#106- Stock-take for entities with incident / experiene of fraud

Management of certain companies may encounter incidents of stocks losses due to misappropriation of assets by its employees, i.e. their employees stole the company’s stocks for personal benefit (i.e. personal usage/ personal profits after selling it out).

Let us discuss together on What Could Go Wrongs (“WCGW”) in the internal control system that may result in the entity exposure to the risk of fraud:

- stock take is not conducted on a regular basis (i.e. stock take on a half-yearly basis)
- quantities and movement of provision stocks / obsolete stocks are not kept tracked (note: these stocks usually carry scrap value, and might be misappropriated if there’s no proper record)
- physical stocks are not stored in safety area
- CCTVs not installed in warehouse
- ineffective procedure in updating inwards/outwards of stocks into stocks record

The list above is not exhaustive and it is for reference only

From management perspective, there are a few areas / procedures need to be carried out when they had experienced / encountered fraud with regard to their physical stocks:

- improve accountability of the employees by assigning different area of stocks of different employees
- impose penalty on all warehouse employees while there’s material stock differences ( e.g. penalty on warehouse employees if stock-take difference is greater than 0.5% of total stocks)
- employ strict security access to the warehouse
- install CCTV in the warehouse and perform random check on certain time slots
- security guard to perform check on employee’s bags before allowing the employees to leave the premises
- ensure that stock-take is conducted on a regular basis and any stock-take difference is investigated


Please feel free to email us Kauditor at myauditing@gmaill.com if you have any comments or you would like to find out more. Kauditor at Accounting & Auditing Blog is an experienced subject matter expert.

#99- Inventory System - Perpetual vs Periodic

Entity can account for its inventory by using either perpetual method or periodic method.

Under perpetual method:
- the entity record for every single movement of the inventory (i.e. in and out of the inventory)
- at any single point of time, the entity is able to recall the inventory on hand
- frequency of stock-take required is lesser than those accounted using periodic method

Under periodic method,
- every single movement for the inventory (i.e. in and out) is not required to be tracked
- the entity perform a periodic stock-take to ascertain the inventory balance
- inventory on hand can only be recalled after the stock-take is performed
- frequency of stock-take required is higher than those accounted using perpetual method
- cost of sales is computed by using the following formula: Opening Stock+ Cost of Goods Manufactured / Purchase - Closing stock

The above summarize the difference between perpetual inventory method and periodic inventory method.

#98- Expectation on FY 2010 inventory level

For audit of year-end 2010 audit, auditors should form an expectations that inventory level has reduced, as compared to previous year. Inventory level can be computed as inventory as % of sales / inventory as % of last 3 month sales. This provide a good guide / benchmark on the inventory level our audit clients are holding.

In view of the recovering business/ economy, inventory turnover are expected to become relatively quicker than prior year. Aged inventory are expected become relatively lesser either.

If the inventory level, as well as aged inventory level, remain relatively constatnt as prior year, this could indicate higher risk of provision for inventory obsolescence. Auditor should discuss this issue with management.

#97- Excess inventory after christmas

We were reading one of the business article online on how to deal with the excess inventory after the christmas sales, especially for retailers.

One of the options suggested was to auction it off online. Companies tend to store higher level of inventory during Christmas season, to meet the demand from customers. Demand from customers are often hard to be projected. Neither historical trend, nor forecast can precisely predict the inventory required. Hence, instead of losing sales resulted from insufficient inventory,Companies tend to store higher level of inventory to meet the demand from customers.

After Christmas sales, Companies are required to reduce the relatively high level (if any) of inventory, considering that the warehouse costs/ inventory holding costs/ liquidity costs could be substantial.

One of the options suggested was to auction the inventories off online. Though the pricing might not be attractive, but auctioning off the inventories allow the Companies to reduce all type of costs mentioned above.

Companies could sell the stocks in all sorts of website, including: e-bay.

#96- Cash audit- internal controls in cash process- cash payment

In our earlies entries in relation to cash audit, we discussed about the audit procedures of auditing unpresented cheques. We will discuss more extensively for audit procedures in auditing cash and bank balances of our audit clients.

