Audit of Items of Financial Statements — Practice

Question 1

State the primary assertion at risk and a corresponding audit procedure for each of the following concerns about a company's PPE: (a) whether recorded machinery genuinely exists; (b) whether the company genuinely owns land shown in its records; (c) whether depreciation has been computed consistently; (d) whether a major repair has been wrongly capitalised.

Accepted Answer

Item (a) concerns the existence assertion, and the corresponding procedure is physical verification, the auditor personally inspecting the recorded machinery to confirm it genuinely exists and is located where the records indicate, this being the single most emphasised procedure for PPE precisely because misstatement risk for this balance concentrates heavily on whether recorded assets are genuinely present. Item (b) concerns the rights and obligations assertion, and the corresponding procedure is inspection of title deeds and registration documents, examining the legal ownership documentation for the land to confirm the company genuinely holds the rights it claims rather than merely having possession or use without ownership. Item (c) concerns the accuracy, valuation and allocation assertion, and the corresponding procedure is testing that depreciation has been computed on a consistent basis using an appropriate method and rate from period to period, comparing the current year's depreciation policy and computation against the prior year's to confirm no unexplained or unjustified change has occurred that would distort the reported valuation. Item (d) concerns the classification aspect of the accuracy, valuation and allocation assertion, since capitalising a revenue expense misstates the balance between capital and revenue expenditure, and the corresponding procedure is examining the nature of the repair against its supporting documentation and invoice description to determine whether it genuinely restores or maintains the asset, which should be expensed, or represents a genuine improvement or addition extending the asset's useful life or capacity, which may properly be capitalised, since a repair wrongly capitalised misstates both the balance sheet, by overstating the asset, and the profit and loss account, by understating the period's expense, simultaneously.

Question 2

Explain what SA 501 requires regarding physical inventory counting, what assertions attendance at the count actually addresses, and what alternative procedures are available where the auditor is appointed after the year end and cannot attend the count.

Accepted Answer

SA 501 requires the auditor, where inventory is material to the financial statements, to attend physical inventory counting, unless attendance is impracticable, and while attending, to evaluate management's instructions and procedures for recording and controlling the results of the count, observe the performance of management's count procedures, inspect the inventory itself, and perform test counts, independently counting a sample of items and comparing the auditor's own count against the entity's recorded count. Attendance at the physical count primarily addresses the existence assertion, confirming that inventory recorded in the accounts genuinely exists in the quantities stated, and the completeness assertion, confirming that inventory genuinely present has been fully captured in the count and therefore in the recorded balance; it does not, on its own, address valuation, since observing a physical count says nothing about whether the cost attached to the counted items, or their net realisable value, has been correctly determined, which requires separate procedures. Where the auditor is appointed after the year end and could not attend the physical count as it occurred, SA 501 recognises that alternative procedures may still provide sufficient appropriate evidence: the auditor may attend a physical count conducted at a later date and, through inspection of the entity's perpetual inventory records and appropriate roll-back or roll-forward procedures, reconcile the quantities observed at that later count back to the year-end date, or, where the entity maintains reliable perpetual inventory records that are well controlled and regularly reconciled to physical counts throughout the year, the auditor may be able to obtain sufficient appropriate evidence about the year-end existence and condition of inventory through inspection and testing of those records combined with evidence from counts performed at other dates during the year, without needing to have observed the specific year-end count itself.

Question 3

A company ships goods to a customer on 30 March and records the sale and removes the goods from inventory on 5 April, once the customer's acceptance confirmation is received, the year end being 31 March. Explain the cutoff errors this creates, and why they should be tested together rather than as unrelated issues.

