#95- Auditing Creditors IV

In previous posts in relation to auditing creditors, we mentioned about:

- Review of Creditors' Statement of Account
- Purchase Cut-off testing
- Comparison of current year balance to prior year balance

In addition to the above, it would be good if a creditors' turnover analysis is performed:

Creditors Turnover (day): Purchase/ Average Trade Creditors x 365 [for periodic inventory system]
Creditors Turnover (day): Purchase/ Average Trade Creditors x 365 [for perpetual inventory system]

Auditor can compare the creditors' turnover (day) computed above to general creditor term given by the creditors to assess if the Company has been repaying on time. If the creditors' turnover (day) is significantly longer than the credit term given by suppliers, this might indicate the liquidity issue the Company is facing.

#94- Auditing Creditors III

In our previous entries in relation to auditing creditors and auditing creditors II, we discussed about the audit procedures for trade creditors balances:

(i) Review of Creditors' Statement of Account
(ii)Purchase cut-off testing [ Please also refer to interesting comments posted by our readers

Apart from the procedures mentioned above, auditor should also perform analytical review, by comparing current year creditors' balance to prior year creditors' balance to investigate if there's any unusual fluctuations or absence of expected fluctuations.

For instance, sales volume for ABC company reduced substantially during the year, while the trade creditors balance has increased significantly. We need to understand / analyse the reasons caused the increase in trade creditors' balance while the sales volume has dropped substantially. One of the possible answer is due to the ABC Company is having liquidity issue, and resulted in delaying in repaying its trade creditors.

A good and thorough analytical review give auditor a better understanding of the business.

#93- Auditing Creditors II

In addition, we should perform purchase cut-off test to address the potential risk of misstatement arising from improper cut-off.

As an auditor, we can examine the Goods Received Notes ("GRN") near year-end and after year-end to check that Goods Received Notes details matached with the supplier's delivery order details and supplier's invoices details.

For instance, Auditor Arthur is auditing Company E (whose year end is 30 June 2010) creditor's balance. As part of cut-off testing procedure, Auditor Arthur requested the details of Goods Received Notes near year-end and after year-end. And noted the following sample:

"Goods received notes was generated on 01 July 2010, however, supplier's invoices, supplier's DO indicated the date of 30 June 2010. Further investigation revealed that, supplier generated their internal documents on 30 June 2010, but only delivered the goods to Company E in 01 July 2010. As such, there's no exceptions for Company E"

Cut-off testing is deemed as a compulsory procedure in auditing creditors' balances.

#92- Auditing Creditors

One of the procedures required to audit trade creditors account is to audit the creditors' statement received from the audit client's suppliers (i.e. external audit evidence).

In normal business circumstances, suppliers will send their monthly Statement of Account to their customers to inform the customers in relation to the outstanding balances. Hence, our audit client will , most likely, receive statement of account from the suppliers.

As part of audit procedure, we can check the suppliers' statement (received by our audit customers) against the creditors' balance recorded in their book. Discrepancies need to be investigated. Statement of account served as an external confirmation to check if our audit client's book has been prepared properly.

However, there are suppliers who do not have practices of sending out Statement of Account to their customers. In this instance, we can send external audit confirmation to the suppliers to confirm outstanding balances.

#77 Auditing Creditors- Creditor Turnover Analysis

In audit, it's essential to form an expectation of the Company's results before we really drill into the details. We compare the actual Company's results to our expectation, and investigate the variances accordingly. This is the analytical procedures adopted by most of the audit Company. Besides, we also compare the result / financial position with prior period.

Creditors' turnover anlaysis is one of the auditing procedure we performed. What are we expecting from the audit client, in general. We expect the creditors turnover (days) to increase, as compared to prior period.

To illustrate, majority of our audit clients are affected by the economy turmoil. They are squeezing suppliers' credit ( by delyaing the repayment), in order to maintain the Company's working capital, as our audit client's working capital are most likely affected by the delay of repayment from customers.

We have formed an expectation, and we will compare the actual result with our expectation. Any unusual movements need to be identified.

