This article provides guidance on how to audit accruals with examples. If you are a student preparing for an audit exam or a public practice professional looking to refresh your knowledge, this article will help you develop a thorough understanding of how plan and test accruals.
Accounting frameworks such as US GAAP, IFRS and other generally accepted accounting frameworks require use of accrual basis of accounting. Further, most financial statements report accruals which are often material amounts. Therefore, accruals are one of the frequently audited balances in most audits of the financial statements. For some context, here are the accruals reported by some of the major companies in their recent annual financial statements:
| Company | Accrued liabilities | As a percentage of total liabilities | As a percentage of total revenue |
|---|---|---|---|
|
General Motors |
$20,069 millions |
25.11%
($20,069 / $79,910) |
16.38%
($20,069 / $122,485) |
|
Tesla |
$3,855 millions |
13.57% |
12.22% |
|
Microsoft |
$7,874 millions |
10.89% |
5.51% |
As you noticed above, the accruals are often material amounts and thus the importance to understand how to audit accruals to obtain required level of audit evidence. Based on our experience, following (structured) approach is highly effective in planning and performing the audit of accruals:
- Determine audit risk of accrual and related assertions
- Planning procedure to identify relevant risks and assertion
- Listing of data required to perform audit of accruals
- Performing tests of controls over accruals
- Performing substantive procedures over accruals
- Potential controls deficiencies in accruals and impact on the audit
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Audit Risks of Accruals and related assertions
There are specific and multiple audit risks associated with accruals. Each of these risks impact one or more financial statement assertions. Understanding these risks will give you necessary knowledge to identify which of these risks are present in your scenario and what audit procedure must be performed to obtain required level of audit evidence.
a) Under-statement of accruals:
Accruals are likely to be understated (and often are!), either due to pressures on or incentives to the management. An understatement in accruals may reduce liabilities in balance sheet and expenses in income statements. Let’s think about why management would want to do so and some of the impacts this can have on balance sheet and income statement:
- Reduce current liabilities to improve liquidity ratios. For example, liquidity ratio thresholds may be prescribed in borrowing agreement signed by a company and deviation from the prescribed threshold may result in borrowing becoming immediately repayable. This creates a pressure on the management to deliberately understate accrual to be compliant with borrowing agreements. This may also happen where companies are preparing for an IPO, major acquisitions or share sales. In these cases, management would want to present lower liabilities to get better valuation of their shares.
- Reduce expenses to improve profitability ratios. This can happen where management is under market pressure to achieve certain profitability targets. Management may have incentive to understate accrual as well if their compensation (e.g., share options or bonuses) level are linked to level of profitability achieved during the year.
Assertion impacted: If you guessed Completeness, then you are absolutely right! It is clear from above that accrual recorded may not completely include the balances/transaction which it should, inadvertently or deliberately!
b) Errors in estimation or calculation of accruals:
Not all accruals are created equal! Joke aside, certain accrual may require complex calculation or judgement to determine the accrual amount. Complexity creates the risk of inadvertent errors by management in valuating the accruals and thus inaccuracies in recorded amounts. This risk is more likely to present in larger organization and in certain industries. Examples of a few complex accruals are:
- Accruals for complicated legal claims where significant judgement is involved by the experts to determine if company will be required to settle the claim or not and to what extent.
- Accruals arising from specific laws (such as tax), which are made further complex if a company operates in multiple jurisdictions
Assertion impacted: Accuracy and Valuation, since complex calculation or estimate may lead to calculation errors or value determined for the amounts being accrued.
c) Cut-off errors in accruals:
Accruals may have cut off errors which is often seen in practice. Cut-off error occurs when accruals for goods are not recorded in the correct reporting period. A few situations where this may happen are:
- Goods were received before the year-end in company’s warehouse, but finance team was either unaware or did not check and therefore accrual to pay for the goods were not in the current year despite being liable to pay for those goods.
- Management year-end closing processes is not mature enough to capture all the accruals (e.g., there are no standard checklist for year-end accruals or invoice log/ payment logs are not reviewed) and as a result some accruals slip into next financial year bookkeeping.
Assertion impacted: Cut-off as the title suggests, since accrual have not been recorded in the correct accounting period.
d) Overstatement of accruals:
We don’t normally expect that accruals are overstated. However, this may happen in certain industries or sectors, for example:
- Not for profit organization which are contractually obligated to spend certain amounts on donor funded programs may overstate the accruals and expenses to achieve compliance with donor agreements.
- Government often incentivizes spending by certain industries on exploration and development of natural resources (mineral, oil and gas) by providing them tax benefits. This also creates incentive for the management to report higher accrual and thus expense to avail those tax benefits.