Accepted Answer

This creates a simultaneous cutoff error affecting both revenue and inventory, and it is exactly the kind of error this chapter identifies as frequently being the same underlying issue viewed from two sides. If the goods were physically shipped on 30 March, before the 31 March year end, and title and risk genuinely passed to the customer on shipment under the terms of the sale, then in substance the sale occurred, and revenue should have been recognised, before the year end, in accordance with the recognition criteria requiring the transfer of significant risks and rewards; recording the sale only on 5 April means revenue for the year ending 31 March is understated by the omission of a genuine sale that occurred within the period. Correspondingly, if the goods physically left the warehouse on 30 March, they should no longer have been included in the year-end physical inventory count or in the inventory balance as at 31 March, since the entity no longer holds them; if the goods were nonetheless still included in the 31 March inventory count and balance because the removal from inventory was not recorded until 5 April, inventory is simultaneously overstated. Both errors stem from the identical underlying timing mistake, treating the transaction as occurring on 5 April, the date of the customer's acceptance confirmation, rather than on 30 March, the date the goods were actually shipped and, on these facts, the date risks and rewards likely transferred; testing revenue cutoff and inventory cutoff together, rather than as unrelated issues assigned to different team members or addressed at different points in the audit, allows the auditor to identify this single root cause efficiently, since a sample of transactions examined around the year-end date for revenue cutoff purposes will very often be the same population of transactions relevant to inventory cutoff testing, and treating them as connected reduces the risk of testing one and missing the corresponding, mirror-image error in the other.

Question 4

Explain the difference between a positive and a negative confirmation for receivables, and state the circumstances in which a negative confirmation would be appropriate to use, given its inherent limitation.

Accepted Answer

A positive confirmation requests the recipient, the customer, to respond directly to the auditor in every case, whether the recipient agrees with the stated balance or not, providing an explicit response confirming agreement or specifying the nature of any disagreement. A negative confirmation requests a response only if the recipient disagrees with the amount stated, meaning the absence of any response is treated, weakly, as an indication of agreement, since the customer was asked to respond only if there was a problem and did not do so. The inherent limitation of the negative confirmation is precisely this weak inferential basis: a lack of response could genuinely mean the customer agrees and simply did not bother to reply, but it could equally mean the confirmation was never received, was ignored, or was set aside without the recipient actually reviewing the stated balance carefully enough to notice a discrepancy, none of which the auditor can distinguish from genuine agreement based purely on silence. Because of this limitation, negative confirmations are considered appropriate only in more favourable circumstances: where the assessed risk of material misstatement is lower, meaning the auditor has less need for the more assertive, corroborating evidence a positive response provides; where the population consists of a large number of small, homogeneous account balances, since a positive confirmation approach applied individually to a very large number of small balances would be disproportionately costly relative to the risk each individual balance presents; and where the auditor has no reason to believe that recipients will disregard these requests, since the whole approach depends on recipients who do disagree actually taking the trouble to respond. Where these favourable conditions do not hold, particularly for larger, higher-risk, or fewer, more significant balances, positive confirmation is the more appropriate and more assertive approach.

Question 5

Explain why testing subsequent cash receipts from customers is considered strong evidence for the valuation of receivables, and why it might sometimes be preferred over sending a fresh confirmation request.

Accepted Answer

Testing subsequent cash receipts, examining actual cash collected from customers in the period after the year end and tracing it back to the specific receivable balances outstanding at the year end, is considered strong evidence for valuation because it provides direct, objective proof that a specific receivable was both genuine and collectible: a customer who actually pays the amount owed after the year end has, by that very act, confirmed both that a real, valid obligation existed and that it was capable of being collected, which is precisely the substance of what the valuation assertion for receivables is trying to establish, namely that the recorded amount will genuinely be realised. This is in some respects even stronger evidence than a confirmation reply, since a confirmation is merely a statement of agreement with a balance, which a customer might sign without close scrutiny, whereas an actual payment represents a genuine economic action with real financial consequences for the customer, making it harder to obtain through carelessness or inattention in the way a confirmation reply's silent or perfunctory agreement might be. It might sometimes be preferred over sending a fresh confirmation request for practical reasons as well: where the audit is being performed some weeks or months after the year end, sufficient time may already have elapsed for a meaningful proportion of the year-end receivables to have been collected in the ordinary course of business, making subsequent receipts testing both more efficient, since the evidence is often already available in the entity's own bank records without needing to wait for third-party responses, and potentially more reliable than waiting for confirmation replies that may be slow, incomplete, or never received at all from some customers, exactly the non-response problem that limits the usefulness of confirmations, positive or negative, on their own.

