Management Assertions
Financial statement assertions are assertions by management, explicit or otherwise that are embodied in the financial statements.
They are categorized as follows:
• Existence
• rights and obligations
• occurrence
• Completeness
• valuation
• measurement
• presentation and disclosure
The auditor must determine which financial statement assertions are relevant to each account balance and formulate appropriate audit procedures to substantiate these assertions. This implies that not all the seven above mentioned assertions are relevant for all account balances but rather the auditor has to determine which ones are relevant to what account balance. This calls for exercise of judgment. For e.g. for debtors the auditor would be interested in proving:
• The completeness
• The existence
• The valuation
Whereas for plant and machinery the auditor would be interested in proving:
• The existence
• ownership rights
• valuation
• Completeness
• presentation and disclosure
This implies that the audit procedures applied in verifying these two balances will be different. liabilities are normally valued at cost unless they involve interest for late payments.
Verification of non-current assets
in an average company, the non-current assets that will be encouraged are: freehold land and buildings, plant and machinery, motor vehicles and fixtures, furniture and fittings. The verification process is similar in all these. Therefore, we shall look at freehold property and plant and machinery.
Freehold land and buildings
Audit objectives
• To verify that there was proper authorization to acquire the land and the buildings • That land and building exist
• That the company has legal ownership rights over these assets
• That these assets are valued at an appropriate amount
• That these assets are properly presented and disclosed in the financial statements according to the relevant financial reporting standards such as international accounting standard no. 16, 17 or 40
Audit procedures
To be able to meet the above objectives, the auditor carries out the following audit procedures: a) Cost and authorization
This is verified by inspecting to the appropriate documentation such as the sale agreement and surveyors certificates. To verify whether the acquisition was authorized the auditor can inspect the minutes of the board of director’s meetings at which such the green light was given acquire the assets in question.
b) Existence
This can be verified through physical inspection of the land or the building.
c) Ownership rights
This can be verified by inspecting the title documents. The auditor should also ensure that such title documents are in the name of the company and are free from ant charges e.g. the land title deed should not be charged as security for loan. if this is the case then such information should be disclosed in the financial statements.
d) valuation
Freehold land should be disclosed at cost. Leasehold lend should be amortized over the life of the lease. Generally buildings should be carried at the depreciated historical cost or at depreciated revalued amounts.
The auditor should ensure that:
• The depreciation policy adopted is appropriate i.e. the rate applied and the estimated useful life.
• Where buildings or land has been revalued that this is carried out by a qualified and reputable valuer and the revaluation seems reasonable.
• That the land and buildings are evaluated for impairment and where necessary written down to the impaired value.
e) presentation and disclosure
For purpose presentation fixed assets should be split into appropriate classes. The following information should be disclosed:
Depreciation policy
Useful life’s
Total depreciation charge for the period additions of new assets or disposals during the period any assets that are charged in favour of another person.
Plant and machinery
Audit objectives
• The auditor will be aiming at proving the following assertions
- proper authorization to acquire the asset
- valuation
- Existence
- ownership rights
- presentation and disclosure
Cost
The significant plant and machinery acquired during the year is vouched supporting documentation such as supplier’s invoices, cashbooks, approved budgets etc.
Authorization
Check in the director’s minutes or aGm minutes for proper authorization for acquisition of the asset. Valuation
Auditor’s responsibility is to ensure that the accounting policy for depreciation is appropriate. For example if the diminution in value of an asset is largely related to time then reducing balance method would not be appropriate but straight line method. Check appropriateness of the useful life. Where the assets have been revalued the auditor should ascertain that an independent and qualified valuer carried out this revaluation.
Existence
Existence should be checked by physical inspection. The problem arises that items of plant & machinery are mobile, numerous, portable and valuable. It becomes difficult therefore for the auditor to be assured that the value attached to the plant and machinery represents plant and machinery that actually exist at balance sheet date. To ensure the existence of plant and machinery, it is necessary to have a fixed asset registrar.
Fixed asset registrar
For it to be independent the person maintaining it must have no responsibility for: the asset purchase, maintenance, custody or disposal.
• Ordering or authorizing the purchase of fixed assets.
• The custody of the fixed assets.
• Authorizing the disposal of fixed assets.
• Maintaining general ledger accounts.
• Custody of readily realizable assets.
The register contains the following information:
i. Fixed asset number.
ii. Fixed asset location and responsibility for custody.
iii. Nature and description of the asset.
iv. The cost and date of purchase.
v. The estimate useful life and residual value
vi. Accounting policy for depreciation
vii. Accumulated depreciation
viii. The gain or loss on disposal
ix. Capital allowances
When the register is reconciled to the general ledger the auditor can check the asset for physical existence by reference to the number and locations recorded.
Beneficial ownership
For plant and machinery, it is usually implied and unless there is clear evidence t the contrary, proof of purchase and possession will suffice as evidence of ownership.
Presentation
This is similar to freehold property
Motor vehicle
Similar considerations should govern verification of motor vehicles as those that govern plant and machinery. The only issue here is existence and ownership.
Existence
If we cannot see the vehicle prove evidence should suffice e.g. if we own a vehicle then we expect that it will incur costs such as insurance, repair, fuel etc. which are proof of its existence.
