UNIT IV
Auditing Techniques- Vouching and Verification
Auditors perform the audit of revenue by testing various audit assertions, including occurrence, completeness, accuracy, and cut-off. Among these assertions, the occurrence may be the most important assertion as material misstatement of revenue usually occurs because of overstatement rather than understatement.
This is because the company usually want to show higher revenue than it actually is, especially when it has the incentive to overstate the revenue. Likewise, the most common inherent risk related to the revenue is the misstatement that could occur due to the management’s incentive or pressure to receive a certain level of sales or to obtain a certain level of bottom-line profit.
Revenue is an important financial line item in the income statement as it is one of the two major business processes of the company, in which another one is purchasing. Because of this, revenue is usually the material item in the financial statement.
In the audit of revenue, the inherent risk is usually high when the client has to deal with many complex sales transactions in its business, e.g. those sales transactions that make it difficult to determine when the sales has taken place and complete. In this case, we usually focus our attention more on revenue recognition where the material misstatement can easily occur either due to error or fraud.
Risk of Material Misstatement in Audit of Revenue
Risk of material misstatement is the risk that the material misstatement can occur on financial statements and the internal controls can’t prevent or detect it. It is the combination of inherent risk and control risk.
In the audit of revenue, the risk of material misstatement is the risk that revenue contains material misstatement but the internal control cannot prevent or detect such misstatement.
Inherent risk of revenue risk is its susceptibility to misstatement. The level of inherent risk usually depends on the nature and complexity of the business. Usually, the more complex the revenue transaction is, the higher the inherent risk it faces.
Control risk for revenue is the risk that the client’s internal control fails to prevent or detect the material misstatement that occurs in the revenue account. The client’s internal control may fail to prevent or detect the material misstatement due to two circumstances.
First, it may be due to there is no proper internal control in the first place. Second, it may be due to the control procedures are not properly executed by related personnel as they are intended.
As auditors, we have responsibly to perform an assessment of the risk of material misstatement in the planning stage of the audit. This includes the assessment of the risk of material misstatement for revenue.
This is so that we can design appropriate audit procedures to respond to the risk that we have identified and assessed. Audit procedures may include both test of controls and substantive tests.
Test of Controls in Audit of Revenue
In the audit of revenue, we may assess the control risk as low in case that we believe that the internal controls are effective in preventing, detecting or correcting the material misstatements that can occur in the revenue account.
In this case, we need to perform test of control to obtain sufficient audit evidence to support our assessment. However, we only perform tests of controls if we intend to rely on the client’s internal controls to reduce the risk of material misstatement.
As a result, if the client’s internal controls prove to be strong and effective after the test, we can reduce some of our tests of details. On the other hand, we may need to increase the sample size of the detail tests if the result of the control test shows otherwise.
Test of controls procedures may include:
- Inquire the client’s staff related to the internal controls processes
- Observe the clients’ staff performing the controls
- Inspect the supporting documents to ensure that the controls have been properly performed
- Re-perform the controls that have been performed by clients’ staff
It is useful to notice that the inquiry procedure is usually performed together with other procedures, such as inspecting the supporting documents or observing the client’s staff performing the controls, in order to ensure that the explanation given by the client’s staff or management is true.
Test of control example in the audit of revenue:
We test the control of authorization of the sales recording by obtaining supporting documents to verify whether the sales order and dispatching document have been approved before sales are recorded.
We test the control of segregation of duties by verifying whether the persons who take order and person who records sales and the person who receives payment are different personnel.
We test the completeness of revenues by verifying the numerical sequences of invoices:
- Substantive Audit Procedures for Revenue
- Substantive Analytical Procedures for Revenue
Like the audit of other financial statements line items, we perform substantive analytical procedures on revenue before performing the test of details.
We usually perform substantive analytical procedures by looking at the trends from the previous months or years and the relationship between sale revenue and other independent items such as cost of sales, selling expenses and the growth of sales in the sectors.
If the client’s record is significantly different from our expectation after looking at the trends or the relationship of other items, we will need to follow up with sufficient appropriate tests of details. On the other hand, if our expectation is not significantly different from what the client has recorded, we might be able to reduce tests of details.
It is useful to note that in the audit of revenue, it is unlikely that the audit evidence obtained from substantive analytical procedures alone will be sufficient; hence the test of details will usually be required, more or less.
Test of Details for Revenue
In the audit of revenue, test of details usually focuses on the occurrence of revenue, completeness of revenue transactions, the accuracy of the revenue record and the cut-off of the accounting period.
Occurrence
Occurrence tests whether the revenue transactions that have been recorded in the client’s accounts actually exist. Under the accrual basis of accounting, all revenues should be recognized and recorded when they occurred regardless of whether the payment have been received or not. In most cases, it happens when the goods are delivered.
Example: The test of occurrence assertion
- Select a sample of recorded sale revenue transactions
- Vouch the selected transactions to sale invoice to ensure transactions recorded are based on sale invoices
- Trace sale invoice to customer order and bill of lading to ensure sales have actually happened and goods have been shipped to customers
- Scan sale journal for duplicate journal entries
Completeness
In the audit of revenue, completeness tests whether all revenues that actually happened have been recorded in the accounts. The completeness assertion here is the opposite of the occurrence assertion above. While occurrence tests the revenues that had been recorded to ensure they actually exist, the completeness tests the revenues that occurred to ensure they have been recorded.
Example: The test of completeness assertion
- Select a sample of bills of lading
- Trace the selected bills of lading to sales invoice and sales journal to ensure they have been recorded as sales revenue.
- Scan the sequential number of sales invoices in the sales journal; ensure that the missing numbers are not unrecorded sales and have an appropriate explanation for.
Accuracy
Accuracy tests to see whether the revenue transactions recorded are free from error. We usually review to see whether the sale invoices prepared are mathematically corrected and there is no misstated amount recorded.
Example: The test of accuracy assertion
- Select a sample of sale invoices
- Verify the selected sale invoices with supporting documents to makes sure they are accurately prepared
- Trace sale invoices to sale journal and accounting record to make sure they are recorded in the correct amount
Cut-off
Cut-off tests whether the revenue transactions are recorded in the correct accounting period. Sale revenues may be recognized in the wrong accounting period due to the complicated process of the sale order, shipment and sale invoice or the client may intend to move accounting transactions from one year to another in order to increase the bottom line.
Example: The test of cut-off assertion
- Select a sample of sales invoices around the year-end
- Inspect the dates on the invoices and compare them with the dates of dispatch of goods and trace to the dates recorded in the sale journal and accounting record to ensure the correct accounting period entries.
- Select a sample of return documents (for sale returns) around the year-end and trace to the related credit entries
Key Takeaways:
- Auditors perform the audit of revenue by testing various audit assertions, including occurrence, completeness, accuracy, and cut-off.
- In the audit of revenue, the inherent risk is usually high when the client has to deal with many complex sales transactions in its business.
We usually perform the audit of expenses by testing various audit assertions including completeness, cut-off, accuracy, and occurrence. Likewise, each audit may require different audit procedures to ensure that we can gather sufficient appropriate audit evidence to make a conclusion.
The risk that we usually have with the expense accounts is the material understatement of expenses. This is due to the understatement of expenses would make the company’s performance look better than it actually is. Hence, the understatement of expenses is likely to occur than overstatement.
Some examples of expenses include rental expenses, utilities, office supplies, stationery, marketing and promotion, transportation, professional and consulting fees, and insurance.
In the audit of expenses, completeness is the most relevant audit assertion, in which we pay more attention to it. This is due to the lack of completeness will lead to the understatement of expenses which results in the overstatement of profit. Likewise, the misstatement, in this case, may due to fraud committed by the internal staff.
The cut-off is also an important audit assertion for expense accounts after completeness. This is due to the risk that the company’s management may try to delay expenses to the next period so that the profit in this period looks higher than it actually is. They may do this by not recording expenses in this period even though the actual business transactions occur in the current period.
Risk of Material Misstatement for Expenses
Risk of material misstatement is the risk that may occur on financial statements and internal control procedures in the company cannot detect or prevent such misstatement.
For the expenses account, it is the probability that the expense account contains material misstatement and expense related control cannot prevent or detect such misstatement. In other words, it is a combination of inherent risk and control risk.
Inherent Risk of Expenses
Inherent risk of expense is the susceptibility of expense account to misstatement. It is related to the nature and complexity of the expense account.
In the audit of expenses, the primary inherent risk is the understatement of expenses which is related to completeness assertion. The risk of expenses here is usually high as the management of the company may intend to not record the expenses which lead to an understatement of expenses and overstatement of profit. This case may happen in the circumstance that involves incentive or pressure in the company.
For example, if the company achieves a certain profit, the management will receive a big incentive. In this case, the management is encouraged to increase profit to a certain level, hence they may intent to understate the expenses in order to achieve their objective.
There is also an inherent risk that the expenses that occur in the current period are delayed recording to the next accounting period in order to increase the profit in the current period. This would also result in the understatement of expenses.
Other risks may occur in the audit of expenses include:
- The company fails to record accrued expenses that already incurred, but not yet paid
- Expense transactions are recorded as an asset resulting in an understatement of expenses and overstatement of asset
- Repairs and maintenance expenses are recorded as additions to PPE
- The company closes the books early for expenses, e.g. close account at December 22 instead of December 31, to delay expenses into the next period.
- Expenses are broken down into smaller pieces to avoid our examination as auditors. For instance, knowing that we examine all expenses over $10,000, the client may intentionally breakdown expenses into the smaller piece below $10,000 and capitalized them as fixed assets.
Control Risk of Expenses
Control risk is the risk that control procedures fail to prevent or detect material misstatement that can occur. In this case, the control risk of expenses is the risk that internal control cannot prevent or detect misstatement on expense account.
In the audit of expenses, the internal control procedures that we usually concern about are those that can reduce the risk of material misstatement for expenses.
In this case, examples of internal control procedures for expenses include:
- Segregation of duties between those who make purchase, receive goods, and record in the accounting system
- Proper authorization on all expenses and payment
- Proper procedures for checking for quantity and quality when goods are received
- Expense invoices are matched to purchase order and goods received note before recording in the accounting system
- Proper procedure to verify for the correct amount before recording in the accounting system
There can be a high risk of error or fraud if there is no proper internal control in place, especially if no such control procedures that we mentioned in the example above.
For example, if there is no proper authorization in place for expenses acquisition and payment, there is a risk that the expenses acquisition may have been made for personal use or the fictitious invoices may have been created and payment is made to a personal account.
Assessing control risk is very important as the control risk will influence the nature, timing and extent of the substantive audit procedures.
When we assess that the control risk is low and we intend to rely on the internal control to reduce the substantive procedures, we need to perform test of controls to obtain evidence to support our assessment.
Test of Controls in Audit of Expenses
In the audit of expenses, we perform test of controls to ensure that the client’s internal controls are effective in preventing or detecting material misstatement in expense accounts. However, we only perform test of controls if we assess the control risk as low and intend to rely on internal control to reduce some of our tests of details.
In this case, we perform test of controls to obtain audit evidence to support our assessment that we believe the internal controls can reduce the risk of material misstatement in expense accounts.
If the client’s internal controls prove to be strong and effective after the result of the test, we can reduce some work of our tests of details. On the other hand, we may need to increase the sample size of the tests of details if the result is different from our assessment.
Test of control procedures may include:
- Inquire the client’s personnel related to the internal controls processes
- Observe the clients’ staff performing their tasks on specific controls
- Inspect the supporting documents to make sure that the controls have been properly performed
- Re-perform the controls that have been performed by clients’ personnel
When performing the above procedures, the inquiry should be performed with inspecting documents or observation procedures to ensure that what the client tells us is actually true.
The main concerns in the controls of expenses are authorization and segregation of duties. Good internal controls should have proper authorization and segregation of duties in the control cycle for expenses from requesting for goods or services to the payment for goods or services.
Example of Test of Controls:
- We test the control of authorization of the expense by obtaining supporting documents to verify whether the expense payment has properly approved by authorized persons.
- We test the control of segregation of duties by verifying whether the person who receives goods and the person who records the transaction are different persons.
It is useful to note that if we assess the control risk as high or we do not intend to rely on the client’s internal controls, we will not perform the test of controls. Likewise, we will go directly to substantive audit procedures. We do not need to test the internal controls to prove that they are weak at all.
Substantive Audit Procedures for Expenses
Substantive audit procedures include substantive analytical procedures and tests of details. We usually perform analytical procedures before the test of details. This is due to we usually determine the size of tests of details based on the result of the analytical procedures. Though, we sometimes go directly to test of details without performing the analytical procedures in the substantive tests.
Substantive Analytical Procedures for Expenses
Substantive analytical procedures are the analytical procedures that we perform in the evidence-gathering stage of the audit. In this case, we perform substantive analytical procedures to obtain evidence about certain audit assertions for the expense accounts.
We usually perform analytical procedures by evaluating financial information through analysis of trend, ratio or relationship between data. The analysis may include both financial and non-financial data.
In this case, we can build our expectation from the result of analysis and compare to the client’s record. If there is a significant difference between our expectation and the client’s record, we will perform further investigations on the difference by performing more detail tests.
For example, in testing the rental expenses, we can build our expectations from the inquiry with the client if they have expanded the operation to other locations during the year. If they have, we would expect a big increase in rental expenses. Otherwise, we would expect less fluctuation in rental expenses.
Hence, we can analyze the fluctuation of rental expenses from year to year and compare with our expectations. If the fluctuation is out of the expectation, we may need to perform further tests to investigate the variance.
Test of Details for Expenses
In the test of details for the audit of expenses, we usually focus our tests on the completeness, cut-off, occurrence and accuracy assertion of the expense transactions.
Completeness
We test the completeness assertion to verify whether all expense transactions have recorded. Usually, any misstatement in the completeness assertion would result in the understatement of the expenses which lead to a higher profit than it actually is.
Example: Test of completeness assertion:
- Select a sample of goods received notes (receiving reports)
- Trace the selected goods received notes to purchase orders and supplier invoices
- Trace the invoices to the expense transactions in general ledger
Also, in testing the completeness assertion, all credit side expenses (or negative expenses) transactions in the general ledger should be examined to see whether there are unusual transactions that could be the result of error or fraud.
Cut-Off
We test the cut-off assertion to verify whether the transactions have been recorded in the correct accounting period. In the audit of expenses, cut-off assertion bears similar risk to completeness as the client’s management may delay expenses to the next period so that the profit of the current period looks better than the actual one. This would make the recorded expense transactions not completed in the current period.
An example of testing the cut-off is reviewing the expense transactions around year-end, e.g. ten days before year-end and after year-end. And examine whether they are recorded in the correcting period by vouching to the supporting documents.
Cut-off assertion can be tested by examining the date recorded in the general ledger and comparing it to the date on the supporting invoices and goods received notes.
Occurrence
We test occurrence assertion to verify whether the expense transactions that have been recorded in the accounting system actually occurred during the period.
Under the accrual basis, expenses should be recognized and recorded when they occurred regardless of whether the payment have been made. It usually happens when the client receives the goods or services.
Example: Test of occurrence assertion:
- Select a sample of recorded expenses transactions from the general ledger
- Vouch the selected transactions to the supplier’s invoices to ensure transactions recorded are based on the supplier’s invoices
- Trace the supplier’s invoices to the purchased orders and goods received notes (receiving reports) to ensure that the goods had been received when the expense was recorded
In the audit of expenses, while we test the occurrence assertion by vouching transactions to supporting documents, we usually also verify the mathematical accuracy of such transactions. Hence, the accuracy assertion test is also complete here with the occurrence assertion.
Accuracy
We test the accuracy assertion to verify whether expense transactions recorded are mathematically correct. As mentioned above, we usually test accuracy together with occurrence assertion for the expenses.
In this case, by agreeing the expense transactions in the general ledger to supporting documents, such as supplier’s invoice, goods received note (receiving report) and purchase order, we can ensure both accuracy and occurrence assertion.
Classification
We test the classification assertion to examine whether expense transactions recorded are properly classified. The major concern in this assertion is that the expenses are recorded as an asset which leading the expenses understated and assets overstated.
As the main concern is about the wrong classification of expenses to fixed assets, we usually perform the test of classification assertion in the audit of fixed assets. For example, we test the classification assertion by examining fixed assets addition to verify whether the addition is indeed the fixed asset, not expenses.
Key Takeaways:
- We usually perform the audit of expenses by testing various audit assertions including completeness, cut-off, accuracy, and occurrence.