Small Business Accounting- Interest Expense

What are the entries to record interest expense incurred on borrowings from bank ? Upon occurrence of interest expense:

Dr. Interest Expense (P/L)
Cr. Interest Payable (B/S)

Upon repayment of interest payable to bank:

Dr. Interest Payable (B/S)
Cr. Cash (B/S)

Breach of Debt Covenant

While a Company withdrawn loans from bankers, a debt covenant condition will be stated on the term loan facility letter require the Company to maintain /meet certain financial position. For instance, the debt covenant might require the Company to maintain current ratio of at least 1, or maintain net worth ( i.e. net asset) of certain amounts.

If the Company does not meet the debt covenant requirement, the bank is contractually entitled to call back the loans immediately. To illustrate, if Company XYZ fail to meet debt covenant requirement of maintaining current ratio of 1, bank is entitled to call back the loans amount immediately.

However, in practise, the Company will negotiate with its bankers to extend the period of review ( ie. extend the timeline for the Company, in order for the Company to improve its financial positoin).

For auditing purpose, the Company must require a waiver letter from the bank as an evidence that the bank will not call back the loan immediately. If not the non-current portion of term loan has to be classified as term loan if waiver letter was not obtained after the Company has breached its debt covenant.

#75 Auditing Interest Expense

What's the most effective way of auditing interest expense recorded?

In order to verfiy the reasonableness of interest expense recorded, we used the following formula:

Principal x Average Interest Rate x Period = Interest Expense

Some of the auditor would perform vouching to bank advice by tracing the amount reflected on bank advice to amount stated on General Ledger. However, vouching only ensure the existence, it does not address completeness.

As a result, reasonableness is always useful to check for the completeness of expenses recorded.

#58 Inter-company Confirmation (cont'd)

If there are balances cannot be reconciled properly, while the difference are not material / not significant to the Financial Statement. The balance can be 'dumped' into trade receivable/ trade payable a/c balance. This is because, amount due from / amount due to inter-company should be nil at Group level Financial Statement.

Un-reconciled inter-company balance can result in inter-company balance not fully eliminated. In practice, the un-reconciled would be written off or classified as trade receivable/ payable (while the difference is not material) to the Group account.

#57 Fixed Asset Acquisition

What are the accounting entries for fixed asset acquisition:

Dr. Fixed Asset
Cr. Cash / Creditors
( Being fixed asset purchased)

What if the fixed asset acquisition is financed via Hire Purchase, what would be the entries then:

D. Fixed Asset
Cr. Creditors

Dr. Creditors
Cr. Hire Purchase Liability

#56 Inter-company confirmation

Intercompany confirmation have to be sent out to respective inter-company in order to confirm the outstanding balance due from/ due to inter-company. Discrepancies have to be reconciled immediately.

Discrepancies on inter-company balance could impact the Group figure during group consolidation. To illustrate, difference on inter-company balance on respective inter-company's book could resulted in inter-company balance not fully eliminated at Group level. If the discrepancies are significant, the Group account is likely to be eliminated.

Hence, it is important to ensure that inter-company balances are reconciled properly.

#55 Unrecorded Liabilities

Generally, unrecorded liabilities could be due to:

- Timing difference
- Management's intention do delay the recognition of liabilities
- Management not aware of the liabilities

Hence, a nencessary steps need to be taken to ensure the completeness of liabilities.

#50- Search for Unrecorded Liabilities (Post 2)

A search for unrecorded liabilites is to check for the completeness of the information disclosed by management / balances disclosed on the management account. However, the work is always the trickiest and toughest. A substantial amount of informations are required to fulfill the audit's satisfactory level.

How can we ensure completeness of contingent liabilities?

- Inquire with management on the status of the on-going project, analyzed the circumstances and identify potential commitments and contingencies which might have been made by managment, but not disclosed.

- Sending bank confirmation to obtain external evidence on potential bills payable, letter of credit, etc.

- Examine all the agreements of the Company to identify potential liabilities, such as: corporate guarantee given to bank for guarantee over subsidiaries' loan.

