How to audit accruals

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:

General Motors
(Dec 31, 2020)

Tesla
(Dec 31, 2020)

Microsoft
(June 30, 2021)

1. Determine audit risk of accrual and related assertions
2. Planning procedure to identify relevant risks and assertion
3. Listing of data required to perform audit of accruals
4. Performing tests of controls over accruals
5. Performing substantive procedures over accruals
6. 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.

• 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!

• 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.

• 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.

• 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”.

• 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:

1. Identify risks associated with Orange Inc.’s accruals
2. Identify the relevant assertions

George has received Orange Inc.’s draft financial statement and noticed below accrued balance: