UNIT 3 AUDIT OF FINANCIAL STATEMENTS

LEARNING OBJECTIVES

After studying this unit, you should be able to:

a) Identify the audit objectives for income statement items and related accounts;

b) Explain the primary substantive audit procedures for income statement items and
related accounts; and

c) Identify assertions addressed by audit procedures for income statement items and
related accounts.

INTRODUCTION

Because the level of earnings of an entity is often given a great emphasis as an indicator of
the financial performance of an entity, the statement of comprehensive income or income
statement is of a fundamental importance to stakeholders of the entity. The income
statement also shows the stewardship of the management on how well they managed the
resources provided by investors and lenders. In some companies, the level of sales or income
is the basis of compensation bonuses of the management. Since management may
deliberately prepare the financial statement to show favorable financial position and
performance, the auditor should place a primary consideration on the following assertion:
a) Occurrence – addresses overstatement of revenues;

b) Completeness – addresses understatement of cost and expenses; and

c) Accuracy – addresses proper measurement of income and expense account.

As discussed in the previous chapters, the related income statement account should be best
considered jointly in connection with the audit of statement of financial position accounts.
For example, the details of repairs and maintenance expenses would be audited while
looking for unrecorded capital expenditures, which are part of the audit procedures for
property, plant and equipment.
The table below provides some example of income statement account that the auditor audits
in connection with the examination of the related financial position accounts.
 BALANCE SHEET ACCOUNTS
Receivables
Inventories (Raw Materials, Work-in-
Process and Finished Goods)
Prepaid Expenses
Investments (e.g. investment in equity
securities, investment in debt
securities, short and long-term
investment, etc.)
Intangibles, including Goodwill
Property, Plant and Equipment
Accounts Payable
Notes Payable
Accrued Payroll (including SSS,
Philhealth, PAG-IBIG, withholding tax)
Income Tax Asset or Payable (current
and deferred)
INCOME STATEMENT ACCOUNTS
✓ Sales (including returns, discounts and
allowances)
✓ Bad debt expense
✓ Interest income on notes receivable
✓ Impairment loss on long-term receivable
✓ Cost of sales/Cost of goods sold
✓ Current period expenses related to
prepaid items such as rent, office supplies,
insurance, or interest.
✓ Investment income (share in net income of
an associate, dividend an interest income)
✓ Gains and losses from the disposal of
investments
✓ Impairment loss (including any reversal of
impairment in the income statement)
✓ Unrealized holding gains and losses
✓ Amortization of intangibles
✓ Impairment losses
✓ Depreciation and depletion
✓ Gains or losses from derecognition of
property, plant and equipment
✓ Impairment loss (including any reversal of
impairment in the income statement)
✓ Rent expense under operating leases;
✓ Repairs and maintenance expense
✓ Purchases
✓ Interest expense
✓ Salaries and wages
✓ Income tax expense
 Provisions, Accrued and Other
Liabilities, and Deferred Income
✓ Current period expenses related to profit
sharing and pension plans, compensation,
compensated absences, taxes other than
income, rents, insurance, advertising,
product warranty repair or replacement
costs

Long-Term Debt (e.g. bonds payable) ✓ Interest expense

✓ Amortization of premium or discount
✓ Debt issuance costs

Retained Earnings ✓ All items affecting net income

Finally, the auditor needs to consider the appropriateness of revenue and expenses from an
ethical and/or legal standpoint, especially with respect to expenses. Expenses such as travel,
entertainment, and advertising, are subject to certain abuses. This is an example of
qualitative materiality, because in most cases, the amounts for individual accounts will not
be quantitatively significant.
Although there are risks to the company if abuses go unchecked, the auditor’s concern for
this type of expense is its impact to income tax.

