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 looks 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.
Audit Assertions for Expenses
In the audit of expenses, we usually test the audit assertions that are included in the table below:
|Audit assertions for expenses|
|Completeness||All expenses that should have been recorded have actually been recorded.|
|Cut-off||All expenses have been recorded in the correct accounting period.|
|Accuracy||All expenses transactions have been recorded correctly.|
|Occurrence||All expenses that have been recorded actually occurred and are related to the client.|
|Classification||All expenses have been properly classified.|
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.
Control Cycle for Expenses
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.
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.
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.
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.
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.
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.