- The risk that we usually have with the expense accounts is the material understatement of expenses. This is due to the understatement of expenses would make the company’s performance look better than it actually is.
Audit of Assets involve verification and valuation of Assets:
Verification
The term ‘verification’ signifies the physical examination of certain class of assets and confirmation regarding certain transactions. Sometimes verification is confused with vouching but they differ from each other on the nature and depth of the examination involved. Vouching goes to prove the arithmetical accuracy and the genuineness of the transactions whereas verification goes to enquire into the value, ownership, existence and possession of assets and also to confirm whether they are free from any mortgage or charge. The fact of the presence of any entry regarding the acquisition of asset does not prove that the particular asset actually exists on the Balance Sheet date, rather it purports to prove that the asset ought to exist; on the other hand, verification through physical examination and confirmation proves whether a particular asset actually exists without having any charge on the date of the balance Sheet.
Verification of assets involves the following steps:
- Enquiry into the value placed on assets;
- Examination of the ownership and title deeds of assets;
- Physical inspection of the tangible assets; and
- Confirmations regarding the charge on assets;
- Ensuring that the assets are disclosed, classified and presented in accordance with recognized accounting policies and legal requirements.
The scope of verification is wide and consequently verification is an important part of the auditor’s duties. An auditor should put all his endeavor to satisfy himself whether a particular asset is shown in the Balance Sheet at proper value, whether the concern holds the title to the asset and the asset is in the sole possession of the concern and lastly whether the asset is free from any charge. If the auditor fails to perform his duty, he will be held liable.
Besides the legal importance, verification also plays an important role to guard against improper valuation of assets like stock-in-trade which may inflate or deflate the profit position of the concern. Improper valuation of assets may also conceal the actual position of the business as reflected in the Balance Sheet.
However, it is not possible on the part of the auditor to physically verify each and every asset because time may not permit him to do so, or he may not have sufficient technical knowledge of the assets concerned. It was decided in the case of “Kingston Cotton Mills: that it is not a part of an auditor’s duty to take stock. No one contends that it is. He must rely on other people for the details of the stock-in-trade.
Again, while going through the decision of Mc Kesson and Robins case in 1939, we find that the auditor should physically verify some of the assets. If possible, title documents like negotiable instruments, shares, debentures, securities, etc. are to be thoroughly examined on the last day of the accounting period. He should satisfy himself that the transactions, if any, having bearing on the Balance Sheet date and date of audit are bonfire and are supported with proper evidence. The auditor is also supposed to verify stock-in-trade with reference to the purchase book, the stock records, the gatekeeper’s book, etc. though law does not specially compel him to take stock-in-trade.
Valuation
Valuation of assets means determining the fair value of the assets shown in the Balance Sheet on the basis of generally accepted accounting principles. The valuation of assets is very important because over-statement or under-statement of the value of assets in the Balance sheet not only distorts the true and fair view of the financial position but also gives wrong position of profitability.
The valuation of the assets is the primary duty of the officials of the company. The auditor is required to verify whether the value ascertained is fair one or not. For this, he may rely on the technical certificate issued by the experts in the field.
Valuation of assets means not only checking value of the assets owned by an organization as on Balance Sheet date, but also critical examination of the value of these assets (comparative analysis of different assets).
The auditor has also to see that the principle of valuation of assets is consistently adopted and is based on established principles of accountancy. For the purpose of convenience, those assets are classified as under to determine their value.
- Fixed Assets
- Current Assets or Floating Assets
- Wasting Assets
- Intangible Assets
- Fictitious Assets.
- Fixed Assets: Fixed Assets are usually valued at going concern value’ which means cost less depreciation. Cost here means purchase price of the assets plus all incidental manufacturing, buying and installation expenses incurred to bring the assets in use. Depreciation is the provision made for the reduction in the value of the assets on account of their usage, natural wear and tear and obsolescence etc. The depreciation provided should be fair, otherwise the value of fixed assets may not be fair. What is a fixed asset depends on the nature of the business organization.