Auditors may consider test the internal controls of the client's cash process. For this entry, we will provide an overview of the possible audit procedures to test the internal controls in cash payment process:

(a) select certain number of random samples, and test that payment voucher are properly prepared and authorised

(b) select certain number of random samples, and test that bank reconciliations are properly prepared and reviewed

(c) select certain number of random samples, and test that journal entries are properly posted into General Ledger

(d) select certain number of random samples, and test that payment voucher details match with the corresponding payment details (e.g suppliers' invoices), etc

#91- No depreciation charge on asset held for sale

This is to confirm that if a property is classified as asset held for sale, no depreciation is to be recorded.

To illustrate, Company ABC entered into Sales & Purchase agreement with 3rd party to dispose one of its property. The Sales & Purchase agreement may take months to complete. In this instance, Company ABC re-classified the property from Property, Plant & Equipment to Asset held for Sale upon entering the Sales & Purchase agreement.

Asset held for sale is de-recognised from the balance sheet upon the completion of the Sales & Purchase agreement.

#90- Review of Credit Term

One of the audit procedures to be performed while reviewing trade debtors balance is to review the credit term given to the customers (i.e. debtors).

To illustrate, we can obtain list of trade debtors, including: credit term given to respective trade debtors, and compare the credit term given to the norm of the industry. We would inquire our audit clients, if credit terms given are unusually long.

For instance, the norm of the credit term in industry A is 90 days. ABC company ( our audit client) allows a credit term of 180 days to customer XYZ. We will have to find out the underlying business reason of giving relatively longer credit term, and evaluate the collectibility of amount owing from customer XYZ.

Analyzing credit term given can be used as a useful tool in understanding the credit policy of our audit client.

#86- Unpresented Cheque- Part II

In our previous post #80 Bank Reconciliation Review- Unpresented Cheque, we posted the following example and question:

Susan is the accountant of Company ABC, who has a December year-end. On 31 December 2008, Susan has approved a few cheques payable to their creditors, amounted to US$200k. Account executive has input the payments into the systems after Susan has approved the cheques. However, the cheques payable to their creditors are not delivered to their creditors until after year-end.

Is there any financial impact to the financial of the Company? Yes or No? If yes, what would be the impact then ?

Answer:

Apparently, cheques are dated before 31 December 2008 while the cheques are only delivered to the supplier after year-end. Susan has posted the following entries and recorded in 2008's book:

Dr. Trade Creditors
Cr. Cash

From accounting point of view, cheque should not be deducted from the above cash account until cheques have been delivered to the supplier. In above example, cash and trade creditors balance have been understated. A re-classification entries should be reversed out.

Auditor's Responsibility

We should inquire our clients that there are no cheques not delivered to supplier as at balance sheet date.

#84- Market capitalization vs book value

In accounting, we look at net asset of the Company as an estimated guide of the value of the Company. However, the market value of the Company might differ from the book value (i.e. net asset of the accounting record).

Auditor can request management to analyze the difference between market capitalization and book value.

If market capitalization > book value. Auditors should consider what are the premium the investors are paying? Any figures on the balance sheet does not reflect true picture? Does the figure stated in accordance to accounting standards?

If market capitalization < book value. Auditors should consider the impairment issue for all assets and goodwill.

#81- Auditing FIFO Costing Method

We received a query from our loyal reader in respect of the auditing procedures on inventory costing method. Our reader specifically points to auditing procedures of First-in First-out ("FIFO") inventory method.

In FIFO inventory method, inventory acquired first acquired / purchased will be the first items sold. To illustrate with an example, Mobilephone retailer purchased one iPhone 3GS in Jun for a cost of US$500. Subseuquently, in end of June, the retailer acquired another iPhone 3GS for a total cost of US$550. What will be the COGS while the retailer sell one iPhone in July?

In FIFO method, it will be US$500. Items stocked first will be sold first.

Auditing Procedures:

In auditing FIFO valuation method, following procedures can be adopted:
- Obtain full stock listing as at balance sheet date, and select certain number of samples
- Obtain stock movement listing of respective sample, where we are able to see the stock-in and stock-out from time to time
- Obtain the stock-in costs for each purchase ( i.e. Jan: Purchase 10 items at US$10 each, Feb: Purchase 20 items at US12 each)
- Test compute the COGS for each deliveries to check that COGS amounts are recorded correctly.

To illustrate with the example above, when the retailer sold the iPhone in July. We can check to profit & loss statement in July, to verify that COGS reflects US$500. (i.e. first in first out basis).