AUDIT OBJECTIVES

When auditing the components of the income statement, the principal objective for
substantive tests is to determine the following:

ASSERTION CATEGORY ACCOUNT BALANCES AUDIT OBJECTIVES

Occurrence ✓ All revenue (including gains) in the income

statement have occurred during the period
and pertains to the entity.
✓ All costs and expenses in the income
statement are properly supported as charges
against the entity in the period and are
appropriately matched with revenues.
 Completeness ✓ All revenues (including gains) related to the
current period are included in the income
statement.
✓ All costs related to the current period’s
revenues and all expenses of the current
period are included in the income statement.

Accuracy 1. Revenue (including gains), costs and

expenses are stated in the income statement
at the appropriate amounts.

Cut-off 2. All revenue (including gains), costs and

expenses have been recorded in the
appropriate accounting period.

Classification 3. All items in the income statement have been

Presentation and Disclosure
recorded in the proper accounts (e.g. revenue
vs. gain, administrative cost vs. selling cost,
etc.)
4. Revenue (including gains), costs and
expenses are properly classified, described,
and disclosed in financial statements,
including notes, in accordance with PFRS.

AUDIT PROCEDURE FOR INCOME STATEMENT ACCOUNTS

The auditor’s primary substantive procedures for income statement accounts will typically
include the following:

1. Performing overall analytical review for significant income statement account;

2. Performing revenue recognition procedures;

3. Reviewing contents of miscellaneous income and expense;

4. Verifying interest and dividend income, including investment income;

5. Testing accuracy of other expense and income transactions;

6. Test cutoff of income and expense accounts; and

7. Reviewing contents of miscellaneous income and expenses.

 NOTE:
Audit procedures presented here merely illustrate typical audit procedures (i.e., primary
substantive procedures) for audits of merchandising and manufacturing entities and are
supplements of audit procedures on selected income statement accounts discussed in the
previous lessons.

Assertions mentioned here relate to primary assertion addressed by the audit procedures
discussed. However, some other assertions may also be addressed.

OVERALL ANALYTICAL REVIEW FOR SIGNIFICANT INCOME STATEMENT ACCOUNT

Primary Audit
Objectives:
Occurrence
Completeness

One essential procedure in the audit of income statement items is to perform analytical
procedure, especially for significant income statement accounts (e.g. Sales, Cost of Sales,
Salaries and Wages, etc.). In performing analytical procedure, the auditor should:

1. Develop an expectation of the amount for the current period using appropriate
data. For example, using average pay per employee or hour to prior year including
employee benefits for payroll, multiplying the average balance of the investment
in the period by the average interest rate for interest income;

2. Disaggregate both the data used to build the expectations and the various recorded
amounts at a level of detail sufficient to enable to identify material misstatements;

3. Determine the amount of difference from the expectation that can be accepted
without investigation;

4. Compare the account balance from the expected account balance;

5. Review and investigate any significant changes or lack of expected changes;

6. Determine whether the explanations received during the review are consistent
with other explanations or evidence obtained during the course of the audit; and

7. If appropriate, vouch sample transactions from the accounting record to the

supporting documents or trace samples from the supporting documents to the
accounting record.
REVENUE RECOGNITION PROCEDURES

Primary Audit
Objectives:
Occurrence
Accuracy
Presentation & Disclosure

After the auditor had gathered information concerning the entity’s nature of operations
and applicable financial reporting framework, the auditor should evaluate the accounting
policies used by the company in recognizing and measuring its revenues in compliance
with the relevant PFRSs. The auditor then will select items for testing to determine if
revenue was recorded based on the accounting policy adopted. For example, the auditor
would select transactions to ensure that revenue should not be recognized not until the
contract of sale was signed and delivery was made. The auditor should also evaluate the
propriety and adequacy of disclosure as prescribed by the relevant PFRSs.