Question 6

Describe the search for unrecorded liabilities as an audit procedure for trade payables, explaining specifically how it works, and connect it to the general principle, developed in the evidence chapter, that completeness rather than existence is the primary concern for a liability balance.

Accepted Answer

The search for unrecorded liabilities is the primary procedure the auditor uses to address the completeness assertion for trade payables, and it works by examining transactions occurring after the balance sheet date, specifically payments made and invoices received in the period following the year end, to identify obligations that genuinely existed at the balance sheet date but had not yet been recorded as a liability at that date. In practice, the auditor selects a sample of payments made, and invoices processed, in the weeks or months following the year end, and for each item examines the underlying documentation, particularly the date goods were received or services were rendered, to determine whether the obligation the payment or invoice relates to actually arose before or after the balance sheet date; where the underlying goods or services were received before the year end but the corresponding liability had not been recorded as at that date, this represents precisely the unrecorded liability the procedure is designed to catch, and the auditor would propose an adjustment to include it in the year-end payables balance. This procedure is a direct, practical application of the general principle developed in the evidence chapter that completeness, rather than existence, is typically the assertion of greatest concern for a liability balance: management has an inherent incentive, whether deliberate or simply through the ordinary tendency to be less diligent about recording unfavourable items promptly, to understate liabilities and thereby present a stronger reported financial position, whereas there is comparatively little incentive to record a fictitious liability the entity does not actually owe, meaning existence risk is much less of a concern here than it would be for an asset balance. The search for unrecorded liabilities is specifically designed to counter that understatement risk by looking outward from the balance sheet date into the following period, precisely where an obligation genuinely incurred before year end but not yet recorded would first surface, rather than by testing only the liabilities already recorded, which by definition would never reveal what was left out entirely.

Question 7

A company has recognised a provision for a pending legal claim. State the three conditions the auditor should verify are satisfied before accepting the provision as appropriately recognised, and describe one procedure for assessing the reasonableness of the estimated amount.

Accepted Answer

The auditor should verify that the three conditions AS 29 requires for recognising a provision are all satisfied. First, a present obligation as a result of a past event, which the auditor would verify by examining the underlying facts giving rise to the legal claim, confirming that an event has genuinely occurred, such as an alleged breach of contract or an incident giving rise to the claim, creating an obligation the company must now address, rather than merely a possible future event that has not yet crystallised into an obligation. Second, that it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, which the auditor would assess by obtaining and reviewing correspondence from the company's external legal counsel, since legal opinion on the likely outcome of litigation is a primary and highly relevant source of evidence for this specific judgement, corroborated where possible by considering the progress and history of the matter and any comparable past claims the entity has faced. Third, that a reliable estimate can be made of the amount of the obligation, which the auditor would assess by examining the basis on which management has computed the provision, including any legal advice on likely settlement ranges, and considering whether a range of reasonably possible outcomes exists that supports the specific figure chosen or whether the estimate appears arbitrary. One procedure for assessing the reasonableness of the estimated amount specifically is to review the history of similar past claims the entity has faced, comparing the amounts ultimately paid to settle those earlier claims against what was originally provided for them, to assess whether management's estimation approach has historically proven reasonably accurate or has tended to be optimistic or overly conservative, which provides useful corroborating context for judging the reasonableness of the current estimate, alongside direct evidence such as the external lawyer's own assessment of the likely range of outcomes for this specific claim.

Question 8

Explain why a bank confirmation obtained directly from the bank is considered particularly reliable evidence, connecting this to the reliability hierarchy from the previous chapter, and what specific matters, beyond the account balance itself, a well-designed bank confirmation typically also addresses.

