Question

The audit of income and expense accounts to ensure an accurate income is highly-inter-related with the audit of a number of balance sheet accounts. For example, several balance sheet accounts that are directly tied to income or expense accounts include:

- Inventory

- Accounts receivable

- Property, plan and equipment

- Long term investments

Notes and bonds payable

a). List the income statement items likely associated with each of the balance sheet accounts listed above.

b). When auditing the income and expense accounts, what are some of the substantive analytical procedures used?

c). For the substantive analytical procedures listed in your answer to part (b), explain what possible misstatement each procedure is designed to discover.

Answer 1

a)

The question has asked for items that are in the income statement (ie. Profit and loss statement) which can be linked or associated with the following items in balance sheet. I will be providing two most likely items for each of the below

Inventory - Sales, Purchase

Accounts receivable - Sales, Discount allowed

Property, plan and equipment - Depreciation, Impairment

Long term investments - Interest income, Fair value gain on longterm investments.

b)

Analytical procedures are audit procedures that are employed by auiditors to identify and affirm the plausible relationships between different items in thefinancial statements. Some of the analytical procedures used when auditing the income and expense accounts include ratio analysis , trend analysis and reasonableness test

c)

Ratio analysis - Using ratio analysis the auditor can compare previous year gross profit with current year gross profit. Now an increase in sales should show an increase in gross profit. Any material difference should be followed up, and can help the auditor identify any sales not recorded in incomestatement.

Trend analysis - Using trand analysis the auditor can compare bad debt growth with sales growth, if there is any drastic increase in the bad debt, the same should be identified and cross-checked with credit policy of business. This can help the auditor identify any debts that is suppressed or any debts caused by selling to customers without proper credit checks.

Reasonableness test - Using reasonableness test the auditor can compare actual employee cost reported during the year, with the amount obtained by multiplying average pay with total number of employees during the period. Any difference could be due to leave compensations or bonus pay, the same should be verified. It is an usual practise to divert un-authorised expeses (like coruption paid) to be reported as employee cost, such malpractices can be identified by the auditor with this procedure.