Assertion impacted: Overstatement can impact multiple assertions. In the examples above, it can achieved through incorrect “Cut-off” (booking next year’s accrual in current year) or “Valuation” (recording higher than the expect value) for amounts being accrued.
An important thing to remember here is that not of all these risks are present in every organization and their severity (from low to high) may also depend on nature of organization and maturity of its processes and controls, among various other factors.
Planning procedure to identify relevant risks and assertions
Your next steps in how to audit accrual is to identify which of the risks we discussed above are most likely present in your specific audit or exam scenario. This also include identifying specific financial statement assertions effected by these risks. These can simply be called “Relevant Risk and Assertions”.
How do we identify these relevant risk and assertions? You can identify these by performing Planning Audit Procedures which are:
- Understanding the nature of organization business, regulatory and legal requirements. Certain business may have large volume of manual accruals vs smaller organization which may not material accruals.
- Variance analysis between current and prior period accruals balance to identify unusual increase or decreases and inquiring management for reasons.
- Inquiring management about significant changes and events during the year and corroborating management’s responses with change in accrual during the year.
- Reading minutes of meeting of Board of Directors/Owners and its sub-committees to identify matter which may require accrual in the financial statements
- Performing an online search for any news about the company which indicate obligation of the company requiring accrual.
Below examples illustrates how to perform and gather information from planning procedure to identify relevant risks and assertions.
Example – Identifying relevant risk and assertions:
George is a second-year staff assigned to the audit of Orange Inc., which is a New York based manufacturer and seller of skating shoes. George has been tasked to perform planning procedure over accruals of Orange Inc., and report on the following:
- Identify risks associated with Orange Inc.’s accruals
- Identify the relevant assertions
George has received Orange Inc.’s draft financial statement and noticed below accrued balance:
| $ in millions | 2021 | 2020 |
|---|---|---|
|
Payable and Accruals |
$2,585 |
$3,640 |
George performed planning procedure mentioned above and noted following key matters:
- Board of Director discussed an increment of 8% in management salaries and also approved bonus equal to 1.5 salaries for all employees.
- There has been news about that Company had a recent fire incident at its facility in San Francisco and as a result 2 of the employees were injured.
- CFO informed that her accountant responsible for preparing accrual entries have resigned near to the year-end closing which has resulted in immense pressure on the finance team. The replacement is yet to be hired.
- CFO mentioned that company has negotiated longer credit terms with its vendors due to better manage its liquidity
- CFO informed that orange had very successful sales year and its sales increased by 30% as result its receivable and payable are expected in increase.
The next step will be to identify relevant risk and assertions (which can lead to risk of material misstatement) based on the factors noted above by George:
| Analysis | Relevant risk | Relevant assertion |
|---|---|---|
|
Accounts payable have decreased by 29% in 2021 compared with 2020 as per the balances in draft financial statement above (($2,585 - $3,640) / $3,640). However, this does not corroborate with the fact the accounts payable are expected to increase as a result of 30% increase in sales (thus also cost of sales) and increased credit terms. This indicates a risk that accruals may have not been completely recorded. |
Understatement of accrual |
Completeness |
|
Board of Directors approved salary increments and bonus. However, we have instead noticed a decrease in accruals of 29%. This indicates a risk that accruals for increments/bonus have either not been recorded or not recorded correctly. |
Understatement of accrual |
Accuracy and Completeness |
|
Due to pressure at the Orange Inc.’s finance team at year-end and the fact that accountant replacement could not be found, there is a risk that accrual calculation may have contained errors or some of the accruals are not booked as a result of the pressure on the finance team. |
Errors in estimation or calculation of accruals |
Completeness and Accuracy |
|
Orange Inc. may be liable to major workplace damage claim as a result of the fire incident at the San Francisco facility. |
Errors in estimation or calculation of accruals |
Valuation, Rights and obligations |
|
Orange Inc. has negotiated a longer credit terms. Typically this would mean that liabilities for a longer period needs to be accrued. However, we are instead seeing a decrease in current year’s accruals. This also indicate the risk that accrual is either not completely recorded or recorded at incorrect amount. |
Understatement, or errors in calculation of accrual |
Completeness and Accuracy |
Data required to perform audit of accruals
As now you are aware of the risks and applicable assertions, you will need detailed information from the management about the accrued balances to perform the audit procedures. I have mentioned information which you need initially to get rolling, and additional information which you will need as you perform the detailed procedures.