The engine and chassis number should be checked to ensure that the vehicle described in the logbook is the same one we are looking at as clients can change the registration number plates from one vehicle to another.
Beneficial ownership
Ensure client’s name is the one in the logbook.
Disposal of non-current assets
• The issue here is authorization for disposal
• Also the auditor tries to ensure that he value obtained was reasonable either by engaging an expert or by looking at the values obtained and related values for assets of that nature.
Verification of current assets
Cash in hand
The cash in hand will mainly be composed of the petty cash float and any unbanked receipts from customers. Most organizations refrain from maintaining substantial cash amounts in their premises due to the risk involved.
Audit objectives
The main audit objective is to ascertain the completeness and existence of the cash in hand.
Audit procedures
i. These audit objectives are fulfilled by carrying out the following procedures:
ii. Where appropriate the auditor should visit the client at the balance sheet date and count cash at hand and compare it with cashbook entries. he should count authorized ioU’s, stamps and cheque drafts as well.
iii. if the company has different cash collection centers cash in all entries must be counted simultaneously to avoid a shortage in one centre being made up with balances from other centers.
iv. The counting should be in the presence of the cahier so that in case of a shortage the auditor can ask for a certificate of shortage from the cashier which should be mentioned in the management letter.
v. The auditor should obtain a certificate of cash in hand from all branches should he be unable to attend a cash count in those branches. he should mention this in his report i.e. he relied on certificate of balances from the branches.
vi. If there is cash held by third parties he should request for a certificate of balance from them.
vii. If the auditor cannot visit the client, he should obtain a certificate from the client’s management confirming the amount of cash held as at the end of the financial period. viii. a reconciliation of the actual cash in hand counted and the expected cash balance per the cashbook should be prepared. Any reported variances should be investigated and appropriate action taken.
Cash in bank
Audit objectives
The auditor will be concerned with ascertaining whether:
• The bank balance exists
• Completeness and accuracy
Audit procedures
The above objectives are tested by performing the following procedures: - The auditor should obtain the bank reconciliation statement as at the end of the period and perform the following procedures;
i. verify that the reconciliation is accurately prepared ii. Ensure that the correct balances as per the bank statement and the cash book have been picked in the reconciliation.
iii. verify that all un-presented cheques had been dispatched to the payees and that all un-credited deposits have cleared. This will assist the auditor in testing for window dressing. Window dressing in this context refers to attempts to overstate the liquidity of the company by keeping the cash book open such that money received after year end is credited to the cash book increasing the cash balance and reducing debtors. it could also take place by debiting cheques paid in the period under review but are not dispatched until after year-end.
iv. This procedure of inspecting the bank reconciliation statement assists in verifying the completeness and accuracy of the bank balance. - The auditor should obtain a direct confirmation from the bank of the amount holding on behalf of the client. The auditor should obtain the clients consent to communicate directly with the bank. Where consent is granted a standard letter of request should be sent to the bank. auditors use a standard letter of request because of the following:
• Use of a standard letter by all auditors facilitates the quick preparation of the reply by the bank as they are well familiar with the contents and the required information in the letter.
• Use of a standard letter ensures that no omission is made in the information required.
• It is more efficient for the auditors because all that is needed is to amend the letter to reflect the specific details of the client.
The reply to this request is a good source of corroborative audit evidence to confirm the existence of the bank balance and other information such as the interest earned, any loans granted to the company or any restrictions placed on the operation of the account.
Stocks and work in progress Stock includes:
• Finished goods held for sales in the ordinary course of business
• Work in progress
• raw materials
Stock comprises a significant portion of the company’s assets and hence has a material effect on the presentation of the financial statements.
Problem encountered in the verification of stock
i. The amounts involved are invariably material.
ii. Stock has a one for one impact on the reported profits i.e. an increase in stock increase the reported profit. It is therefore open to distortion by management.
iii. Stock does not derive from the normal double entry system; it is arrived at by stock taking carried out at the year-end. iv. Stocks are portable and valuable opening themselves to pilferage and deterioration either intentional or accidental.
v. The number of items involved is usually numerous creating verification problems as far as existence and condition is concerned.
vi. although stocks are valued at the lower of cost and net realizable value, what constitutes cast can vary from one management to another and the basis of determining that cost can be subject to so many different methods all resulting in different values for the same items.
vii. it is an area that is susceptible to manipulation by management provision for obsolescence, slow moving and damaged stocks is a question of judgment therefore it is easy for the auditor to disagree with management.
viii. stock is normally made up of different items e.g. work in progress, raw materials all these can be valued on a different basis and amalgamated and described as stocks.
ix. Stock may be overstated by inclusion of goods sold but not dispatched to customers.
Audit objectives
a. ascertain the existence of stock.
b. ascertain that stock is appropriately valued at lower of cost and net realizable value.
adequate provisions are created for dead and slow moving stock.
c. verify the completeness and accuracy of the stock balance.
d. Verify that stock is appropriately presented and disclosed in the financial statements. Audit of stock
Cost
This involves determining the method adopted by the organization in costing stocks. The auditor should then check the acceptability and appropriateness of the adopted policies.
The rest of the exercise is to test that the adopted exercise if correctly applied.
Valuation
Stock should be valued at lower of cost and net realizable value where net realizable value is defined as the amount that could be realized on the open market in the ordinary cause of business less the cost of putting them into a saleable condition and less the cost of sales.
it is up to the auditor to ensure that the net realizable value is properly calculated and is in accordance with the accounting standards.
