Audit - cut-off test for inventory - implication arising from attendance of stock-take

Attendance of stock-take is an audit procedure carried out by auditor to test the existence and completeness of client's inventory balance as at the audit period.

Generally, auditors would select random samples from inventory list and test count the physical stock to test the existence of the inventory recorded on inventory list. Also, auditors would pick some physical random stocks from the floor and test that these stocks have been recorded in the inventory to address the assertion of completeness.

Random samples are selected by auditors for the purpose of auditors' procedures - however, this may not be sufficient. What are the procedures to be carried out to ensure that stocks are not added to stock list incorrectly subsequent to auditors' count?

- Auditor need to obtain the complete inventory list on the stock count day - with quantity, value and total value been stated clearly
- Auditor is required to perform cut-off test by checking to delivery orders (for goods outward) and goods received notes (for goods inward) subsequent to stock-count day to test that these inventories are not included in the inventory list obtained.
- Also, please match the inventory list obtained on the stock-take day to final inventory list to identify any variances. Any movement in stocks must be explained and supported by appropriate evdience.

A inventory cut-off test has a similar objective of sales and purchase cut-off tests, which assist to ensure that inventory movements are recorded in the proper period.

Please drop us an email at myauditing@gmail.com if you require any further clarification.

Auditors' poor soul

Do you as an auditor feel that you have a poor soul in most of the times? While the surrounding people are busy with their life, you are burying yourself in piles of working papers.

Reminders from partners, chasers from audit clients, juggling to meet the time-line - do you feel poor?

Review of cash flow statement: operating activities, investing activities, financing activities

In cash flow statement prepared on an indirect method, the preparer is required to assess the cash flow activities belongs to which categories: operating, investing or financing activities. It is important to have a clear mind and exercise cautious in reviewing the "classification" of cash flow activities.

To illustrate, during the year, a Company ABC received non-current funding from its holding company. It is the intention of the Company to borrow the fund from its holding company to run the opeartions. As such, the fund received from the holding company need to be disclosed as "financing activities" instead of "opearting activities". This will assist the financial statement user to understand the nature of fund received from holding company.

We also want to highlight the following items where the financial statement preparer may mess up:
Dividend received: this is part of investing activities, as it represents the return on investment the Company made
Dividend paid: this is part of financing activities, as it represents the return given to the shareholder - who had invested in the Company's shares
Acquisition of property, plant and equipment: investing activities- as this represent the company's investment in asset to generate return

In short, we propose the auditor to review the classification of cash flow activities cautiously to assess the reasonableness of the disclosure.

How to identify provision for warranty / goods returned - credit notes review

During the course of your audit, you may note that there is high % of goods returned or customer utilised the warranty provision. Goods returned / utilisation of warranty could be quite common in certain industry, e.g. retail / electornic / mass production industry. What will be the implication to our audit?

In this instance, we should request our audit client to perform a retrospective review of the history of goods returned and determine how many % of total goods sold had been returned to the Company in the past. A provision for goods returned or warranty should be recorded on a monthly basis. This is because, based on historical experience, the Company will not be able to earn 100% of its goods sold / delivered.

A good way for auditor to test / review the goods returned history is to check the credit note issued during the year and check the nature of the credit note. If there is high volume of credit notes being issued for goods returned, then it is important for us to emphasize to client to accrue for provision for gooods returned.

Auditing technique - experience of an audit manager/ executive: talking to audit clients

We would like to share with you on one of the useful / fruitful auditing techniques for jounior / senior auditors / executive / managers - talking to audit clients.

What we noted recently in the auditing industry is we noted that auditors have been spending time in digging out documents / reviewing documents / checking sales invoices, suppliers' statement of accounts, goods- received notes etc etc. No doubtul that test check to supporting documents is an important element of our audit. However, it is also important to talk to our audit clients.

By talking to our audit clients ( or rather chatting), we will understand that significant business developments, potential changes to the business, significant accounting and auditing issues - all these may help us to identify issues. Identifying accounting and auditing issues allow us to address the issues and resolve the issues earlier.

