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 :
Earnings transferred to retained earnings
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.
The 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.
The dividends that arise out of deduction of retained earnings shall be approved and declared in the board meetings.
Presentation and disclosure
The 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:
Taking 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
Verifying 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 disclosure
Ensuring 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.
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.
Ensuring that reported capital actually exists on the date of reporting
The nature and types of share capital transactions that have been issued should be recorded.
Share capital is recorded in line with applicable accounting standards.
Present and disclosure
An 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.
Verification with a certificate of incorporation, articles of association, and Memorandum of association. Matching the balances with SEC/relevant authority filings.
Verification 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.
Matching 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 disclosure
Ensuring 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.
Investment is the deployment of capital in order to earn interest, dividend, or capital appreciation. Investments are basically either held to maturity or available for sale securities. Held to maturity securities are those that are held with intent until maturity.
These are reported at cost, provided for amortization and accretion of discounts. Available for sale investments are reported at fair value where any unrealized profits or losses form part of stockholders’ equity.
While auditing the investment of any entity, the auditor needs to be aware of applicable accounting guidance. They should be familiar with the knowledge of client business and the nature of investment it holds.
Audit assertions for Investments
Investments are audited by testing various audit assertions as existence, completeness, valuation, and rights and obligations. These are explained in detail below:
Inspecting investment securities on hand and comparing with previous year balances and accounts along with purchases and sales in the current year. This also takes into the movement of cash from and towards the investment
Examining financial statements to check recognition of gains or losses from investment. This also would mean checking carrying amounts of securities under the equity method
The investments have been completely recorded with respect to interest, dividends and fair value, if applied.
Rights and obligations
Checking and verifying that the client has ownership rights for investments on the date of balance sheet.
Presentation and disclosure
Verifying that all investments have been properly classified and notes have been placed with respect to restrictions in investments.
Primary risks for Investments
The inherent risk and control risk in the obligations form the risk of material misstatement in investment reporting and compliance. The risk of being susceptible to misstatement due to the nature of the investment is the inherent risk of the investment.
Control risk occurs when the internal control system of the auditee fails to prevent or detect material misstatement in the investment. The inherent risk further involves issues related to existence and valuation of investment on books.
When the value of investment is overstated, there is higher risk it could be due to fraud with intention. The investment of the client may come with certain restriction which have not been disclosed and circumstances would lead to non-detection of such restriction.
These are where internal control fails due to complexity of terms and conditions in arrangements of investments being done.
The various other risks for investments would include:
Investments are intentionally overstated to cover up fraud
Investments are not correctly valued due to complexity and management’s lack of accounting knowledge
Misstatement of investment with improper cut-off
Proper disclosures not made with respect to investments.
Substantive audit procedures for investment
Auditing investment requires a deep working knowledge of accounting and auditing standards along with knowledge of client business and the type of investments they hold.
The substantive audit procedures related to investments should respond to risks identified by the management and auditors which involves confirmation of investments, an inspection of cut off of investment with respect to date and amount, and vetting the investment documents for the requirements related to disclosure and checklists.
It would better to show the audit assertions and relevant substantive audit procedures carried out for such assertions as:
Substantive audit procedures
Balance confirmation from broker company in respect of securities held. Inspecting the investments that are tangible physically. Vouching and verification of all the purchases and disposals of the investments.
Verifying that investment balances reflect market values at the reporting date, if applicable. Re-computation of interest and dividends Determining if gains and losses have been properly recorded
Checking arithmetic accuracy of the schedule by footing and cross-footingPreparing and verifying the balances with reconciliation of investment balances from previous year.Verifying that all investment related transactions have been recorded in the proper accounting period.
Rights and obligations
Inquiring the management on restrictions if any on investment studying the terms and conditions of investments and checking if they have complied.
Presentation and disclosure
Verifying that if any restrictions have been placed on investments are properly disclosed in the notes to accounts. Verifying that investments have been properly classified and reported.
Revenues that the entity recognizes in the income statement during the year are income that the entity sells the goods or services to its customers. These revenues are recognized when the control is passed from the entity to its customers.
It is recognized either when the customer pays immediately or sold on credit which means the goods or services are sold but the payments will be collected later.
In general, revenue is one of the key performance indicators that not only the entity itself want to archive, but the board of director as well as the management of the entity want to accomplish.
That is the main reason why revenues are generally set as the high risks of material misstatement when it comes to auditing due to its nature and amount that recognizes in the income statement.
In this article, we will discuss about the risks of material misstatements related to the revenues.
