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Hello,
Substantive procedures are a little bit of a struggle for me and I’m trying to allocate quite some time in my studies to them as well as break down this topic into manageable pieces.
I noticed in the Kaplan book for example that completeness is a key assertion for inventory but not for receivables. I decided to try to understand why that would be. Here are my thoughts:
1.The company is more likely to have all of their receivables accounted for whereas inventory may appear incomplete in the financial statements.
2. The reason for incomplete inventory would more likely be error than fraud – it is easy to imagine that there is some physical inventory that the company has not accounted for, especially in large organisations.
3.The main procedure to test completeness of inventory would be to trace physical items of inventory to the inventory count sheets (on this note, is inventory valuation included in TB taken from inventory sheets?).
4.On the other hand the receivables system which ensures completeness of entries seems more straightforward to maintain, with each sale invoice eventually making its way into the receivables ledger.
5.Also, it is in the company’s interest to ensure that every credit sale is included in the receivables.Is my thinking above correct and are there any parts where I’m wrong? Would this answer score marks if it was a hypothetical question on the exam?
I would greatly appreciate some feedback here.
1. Yes there can be a significant risk of overstatement in receivables – which I expand on below.
2. It would depend – if controls of recording of inventory are strong, the more likely cause of incomplete inventory is fraud (e.g. theft – especially if inventory is high value/portable).
3. Yes this is a test for completeness. Yes the final figure for inventory in the trial balance would be taken from the “costing up” of the inventory count sheets.
4/5 Yes on the face of it there seems no obvious reason why, if a company bothers to make a sale, that it should not record it. But there are still reasons why revenue – and hence receivables – might be understated – e.g. underpricing errors on invoices or giving unauthorised discounts.My take on this is – debit balances are more effectively tested for overstatement than understatement – consider, for example, when asking a customer to confirm what they owe, if they think they owe $1000 and you ask them do they owe $2000 they are more likely to say disagree than if they are asked do they owe $100.
So if all debit balances are tested for overstated – because every debit has a credit – all the other sides of the entries are also tested for overstatement. To test for understatement, therefore, you look at the other side of the entry. The customer won’t shout if you undercharge them – so you don’t examine the receivable directly for understatement but revenue.
But then inventory is unique – because it is “it’s own” double-entry – the same figure costed from the inventory count sheets is Dr SoFP and Cr SoPL. That is why both directions – physical-to-book and book-to-physical are so important.
I would actually say that although completeness (understatement) may be a key risk for inventory – because it is debit BALANCE (i.e. asset in SoFP) – overstatement is a greater risk because management is far more likely to be biased/incentivised to overstate rather than understate profit. But this too “depends” – if management wanted to understate profit to reduce tax liabilities, there would be a greater risk of understatement of inventory (deliberate omission of items of inventory and/or excessive allowances).
This is all for your understanding – the way in which audit risk and substantive procedures are examined does not call for explanations like this.
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