Accepted Answer

A bank confirmation obtained directly from the bank is considered particularly reliable evidence because it satisfies several of the reliability generalisations from the previous chapter simultaneously: it comes from a source independent of the entity being audited, being the bank rather than the client itself; it is obtained directly by the auditor, typically sent and returned through a controlled process minimising client involvement in the response; and it is documentary, a written response rather than an oral assurance. This combination of independence, directness and documentary form places it near the top of the reliability hierarchy, and it is why bank confirmations are a standard, near-universal procedure on virtually every audit where a bank balance is material. Beyond simply confirming the account balance itself, a well-designed bank confirmation typically also addresses several other matters relevant to a complete picture of the entity's banking relationship: any other accounts the entity holds with that bank that the auditor might not otherwise be aware of, addressing completeness of the cash and bank disclosure; any loans, overdraft facilities or other borrowings from the bank, together with their terms, interest rates and any security given, which is relevant both to verifying recorded liabilities and to identifying any charges or security interests over the entity's assets that should be disclosed; any guarantees the bank holds on the entity's behalf, or that the entity has given in favour of others through the bank, which may represent contingent liabilities requiring disclosure; and any other matters such as bills discounted or forward exchange contracts that the bank is aware of. Requesting this broader set of information in a single confirmation is more efficient than a narrower request confined only to the account balance, and it also serves as a valuable independent cross-check for completeness of the entity's own disclosures about its banking relationships generally, not merely for the accuracy of the specific balance being verified.

Question 9

A company holds both current investments and long-term investments. Explain how the audit approach to valuation differs between the two categories, and why misclassifying a long-term investment as current, or the reverse, would itself misstate the valuation even if the underlying figures were otherwise correctly computed.

Accepted Answer

For current investments, valuation is tested against the requirement that they be carried at the lower of cost and fair value, so the auditor's procedure focuses on obtaining evidence of both cost, typically straightforward from purchase records, and current fair value, such as quoted market prices at the balance sheet date for listed securities, and confirming that the lower of the two figures has been used; any decline below cost, however temporary it might later prove to be, is required to be recognised for a current investment. For long-term investments, valuation is tested against a different standard, cost, less a provision only for a decline that is other than temporary, so the auditor's procedure instead focuses on evidence bearing on whether any observed decline in value is genuinely other than temporary, such as evidence of the investee's own sustained financial deterioration, a fundamental change in its business prospects, or a market-wide, non-temporary shift, as against a short-term market fluctuation that the entity, holding for the long term, might reasonably be expected to see reverse; a temporary decline is not provided for at all under this basis. Misclassifying a long-term investment as current, or the reverse, would itself misstate valuation even with otherwise correct underlying figures, because the two categories are tested against entirely different valuation rules: an investment genuinely intended and held for the long term, wrongly classified as current, would be forced through the lower-of-cost-and-fair-value test and could be written down for a merely temporary market dip that would not have required any provision at all under the correct long-term basis, understating its carrying value; conversely, a genuinely current investment wrongly classified as long-term might escape recognition of a real decline in value on the mistaken basis that only an other-than-temporary decline need be provided for, when the current classification would have required the decline to be recognised regardless of whether it proves temporary or not, overstating its carrying value. The classification itself is therefore not a mere presentation matter for investments in the way it might be for some other balances, but directly determines which valuation rule applies and can produce a materially different carrying amount depending on which side of the classification line the investment falls.

Question 10

A company issues additional equity shares during the year through a rights issue. State the documents the auditor should verify against, and the two assertions primarily at risk.

Accepted Answer

The auditor should verify the rights issue against the board resolution and, where required, the shareholders' resolution authorising the issue, the offer document or letter of offer setting out the terms, the record of applications and allotments made, and the amended capital clause of the Memorandum of Association reflecting the increased subscribed and paid-up capital following the issue, together with confirming compliance with the relevant provisions of the Companies Act, 2013 governing a further issue of share capital, including the pre-emptive rights of existing shareholders that a rights issue is specifically structured to respect. The two assertions primarily at risk are occurrence, whether the share issue was genuinely and properly authorised and did in fact take place as recorded, verified by matching the recorded issue against the authorising resolutions and the actual allotment records; and presentation, whether the resulting movement in share capital and any associated securities premium has been correctly classified and disclosed in the financial statements in accordance with Schedule III, since a rights issue at a premium involves both an increase in share capital at nominal value and a corresponding increase in the securities premium account, and these two components must each be correctly identified, recorded and disclosed separately rather than conflated into a single, undifferentiated increase in equity.