Initial information request commonly includes:
- Process documentation or flowchart related to accruals (this will help you to identify the risks, documentation produced, controls and/or lack of controls and journal entries prepared)
- Copy of the minutes of the meeting of Board of Directors, Audit Committees and other relevant subcommittees of the Board and/or management.
- General ledger break down of accruals presented in the balance sheet. You may be able to extract this information from trail balance if trial balance to financial statement mapping information is provided.
- Vendor wise break down of accrued balances for both current and prior year
- Individual journal entry level breakdown of the period end accruals which contains information such as; journal entry ID, date and amount, vendor ID and name, information or nature of accrual. You will need this information for sample selections to test the accuracy of amounts accrued.
- Copy of the period-end accrual check list, if maintained by the management
- Listing of litigation and claims against the company (these may require accruals).
Follow up information commonly includes:
- Inquiries arising out of the review of the process documentation, flowchart, and minutes of the meetings.
- For a sample of accruals, ask for supporting documentation such as management’s calculation underlying the accruals, invoice received post year-end, documentation related to goods and services received before and after the year-end date.
- Copy of relevant approvals for certain type of accruals such as bonus, obtain board of directors’ approval
- Expert opinion for accrual which involve complex judgement or calculation. For example, accrual for legal claims, tax liabilities, or asset retirement obligations.
Test of controls over accruals
You can decide to test the controls over the accruals if you have assessed that the organization has an appropriate process and designed controls to address any potential material misstatements in recording of accruals. You will need to decide this after discussion with your engagement manager and/or partner. If you decide to rely on the controls, it may reduce the extent of you substantive testing. Typically the test of controls involves understanding of:
- The process, systems used, documentation produced and controls over the accruals
- The risk of material misstatement at each step of the process
- The competence, capabilities and expertise of the control owners.
- The frequency of the controls, such as daily, weekly, monthly or yearly. This will help in deciding the sample size you will need to select for testing purpose. Higher the frequency, higher the sample size, among other factors.
- How controls are performed, and if the controls are documented in a sufficient manner.
From my experience, some of the controls commonly seen in organization over recording of year-end accruals are:
| Common controls over accruals | Assertion addressed |
|---|---|
|
Review of year-end accrual checklist to ensure all reporting period end accrual have been recorded. |
Completeness |
|
Review year-end management package which includes reason for changes in accrued balances from prior year, quarter, and/or budget |
Completeness and Accuracy |
|
Review of all accrual entries above a material amount, which include review of the underlying documents and calculations |
Accuracy |
|
Reconciliation of accrued general ledger balances with supporting calculations or documents. |
Accuracy |
|
Review of post year-end goods or services received logged to identify good & services which have been received and should be accrued for. |
Completeness |
|
Review of post year-end invoice log and bank statement to identify any missing accruals |
Completeness |
|
Review of year-end litigation and claims to identify any potential accruals. |
Completeness, Accuracy, Right & Obligations |
|
Obtaining external or internal expert opinion related to complex accruals such as, tax, litigations, asset retirement obligations |
Valuation |
Depending on the nature of industry and size of the organization, some or all of the above, or even more controls may apply to your particular audit or exam scenario. You will again need to have a discussion with your manager or partner to decide which of the controls you plan to rely on and test. For such controls you will need to:
- Perform a walkthrough with the management to understand how the control is performed.
- Determine if the controls is designed properly to catch any material misstatement. For example, a control where reviewer does not have knowledge or background to review accrued balance may not be able to catch material misstatement.
- Obtain supporting documentation for a sample of transactions and test if the controls was performed similar to how it was performed during your walkthrough.
The end result of your control test will be to conclude if the controls operated effectively and if not, then what is the impact on your audit. Typically, this would mean you will need to increase the extent of the substantive testing. However, failure of a key controls which address fraud risk may indicate a more pervasive issue and have impact on other account balances.
Substantive audit procedure over accruals
This is where you will likely spend most of the time auditing accruals to obtain bulk of the audit evidence. Don’t worry! We have made it easier for you by listing some of common audit procedure over accruals and assertions addressed. Extent of substantive testing will depend on the outcome of your test of controls (if tested), nature and size of the accruals.