Inherent risks are the risks that not related to the control, but it is highly related to the nature of the account itself, the level of judgment involve in the management, and the complexity of accounts and transactions.
The inherent risk of the revenues is normally considered as high due the revenues have many criteria with significant judgments are involve by the management of the entity.
Here are the examples of inherent risk relate to the revenues that auditor should pay attention during the audit:
Management manipulates the figure to achieve the target set by the board. For example, the is the budget sales set by the board or shareholder and at the end of the year, the actual sales are almost reaching the budget. Management might try to manipulate the sales so that the budget will be achieved and management could entitle to receive the bonus that might agree with upfront with the board or shareholders.
Risk of recognizing the revenues that do not occur during the period. These might happen at the middle management where a fake sales account is mad at the end of the year and sales are canceled after the year so that their performance is meet.
Due to the complexity of sales terms, revenues might be incorrectly recognized for those goods that are in transit or consign at the customers’ store.
The company might fail to derecognize the sales return and result in the overstatement of sales as well as account receivables.
Due to the complexity of sales term and a large amount of sales transactions, revenues might be incorrectly sales in a different period that its be recognize. For example, the revenues are recognizing in December 2020 for those transactions that occurred in January 2021.
Therefore, there is a significant risks of material misstatement for the revenues recognition that link to inherent risks of the revenues.
It is obvious or default that fraud risk relate to the revenues are always high. It is due to its nature. The fraud could be committed by entity staffs or at the top management level.
And the form of fraud could be in the form of misappropriation of assets and fraud over financial reporting. For example, the fake sales transactions are creating by sales team by creating the fake customers accounts. Those account will them write off dur to the customers are unable to contact.
However, this kind off fraud might be detected by management by setting up a strong internal control.
Fraud over financial reporting, in the other hand, are very difficult to detect and auditor might need to pay a very great attention since the detect risk are high considering the fraud might be committed by management or even at the board level.
Therefore, there is a significant risks of material misstatements for the revenues related to fraud.
The risk of material misstatement of the revenue due to control might be occurred but depending on the control of each entity that the auditor auditing.
Auditor normally need to obtain an understanding on the internal control that entity setting to see if there is any loophole could lead to risks of material misstatements on the revenues.
Auditor need to assess the implementation of control whether the key control that help to present error or fraud are effectively and efficiently implement by the company.
If the control is effectively and efficiently implemented, then the risk of material misstatements might be low. And if the control is not strong and the implementation is not effective and efficient, then the risk of material misstatement is high and the auditor should prepare the procedures to address those risks.
Search for unrecorded liabilities is the audit testing procedures that auditors perform to verify if the liabilities are understated by completely not recording it. Such tests of the search for unrecorded liabilities is performed by auditors to give an appropriate response to assess the risk of understatement of liabilities.
In industrial environment, search of unrecorded assets like searching for debtors or accounts receivable as being unrecorded is very unlikely than as to search for unrecorded liabilities like accounts payable or notes payable.
The reason is that management of the company normally intend to understate the liabilities or expenses rather than the understat assets or revenues. Since these are the key financial figure that link their performance.
This would mean that liabilities have more risk of being unrecorded than the accounts of asset. Auditors shall perform audit procedures for search for unrecorded liabilities in order to test completeness aspects of all the liabilities of books of account. This also helps to determine if liabilities shall be excluded or included from the current accounting period.
Examples of Search for Unrecorded liabilities
Here, we discuss what audit procedures need to be followed to search for two liabilities i.e. accounts payable and notes payable as:
In case of accounts payable, audit procedure is performed to test completeness assertion through following steps:
First, samples are selected of transactions that are made after closing of books of account
The auditor then proceeds to examine the sample payments by making verification with document evidence and assess if the liabilities existed on the date of balance sheet.
The auditor also inquires with appropriate personnel on any unrecorded invoices.
In audit using sample, the risk of material misstatement is directly proportional to the selection of sample size. Hence, the auditor needs to exercise his professional judgement and competence. If risk of material misstatement is assessed as high by the auditor, the sample size selection should be enlarged and the auditor shall try to reduce the risk to an acceptable level.
The audit procedures in case of notes payable is similar to that of accounts payable. As it happens, the notes payable has large sum involved and hence, the risk of material misstatement in case of notes payable increases massively.
Substantive audit procedures need to be performed in case of notes payable. The auditor needs to confirm the existence and year end balances by making direct confirmation from the third parties. Further, the auditors should analyze board meetings minutes for authorization of debts and check if any debts have been unrecorded as such.
Audit Procedures to search for unrecorded liabilities.
