Are you wondering how to perform the audit of expenses?
The topic “Audit expenses” lists audit procedures for testing the expenses.
Expenses can be operating or non-operating in nature. Operating expenses help in the effective and efficient operations of any business. There isn’t an exhaustive list of all the expenditures that fall under the operating expenses bucket. It depends on the nature of the company’s business.
Estimated reading time: 9 minutes
We all know what an expense means. Operating expenses are a sub-topic under expenses. Let’s try to understand the concept of operating expenses with an example.
Note: Non-operating expenses are generally outside the scope of testing. However, their quantitative significance might warrant testing using the two approaches mentioned below.
Table of contents
- Audit Expenses – Example:
- What’s the key takeaway from the above example?
- Audit of Operating expenses:
- Will both Financial and Non-Financial Data be considered for Analytical procedures?
- What’s the Combined Testing Approach to Audit Expense?
- Conclusion for Auditing Expenses:
Audit Expenses – Example:
Consider two Companies—Mini Loss and Major Loss—in the Manufacturing of Automobiles and Cab Services. Both companies incur electricity expenditures as part of their business operations.
Mini Loss Company has an Automatic Plant and machinery to assemble various parts and manufacture Automobiles. Thus, humans aren’t involved much, and the company heavily depends on electricity.
Major Loss has just an office building for administrative purposes. So, the Office Building is the primary consumer of Electricity.
What’s the key takeaway from the above example?
Mini Loss Company can’t conduct business operations without electricity, so those expenses are not operating expenses for the company.
Electricity expenses support the business of the Major Loss company, but not directly. The necessity of electricity isn’t the core ingredient for running a business.
The above example is classic for understanding the differentiating factors between an operating and vs. non-operating expense.
Therefore, the operating expenses constitute a significant portion of the total costs of business. The amount involved is huge and material. Business operations can’t be carried out without these expenses. So, the auditors’ scope for this expenditure is testing.
Here, Scope in would mean that the auditor decided to test an account balance given the quantitative and qualitative factors.
Also Read: Physical verification of Stock procedure.
Audit of Operating expenses:
Testing of Operating expenses can be performed through any of the following two approaches:
- Substantive procedures
- Substantive analytical procedures
The audit team might decide to perform the above procedures based on the nature of the risk involved, Misstatements(either prior year or current year), adverse operating expenses ratio, and the industry in which the entity operates.
Audit of Operating Expenses through Substantive Procedures:
Substantive procedures are nothing but the test of details procedures. The audit team obtains and tests the details of transactions. Here, details mean supporting documents from outside the entity, like invoices, contracts, or agreements, or internal support like internal emails, and entity policies.
Runners Insight:
Sometimes inquiries with the relevant entity personnel also form part of audit documentation. Such inquiries need not be corroborative evidence but can be concluding audit evidence.
Are you wondering how inquiry supports audit evidence?
Auditors might not know beforehand about the nature of expenses through testing. So, conducting inquiries helps in the expense audit.
For example, an expense entry for purchasing an actuator for a batching plant is part of the test of details. The audit team inquires with the entity personnel to understand its nature and use. This helps determine whether that entry comprises capital vs. revenue items.
Runners Insight:
Even auditors might go to the plant site and check with site personnel (independent of the client staff, to whom auditors generally deal) to see if the entity office personnel’s responses are accurate.
For example,
Auditors need not rely on the inquiry responses provided by the fixed asset department. Instead, they will inquire with the factory staff working inside the Plant and machinery or Fixed assets. This kind of verification provides more persuasive evidence.
Involving Industry Experts for Auditing Expenses:
The audit team is not generally aware of all the industry knowledge. Based on the item’s value, the audit team might also approach industry experts for subject knowledge questions. Then those discussions form part of audit documentation as evidence.
Key Test – Capital vs Revenue
The distinction between capital and revenue items is a key aspect of this substantive testing. If the expenses result in an enduring benefit, then the benefit can be eligible for capitalization, subject to the value of the expenses and the entity’s capitalization policy.
How about an example here?
ABC is in the Soap Manufacturing business. The entity purchases ten calculators for the finance department, each costing $100. These calculators generally last over four years but have a three-year product warranty.
Per ABC Entity Policy, expenses can be capitalized if they provide a recurring benefit of more than one year and a value of at least $7,500.
Therefore, calculators are not capitalized even though their benefits are for more than one year, as their value is negligible.
Runners Insights
The thumb rule to differentiate the capital vs. revenue expenses is –
Ask yourself: Will the expenses under audit distort the profit and loss statement if they’re charged off as expenses in the current year?
This rule can be helpful, primarily when no such entity policy exists. We can correlate this with the concept of deferred revenue expenditure.