Stocks should be reduced by a provision for obsolete or damaged and slow moving stock. This provision should not be excessive or inadequate. The auditor is guided by the factors such as age of stock, condition of stock, its turnover, technological advances in the industry, nature of stock (perishable or not), prevailing economic conditions etc. these guide him on judging the adequacy of provision for slow moving, obsolete or damaged stock.
Existence
The auditor must obtain adequate independent evidence that the stocks concerned are in existence. On several occasions auditors have certified accounts as giving a true and fair view when the stocks concerned were non-existent. The unfavorable decisions against the auditor have resulted in the profession making it obligatory that where stocks are of a significant figure in the accounts the auditor attending to observe the stock take. It is not the auditor’s duty to take stock
He/she must however satisfy himself as to the validity of the amount attributed to stocks in the accounts that are the subject of his audit. The auditor should examine the internal control in order to determine the nature and extent of audit steps. Where stock is held at a number of locations the selection of the location to be visited should be planned so as to cover all significant locations over a period of years.
When stock is based on records these must be substantiated by continuous or periodical physical stock takes. The records must be up to date.
Stock Taking exercise
It is the responsibility of management to ensure that the amount at which stocks are shown in the financial statements represents stocks physically in existence. The auditor should obtain evidence in order to enable him to draw conclusions about the validity of amounts attributable to stocks. Where stocks are material in the financial statements the auditor should attend the stock take. The auditor must be present during the stock take mot necessarily to count stock but to witness and observe the way stock taking is done to obtain assurance on the existence and value of stock in trade.
The procedures to be followed during the count vary according to the size and circumstances of the business, nature of its stock and its stock records. Define instructions preferably in writing should be issued in all cases for the guidance of those who will be engaged in the actual stock taking. The instructions should contain:
i. Identification of the sock items and their ownership.
ii. Counting, weighing or measuring.
iii. reporting
- of stocks which are damaged or defective. The following issues should be addressed:
• Stock taking should be well planned and carried out systematically by persons who are fully informed of the duties involved.
• These persons should be familiar with the stock but supervisors should be from different departments. Counting should be done by at least two people, one to count and the other to check and record what has been counted.
• Stocks should be marked to facilitate counting. The whole stock taking area should be divided into sections for control purposes and avoids double counting.
• Ensure that properly qualified personnel are available where specialized knowledge is necessary to identify, quality and quantity of stock.
Cut off procedures should be performed i.e. dispatch documents for all goods belonging to customers and still held by client and those that have already passed to the customers. Exclude these from stock take.
include al goods that have been purchased by client. This is in spite of them not being in the client’s premises.
Goods held in safe custody for others should not be recorded as part of the client’s stock.
Arrangements to confirm the goods held for the company by outside parties should be made.
There should be procedures to identify the slow moving and obsolete/damaged stock.
There should be procedures for identification of stage of completion of work in progress.
The following details should be available for the auditors during the stock take:
a. Details of stock movement during the count.
b. The last numbers of goods inwards and outward records for testing the cut off procedures.
c. The details of the numbering of stock sheets issued of those complete and those cancelled ad unused.
Auditors Duties
The procedures to be carried out by the auditor when attending stock taking are divided into:
• Duties before stock take.
• Duties during stock take.
• Duties after stock take. Duties before stocktaking The auditor should:
• Study of the clients stock taking instructions and recommend for changes or improvements if the auditor consider them inadequate.
• Familiarization with the location of the stocks and the opportunity to plan for the work to be undertaken.
• Familiarization with the nature and volume of stocks and especially with high value items. Review of previous year’s working papers and discussions with the managers of any significant changes from the previous year.
Consideration of the location of stocks and likely points of difficulty e.g. cut off.
Consideration of any involvement of the internal audit department and the extent of reliance to be placed upon their work.
Arranging to obtain from third parties confirmation of stocks held by them.
Establishing whether expert advice may be needed.
Duties during the stock take
• The main task id to ascertain whether the client’s employees are carrying out their instructions properly so as to provide reasonable assurance that the stock take was accurate and not necessarily to count stock. He will do this by testing efficiency of the counting by counting selected items.
• he should make notes for follow up purposes of items counted in his presence, details of damaged, obsolete or slow moving items.
• Details of items for cut off purposes should be noted.
• He should find out the methods of identifying slow moving, obsolete or damaged stock.
• record fully the work done and his impression on the stock take exercise.
• he must form a conclusion as to whether the stock take can be relied on.
• Get photocopied of rough stock sheets.
• Get details of the sequence of the stock sheets.
• pay special attention to high value items.
• If the auditor is not satisfied about the way stock taking was conducted, he should inform management and may request a recount.
Note that
The auditor should conclude whether stock taking was properly carried out and can be relied upon for determining the existence of stock. he should also try to gain from his observations an overall impression of the levels and values of stocks held so as he may judge whether the value of stock appearing in the financial statements is reasonable.
Duties after the stock take
This is mainly a follow up exercise and it involves:
• Checking the cut off with the details of last numbers of stock movement forms and goods inwards and goods outward notes during the year and after the year end.
• Ensuring that the final stock checks have been properly prepared from the count records. He/she must particularly check that all the counts sheets issued were returned.
