Welcome to the "Heart" of the Audit!
Hi there! If you’ve been following the Audit and Assurance (AA) syllabus, you’ve already learned about the "rules" of evidence. Now, we are getting into the exciting part: The Audit of Specific Items. This is where we stop talking about theory and start looking at how we actually check the numbers in the financial statements.
Think of an auditor like a detective. Management has given you a "story" (the financial statements), and your job is to find the proof (evidence) to see if that story is true. Don't worry if this seems like a lot of detail at first—we’re going to break it down item by item using simple logic!
Quick Reminder: In this chapter, we focus on Substantive Procedures. These are the actual tests we do to find material misstatements in the numbers. We are checking Assertions like: Is it really there? (Existence/Occurrence), Do they own it or owe it? (Rights and Obligations), Is everything included? (Completeness), and Is the amount right? (Accuracy, Valuation and Allocation, Cut-off).
1. Auditing Inventory (The Warehouse Check)
Inventory is often high risk because it involves counting physical goods and determining what they are worth.
The Inventory Count (The Big Event)
As an auditor, you don't usually count every single item yourself. Instead, you observe the client’s staff doing the count. This checks for Existence.
• Before the count: Review the client's count instructions. Are they organized? Will they stop production so items aren't moving around?
• During the count: Perform "test counts."
- Floor to Records: Pick an item on the warehouse floor and trace it to the inventory sheet (Checks Completeness).
- Records to Floor: Pick an item on the inventory sheet and locate it on the warehouse floor (Checks Existence).
Valuation: How much is it worth?
Inventory must be valued at the lower of Cost and Net Realisable Value (NRV).
Formula: \( \text{NRV} = \text{Estimated Selling Price} - \text{Costs to Complete} - \text{Selling Costs} \)
Auditor Trick: Look for dusty or damaged boxes during the count. If an item is damaged or obsolete, its NRV might be lower than its cost, and the value must be written down!
Key Takeaway: For inventory, we care most about it actually being there (Existence) and being valued correctly (Valuation).
2. Auditing Receivables (Money Owed to Us)
When customers owe the company money, how do we know the balances exist and will actually be paid?
Direct Confirmation (The "Letter" Method)
The best way to check receivables is to ask the customer directly. This is called a Circularisation.
1. We (the auditors) select a sample of customer balances from the sales ledger.
2. We ask the client to prepare the letter, but we control and mail it ourselves.
3. The customer replies directly to us (the auditor), not the client. This prevents the client from altering or hiding responses!
What if the customer doesn't reply?
Don't panic! If they don't answer, we use Alternative Procedures:
• Check Subsequent Cash Receipts: Did the customer pay the balance after the year-end? If they paid it in January, it proves the debt was genuine and collectible at December 31!
• Inspect underlying sales orders, delivery notes, and sales invoices to prove the sale occurred.
Did you know? Checking if a customer paid after the year-end is the strongest evidence for the Valuation of trade receivables. If they paid it, it is clearly recoverable!
3. Auditing Bank and Cash
Cash is liquid and susceptible to misappropriation, so auditors test it thoroughly.
The Bank Confirmation Letter
We send a standard confirmation request to the client’s bank. We aren't just checking the current balance; we are checking for:
• All bank accounts held (including closed accounts and foreign currency accounts).
• Outstanding loans, overdrafts, and accrued interest.
• Any assets the bank is holding as security (collateral) or guarantees given.
The Bank Reconciliation
The company's cash book balance rarely matches the bank statement balance due to timing differences (e.g. unpresented cheques or outstanding lodgements).
Step-by-step:
1. Obtain the year-end bank reconciliation prepared by management.
2. Agree the balance per the bank statement/confirmation to the Bank Confirmation Letter.
3. Agree the balance per the cash book to the General Ledger.
4. Re-perform the arithmetic on the reconciliation to ensure mathematical accuracy.
5. Trace outstanding lodgements and unpresented cheques to post-year-end bank statements to ensure they cleared in a reasonable timeframe.
4. Auditing Non-Current Assets (Buildings, Vehicles, Machinery)
Non-current assets (NCA) are usually material figures on the statement of financial position. Our main focus is Existence, Rights and Obligations, and Valuation.
Procedures for NCA:
• Inspection: Physically inspect a sample of assets from the non-current asset register to the factory floor to confirm Existence.
• Title Deeds & Registrations: For land and buildings, inspect title deeds or Land Registry certificates; for vehicles, inspect registration documents to confirm Rights and Obligations.