Audit of Operating Expenses through Substantive Analytical Procedures:
Analytical procedures are nothing but analyzing the data, either financial or non-financial.
In General, Auditors arrive at expected numbers and compare them with the current year’s data. Let’s understand this with an example.
Assume that the Auditor is performing analytical procedures on the entity’s bad debts, which are correlated to sales.
Average Bad Debts to Sales Ratio is (12.5%+7.4%+10.9%)/3 = 10.3%
The audit team will apply the above-average current sales ratio to arrive at the expected bad debt number for the current year.
Estimated Bad debts = $134M*10.3%
= $13.8M
The difference of $1.2 M is immaterial considering the sales figures.
There shall be a basis for any audit procedure. So, all the differences between the estimates and actual amounts are subjected to thresholds. From the example below, let’s understand the logical reasoning for having a threshold.
What’s the Need for a Threshold to Audit expenses?
The numbers the auditor arrives at for analytical procedures are a best estimate. The audit team might not consider all the business implications of the calculation. This is because they are not expected to know every factor when calculating. The Auditor can’t derive a standard formula to arrive at an accurate estimation for testing all the account balances.
For example, an entity under audit levies a service charge for each sale made, depending on the nature. The service charges vary from 4% to 8%. If the sale transactions are in millions, it’s not feasible and economical for the Auditor to categorize each transaction and apply appropriate service charges. Then, the Auditor goes with a realistic percentage. So, the average service charge is more relevant here.
So, the Auditor generally arrives at a threshold figure based on professional judgment and materiality. The threshold gives a buffer for all those unknown factors. The difference obtained after analytics is verified to be lower than the threshold.
Different ways of performing Analytical Procedures to Audit expenses:
Analytical Procedures are performed in any of the following manners as well:
- Comparing the current year’s data with the previous year’s. For example, Rental Payments for each month shall be equal. There shall not be any extra payments made to the Landlord unless warranted by any amendment to the rental agreements. So, comparing the current year’s data with the previous year’s data provides the auditor with inconsistent payment details. Then, the auditor discusses with the entity to understand the reasons for such variances.
- Comparing the Current year’s data with the Auditor’s estimated numbers (See above example)
- Compare the current year’s data with industry data. For example, the industry credit period for purchases is 30 days. However, the entity that operates in the same industry has a credit period of ten days. This isn’t an indicator of the good financial health of an entity. Then the Auditor shall understand the reasons, verify if the company has enough liquid assets, and check the Quick & Current ratio. The decreased credit period against purchases generally results from the company’s inability to honor its commitments within due dates or deteriorating credit position. So, the Auditor might also need to evaluate the assumption of going concern, considering the situation.
- Ratio Analysis. For instance, consider Sales vs. Sales Commission. If sales commission increases in the current year while actual sales decrease, we should involve entity personnel to understand the reasons for the increase.
Will both Financial and Non-Financial Data be considered for Analytical procedures?
While arriving at estimates, the Auditor might also employ non-financial data. For example, if the Auditor is building expectations of the AMC Charges, the inputs are the AMC for each Computer Software and several Computer Software information.
AMC Per Each Computer Software is a financial data
The number of Computer Software is a non-financial data
Runners Insight:
Analytical procedures are applicable only when there is a reasonable basis for the Auditor to arrive at estimated amounts
What’s the Combined Testing Approach to Audit Expense?
Considering the risk of material misstatement relating to operating expenses, the audit team might test using both methods (Test of details and Analytical procedures).
What are the considerations for adopting both testing approaches?
- Prior year misstatements and errors in this account balance
- Performing only one of the procedures does not result in sufficient and appropriate audit evidence
- Higher risk of material misstatements
- All the Internal Controls relating to this account balance are not designed or operating effectively.
Runners Insight
It’s always advisable to perform most testing in an interim period (6 months, 9 months, or 10 months). Interim testing enables auditor to spread their work over the year. So, the audit team might choose any of the below combinations with the assumption that the client’s year-end is 12/31/2025:
- Interim, as of 6/30, covers the first 6 months, and Year-end, as of 12/31, covers the balance period
- Interim, as of 9/30, covers the first 9 months, and Year-end as of 12/31, covers the balance period
- Interim, as of 6/30, covers the first 6 months, as of 9/30 covers the next 3 months ,and Year-end as of 12/31, covers the balance period
Testing the interim and final phases will reduce the workload at year-end.
Conclusion for Auditing Expenses:
Operating expenses drive the entity’s business operations. Such expenses will be tested by either a test of details, analytical procedures, or both. A test of details involves obtaining all the related supports of the tested samples and verifying their authenticity, accuracy, valuation, classification, and cut-off. Analytical procedures test the current year’s data with the Auditor’s determined expected amounts and subject the difference to a threshold computed based on the auditor’s professional judgment and materiality levels.
