Audit Method: The Unrecorded Liability

Liability is defined in Conceptual Framework of International Financial Reporting Standards as “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits”.

There can be many instances where management will be prone to not record a liability due to various reasons. The management may not record a current liability to improve its current ratio and present its liquidity position higher. Management may also skip to record a long term liability at year end to improver it debt to equity ratio. A high current ratio and low debt to equity ratio makes it easy for the management to obtain new financing for the company.

Auditor should verify the unrecorded liability by applying the following procedures:

• Vouch a sample of cash disbursements recorded just after year end to receiving reports and vendor invoices. In a voucher system, a voucher is not prepared until the requisition, receiving report, and sellers invoice are reconciled with the purchase order.  Auditors search open files for unmatched documents.
• In searching for unrecorded payables, the auditor would look at disbursements made after year end to see if they should have been, and were, properly recorded as payables at year end.
• Tracing a sample of purchase orders and the related receiving reports to the purchases journal and the cash disbursements journal will enable the auditor to determine that the purchases were properly recorded.
• Analytical procedures.  Accounts payable turnover is very important.   Unusual relations should be investigated.
• Cash disbursements cutoff test.  Test if cash disbursement and accounts payable reduction are reconcilable. Inspect the last checque written and trace it to the accounts payable subsidiary ledger. Reviewing subsequent cash disbursements enables the auditor to detect items purchased before year end but not yet recorded, i.e., unrecorded accounts payable.
• Purchases cutoff test tests to determine if goods for which title has passed or not passed are appropriately accounted for. FOB shipping point and FOB destination are critical to this test.
• Trace subsequent payments to recorded payables.  Match checques issued subsequent to year end with the related payable.  Checque should be issued only for payables that existed on the balance sheet at year end.  Any checque that cannot be matched may represent an unrecorded liability at year end.
• If confirmations are used, small and zero balances should be sampled as well as large balances.  For example, if orders are placed with a vendor on a consistent basis, a confirmation should be sent to the vendor regardless of the balance due at year end.

Practice

The auditor should check for all the audit assertions while verifying unrecorded liabilities. Valuation assertion will verify whether accounts payable are valued in accord with GAAP/IFRS? Presentation/Disclosure assertion will verify whether the accounts liability balances are properly presented and disclosed? Accounts payable should be listed as a current liability.  Purchases should be listed in the calculation of cost of goods sold. Unusual transactions involving accounts payable should be disclosed, such as related party transactions involving accounts payable. Obtain a management representation letter with assertions relating to accounts payable and purchases.

Audit Method: Testing Revenue

Audit-is-cool continues to supply auditors with information on different topics of audit methodology. This week we provide most popular procedures to provide assurance on financial statement line "Revenue".

TEST OF CONTROLS

• Make a selection of sales transactions from independent source records e.g. shipping records, delivery orders, purchase orders etc.
• Test the completeness of source records by ensuring their numerical sequences.
• Check that sales data is input only once and is subject to validation.
• Access to sales system is restricted by user ID and password.
• Check that prices are charged in accordance with the approved price list.
• Check that the quantity discounts are in accordance with the approved limits.

ANALYTICAL PROCEDURES

• Have the client prepare a comparative monthly analysis of sales by product line, division or other business segment, including gross sales, returns and allowances and discounts. Verify the clerical accuracy of the analysis.
• Perform analytical procedures on sales by developing an expected amount of sales based on prior year’s figures or current period economic conditions and then comparing it with actual amount. Any significant differences should be enquired into and corroborated.