• Check the final stock sheets for pricing, extensions, casting, summarization and the necessary improvement.
• The auditor should ensure that the stock records have been adjusted to amounts physically counted and that all reported differences have been investigated.
• Follow up any notes made in the attendance. Inform the management of any problems in the stock taking exercise so that they can act accordingly.
Non-attendance at stock takes
If the auditor is unable to attend a stock take either, because he has numerous clients with similar year ends or stock is located in remote locations, the auditor must still certify himself on the stock take. The auditor can in such cases:
i. arrange for stock take to be done earlier.
ii. appoint as agent.
iii. Examine perpetual inventory records more thoroughly.
obtain representations from management on the existence, completeness and valuation of stock. - SUBSTANTIVE TESTING Notes
Ownership of stock
in January 1976 the case of aluminium industries vasen bv v. romalpa aluminium ltd, radically altered the law with regard to normal trading practices. Commercial law states that title to good passes to the buyer once they are delivered on a valid contract, therefore if the buying company went into liquidation then the seller company would probably lose the stock and money. This was accepted practice for centuries.
The romalpa case rules that transactions can be made subject t reservation of title such a time as the buying company makes payment. The case further rules that such a reservation should be clearly stated in the appropriate sales documentation and that the rights of the selling company over unpaid for stocks can even extend to goods produced from the store and the sale proceeds there from.
in the strict legal sense, stocks subject to such a reservation clause should not be included in the buying company’s accounts until they are unpaid for.
accounting treatment acknowledges substance over form and as a result the amounts are shown as sales if the selling company is a going concern. If the financial position of the buying company is in doubt then the amounts in question should be removed from both stocks and creditors in the buying company’s books. If the amount if stock is significant then it may be necessary to disclose in a note to the accounts that such creditors are secured by a specific stock.
Presentation
This as in all other assets should be in accord with the appropriate international accounting Standards. The stock should be classified in a manner which is appropriated.
Disclosure
The Companies act and the presentation of a true and fair view require disclosure of secured creditors even though it is not clear whether the creditors secured in this way are covered by the act.
An example of a note to the accounts
The company purchases goods from certain suppliers subject to reservation of title. This gives the suppliers included in creditors in the balance sheet was Shs. X. accounting policies must be disclosed and changes therein as well.
Work in Progress
This item presents greater problems of ascertainment and valuation to the directors and to the auditor even though what applies to stocks applies to work in progress.
The auditor work will include:
• Enquiring into the costing system from which Wip is ascertained.
• Enquiry into checks that are made as part of the system on statistical data concerning inputs of materials and output of products and expectations
• Enquiry into the system of inspecting and reporting on work done so that allowance is made for scrapping and rectification work.
• Determine the basis on which overheads are included in costs.
• Making enquiry into the basis on which any profit elements are dealt with. Profit should be eliminated from work in progress.
• Where the organization constructs intentionally some of its own fixed assets, the auditor must make sure that such items as are under construction are not accounted for twice i.e. in fixed assets and in work in progress.
Debtors
For companies trading in credit debtors are significant balances.
Audit objectives
The auditor will be seeking to obtain sufficient appropriate audit evidence on the following assertions that:
• Debtors are complete
• Debtors exist
• Debtor’s balances are accurately stated
• Debtors are appropriately valued.
Audit procedures
a) Carry out analytical review procedures by:
• Comparing the current year’s debtors to the previous year and obtaining explanations for significant movements reported.
• Compute current year’s debtors’ days and compare this with that reported in the previous period and obtain explanations for the reported trend.
• Compare the ratio of bad debts provision in the current period and compare this with the previous period.
The purpose of these analytical procedures is to provide the auditor with indications as to whether the debtor’s balances are complete and correctly valued.
b) The auditor should obtain a debtors listing and carry out the following procedures:
• verify that the total debtors per listing agree to the ledger balance.
• verify that the balances are not above the credit limit.
c) To test the completeness, existence and ownership carry out debtors’ circularization. obtain payments that have been received from the debtors subsequent to the end of the year. This will confirm the existence of the debtor and will provide evidence as to the valuation. Where the full amount is settled after the year-end, this indicates that the debt was fully recoverable as at year-end.
d) basing of the cumulative information gathered ascertain whether the company has created an appropriate provision for doubtful debts and where appropriate discuss with management as to the recoverability of amounts not settled as at the balance sheet date.
e) Test that the company’s cut off procedures for completeness of debtors.
Provision for bad and doubtful debts
valuation of debtors is a consideration of whether the provision of bad and doubtful debts is adequate or not. The auditor must therefore consider the following matters:
i. The adequacy of the international Control System (iCS) for approval of credit and follow up of poor payers.
ii. The period of credit allowed and taken.
iii. Obtain the list of provision for bad and doubtful debts. Cast the list. Agree the total to the trial balance and the general ledger account. Compare the list to the aged debtors listing to ensure that no debtor has provision against them greater than the total amount due from those debtors.
Examine the evidence justifying the need for a provision. This include: debtors, payment record and correspondence with the debtor, legal action taken against the debtor and information from external sources such as liquidation on receiverships. Review also after date payments to confirm that the provisions are necessary and have not been set up against a debtor who has subsequently settled.
review the debtors not provided for to assess whether they should be in fact provided for. This will involve reviewing the payment record of those debtors who have exceeded their limits or those debtors where other evidence indicates that they could be doubtful.