• Additions: Vouch a sample of asset additions to purchase invoices and board approvals to verify cost and capitalisation.
• Disposals: For assets sold, agree proceeds to bank statements and recalculate the profit or loss on disposal.
• Depreciation: Re-calculate the depreciation charge for the year, evaluate whether useful lives and residual values remain reasonable, and check consistency with prior years.
5. Auditing Payables and Accruals (Money We Owe)
Here, the risk is different. Management might want to understate debts to make the company look more liquid and solvent. This means we focus heavily on Completeness.
The Search for Unrecorded Liabilities
This is a fundamental substantive test for payables! We review payments made after the year-end in the bank statements and cash book.
Example: If the year-end is December 31, and we see a payment to a supplier in January for goods received before December 31, we trace it back to check if that liability was accrued or included in payables at year-end. If not, payables are incomplete!
Supplier Statement Reconciliations
Suppliers send monthly statements saying "You owe us \$X." We reconcile a sample of supplier statements to the client's purchase ledger balances and investigate reconciling items (such as invoices in transit or disputed invoices).
Memory Aid: For Assets, the primary risk is Overstatement (Existence/Valuation). For Liabilities, the primary risk is Understatement (Completeness). Just remember: "Assets = Are they there? Liabilities = Are they ALL there?"
6. Auditing Provisions and Contingencies
Provisions involve significant management judgement and estimation uncertainty (e.g. warranties, legal disputes, restructuring), making them high-risk areas.
Key Assertions: Completeness, Valuation and Allocation, Presentation
• Inquire & Inspect: Inspect board minutes, correspondence with lawyers, and customer complaint logs to identify any potential legal claims or obligations (checks Completeness).
• Legal Letters: Review responses to direct enquiries sent to the client’s legal advisers to corroborate the probability and estimated cost of pending lawsuits.
• Evaluate Assumptions: Assess the reasonableness of management’s assumptions and calculations for provisions against historical data (e.g. past warranty claim rates).
• Subsequent Events: Check payments or settlements made after the year-end to verify whether the estimated provision amount was accurate (checks Valuation).
• Disclosures: Inspect financial statement notes to ensure contingent liabilities and provisions comply with disclosure criteria.
7. Auditing Revenue (The Top Line)
Revenue is usually the largest figure in the statement of profit or loss, and auditing standards highlight a rebuttable presumption of fraud risk in revenue recognition.
Key Assertions: Occurrence, Completeness, Cut-off, Accuracy
• Cut-off Testing: Select a sample of Goods Dispatch Notes (GDNs) recorded just before and just after the year-end date. Trace them to the corresponding sales invoices and the sales ledger to ensure revenue is recognised in the correct accounting period.
• Occurrence: Select a sample of sales transactions recorded in the sales ledger and vouch them back to customer purchase orders, approved price lists, and signed GDNs to ensure goods were actually delivered.
• Completeness: Select a sample of GDNs issued during the year and trace them forward to the sales invoices and the sales ledger to confirm all deliveries have been billed and recorded.
• Substantive Analytical Procedures: Compare monthly revenue against budgets and prior years; calculate gross profit margin by product line and investigate significant fluctuations or unexpected trends.
8. Auditing Share Capital and Reserves (Equity)
Equity transactions are typically low in volume but material in value, subject to legal and statutory requirements.
Key Assertions: Completeness, Occurrence, Classification
• Authorised & Issued Capital: Agree the nominal value of issued shares to statutory documents (e.g. certificate of incorporation, articles of association, and the register of members).
• New Share Issues: For any shares issued during the year, inspect board minutes for proper authorization, verify cash proceeds received to the bank statement, and confirm the split between share capital (nominal value) and share premium.
• Dividends Paid: Agree dividend payments to board and shareholder approval in minutes, re-calculate the dividend per share, and verify payment transactions in the cash book and bank statements.
• Retained Earnings & Reserves: Re-perform the calculation of closing retained earnings by taking opening retained earnings, adding the profit for the year, and deducting dividends paid.
Summary Checklist for Students
When you are asked to write audit procedures in the exam, try to use the AEIOU mnemonic to help you think of actions:
• Analytical Procedures (Comparing this year to last year or budgets).
• Enquiry (Asking management and third parties questions).
• Inspection (Looking at documents or physical assets).
• Observation (Watching a process, like the inventory count).
• recalcUlation (Checking the mathematical accuracy of client workings).
Final Tip: Always be specific. Don't just say "check the invoice." Say "vouch the purchase price of the asset to the supplier invoice to confirm the cost recorded." Specificity earns the marks!