- Current Assets or Floating Assets: These are usually converted into cash at the earliest opportunity in the process of business activity, e.g. stocks, bills receivables, sundry debtors, etc. Based on conservatism principle, usually current asset are valued at original value (cost price) or market value (realizable value) whichever is lower. Because they are intended to be converted into cash at the earliest possible time, hence what value we may realize is important. This method is adopted to strengthen the financial position of a concern by indirectly providing for expected loss by way of fall in the market value of the assets. This principle is held by the conservatism convention of accounting, i.e. do not expect profits but provide for anticipated losses.
- Wasting Assets: Wasting Assets means those which lose their value gradually upon their use, e.g. a mine, a quarry etc. To value these assets firstly we should determine the usefulness of the assets in terms of units of production etc. and as per their actual use the value is to be reduced on proportionate basis. If in a particular period this type of asset is not used then the value may not diminish also. Thus, these assets are to be reduced on the basis of consumption. But sometimes it may be difficult to adopt this method, then the cost less depreciation’ principle may have to be applied.
- Intangible Assets: Usually intangible assets like goodwill, patent rights, know how, etc. are valued on cost basis. But if the same are acquired by a non-cash transaction, then the fair market value is to be taken as the value of intangible assets. Auditor should also see the period of time and till it is fully written off, they are shown as assets because they do not have any realizable value. They are to be valued at actual cost less amount written off as depreciation upto Balance Sheet date.
- Fictitious Assets: Certain lump sum expenses giving benefit for more than one year when incurred are written off over a period of time, and till it is fully written off, it is shown as an asset in the Balance Sheet e.g. preliminary expenses, discount on issue of shares etc. These are all fictitious assets because they do not have any realizable value. They are to be valued at actual cost less amount written off upto the Balance Sheet date.
Methods of Valuation
The following are the various principles of valuation of assets
- Cost Price (Going Concern Value): Under this method actual cost of assets are reduced by the depreciation provided. Usually this method is applied to value fixed assets.
- Market Value: This refers to the market value of the asset i.e. the price at which the asset is being transacted in the market. This is applied to value the current assets only when this is lower than cost of the asset. Usually market value is adopted to value items having perishable nature.
- Scrap Value: Assets which are useless for the enterprise may be sold as scrap in the market. The value for which such assets can be disposed of as scrap, is called as scrap value of assets.
- Replacement Value: This represents the value at which the existing assets can be replaced. That means the price to be paid to acquire such type of assets in the market on the date of the balance Sheet.
- Realizable Value: The value that can be obtained if the asset is sold in the market i.e. anticipated selling price. Usually, expenses such as commission, brokerage etc. are deducted from it.
Key Takeaways:
- The term ‘verification’ signifies the physical examination of certain class of assets and confirmation regarding certain transactions.
- Valuation of assets means determining the fair value of the assets shown in the Balance Sheet on the basis of generally accepted accounting principles.
The audit of liabilities implies an enquiry into the nature, extent and existence of liabilities.
It involves ensuring the following:
- That all the liabilities have been clearly stated on the liability side of the Balance Sheet.
- That all the liabilities relate to the business itself.
- That they are correct and authorized.
- That they are shown in the Balance sheet at their actual figures.
It is an important duty of an auditor to verify the liabilities appearing in the Balance Sheet of the company. The object of verification of liabilities is to ascertain whether there is any improper inflation or deflation of values or improper creation of an imaginary liability in the books. This form of manipulation is done in most cases to inflate or deflate the profits of the concern and thus make the position of the business appear stronger than what actually is, to create a secret reserve. As a result of such manipulation, the Profit and Loss Account and the Balance Sheet prove to be incorrect and thus the Balance Sheet does not exhibit a true and fair view of the state of affairs of the concern. So, the auditor must take all possible steps to ensure that all liabilities are recorded properly in the books of accounts of the business. It is advisable that the auditor should, besides verifying the liabilities as shown in the Balance Sheet, get a certificate from the management that all liabilities of any nature have been included in the books of accounts and the contingent liabilities have been shown by way of a foot-note to the Balance Sheet or have been provided for.
Key Takeaways:
- The audit of liabilities implies an enquiry into the nature, extent and existence of liabilities.
- The object of verification of liabilities is to ascertain whether there is any improper inflation or deflation of values or improper creation of an imaginary liability in the books.
References:
- ‘Auditing and Assurance services’ by Alvin A. Arens and Randal J. Elder
- ‘The Why and How of Auditing’ by Charles B. Hall
