Performing the cut off procedures in audit is a testing approach to identify if the recording of financial information occurs within correct period.
Cut off is an audit assertion. Auditor test this assertion to obtain sufficient audit evidence that an account balance is recorded in the appropriate accounting period.
Let’s understand the context before moving on to the core topic. In other words, we will understand what does audit means here?
Estimated reading time: 6 minutes
Table of contents
Why to perform Audit?
Audit is to verify the financial information of an entity whose objective is either to earn profits (Business) or to achieve social economic objectives (NGO).
Statutory and regulatory legislatures govern the audit reporting. Further, there can be management requests as well for audits.
So, auditor performs testing of the financial statement and test the account balances for the cut off assertion. There are many other assertions such as Occurrence, Classification, Completeness, Accuracy, Rights and Obligation, Valuation, etc. So, auditor also devise procedures to test the account balances for above assertions as well
We will jump into further details of the cut off procedures in audit
What does the word cut off mean?
Cut off is an audit assertion which focus on verifying whether the transaction recorded in correct period to which it pertains to.
There can be high chance of occurrence of cut off error towards the end of the accounting period (month end, quarter end or year-end). This error can be unintentional (overlook) or intentional (fraud). Either of the case, the financial information shall not be misleading or incorrect.
Which account balances are tested through Cut off?
Cut off assertion is applicable for all of the account balances which are part of the Income Statement. The focus of this cut off assertion is to validate the appropriateness of recording a transaction in the applicable time period.
Note: Along with Cut off, the first four assertions mentioned above are also applicable to income statement.
We will understand the cut off with an example.
Cut off Procedure example
For instance, Auditors plans to perform the test of details on the Operating expenses GL balance. Audit team performs testing by following sampling approach as per the inherent risk for this balance.
Auditor obtains the invoices relating to the each of the expense selections from the entity records and check if the service period falls within the accounting period under audit. Audit team need to document the same within the audit workpapers with details such as period as per the invoice and the posting date of the expense. If there are any discrepancies between the two periods then auditor need to investigate the reasons and conclude if the recording of transactions is proper.
How is the cut off testing done?
We can perform the cut off testing by obtaining details of the period to which the transaction relates to. Entity records the transaction as per the supports received from the Vendor, Supplier or Contractor. Those supports can be Invoice, Purchase order, Contracts or agreements.
There can be difference between the recorded period vs actual period in which it should have been recorded. This can be a error in cut off procedure. That’s why stake holders warrant an audit by independent auditor.
Audit team compares the period as per supports with the what’s as per the books of accounts. This check ensures that the financial details are correct.
The preferred method of testing the Income statement balances is Substantive analytical procedures. This testing approach requires of arriving at expected GL account balance for the full year with a predicting data.
How to derive the predicting data?
The predicting data can be either of them below
- Prior year balances
- Average of the last two prior year balances
- The expected depreciation balance is calculated by deriving the percentage of prior year depreciation over the last year Fixed asset balance and multiplying the derived percentage on current year fixed asset balance. However, it will be more appropriate to utilize the average fixed asset balance (Average of the opening and closing balances). Considerations of average balances ensure to normalize the current year activity which is doesn’t occur equally throughout the year.
- The expected Payroll data is arrived by starting with the prior year data and adjusting it for change in the head counts, inflation and average hike percentage.
After arriving at expectation, audit team compares with its actuals and checks if the difference is reasonable.
Generally, audit team subjects the difference between expectation and actuals to a threshold. Threshold calculation involves as per professional judgement. For instance, it can be 50% of the audit materiality.
If the difference exceeds the thresholds, then auditor understand the reasons and checks if there is any need for modifying the predicting data or perform different audit procedure (Test of details).
What if there’s any error in performing such cut off procedures in audit?
Error is a case where there is possibility of misstatement exists and is proved through audit testing. For example, the Substantive analytical procedure results in difference between the expectation and actual exceeds the threshold and its unexplainable by entity.
Note: Evaluation of the error doesn’t differ for each of the assertion. In other words, this evaluation of error in case of cut off procedure applies equally to other assertions.
Audit team will quantify such error and evaluate the qualitative factors around it. Most of the times, auditor extrapolates the error in one transaction to whole account balance to understand the magnitude of misstatement. This number will help audit team to check if such errors are pervasive to financial statements as whole.
If these errors are result of frauds, then the auditor might choose to qualify or disclaim the opinion on financials.
Most cases, the errors are unintentional. So, audit team varies the extent of testing, performs alternative procedure, disaggregate the population and evaluate it separately. Its all-professional judgement.
How to disaggregate the population as part of error evaluation?
Lets understand the concept of testing disaggregated population. For instance, assume auditor is testing the administrative expense which comprises of the Periodicals, Factory Salaries, Telephone expenses and building maintenance. Lets assume there is a misstatement in administrative expenses. Per evaluation, its noted that the error pertains to transaction from telephone expenses only. So, auditor decides to perform test of details only on telephone expense balances.
Key Takeaways
Performing the Cut off procedures in audit is a way of obtaining evidence that the recording of transactions is in right period. These procedures best suits for income statement balances. Focus here is to check if the period as per the invoices, bills, contractor application tallies with that of what’s recorded in the books.
Considering the risk of overstatement and understatement of revenues and expenses respectively, auditor emphasize more on testing the period end transactions. This approach helps to detect material misstatements, if any.