Debtors’ circularization
This is a procedure by which the auditor obtains corroborative evidence regarding the existence, ownership and the value of debtors appearing in the financial statements. This is done by writing directly to the debtors and requesting written confirmation to be sent directly to the auditor.
Purpose for circularization
• To provide independent third party confirmation of the existence of the debt.
• To confirm the ownership rights to the amounts owned.
• To confirm the money amount.
• To provide support to compliance tests as to the functioning of the internal Control over sales and debtors.
• To bring to light any disputed amounts which could point out irregularities or frauds in the area of debtors.
• To support other evidence with regard to the effectiveness of the cut-off procedures.
Types of circularization
Negative circularization
The debtor is expected to respond to the circular if they do not agree with the contents of the circular. The major drawbacks of this method of circularization is that should the debtor fail to receive the circular and therefore not reply, the auditor may wrongly assume that the debtor is in agreement with the contacts of the circular. Therefore unless the client has a very effective system of internal control or there exists other evidence to enable the auditor satisfies themselves with regard to the purposes of circularization the negative method should not be used.
Positive circularization
The debtor is required to respond to the circular whether they agree or do not agree with the contents of the circular. accordingly the positive method if the preferred method of circularization.
The approach for circularization is as follows:
i. Obtain the client’s consent to send the requests to the debtors. ii. Select the date at which you desire to perform the circularization.
iii. Select the debtors you wish to circularize and confirm management’s acceptance of those debtors.
iv. Draft a circular, which should be from the client to the debtor with the request that the debtor should reply direct to the auditors.
v. Send reminders to non-repliers.
vi. Evaluate the replies. This involves comparing the amount acknowledged in the reply with what appears in the clients’ ledger and investigating any differences.
vii. Perform alternative test to non-repliers.
viii. Conclude on whether the objectives of the debtors’ circularization have been achieved.
Selecting the debtors for circularization
a representative sample should be selected from the debtors listing. When selecting the sample the following classes of accounts should receive special attention:
i. All large debtors would be circularized i.e. debtors above the materially level set for debtors.
ii. Credit balances would also be selected to try to confirm that they are genuine credit balances. This is because debtors system should produce debit balances and not credit balances.
iii. Debtors who seem to have exceeded their credit limits in terms of amounts or time may also be selected.
iv. Small or nil balances on accounts that are normally very active during the year would be selected to confirm that there is no window dressing.
v. Newly opened accounts also tend to be circularized. The remaining accounts tend to be selected on a random basis.
vi. Long outstanding balances. This helps in assessing the need to create a provision for irrecoverable balances.
vii. Accounts in dispute.
Alternative
Where it proves difficult to get confirmations from individual debtors the following alternative procedures can be applied:
i. Review of the after-date payments: because if the debtors have subsequently paid then there is evidence that the debtor was in existence.
ii. Review of supporting evidence for the invoices that make up the balance. These include:
customer orders and acknowledgement or receipting of the goods.
iii. Sometimes the correspondence with the customer is also reviewed.
Cut off procedures
Cut off procedures are tests performed to ascertain whether the company’s transactions are recorded in the financial period to which they relate. If transactions are recorded in the wrong financial period account balances could be over/under stated. E.g. where there is a time lag between the dispatching of goods and the recording of these dispatches as sales, such sales may be recorded as sales in the wrong period.
Cut off test with regards to debtors should be performed to ensure that debtors are recorded in the correct period.
Illustration of testing the sales cut off procedures The following tests can be performed:
i. Take note of the last serial number of the goods dispatch note for the period under review.
ii. verify that the sale was recorded in the current period. iii. verify that such items sold were not included as part of closing stock.
Teeming and lading in debtors
This is a fraud that can occur in debtors if the person in charge of posting entries to the debtors account has access to cash receipts. This can also occur by colluding with the cashiers. This fraud involves the concealment of cash received from debtors by delaying to record the receipts. The cash received is then misappropriated. The debtor could then be written off as a bad debt or money received from another debtor could be credited to such an account concealing the fraud.
Verification of liabilities
The auditors’ duties with regard to liabilities can be summarized as:
a. To verify the existence of liabilities shown in the balance sheet and that these are genuine obligations of the company.
b. To verify the correctness or accuracy of the money amount of such liabilities
c. To verify the appropriateness of the description given in the accounts and the adequacy of the disclosure.
d. To verify that all existing liabilities are actually included in the accounts i.e. completeness
Number (d) poses the most difficulty to the auditor.
Inclusion of all liabilities
It is not enough for the auditor to be satisfied that all liabilities recorded in the books are correct and are incorporated in the final accounts he must also be satisfied that no other liabilities exist but which are not for various reasons in the books and in the accounts.
Examples of such liabilities include:
• Contingent liabilities such as claims by ex-employees for unfair dismissal, pending law suits etc.
• Bonuses under profit sharing arrangements
• Tax liabilities
• Claims under warranties and guarantees
• bills receivable discounted
The auditor must take steps to identify such liabilities. The procedure carried out would include:
• Enquiry of the directors and other officers
• Examination of post balance sheet events, which includes inspection of purchase invoices and the cashbook etc.
