Financial Report Assertions

Introduction

Financial reports are the product of an entity's accounting system.
The preparation of financial reports involves judgments made by those charged with governance and management.
Different financial reports can be prepared from the same data based on judgments and choices within accounting standards.
Accounting standards allow choices between different acceptable methods (e.g., AASB 116 allowing cost or revaluation model for property, plant, and equipment).
Professional judgment is used in determining amounts for items like provisions for warranties, allowance for doubtful debts, and accumulated depreciation.
Different judgments can lead to different accounting treatments and numbers.

Overall Objective of an Audit

The overall objective of an audit is to enable the auditor to express an opinion on the financial report.
This enhances the confidence that intended users have in the financial report.
The auditor must look behind the numbers to assess the data and allocations, using professional judgment and skepticism to determine if the report presents a true and fair reflection.

Professional Skepticism vs. Professional Judgment

Professional Skepticism

Auditors must plan and perform audits with professional skepticism.
This involves a questioning mind and a critical assessment of evidence.
Critical does not mean negative; it means maintaining neutrality.
Auditors should be open to circumstances that might confirm or raise suspicion.
A questioning mind is crucial for assessing evidence, questioning the reliability of documents, information, and explanations.
It enables auditors to be alert to contradictory evidence and to question the sufficiency and appropriateness of the evidence.
It also involves being alert to conditions that may indicate fraud risks and critically challenging management's judgments, assumptions, and estimates.

Professional Judgment

Auditors must plan and perform audits with a high level of professional judgment.
Professional judgment is the application of relevant training, knowledge, and experience within the context of auditing, accounting, and ethical standards.
It involves making informed decisions about courses of action.
Professional judgment includes:
- Determining when something is material (importance).
- Assessing audit risk.
- Evaluating audit evidence.
- Assessing the reasonableness of accounting estimates.
- Evaluating management's judgment.

Financial Report Assertions

Accounting standards allow choices and require accountants to use judgment (e.g., allowance for doubtful debts, lower of cost and net realizable value for inventory, accumulated depreciation).
Financial reports can be biased due to preparers having a vested interest in the information presented.
Accounting methods impact the income statement, affecting expenses and income.
Directors declare or assert that the financial report presents a true and fair view of the entity's financial performance (income statement) and financial position (balance sheet).
This assertion covers the balance sheet, income statement, and notes to the account.
Assertions help auditors assess risks and consider potential misstatements.

What are Assertions?

Assertions break down the concept of 'true and fair' into meaningful characteristics.
If these characteristics are not true, the balance sheet is not true and fair.

Balance Sheet Assertions

Existence: Assets, liabilities, and equity items represent something real.
- Example: Inventory worth $500,000 suggests the inventory exists.
Rights and Obligations: The entity has the right to include assets and liabilities in the balance sheet.
- Example: $500,000 in cash at bank implies the entity has the right to that cash.
Completeness: Everything that should be included in the balance sheet is included; nothing is missing.
- Example: All debts and cash holdings, including those in offshore accounts, are accounted for.
Valuation and Allocation: Amounts in the balance sheet are correct and appropriate.
- Assets are stated at carrying amount (e.g., accounts receivable minus allowance for doubtful debts).
- Depreciable assets are shown at cost less accumulated depreciation and impairment losses.
- Intangible assets are shown less accumulated amortization.
Classification: Assets, liabilities, and equity are classified in the proper accounts.
- Spending money should be correctly classified as either an asset or an expense.
- Items are correctly classified as current or noncurrent.
- Example: Centro Properties case where debt was incorrectly classified as noncurrent instead of current.
Presentation: Notes to the account are clear, relevant, and understandable, and everything that should be included is included.

Elaboration on Assertions

Existence

There's something real represented by the assets, liabilities, and equity figures.
Example: A debit to accounts receivable and a credit to sales (e.g., $2,500). If the sale is fictitious, the accounts receivable does not exist.
Stolen items still showing on the balance sheet asset account also violate this assertion.
Double counting items during a stock take can lead to overstated inventory records.

Rights and Obligations

The entity holds or controls the rights to assets, and liabilities are the obligations of the entity.
In group accounting, it's important to ensure assets and liabilities are in the correct entity's accounts.
Example: Determining which entity (A, B, or C) rightfully owns cars in a car lot.