Question 11

An auditor compares a company's monthly revenue trend against the prior year and notices a sharp, unexplained spike in the final week of the financial year, well above the pattern seen in every other week of the year. Explain what this observation should prompt, and connect it to a specific risk this chapter identifies.

Accepted Answer

This observation, arising from analytical procedures comparing revenue trends, should prompt the auditor to investigate the unusual spike specifically and with heightened professional scepticism, since a pattern this far outside the entity's normal weekly trend, concentrated precisely at the year-end cutoff point, is a classic indicator of a cutoff-related risk, specifically the risk that revenue has been recognised prematurely, pulling sales that should properly belong to the following period into the current year in order to inflate the reported figures for this year. This connects directly to the cutoff testing this chapter identifies as the most emphasised procedure for revenue, precisely because year-end is when the pressure and opportunity to manipulate the timing of revenue recognition, whether through genuine urgency to close deals or through less legitimate means such as recording sales before goods have actually been shipped or before risks and rewards have genuinely transferred, is at its highest. The auditor's response should include specifically targeted cutoff testing on transactions recorded in this final week, examining underlying shipping documentation, customer acceptance evidence, and the timing of the actual transfer of risks and rewards for a sample of the transactions driving the spike, rather than accepting the analytical result as merely an interesting observation with no further follow-up; an unexplained spike concentrated exactly at the point cutoff risk is highest is precisely the kind of signal analytical procedures are designed to surface and that the auditor is required to investigate further before concluding revenue is fairly stated.

Question 12

Explain why a fixed asset register reconciled to the general ledger is important evidence for the completeness assertion regarding PPE, and describe what a discrepancy between the two might indicate.

Accepted Answer

A fixed asset register, maintaining a detailed, item-by-item record of each individual asset the entity owns, including its description, location, cost, accumulated depreciation and carrying amount, provides important evidence for the completeness assertion because it offers a granular, independently maintained cross-check against the single, summarised PPE figure appearing in the general ledger and financial statements; without such a register, or without confirming that the register reconciles to the ledger, the auditor would have only the aggregate ledger figure to rely on, with no independent means of confirming that every individual asset genuinely owned by the entity has actually been captured within that aggregate total. Reconciling the register to the general ledger confirms that the detailed, item-level records and the summary financial reporting figure agree, providing assurance that no assets have been omitted from, or duplicated within, the overall balance reported in the financial statements. A discrepancy between the register and the general ledger might indicate several possible problems: assets that were disposed of during the year but never removed from the register, meaning the register overstates what the entity currently holds; assets acquired during the year that were recorded in the ledger, perhaps as part of a general expenditure account, but never added to the individual asset register, meaning the register is incomplete relative to the ledger; or a more fundamental control weakness in how the entity maintains its fixed asset records generally, any of which the auditor would need to investigate and resolve before being able to rely on either the register or the ledger figure with confidence, and any unreconciled discrepancy would itself be a red flag warranting further, more extensive testing of the completeness of the PPE balance as a whole.

Question 13

A company's receivables ageing analysis shows a significant increase in balances outstanding for more than 180 days compared to the prior year, but the provision for doubtful debts as a percentage of total receivables has remained unchanged. Advise the auditor on the concern this raises and the procedure to address it.