• Examination of minutes of meetings
• Review of previous years working papers
• Awareness of the possibilities at all times when conducting the audit e.g. discovering during the audit that the client deals in future will alert the auditor of the possibility of outstanding commitment.
• Obtain a letter of representation from the client.
General verification procedures for liabilities
• Obtain or prepare a schedule for each class of liability. This should show the make-up of the liability i.e. the opening and closing balance and the changes.
• The auditor should verify cut-off for example a trade creditor should not be included unless the goods were acquired before the year end.
• Consider the reasonableness of the liability asking the question whether there may be circumstances which ought to excite suspicion.
• Where there exists a system of internal controls covering that liability, determine, evaluate and compliance test the internal control procedures.
• Consider the liabilities at the previous accounting date. have they all been cleared
• Terms and liabilities. This applies principally to loans. The auditor should determine that all terms and conditions agreed when accepting a loan have been complied with.
• Authority: the authority for all liabilities should be sought. This will found in the company minutes on director’s minutes. Authority of the articles of association or memorandum may be required.
• Description: he should see the description that the account for each liability is adequate.
• He/she should examine all the relevant documents.
• The auditor should find out if there is security and he should ensure that it has been registered. The company’s act requires that the nature of security, the item covered and aggregate amount of debt be disclosed.
• The auditor must satisfy himself that appropriate accounting policies have been adopted and applied consistently.
• External verification: With many liabilities it is possible to verify the liability directly with the creditor.
• The auditor must always perform a post balance sheet review with regard to liabilities.
Current liabilities
Tax payable
Audit objectives To verify that:
• all tax liabilities have been taken up in the books i.e. completeness
• Tax liabilities have been accurately computed.
• All tax liabilities are disclosed in the financial statements.
Audit procedures
• Obtain or prepare the tax computation.
• Review the correspondence between the clients and the tax authority in case any queries have been raised so that the auditor can determine the status of those year’s returns.
• Vouch installment payments to the cashbook and the receipts from the income Tax Department.
• Obtain or prepare a schedule showing the year of income, the balance brought forward, the amount paid in year under audit, charge to the p&l a/c and the balance carried down.
• Balance brought forward should be in agreement with the balance for the previous year.
• The amount paid in the year should be agreeing with the cash flow statement and the cashbook.
• Balance carried forward to the draft balance sheet.
The auditor should ensure that disclosure is adequate. Note to the accounts should explain the basis for driving at the provision for tax that year. On the face of the p&l account the corporation tax charge for that year should be separately disclosed.
Trade creditors
Audit objectives
The auditor seeks to ascertain:
• The completeness and accuracy of the creditors balances.
• That all creditors exist and are genuine liabilities of the entity.
• Creditors are properly presented and disclosed in the financial statements.
Audit procedures
i) Obtain a creditors listing and verify that the total per the listing agrees with the total per the ledger.
ii) From the listing select a sample of creditors and carry out the following procedures
• Obtain or prepare a reconciliation of the creditors balance per the ledger to the suppliers’ statements.
• obtain explanations for all the reconciling items and where appropriate ensure that the reconciling items have been adjusted in the books of account. The reconciling items will mainly include suppliers invoices not posted in the clients ledger or payments not reflected in the suppliers statements.
iii) obtain a sample of payments made to suppliers after year-end and verify that all the invoices that related to the period under review had been accrued for.
iv) obtain all the pending invoices and verify that these had been accrued for.
Provisions and Reserves
Students tend to confuse these two words, which are in common use. The correct use of these two words is:
Provision
any amount retained as reasonably necessary for the purpose of providing for any liability or loss which is either likely to be incurred, or certain to be incurred but uncertain as to amount or as to the date on which it will arise.
Thus a provision:
i. Is a debit on profit and loss account (reducing profit and therefore dividends and retained profits)
ii. is for a likely or certain future payment. iii. is where the amount or the date of payment is uncertain.
Reserve
That part of shareholders’ funds not accounted for by the nominal value of issued share capital or by the share premium account.
The need for the creation of provision is an important consideration for directors who are responsible for accounts and consequently for the auditors. Post balance sheets events can often cast light on the amount of provision required. The auditor has a duty to see that any provisions set up are used for the purpose for which they were set up and that any provision s which are no longer needed are transferred back to profit and loss account.
The verification procedures are:
Verification of provisions and accruals:
a. Review of post balance sheet events often casts light on the amount of the provision required.
b. The creditor’s duty is to see that any provisions set up are used for the purpose for which they were set up and that any provisions which are no longer needed are transferred back to profit and loss account.
c. Consideration attention needs to be paid to accruals as like prepayments they are not checked by the double entry system and therefore open themselves to distortion of the accounts by the senior management.
d. The auditor must ensure that last years accruals are written back.
e. Accruals do not alter mush from year to year and therefore comparison of last year’s and this year’s listing is an essential audit procedure and any that are substantially greater or lesser would call for investigation.
Long-term liabilities
Long term liabilities mainly include term loans and debentures repayable within a period of more than one year. Such liabilities are usually evidenced by an agreement called a debenture. They may be secured by a fixed charge over a specific asset or secured by a floating charge on all the assets or they may be unsecured in which case they are called naked debentures.