Completeness

Means nothing is missing that should have been brought to account.
Involves checking for off-balance-sheet amounts, such as bank accounts in tax havens or unrecorded debt (as in the Enron case).
Difficult to verify because you are looking for what is not there.

Valuation and Allocation

Dollar amounts in the balance sheet for assets and liabilities are recorded at appropriate amounts after adjustments.
Example: A fleet of airplanes is shown at cost or fair value less accumulated depreciation and impairment losses.
For inventory, consider "dose items" (defective, obsolete, slow-moving, and excess) to ensure items are reduced to net realizable value (NRV).
$Dose = Defective + Obsolete + Slow-Moving + Excess$

Classification

Items are placed in the proper accounts per the chart of accounts.
Assets are correctly classified as current or noncurrent.

Presentation

Notes to the accounts are clearly described, relevant, and understandable.
Includes significant accounting policies, basis of preparation, use of estimates, basis of inventory valuation, and principles of consolidation.

Income Statement Assertions (Transactions and Events)

Aligned with balance sheet assertions but have different names.

Occurrence

Equivalent to existence in the balance sheet.
Transactions and events recorded are validly authorized and pertain to the entity.
There are no fictitious or fake sales or non-entity expenses included.

Completeness

Same as the balance sheet assertion: nothing is missing.
No income or expenses that should have been brought to account have been missed.

Accuracy

Also called Valuation and Allocation.
Dollar amounts recorded for revenues and expenses are at appropriate amounts.

Cutoff

Transactions and events have been recorded in the correct accounting period
Income and expenses are recorded in the correct financial year.
Focuses on transactions processed late June/early July, ensuring proper allocation between financial years.
Example: Income and expenses for the twelve months ended 06/30/2021 are all included in that period.

Classification

Items are classified in the proper accounts.

Presentation

Information is clearly and appropriately disclosed in the financial statements, including notes.

Elaboration on Income Statement Assertions

Occurrence

Sales represent something real.
Expenses represent actual expenses of the business.
If the occurrence assertion is at risk, there may be sales or expenses in the general ledger that are not real or valid.
Example: Suspicion that sales entries in the sales account should not be included because they don't represent a real sale.

Completeness

Trying to ascertain whether any income or expenses are missing.
Income may be omitted to evade tax, and expenses may be omitted to report higher profits.

Accuracy, Valuation, and Allocation

Dollar amounts in the income statement as income or expenses have been recorded at appropriate amounts.
Problematic when foreign exchange calculations are required or due to poor processes.

Cutoff

Income and expenses have been recorded in the correct financial year.
Ensures that income is not brought forward and expenses are not delayed to manipulate profit.

Classification

Items have gone into the correct accounts as per the chart of accounts.

Presentation

Clear and appropriate disclosure of information in the financial statements.

Why Use an Assertion Risk Approach?

Once the assertion at risk is known, the appropriate response to test its validity is also known.
If valuation and allocation of inventory is at risk, audit procedures related to inventory value are undertaken.
Focus on identifying defective, obsolete, slow-moving, or excess items to determine if they have been reduced to net realizable value.

Audit Procedures and Evidence

Auditors must gather sufficient appropriate evidence to base their audit opinion.
Audit evidence is all the information used to arrive at conclusions.
Procedures are the actions taken to acquire evidence.
Common audit procedures include inspection, observation, external confirmation, recalculation, reperformance, analytical procedures, inquiry, and tracing and vouching.
Selection of audit procedures is influenced by the auditor's understanding of the entity, risk assessments, materiality, knowledge, experience, results from other procedures, source and reliability of information, and persuasiveness of evidence.

Sufficiency and Appropriateness of Evidence

Sufficient: Enough evidence to form an opinion.
Appropriate: Evidence of a type that will enable auditors to form an opinion about the assertion at risk.
Sufficient but inappropriate evidence is inadequate.

Reliability of Audit Evidence

Evidence from external sources is more reliable than from the entity's records.
Internally generated evidence is more reliable when related controls are effective.
Evidence obtained directly by the auditor is more reliable than through the entity.
Documents and written representations are more reliable than spoken word.
Original documents are more reliable than photocopies or facsimiles.