#80 Bank Reconciliation Review- Unpresented Cheque

One of the audit procedure we perform while auditing cash account is review of bank reconciliations for year, especially at month end. Auditor need to excel higher level of cautiouness while reviewing year-end bank reconciliation.

In this thread, we would like to highlight to our readers on the potential distortions ( on cash balance) resulted from unpresented cheque. To illustrate with an example:

Susan is the accountant of Company ABC, who has a December year-end. On 31 December 2008, Susan has approved a few cheques payable to their creditors, amounted to US$200k. Account executive has input the payments into the systems after Susan has approved the cheques. However, the cheques payable to their creditors are not delivered to their creditors until after year-end.

Is there any financial impact to the financial of the Company? Yes or No? If yes, what would be the impact then ?

#79 Goodwill written off ( Part II)

In previous Goodwill written off post, we posted a question for our reader whether the goodwill should be written off after the Company and its subsidiaries has switched its businesses.

Goodwill is considered the premium the Company pay , during acquisition, in anticipation of future economic benefits. In the above case, Company A paid higher premium for Company B's existing customer base in computer hardware industry.

Company A and Company B have shifted its focus to computer software business, the goodwill the Company A paid for no longer exist. As such, the goodwill should be written off accordingly! There's no probable ground that the future economic benefit is going to flow into the Group.

#72 Debtors Turnover Analaysis

In auditing debtor balance, auditor will perform some analysis of the debtors turnover of the audit client, and compared the result to prior year to identify unusual fluctuations.

Debtors Turnover (day) is computed as below:

Average Debtor Balance / Sales x 365 days = Debtor Turnover (day)

Debtors turnover ratio indicates the velocity of debt collection of a firm. In simple words it indicates the number of times average debtors (receivable) are turned over during a year.

We will expecting a deteriorating debtor turnover (day) in this gloomy economy environment. To illustrate with an example, a customer of our audit client would take longer period to repay its outstanding balance due on time, and herein increase the number of day the receivable stays in the debtors balance.

Customers are squeezing their creditors by pro-longed their repayment period. Our audit client may, in another leg, delay the repayment to its (audit client's) suppliers.

A economy efficient would have been created, as the delaying in repayment has direct impact on the ultimate's suppliers decision on resource allocation. In afraid of selling items to doubtful customers, the ultimate suppliers might have cancel/ stop the supplies to our audit client.

As such, working capital need to be analyzed by auditor to identify unusual circumstances that might occur.

Small Business Accounting - Prepayment

In practice, small business made one lump sum prepayment or downpayment for purchases or services accross a certain period. For instance, the business may entered into insurance contract to insure its asset for a period of 12 months.

From accounting perspective, the amount prepaid should be expensed over the period of servie covered. To illustrate, the 12-month insurance premium paid should be expensed off over a period of 12 months. What would be the accounting treatment then?

Assuming Company XYZ entered into insurance contract to insure its inventory. Total insurance premium paid is US$12,000.

Upon payment of insurance, the Company passed the following entries:

Dr. Prepayment (B/S- Asset)12,000
Cr. Cash 12,000
(Being prepayment to insurer for insurance contract)

At month end, the following entry will be passed to recognise the insurance expense

Dr. Insurance expense (P/L)1,000 (12,000/ 12)
Cr. Prepayment 1,000
(Being utilisation of monthly insurance expense)

At the end of 12 months, the prepayment accounted will be fully utilised.

#70- Objective of IAS 36- Impairment of Assets

The objective of IAS 36 is to ensure that the Company's assets are carried at no more than their recoverable amount. An asset is carried at more than its recoverable amount if its carrying amount exceeds the amounts to be recovered through use or sales of the asset. If the carrying amount > recoverable amount, the asset have to be impaired.

IAS 36 is considered extremely for financial statement users. Let's illustrate a scenario where no Company does not apply IAS 36 appropriately.

Company ABC have recorded a few machineries in its accounting books for the year ended 31 Dec 2008. However, due to excessive usage of the machineries & improper maintenance, the machineries are at the end of its life cycle with approximately nil value. Company ABC is going to scrap off the machineries in one month time. However, in the book, the Machineries have a net book value of US$1million.

A few investors are in the process of taking over Company ABC. While reviewing the Company ABC's financial statement, they are more than happy to find out that the Company has US$1million worth of machineries on hand. As such, they are willing to pay another US$1million on top of the initial offer price!

