area.
Understand of inventories are the common key concerning areas for auditors and they have to make sure that the risks are address in the procedures.
Confirm existing of inventories:
Inventories are the accounting balance in the balance sheet. And if auditor decided to perform their review on the entity’s inventories, existence is one of the financial statements assertions that auditor needs to confirm.
Physical verification is one of the procedure that auditor use to confirm this assertion. The auditor may consider to join the observation of a client’s year-end inventories count or perform their own sampling.
Physical verification is not only helping the auditor to confirm the existence of inventories that report in the balance sheet, but it also helps auditors to assess the condition of inventories, physical controls and asses the procedures that client use to perform their year-end counts.
When auditor assesses the counting procedures that perform by its client, auditors should focus on three main areas including the procedures before the count, during the count, and the procedure after the count.
These procedures are really important for the client to ensure that any error to the quantity of inventories report is identified and reflected financial statements.
Inventories are the current assets and entity could recognize the inventories in its financial statements only if those inventories meet the definition provided by IFRS Conceptual Framework.
Normally, auditor review the ownership (Right and Obligation) of the entity over the inventories by reviewing the Contracts, Quotation, Invoices, and Delivery Noted. Term and Condition in the contract are very important for ownership verification.
Assess the value of inventories:
IAS 2 is the current standard that issued by IFRS for dealing with inventories measurement, recognition, and disclosure and so on. Measurement of inventories should be at the lowest of cost and net realizable value.
Normally, the cost of inventories including cost of acquisition, cost of conversion, and others related cost that bring inventories into their present location and condition. Auditor should:
- Review the costing method and accounting policy that uses by the entity to value its inventories.
- For raw material, review the cost of purchasing and other related delivery costs.
- For WIP and finish goods, review the cost of conversion that brings raw material into WIP and Finishes goods.
- Review if there any other costs that not related to inventories or not allow by IAS 2 are included in the cost of inventories.
The LIFO method is not allowed by IAS 2.
Review cut off:
Cut off is very important because if there is any problem in cut off, there will be a problem in the total amount of inventories at the reporting date. In this point, the auditor should review and confirm inventories are records in the period that they are belonging to.
Goods received noted at the client’s warehouse and goods delivery noted that provided by client’s suppliers are the important documents to verify cut off.
Shipping documents and any others form that prove the delivery and receive date are importance for auditors to review cut off.
The auditor should perform an analytical review on inventories to identify the unreasonable event or transactions related to inventories including the slow-moving, unreasonable low & high amount of inventories, and unreasonable adjustments.
This analytical review will help the auditor to have a better picture to perform the additional review to that the risks related to inventories more efficiently.
Reviewing the trend of sales revenues against the cost of goods sold as well as purchases might help auditors get a better understanding of what happens to the inventories during the period and where to test it.
Others Procedure to consider:
- Review Consign Inventories: Some inventories that store in the entity warehouse maybe not belong to the entity. And some inventories that including in the inventories list, as well as financial statements, are not in the entity warehouse. These types of inventories called consigned inventories. Auditors should also review this.
- Inventories in transit. Inventories in transit are sometimes large and sometimes small amount.
- Review inventories are written off during the year