Audit objectives To ascertain that:
i. All long-term liabilities are included in the financial statements i.e. completeness and accuracy.
ii. All long-term liabilities are genuine obligations of the entity.
iii. All long-term liabilities are properly presented and disclosed in the financial statement.
all information that is relevant such as terms of the facilities should be disclosed.
Verification Procedures
• Obtain a schedule detailing the sums due at the beginning of the year, additions and redemption’s and the sum due at the year-end.
• Obtain the terms and conditions of the loan as evidenced in the deed. This includes the amount lent, maturity date, repayment terms, interest payable etc.
• Agree the opening balances with last year’s accounts and working papers.
• If any new loans have been received, verify that this was authorized by inspecting the minutes of the board meetings.
• Repayments made should be vouched through the cash book and the register of debenture holders and charges.
• Interest payments should be vouched through the cash book and any outstanding amounts should be correctly accounted for.
• If the loans are secured, confirm that the charge is registered at the registrar of companies.
• Agree total amounts outstanding with the register of debenture holders or the lender.
• Review restrictive terms of the contract and provisions relating to default in payment of interest and principal. if the company defaults in repayment determine the effect on the financial statements such as the need to provide for penalties. In extreme cases the company could be put under receivership.
• If the facility was acquired for a specific purpose, verify that it was actually applied for that intended purpose.
• Ensure disclosure is in accordance with Companies act requirements, clearly stating the date of redemption of the debentures.
Verification of contingencies e.g. Pending Litigation
The auditor should carry out procedures to become aware of any material litigation or claims involving the entity. Such procedures would include:
• Review of the client system for recording claims and disputes and the procedures for bringing this to the attention of the board.
• Examination of the minutes of the board for reference to and indications of possible claims.
• Making appropriate enquires from management including obtaining representations about the existence and nature of litigation against the company. Inspection of bills rendered by the solicitors.
• Reviewing correspondence with solicitors with an estimate of the possible ultimate liability.
• Written assurance in the form of a representation letter from an appropriate director that he is not aware of any other matters referred to the lawyers other than those disclosed. If the auditor is in doubt, he should obtain a direct confirmation from the company’s lawyers. The request must be sent by the client not the auditor.
Share Capital
This is a special sort of liability of a company. When share capital has been issued in a year its verification is as follows:
i. Ensure the issue is within the limits authorized by memorandum and articles of association.
ii. Ensure the issue was subject to a director’s minute.
iii. Ascertain and evaluate the system for control of issue.
iv. Verify that the system has been properly operated. This will involve examining the prospectus (if there is one) applications, applicators, application and allotment sheets, the share register, cash received records, share certificate counterfoils and repayment to unsuccessful applicants.
v. When the issue was one which was contingent upon permission to deal being received from stock exchange then:
• Ensure that permission has been obtained. if it has not been given, all money subscription must be returned.
• Ensure all the money was kept in a separate bank account until all conditions were satisfied.
• Ensure that the minimum subscription has been received. if there are not enough subscribers then the whole is returned.
When the issue is not for cash but for other consideration vouch the agreement and ensure that all entries are properly made.
Vouch the payment of underwriting and other fees. When no new issue of shares has been made the audit work will include:
a. Determine the total shares of each class as stated in the balance sheet and obtain a list of shareholdings which in total should agree with the balance sheet total.
b. Test the balances in the share register with the list and vice versa.
c. if this is not possible at the balance sheet it may be permissible to do it earlier provided that the auditor is satisfied with the system of control over transfers.
d. When the share register is maintained by an independent firm of registrars, the auditor should obtain a certificate that the above work (a & b) has been done.
Loans
Loans can be secured or unsecured. Secured by a fixed charge over a specific asset or secured by a floating charge on all the assets. Secured liabilities are at times called mortgage debentures.
The verification procedures are:
i. obtain a schedule detailing the sums due at the beginning of the year, additions and redemption/repayments and the sum due at the year end.
ii. Note or photocopy, for the permanent file the terms and conditions of the loans as evidenced in the debenture.
iii. Agree opening balance with last year’s papers.
iv. Vouch receipt of new loans with prospectus, board minutes, memorandum and articles of association, register of debenture holders etc.
v. Vouch repayments with debenture deeds. (Terms are correctly interpreted) cashbook, register of debenture holders.
vi. Vouch interest payments with debenture deed, cash book and see amount paid is correctly shown as a percentage of amounts outstanding.
vii. Agree total amount outstanding with register of debenture holders.
viii. If loans are secured, verify charge is registered at company’s house.
ix. Verify disclosure is in accordance with Companies act requirements. Note that long term loans which are repayable within 12 months of the accounting date must be shown as such.
Post balance sheet events considerations
post balance sheet events are those events both favorable and unfavorable that occur between the balance sheet date and the day the accounts are approved by the board of Directors.
Types of events
• Adjusting events – those that provide additional evidence about conditions existing at the balance sheet date.
• Non- adjusting events – those that are indicative of conditions that arose after the balance sheet date.
Examples of adjusting events
An enterprise should adjust the amounts recognized in its financial statements to reflect adjusting events after the balance sheet date. The following are adjusting events which require an enterprise to adjust the amounts recognized in its financial statements.
• The resolution after the balance sheet date a court case which, because it confirms that an enterprise already had a present obligation at the balance sheet date, requires the enterprise to adjust a provision already recognized or to recognize a provision instead or merely disclosing a contingent liability.