Certain changes may not be easily identifiable/ visibly obsivous from the financial results. A discussion with audit client may make you become aware of the impact of certain changes / events/ matters. As a result, we emphasize to all auditors on the importance and the need of talking to our audit clients frequently. Maintaining a good relationship with audit clients allow you to execute the audit smoothly.

Review of management's assessment for compliance with debt covenant

It is common that debt covenants are imposed on loans extended by bankers to their own customers, including: financial covenants based on year-to-date financial performance/ financial position of our audit client.

It is important to remind our audit client to read the clauses carefully and understand that term completely. For instance, a banker required an audit client to maintain consolidated net worth of US$60 million at all times. The definition of interpretation will be clearly defined in the clause the bank facility letter. This need to be reviewed carefully to ensure that breach of debt covenant is identified on a timely basis.

To illustrate, our audit client XYZ may have a consolidated net worth of US$62million, including foreign currency translation reserve of S$5million. Certain banks may exclude foreign currency translation reserve in computing the net worth- this will lead to the breach of debt covenant if the requiement is US$60million.

In short, it is important for auditor to understand the bank facility letter and review management's assessment cautiously.

Important notes while using debtors' turnover (days) analysis

In analyzing debtors' balance, it is common for us to compute debtors' turnover (days) in our analytical review procedures to assist us in understanding the fluctuation of debtors' balance. The formula of debtors' turnover (days) is as follows:

Debtors turnver (days) = Average Trade Debtors balance / Sales for the year x 365 days

Generally, in the audit industry, we will compare current year debtors' turnover (day) with preceding period and identify any movement. Nevertheless, it is important to note that debtors' turnover day is the result of a computation based on the formula above. The result may not represent the actual events.

For instance, by using the formula above, an auditor note that the debtors' turnover day has improved 60 days in prior year to 30 days in current year. It is dangerous to conclude that the debtors' turnover day has improved. It is important for us to understand further from management on the reason for the decrease in debtors' turnover day. This is because, assuming that there is no significant changes to the pool of customers, it is unlikely for a customers to pay faster than prior period. Unless, there is special incentive (e.g. discount on early settlement) given to customer in current year to settle outstanding debts promptly.

As a result, we should not solely rely on the result of a formula. We should always match the data computed against actual business scenario to ensure that we understand the business and cross- check the data.

Question for auditors- do you all factor in inflation while doing sales analysis

We have one question that we want to hear from our fellow followers and readers of accounting and auditing blogs. As part of audit procedures for most of audit firms, it is compulsory to review and understand the fluctuation of certain accounts, for instance your sales revenue.

We would like to understand from you, do you all factor in inflationary rate while factor in the review of income statement, e.g. sales revenue, operating expenses, etc? To illustrate, your expenses level may stay relatively constant at prior period level. However, given the inflatinonary rate of 5%, should the expenses be higher, assuming volume stay constant??

We would like to hear from you on whether did you factor in the inflationary factor, and how did you address that. Thank you very much.

Something interesting: Warren buffet's comments on goodwill

Just want to share with you some interesting comments by Warren Buffet, a promoninent value investor relating to goodwill.

" ... $15.5illion of goodwill that is attributable to our insurance companies and inlcuded in book value as an asset. In effect, this goodwill represents the price we paid for the float-generating capabilities of our insurance operations. The cost of the goodwill, however, has no bearing on its true value, For example, if an insurance sustain large and prolonged underwriting losses, any goodwill carried on the books should be deemed valueless, whether its original cost" (Extracted from Berkshire Hathway- Letter by Warrent Buffet to the shareholders- 2012"

What Warrent Buffet commented is true from a commercial perspective. Goodwill represents the premium a company paid for in an acquisition. The true value on the book could be higher than its book value. If management opined that the true value of the goodwill is lesser than its book value, then the goodwill need to be written down to its recoverable amount. For a company in sustained losses position, it is no easy to proof that no impairment is required for this goodwill.

As a result, as a auditor, we need to perform thorough review on the impairment assessment of goodwill instituted by management.