If IAS 36 has been applied appropriately, the Company should have impaired the Machineries to its recoverable amount. Investors would not have paid another US$1mil for the end-of-life machineries. Hence, it is important to carry out proper impairment testing for significant assets on the Company's books.

#69- Implication of Credit Crunch on Money Market Fund

Before the spread of credit crunch, company's investment in money market funds are, in normal circumstances, classified as cash & cash equivalence. The classification is in view of the feature of high liquidity and easily/ readily convertible to known amount of cash.

However, the classifications above need to be challenge. We need to re-consider if the money market funds in current climate continue to meet the criteria of classified as cash & cash equivalence, by considering the following factors:

- short term
- hihgly liquid
- readily convertible

Satyam Fraud Case- Implication of Bank Confirmation / Bank Certificate

Subsequent to our previous post of " Saytam Fraud Case- Misrepresentation of Cash" , our further examination reveals that the misrepresentation pertains to misrepresentation of the Company's Fixed Deposit. The CEO, Raju, is personally in charge of the Fixed Deposit! An improper segregation of duties ( improper corporate governance) has given the CEO committed the fraud.

Investigation into the fraud case is on-going, and media widely reported that the investors are questioning what audit procedures have the Stayam auditor, Pricewaterhouse Coopers performed to ensure the existence of the asset.

The implication of Satyam Fraud Case highlited the importance of obtaining independent bank confirmation from the bank directly. No audit engagement should be closed without obtaining the bank confirmation as an audit evidence. Bank confirmation replies will also reflect any contingent claims by the bank towards the entity. As such, the auditors can ensure the completeness of the disclosure of Company's contingent liabilities.

In short, an independent bank confirmation / cash certificate is an important audit evidence, as evident in Satyam's fraud case.

#68 Evaluation of Doubtful Debt

Subsequent to the topic of #67 Identification of Doubtul Debt, we would like to proceed further on how to evaluate the exposure to doubtful debt. A very critical question to ask: Does all long outstanding debt represents doubtful debt, for which the provision need to be provided for ? The answer is very subjective, and involved a lot of professional judgement.

Let's start the evaluation with asking our readers a few scenarios as below:

[Scenario A] XYZ Company has outstanding amout due from Company A (aged > 90 days), who is long standing customer of XYZ Company for the past 10 years with no history of default in repayment. The long outstanding amount is attributable to the slow-repaying from Company A.

[Scenario B]XYZ Company has outstanding amount due from Company B(aged > 90 days), who is long standing customer of XYZ COmpany for the past 20 years with no history of default in repayment. Company B usually paid the amounts on time. There is no dispute involved in the outstanding amount due from Company B.


We invite our 'Accouting & Auditing blog' readers to evaluate the recoverability of outstanding amount due from Company A and Company B respectively.

#67 Identification of Doubtful Debt

How do we identify potential doubtful client while performing audit ?

We have to identify the doubtul receivable before assessing the potential provision for doubtful debt for respective client. Be noted that, provision for doubtful debt should be assessed on a specified basis. General provision is no longer allowed in IAS 39. IAS 39 requires existence of objective evidence of impairment on doubtful receivable. General provision does not take into consideration of any evidence.

Let's come back to the topic on how do we identify slow moving debtors step-by-step:

1. Obtained trade debtor aging listing ( by customer) as at the balance sheet date
2. Pay attention to debtors who have outstanding debts overdue more than 60-90 days
( the number of days could be changed according to the industry norm)
3. Selected the debtors ( with significant outstanding long outstanding debts according to the audit materiality of the engagement

In short, we analyze the debtors who has: 1) long outstanding balance ( generally overdue more than 60- 90 days) and 2) the long outstanding balance is considered material for the purpose of audit.

#62 Deliveries without Billings

In construction industry and service industry (that involved installation service), there are instances that goods are delivered to customer, while billings have not been done. Can the Company, who delivered the goods, recognize revenue upon deliveries of the goods? Can the Company recognize revenue even if the installation services have not been done?

It depends on the term of the contract. In industry norm, the deliveries of goods to client’s location do not constitute a probable ground to recognize revenue.

Then, how should we record the goods delivered to client’s location?

The answer is: the items delivered are stocks in nature. As such, it should be recorded as part of the inventory recorded in the Company’s balance sheet.