Auditor should verify the unrecorded liability by applying the given audit procedures:
The auditor shall verify purchase orders and all supporting documents with journal entries related to purchases and cash disbursals. This helps the auditor to assess if purchases have been properly recorded and with the correct amount.
Analytical procedures are done in order to test the trend and look for unusual relations. The various accounting ratios as accounts payable turnover is important in the search for unrecorded liabilities. All the unusual relations shall be properly investigated by the auditor. While auditing accounts payables and looking for unrecorded portions, the auditor would need to look at cash disbursals after the year-end and verify they have been properly recorded as payables at the end of the year.
The auditor shall audit and test all the audit trails leading the payments to liabilities that have been recorded. This can be done for payables that exist on the year-end balance sheet date. The auditor can clearly state that if cheques that cannot be matched to recorded payables would amount to unrecorded liability at year-end.
The auditor shall carefully examine all the cash disbursements using the Cash disbursements cutoff test. This would help to reconcile the cash disbursements and accounts payable. The auditor shall also inspect the cheques issued and trace them to ledgers of accounts payable. Doing so would help the auditor to detect items that have been purchased before the end of the year but not recorded i.e. unrecorded accounts payables.
In case the company employs a voucher system, all the requisition, receipts, and suppliers’ invoices shall be reconciled with purchase orders. The auditors should therefore in such companies employing voucher system, vouch for samples of invoices related to cash disbursals after the end of the year and compare with all the receipt reports and suppliers’ invoices. This helps the auditors to search for unmatched documents.
The audit can also make direct confirmation from the vendors regardless of the balance dues at the end of the year.
The Risk of material misstatement requires that the auditor must identify and assess the risk of material misstatement at the financial statement level, individual account level, and provide disclosure of performing different audit procedures.
Risk of material misstatement basically includes both inherent risk and control risk. Hence, the impact of RMM for investment will be subject to the intensity of inherent risk and the intensity if that impact is controllable by adopting different procedures or not. The risk is controllable before it impacts the financial statement of the company.
Economic conditions in the jurisdictions in which resources are invested which may have an impact on the assessments of auditor’s Inherent risk of relevant assertions in the financial statements of an investment firms. The level of inherent risk is based on the nature and kind of business dealings/contracts. As we know if the inherent risk of investment is high, then the level of risk of material misstatement is totally depend upon control risk.
Some of the important factors from which auditors can evaluate includes:
Stability of the Government
Rate of inflation
Some of the Important Examples of Inherent Risk Investments are as follows:
Revenues generated from investments are overstated.
Recording of fabricated investments.
Classification of investment (lack of knowledge of staff on accounting principles)
Recording incorrect values of investments.
Incorrectly use of accounting Principles.
The investment advisors or decision makers maintains extensive controls which includes the following:
Portfolio management controls:
To separate trading functions and portfolio management
Do frequently reconciliation of portfolio holding and cash to custodian records
Reviews of journal entries
Monitoring the activity on dormant shareholders accounts
Controls to prevent, deter, and detect fraud:
Use of system control like security admittance
Develop many channels for employees to report any kind of fraud or fraud-related concerns.
Periodic recording of an investment company’s compliance with its investment goals and restrictions
Many compliance programs
Risk of Material misstatement due to Fraud:
In the Investment Company or industry, the unusual or unexpected risk of misstatement due to the reason of fraud are as follows:
Investment performance substantially higher (or lower) when compared with industry peers or other relevant benchmarks, which cannot be readily attributed to the performance of specific securities when prices are readily available in an active market. Particular considerations include the following:
Significant gains (or losses) from securities held for extremely short periods of time
Significant gains (or losses) from instruments not typically acquired by the fund
Unusually high levels of acquisitions and sales of investments in comparison to overall net assets of funds without an obvious economic intent.
Expense ratios that change frequently after the year and next year with insufficient justifications. Expense ratios and the transaction cost increased the company’s norms.
Examples of internal controls procedures that can reduce risk.
Do internal audit on periodic bases.
Review of investments occasionally
Adequate policies on valuation and classification of investment
Proper physical controls of investment to prevent from loss.
It is valuable to note that when auditors evaluate that the investment control risk is low and that they want to rely on internal controls to minimize some of their substantive work, they need to carry out a control test in order to obtain adequate audit evidence to support their assessment.
On the other hand, if they determine that the risk of control is high, they would actually skip the control test and go straight to substantive testing (by doing more work). There is no point in attempting to show after all that internal monitoring is inadequate and Ineffective in preventing or identifying the possibility of material misrepresentation that may occur in investment accounts.