- Examine minutes & resolutions to identify on-going activities which might require commitments and contingencies

#45- Timing of accruing expenses

We got the following query from the reader:

" ...Could you please tell me when the accrued expenses should be accounted for in system (AP)? is it at the beginning of each month? and once accounted should it be reversed immdiately after entering the corresponding expense for the accrual or should it be done in one go at the end of each month"

Before answering the question, we need to find out the nature of accruals, which is:
- to account for service received but billing not received from suppliers
- to account for expenses incurred ( e.g. montly provision for bonus)

Hence, practially, accruing for expenses should be done at the end of each month while doing month end closing. Yes, the amount should be reversed out immediately upon receiving the billing / payout the expenses. To illustrate with the following example:
Company XYZ has received repair & maintenance services from a service provider. The service amount has been agreed at US$500. However, at the end of the month, no billing has been received and the following entry have to be passed:
Dr. Repair Expenses
Cr. Accrued Expenses

Upon receiving the billing from service provider, the following entry should be passed to reverse the accruals:
Dr. Accrued Expenses
Cr. Trade Creditors

#43- Trade Creditors confirmation

We received a questions from our blog reader with respect to the trade creditors' confirmation, as the following:

"... I realised one of my client have many creditors. And most balances are very healthy with 0 balance at year end. Their transactions is quite material ranging from RM300,000 to RM500,000 mostly. Do I need to send confirmations to these 0 balances too or just pick randomly. Thanks lots! :).."

The purpose of sending trade creditors confirmation is to obtain external evidence that the risk of liabilities not recorded are minimal. Although all the trade creditors might appear to be material, some of the balances might be made up of one single transactions and the volume of trading might be low.

Hence, to answer your queries, trade creditors confirmation should be sent to 'Major' trade creditors, with whom the Company has high volume of transactions. Amount might be immaterial as at the balance sheet date, due to recent repayment before year end. However, the risk of liabilities not recorded are usually associated with trade creditors, with whom the Company has high volume of transactions.

Besides, you could rely on statement of accounts forwarded from suppliers as an external evidence.

#28 Auditing audit fees

How do we conduct the auditing process for audit fees as an auditors? What do we have to do?

Firstly, we have to obtained the agreed/ proposed audit fees for current year. And we used the formula below to assess the sufficiency for recorded audit fees:

Agreed audit fees + Reversal of Overprovision (if any) - Additional Accrual for Underprovision (if any)+ Additional audit related charges incurred during the year

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#23- Accounting for Accrual for Expense

In accordance with matching principle, we make provision for the expenses which have not been billed by our suppliers or the company has not paid out the expenses, if the underlying services are rendered in the corresponding period. Example for accrued expense, include:

1. Accruals for audit fees, tax agent fees
2. Accruals for Payroll, Bonus & CPF
3. Accruals for rental

etc.

The company can make the accruals based on the agreed quoting from the suppliers. The accruals for expense entry:

Dr. Expense ( P & L)
Cr. Accrulas (Balance Sheet- Liabilities)

#22- Search for Unrecorded Liabilities

How do we ensure that the Company has accounted for the expenses incurred before year end? ANd it should be recorded in the appropriate period if the expenses has not been billed by the suppliers?

1. Look through unpaid invoices - look at the description of the services provided, and invoices date, Delivery Order date

2. Look at payment voucher after year end to find out the expenses that should be recorded in prior period, if any

3. Sent confirmation to suppliers to confirm the amount outstanding as at year end

4. Look at the expenses account, for potential indication of services which should be accrued in current year Profit & Loss

5. Perform cut off test.

#9 Is banker's guarantee a contingent liability?

Companies sometimes have outstanding banker's guarantee such as those given in lieu of deposits, performance guarantees given to customers etc. Such banker's guarantees do not meet the definition of contingent liabilities under FRS 37.

The events that may trigger payment by the banks are within the control of the Company and are not uncertain future events. The Company does not have any present obligation until it defaults on payment of lease or fails to perform the contracts. These banker's guarantees should not be described as contingent liabilities of the Company in the financial statements.