• The bankruptcy of a customer which occurs after the balance sheet date usually confirms that a loss already existed at the balance sheet date on a debtor and that the company needs to adjust the carrying amount of debtors by writing off the amount that is irrecoverable.
• The sale of stock after the balance sheet date may give evidence about the net realizable value at the balance sheet date. This can be used to revalue the stock to the lower of cost and net realizable value.
• The discovery of a fraud or errors that show that the financial statements were correct.
Examples of non-adjusting post balance sheet events
A company should not adjust the amounts recognized in its financial statements to reflect non adjusting events after the balance sheet.
Decline in the market value of investments between the balance sheet date and the date when the financial statements are authorized for issue. The fall in the market value does not normally relate to the condition of the investments at the balance sheet date, but reflects circumstances that have arisen in the following period. Therefore the company should not adjust the carrying value of its investments.
Post Balance Sheet Events
Included under considerations of post balance sheet events are those events ordinarily referred to as window dressing. This involves transactions that are entered into before the balance sheet date with the sole purpose of altering the appearance of the balance sheet. They mature or reverse immediately after the balance sheet date.
The provisions of the standard are that,
• Changes should be made to the amounts in the financial statements when it is an adjusting event or it indicates that the going concern assumption is not appropriate to the whole or a significant portion of the entity.
• Material non-adjusting events should be disclosed in the financial statements if their non disclosure would affect the ability of the reader to reach a proper understanding of the financial position or they include transactions which reverse or mature immediately after the balance sheet date but were entered into before the balance sheet date with the primary purpose of altering the appearance of the balance sheet. The information to be disclosed is:
The nature of the event.
A prudent estimate of the financial effect or a statement that it is not practicable to make such a statement.
Management’s use of Post Balance Sheet events
Financial year ends artificially breakdown the line of companies into fixed periods of time. In reality, an entity’s life is continuous. Invariably, there will always be transaction in progress at the balance sheet date i.e. started in the year under review and materializing/maturing in the following year. To determine the portion at the balance sheet date, reference will have to be made to the transactions concerned. Thus to value assets and liabilities for balance sheet purposes and to determine the charges or credits to the profit and loss account, management must consider post balance sheet events.
Audited financial statements become public knowledge well after the year end and even though they relate to past date, they are used for making decisions in the period after become public knowledge. Consequently, should an event take place between the balance sheet date the financial statements become public and such event is not brought to the attention of the readers of the financial statements, those financial statements may be considered not to be giving a true and fair view.
The Auditors interest in Post Balance Sheet Events
Therefore management have used post balance sheet events in preparing the financial statements, the auditor has an interest in ensuring that the post balance sheet events have been properly accounted for.
Timing considerations
a. balance sheet date.
b. Date the directors approve the draft accounts.
c. Date the auditor signs his audit report.
d. The intervening period from the date of signing the audit report to the date of dispatching the audited financial statements to the shareholders.
e. An AGM at which the members either adopt or reject the financial statements.
At the AGM if the financial statements are adopted then the auditors’ responsibility towards those financial statements ceases.
The auditors’ procedures with regard to post balance Sheet Events
i. Discuss with management whether they are of nay such events and if so obtain a full listing of those events.
ii. review minutes of management’s looking for such matters as losses of major contracts, acquisition of a major new business, approval of capital expenditure, the effect of manmade and natural disasters and management plans on discontinuance of sectors of the entity.
iii. review major transactions documents and primary books such as material payments, material receipts, material sales and material purchases.
iv. Consider whether all material post balance sheet events have been identified and accounted for properly.
Contingencies
The standard describes a contingency as a condition existing at the balance sheet date whose ultimate outcome is dependent on the occurrence or non-occurrence of one or more uncertain future events. a contingent gain or loss is a gain or loss dependent on a contingency. The standard then identifies 3 possible conditions of a contingency:-
a. probable
b. possible
c. remote Where: probable means very likely to materialize possible means can materialize remote means unlikely to materialize The standard then says: Losses
If a loss is probable, and it can be estimated with reasonable accuracy it should be provided for in the financial statements.
If a loss is probable but it cannot be estimated with reasonable accuracy it should be disclosed.
If a loss possible it should be disclosed.
If the possibility of loss is remote, even disclosure is not necessary.
Gains
If a gain is probable, do not accrue in the financial statement only disclose.
If a gain is possible or remote, disclosure is not necessary.
The information to be disclosed is:-
• The nature of the contingency.
• The events likely to affect the ultimate outcome.
• A prudent estimate of the financial effect or a statement that it not practicable to make such a statement.
The Auditor’s Procedures
i. Obtain a listing of contingencies identified by management with full management assessment as to whether the contingency is probable, possible or remote.
ii. Examine the evidence or documentation that management have used to identify and classify the contingencies.
iii. Search for any other contingencies that may have been recognized by management. iv. Communicate with the relevant third parties for their assessment of the position. v. Consider whether the requirements of the standard have been complied with. The most common contingencies are:
• Guarantees
• pending litigation or claims
• Discounted bills.
Guarantees
The auditors should refer to the minutes and send and obtain a reply to a bank letter. Discounted Bills again a bank letter should be obtained.
Claims Refer to earlier notes on pending litigation