TEST OF DETAILS

• Have the client reconcile totals for gross sales and sales deductions to the general ledger control accounts.
• Verify the sales invoices and check that the customer name, product description and quantities and price are mentioned on the invoice and compare it with the description of sales order.
• Review applicable sales invoices and shipping documents to determine the accuracy and validity of each selected sales transaction and sales tax charged thereof, if applicable.
• Document the criteria for selection of sales invoices for verification purposes and ensure that sample is representative both for volume and amount of transaction.
• Scan the sales journal to check whether there is any duplication of sales invoice numbers or gap in the sequence of invoice numbers to identify invoices cancelled, if any.
• Review significant sales returns and credit memos issued during the period as well as subsequent to the balance sheet date to determine whether they were properly authorized and recorded in the proper period.
• Discuss with appropriate client’s personnel the existence of significant uncertainties at the time
• of sales, if any, like recoverability, warranty and other obligations, price protection agreement or revenue limitation.
• Make a selection of transactions from recorded sales and shipping records for prior and after period-end and ensure proper cut-off.
• Ensure that all sales in foreign currencies are translated using exchange rate prevailing at the date of sale (a rate that approximates the actual rate for example, weekly / monthly average is also acceptable).
• Consider reasonableness of revenue by multiplying the number of units with the average selling price.
• Determine that the accounting policies and methods of revenue recognition are appropriate and are applied consistently.

Audit Method: Audit Approach

Audit planning is one of the most interesting steps in the audit process. It requires to apply audit specific knowledge, business skills, understanding of the own resources and velocity of their usage.

In this post I am going to make the brief overview of some audit approaches and their applicability in real life.

Audit Process

The audit process could be depicted very simply, but work done and time spent on each stage of audit process have crucial effect on audit efficiency and effectiveness (audit risk). The illustration demonstrates that basically we have two types of approach: business risk approach with controls testing and substantive approach.

Audit Process

The approach in strategy should not be confused with approach in tactics regarding the concrete account connected with business process. In any case, we have to detect most risky and material areas of clients’ financial statements, i.e. substantive testing of all accounts is not reasonable.
         The second step is to identify our tactic regarding concrete type of account and assertion. For example, account is “fixed assets” (FA) and assertion is “valuation”. The process which is reflected by these two elements is “FA purchases” process. So at this point we might decide to test value of FA items substantively or do some preliminary purchases tests of controls to reduce substantive work in later stages. 

To test or not to test?

The outcome of control testing should be combined risk assessment of financial statement risk and audit risk, i.e. the result per well-known models:

         Audit Risk = Inherent Risk x Control Risk x Detection Risk (1);

Audit Risk = Financial Statement Risk x Detection Risk (2).

The audit firms try to formalize risk assessments (low, moderate, high) and spot the point at which it would be reasonable to reduce substantive procedures. However, there is still a problem: test of controls is time and money spent on procedures. And how do we know whether we should even start testing controls? What if after extensive control testing they proved to be ineffective? The mistakes might lead to inefficient audit, harming auditors’ profit margin. Unfortunately, I might say in majority cases the decision is made based on common sense and subjective opinion, i.e. there is no 100% proven scientific way to figure this out. Admittedly, to facilitate a right decision auditors should understand client’s business process, document suggested controls, and do process walk-through. There are also some rules of thumb, e.g. if there are lots of small routine transaction, then tests of controls are likely to be the right option.

Additional factors

The audit with accurate planning stage, through understanding of business processes and risk detection would require highly proficient audit team. However, we live in a real world and we do not always have access to the best dream audit teams J . The point is that the audit approach should be understandable by team members and fit their abilities: for someone it would be easier (time/budget factor) to vouch 1000 transaction than make decision based analytical job of connecting facts from process narrative, walk-through, initial strategy, and audit methodology. I mean, that process need not be overcomplicated. I would suggest following basic principles for establishing strategy:

1. Efficiency (budget);
2. Effectiveness (prudence, audit risk);
3. Complexity/easiness to bring about;
4. Understandability (and acceptability) for all members of team: from partner to audit staff.

In the future blog posts, it would be interesting to elaborate each of the above principles.

Conclusions

This is only outline of audit approaches. The topic is enormous and I will try to cover most arguable areas. Your comments are welcome as usual.

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