REVIEW CONTENTS OF MISCELLANEOUS INCOME AND EXPENSES

Primary Audit
Objectives:
Occurrence
Completeness
Classification
Presentation & Disclosure

Miscellaneous income and expenses, by their very nature, are mixtures of minor items. In
auditing miscellaneous items, the auditor should:

1. Understand the contents of the account;

2. Obtain an analysis or breakdown of the account from the client;
3. Check the appropriateness of classification of the items included in the account (as
some of the items included should be reported in another appropriate
classification); and
4. Investigate any significant unusual transactions, if not already covered by balance
sheet account testing.

TEST OF INTEREST AND DIVIDEND INCOME

 Primary Audit
Objectives:
Occurrence
Completeness
Accuracy
Presentation & Disclosure

The auditor should test interest, dividend and investment income for significant
investments by:

1. Comparing interest and dividend income with the prior period and obtaining
explanations for any significant unexpected variations;
2. Performing a reasonableness check on interest income by multiplying the average
balance of the investment in the period by the average interest rate received;
3. Agreeing dividend income to the dividend statement, published records of
dividend paid, and/or bank statements;
4. Testing accrued interest and interest earned during the period on receivables;
5. Determining imputed interest by preparing amortization table;
6. Verifying the investment income from an associate from the associate audited
financial statement; and
7. Determining the adequacy of disclosures in accordance with the relevant PFRSs.

TEST OF DETAILS ON OTHER EXPENSE ND INCOME TRANSACTIONS

Primary Audit
Objectives:
Occurrence
Accuracy

After defining the population, the auditor will select samples and obtain supporting
documentation and perform the following:

• Cost and Expenses

a) Test the computation of recorded amounts if the expense was recorded

with corresponding credit to payables (or paid directly with cash) based on
contract, invoice, and/or other document(s).
b) Test the computation of recorded amounts if the expense was recorded
with a corresponding credit to an accrued expense account.

• Income (Revenue and Gains)

 a) Test the computation of recorded amounts if the income was recorded with
a corresponding debit to receivable (or received directly with cash) based
on contract, invoice, and/or other document(s).
b) Test the computation of the recorded amounts if the income was recorded
with a corresponding debit to an accrued income account.

TEST CUTOFF OF INCOME AND EXPENSE ACCOUNTS

Primary Audit
Objectives:
Occurrence
Cut-off

The auditor should make an audit sample of recorded income and expense before and
after the reporting date and:

• Cost and Expenses

a) Trace the selected expenses to invoices, receiving reports, purchase orders,

or other support evidencing when goods were received or services were
rendered.
b) Determine that the expenses were recorded in the correct period by tracing
the selection to the general ledger.

• Income (Revenue and Gains)

a) Trace the selected income sore revenue to sales invoice, shipping

documents or other support evidencing when goods were provided or
services were rendered.
b) Determine whether the income or revenue was recorded in the correct
period by tracing the selection to the general ledger.

Note that this procedure was discussed in detail under sales and receivable cutoff,
and purchase and accounts payable cutoff.

SUMMARY OF AUDIT PROCEDURES CLASSFIED PER ASSERTION

ASSERTION CATEGORY PRIMARY AUDIT PROCEDURES

Occurrence ✓ Perform overall analytical review for
significant income statement account.
✓ Perform revenue recognition procedures.
✓ Test interest and dividend income.
✓ Review contents of miscellaneous income
and expenses.
✓ Test of details on other expense and income
transactions.
✓ Test cutoff of income and expense accounts.

Completeness ✓ Perform overall analytical review for

significant income statement account.
✓ Review contents of miscellaneous income
and expenses.
✓ Testing interest and dividend income.

Accuracy ✓ Perform revenue recognition procedures.

✓ Test interest and dividend income.
✓ Test of details on other expense and income
transactions.

Cut-off ✓ Test cutoff of income and expense accounts.

Classification ✓ Review contents of miscellaneous income

and expenses.

Presentation and Disclosure ✓ Perform revenue recognition procedures.

✓ Review contents of miscellaneous income
and expenses.
✓ Test interest and dividend income.