| Procedure | Assertion addressed |
|---|---|
|
Agree the amounts in general ledger for accrued balances with the trial balance. Reconcile general ledger balance totals with the financial statements. Also compare the prior year GL breakdown with prior audited financial statements. This should be the very first procedure you should perform, as it will ensure that you are working with the correct population and if there any material discrepancies between general ledger, trial balance or financial statement, those are identified and communicated on a timely basis. |
Disclosure and Accuracy |
|
Perform a year-on-year variance analysis by comparing current and prior year’s general ledger balances, and vendor/supplier wise accrued balances. You should investigate any unusual variances over or under the tolerable threshold, and should also corroborate this with minutes of the Board, Committee and Management’s meetings. |
Completeness and Accuracy |
|
Perform a review of the minutes of the Board of Directors, Committees, and Management meetings to identify any matters which require accrual (e.g. litigations, tax, restructuring) and check if accrual for those have been recorded or not. Similarly, perform an online search to identify matters which may require accruals e.g., news about incidents at facilities. You will likely have performed some of all this procedure during your audit risk assessment stage. You can leverage your work there to check if corresponding accrual has been recorded or not. |
Completeness |
|
Select a sample of accrued journal entries from the general ledger and obtain the underlying supporting documents or calculation from the management. Check if accrued amounts have been accurately calculated and recorded. |
Accuracy |
|
Perform a search for unrecorded liabilities (also called test of omitted liabilities). This is an important substantive procedure to test completeness of accruals. You can perform this test in various ways as follows:
|
Completeness |
|
Obtain listing of external and internal legal counsel used by the management (at anytime during the reporting period) and send them letters to report any litigation or other matter they have dealt with. I also suggest to perform a scan of the general ledger used for booking legal and professional fees to ensure the completeness of legal counsel listing received above. Another important item to ensure audit efficiency is to mention a certain dollar value threshold above which legal counsel should report matter in their responses. This will increase the chances of a response to your letter, save time/effort for legal counsel to respond, and your audit effort will be focused on material matters only. |
Completeness and Valuation. |
|
Obtain expert opinion on complex accruals. You may need to consult with both management’s expert and your own to determine if the accruals have been valued at appropriate amounts. A good example is asset retirement obligation, where you may need an opinion from engineering, environmental, reclamation experts to determine the reasonableness of amount accrued. |
Valuation |
|
It’s no good if accruals are correct in all aspects but not disclosed properly in financial statements. For accuracy of disclosure related to accruals, check that:
|
Disclosure |
Potential control deficiencies in accruals and impact on the audit
There may be deficiencies in controls over accruals. If you identify a deficiency, you will need to assess its impact on the substantive audit procedure. Most often this will increase the extent of substantive testing i.e., either increase in the sample size or additional audit procedure to obtain required level of audit evidence. I have listed example of some of the deficiency you may encounter during the audit of accruals:
| Deficiency | Risk and Impact | Additional procedure |
|---|---|---|
|
Management does not prepare year end accrual checklist, or does not perform a variance analysis (also called flux analysis) of the accruals. |
Increase the risk that accruals recorded are not complete i.e., material and important accruals are missed during year-end closing process by the management. This increase the level of risk associated with completeness assertion. |
Increase the sample size for procedures over completeness of accrual such as test of omitted liabilities or perform additional completeness procedures. |
|
There is no review of the accrual journal entries, or no threshold is specified above which accruals are reviewed, or review is performed on an ad-hoc basis |
Lack of review leads to the risk that accrual entries may been incorrectly calculated and/or recorded. This increase the risk associated with Accuracy assertion. |
Increase the sample size for accrual transactions selected from general ledger to test the supporting calculation and documents. Higher sample size means that you will test more accrual entries to ensure that those were correctly calculated and recorded in general ledger. |
|
Management does not reconcile the accrued general ledger balances with the underlying schedules, calculations, and/or sub-ledgers. |
Since the general ledger balances are used in the trail balance and ultimately financial statement, there is a risk that incorrect balances are included in the financial statements. This impacts both completeness and accuracy of the accruals. |
Perform additional procedures or sample testing as mentioned above. |
|
Management does not review the post year-end goods and services received log, invoice log, or payments made before and after the year-end to identify any missing accruals. |
Lack of this control leads to the risk that accruals for some of the goods or service which have been received during the reporting period end have not been recorded. This increase the risk associated with Completeness assertion. |
Increase the sample size for procedures over completeness of accrual such as test of omitted liabilities or perform additional completeness procedures. |
|
There is no list maintained for litigation and claims or no review of the list is performed at year end by the management to ensure it is up to date and reflects the most recent status of litigation matters and most likely outcome. |
Lack of this controls can result in an accrual for potential litigations and claims which is incomplete, incorrectly valued, and material disclosure missing in the financial statements. |
In this case, send letters to all the legal counsel in the management’s listing. Review Board and its Committee’s minutes to identify any legal counsel not included in management listing and send them letters. Obtain a representation from the management in-house head of legal that all legal counsel engaged by the company have been disclosed to the auditors. |
I will be adding more content to this topic in future to make it a one stop shop for all the guidance related to accruals. If you like the article, feel free to share it with others.