Audit Procedures for Income Statements
Small-business owners facing their first audit might not know what to expect. Auditors gain reasonable assurance over the financial statements taken as a whole by examining transaction on a test basis. While you may not know exactly what your auditors will be testing, it can be useful to understand some common audit procedures. This way, when an auditor asks you for support for your transactions, you can be sure to have the information she is looking for.
During most audit engagements, revenue is identified as as specific risk account. This occurs both because revenue recognition rules can be complex and because companies may be tempted to attempt to inflate revenues in order to make the company look better off than it actually is. As such, auditors will often test the revenue account for both overstatement and understatement. To test for overstatement, auditors will review the company's revenue recognition policies and ensure that revenue is only recorded when appropriate. Often, they will also select transactions to ensure that it was appropriate to record a sale. To test for understatement, auditors will make selections from reciprocal balances. Reciprocal balances are balances that are related to the account of interest. For revenue, the auditor may examine accounts receivable. If sales were recorded when sales were made on an account properly, then the auditor gains some assurance that sales are properly stated.
Cost of goods sold testing is often conducted at the same time that inventory testing on the balance sheet is completed. The cost of goods sold of a company has two components. First, the auditor must determine the amount of inventory sold. If the auditor has already tested the amount of inventory initially on hand, the amount lost due to theft or spoilage and the amount remaining at the end of the year, then the amount sold is simply the difference between these figures. In addition, the auditor must determine the cost of the inventory sold on a unit basis. This is usually completed by making selections from a listing of the items sold by the company during the period and drilling down to original source documents. For example, an auditor may make a selection of a table from a listing of all furniture sold at a furniture store. The auditor would then ask to see an invoice that substantiated the cost of the item. This cost would then be compared with the amount recorded in the accounting system.
Operating expenses include nearly all expenses other than cost of goods sold and interest expense. As such, these costs differ greatly among companies. Generally, testing operating expenses involves two types of procedures. For some types of operating expenses, auditors will randomly choose expense transactions and ask for supporting documentation for the expenditure. However, for transactions that are related to other accounts, the auditor may complete an analytic test. Analytic testing uses relationships between accounts to build an expectation of the account balance. The auditor then compares the actual account balance to the expectation. If they are materially the same, the auditor considers the amount to be fairly stated. If not, additional procedures are performed to determine why the account balance differs from the expectation.
Small businesses that make debt payments often include interest expense on their financial statements. To test interest expense, auditors will often obtain the original loan documentation or promissory note and recalculate the amount of interest expense owed. Because this calculation is closely related to the amount of debt owed, this testing is often conducted as a part of the testing of long-term debt on the balance sheet.