Accepted Answer

This raises a genuine concern that the provision for doubtful debts may now be inadequate relative to the entity's actual collection risk, since an ageing analysis showing a significant increase in long-outstanding balances, specifically those over 180 days, which are generally understood to carry meaningfully higher collectibility risk than more recently raised balances, would ordinarily be expected to prompt a corresponding increase in the provision as a percentage of total receivables, reflecting the deteriorating age profile and the correspondingly elevated risk that a larger proportion of the total balance will ultimately prove uncollectible. The provision having remained unchanged as a percentage despite this shift in the underlying age profile suggests either that management has not updated its provisioning methodology to reflect the changed circumstances, or that the provisioning approach is applied too mechanically, perhaps as a flat percentage of total receivables regardless of age, without genuinely responding to the specific risk profile the ageing analysis itself reveals. The auditor should test the reasonableness of the provision specifically by examining the ageing analysis in detail, considering historical collection experience for balances of comparable age in prior periods to assess whether the entity's own history supports maintaining an unchanged provision rate despite the shift, reviewing a sample of the specific long-outstanding balances individually to assess their collectibility based on available evidence such as customer correspondence, disputes, or the customer's own financial condition where known, and considering subsequent cash receipts after the year end as strong direct evidence of whether these older balances have in fact been collected or remain outstanding; if this further work does not support the unchanged provision rate, the auditor should propose that management reassess and likely increase the provision to properly reflect the elevated risk the ageing shift has revealed.

Question 14

During the physical inventory count, the auditor observes a substantial quantity of a discontinued product line still held in the warehouse, with no sales of this product recorded for the past eight months. The company has valued this stock at its original cost. Explain the audit concern, the assertion at risk, and the procedure the auditor should perform, connecting this to the relevant accounting principle.

Accepted Answer

The audit concern is that this discontinued stock's net realisable value has very likely fallen below its original cost, given that it has not sold for eight months and relates to a product line the company has discontinued, meaning continued valuation at original cost may materially overstate the inventory balance; this is precisely the accuracy, valuation and allocation assertion at risk, since the concern is not whether the stock physically exists, which the auditor has already directly observed during the count, but whether the amount at which it is carried in the financial statements correctly reflects its true recoverable value. This connects directly to the accounting principle that inventory must be valued at the lower of cost and net realisable value, and net realisable value is defined as the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale; for a discontinued product with no sales activity for eight months, the estimated selling price achievable, if the stock can be sold at all, is very likely to be well below original cost, particularly once any further costs necessary to actually dispose of it, such as discounting to clear it or dismantling and disposal costs if it cannot be sold at all, are taken into account. The auditor's procedure should include obtaining evidence of what the company genuinely expects to realise for this stock going forward, such as any post-year-end sales of the same or similar discontinued stock at reduced prices, management's own specific plan for disposing of it, whether through a clearance sale, return to a supplier, or scrapping, and any independent evidence of current market value for comparable discontinued goods; if this evidence indicates net realisable value is indeed below cost, which the facts here strongly suggest, the auditor should propose that management write the stock down to its estimated net realisable value, and if management declines to do so, the auditor would need to consider the materiality of the resulting misstatement and its implications for the audit opinion, since carrying obsolete, discontinued stock at an unsupported original cost is exactly the kind of valuation overstatement this principle exists to prevent.

Question 15

State when a physical cash count is an appropriate audit procedure, and explain one specific control the auditor should apply when performing the count itself, connecting it to the risk the control addresses.

Accepted Answer

A physical cash count is an appropriate audit procedure where the entity's cash-on-hand balance, whether held at a single location such as a cashier's till or across multiple locations such as retail outlets, is material to the financial statements, and it directly addresses the existence assertion, confirming through the auditor's own inspection that the cash recorded actually exists in the amount stated. One specific control the auditor should apply when performing the count is to count all cash and cash-equivalent items, such as unbanked cheques, simultaneously if multiple locations or funds are involved, or otherwise to maintain control over the cash being counted, for instance by having the client's cashier remain present throughout and by counting continuously without interruption, to prevent the possibility that cash counted at one location or one point in time is subsequently moved and presented again at another location or a later point, artificially inflating the apparent total through a kind of double-counting the entity's own staff could otherwise exploit if the auditor's count were performed piecemeal with gaps during which cash could be shifted between locations not yet counted. This control directly addresses the specific risk that a client, aware in advance that a cash count will occur, could attempt to conceal a genuine cash shortage by moving a limited amount of actual cash between locations just ahead of the auditor's count at each one, and simultaneous counting, or otherwise maintaining continuous control over already-counted cash, is what closes off that specific opportunity for concealment.

Practice — Audit of Items of Financial Statements

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