To our Accounting & Auditing blog readers

Dear all,

We would like to thank you for the supports you have given to us in the past. We are very proud that the followers of our blog has been increasing gradually over the past few years from nil to approximately 125. Given the fact that accounting and auditing is a rather niche area, we have no complaints.

Nevertheless, we would like to remind our readers that: please feel free to drop us email at myauditing@gmail.com if you have any questions relating to accounting and auditing issues, client-related matters, career advancements, university-related questions. We will try out best to answer the concerns you posted to us.

Again, thank you very much for your support in the past.

Review of petty cash amount- potential financial loss

As an auditor, we should also review the reasonableness of petty cash amount held by individual. Petty cash are generally held by invidiual (usually employees of a company) for disbursement of daily expenses / urgent payment when necessary.

Nevertheless, an individual shall not hold petty cash amount far exceeded the amounts required. This is because there is potential risk that individual may mis-appropriate the funds and resulted in financial loss to the Company.

As a result, management should exercise control to review the budgeted petty cash outflow for the month and furnish this petty cash to the person in-charge. It is not ideal for the Company to disburse significant cash amount to an individual. The Company can always top-up the petty cash amount when requested.

Audit clients with presence in China and Malaysia

Some of our audit clients may have subsidiaries in overseas, e.g. China and Malaysia.

If your audit clients have presence in China and Malaysia, pelase take note that there is a increase in minium wages in certain provinces of China and the entire Malaysia. The minium wages differ among differnt provinces in China. It is important for you as auditor to find out the actual minimum wages rate for the particular regions where you audit client has presence. For Malaysia, the minium wages has increased to RM 900.

It is important to form an expectation that the salary costs are expected to increase in FY 2012, if your audit clients have presence in the countries mentioned above.

Disclosure of the source of deferred tax assets and liabilities

Our audit client may have recorded deferred tax assets and liabilities on its balance sheet/ statement of financial position. Deferred tax is essentially the tax impact arising from the temporary difference between the Company's accounting and tax carrying value. For instance, the net book value of a property-plant and equipments are usually different between accounting book and tax book. This could be because the depreciation policy for accounting book ( i.e. set by the Company) and tax book (i.e. set by the authority) is different.

In reviewing the financial statement of our audit clients, who has recorded the deferred tax, we need to ensure that the Company has disclosed the source of the deferred tax assets / liabilities. This helps the financial statement users to understand the nature of the deferred tax assets / liabilities.

Generally, deferred tax assets are mainly attributable to:
- recognition of unutilised tax losses
- recognition of unabsorbed capital allowance
- differences on depreciation

Whereas, deferred tax liabilities are attributable to:
- differences on depreciation
- differences on provision

By disclosing the source of deferred taxes, the financial statement users can understand the balance sheet, as well as the tax expense of the Company.

Provision for restoration cost/ provision for reinstatement cost

When an audit client signed an rental / lease agreement to lease a space (i.e. office / warehouse), please make sure that we, as an auditor, we review the agreement thoroughly.

Generally, audit client has to reinstate/ restore the lease space to its original state. To illustrate, audit client may have renovated the building for its own purpose. The owner would request the audit client to reinstate the lease space to its original state when the lease expire and the audit client decided not to renew the lease agreement.

A provision for instatement cost / restoration cost need to be recorded, as it is an existing obligation of the audit client. This amount relates to the cost to be incurred to reinstate the lease space back to its original state. This amount can be estimated by obtaining quotation from the renovator / building contractor.

The accounting entries are:
Dr. Fixed asset- reinstatement cost
Cr. Accrual

The amount capitalised above relates to the full cost to be incurred when the lease expire ( note: assume the inflationary adjustment to be not material. On an annual basis, the following entry need to be recorded:

Dr. Reinstatement cost- P&L
Cr. Accum Dep- Fixed asset- reinstatement cost
This amonut is computed based on the amount capitalised divided by remaining lease period.

The depreciation entry is to record the cost capitalised into P&L on a straight line basis.