Journal Entry Testing

Journal Entry testing is a financial check point.

What’s the purpose of this test?

• Checks if all the transactions represent a valid business transaction
• Proves that there is no record of inappropriate entries

In other words, its a kind of testing the GL dump with all entries for a specific period.

How about an example to understand the purpose?

Consider an entity that is majorly financed by debt.

Fixed deposits comprises of more than half of the entity Capital.

The scenario seem to be strange and alarming.

If the entity has a decent amount of bank deposits, it does not need to borrow funds for the higher interest rate. Therefore, it’s the Auditor’s job to investigate and understand the reasons.

We will understand the Journal Entry Testing with the basic questions like What, Why, and How.

What is Journal Entry Testing?

Journal entry testing is an audit procedure to verify the transactions recorded in the given period. The Population which needs to be tested comprises of all the entries dump. 

Journal entry population includes the following types of transactions:

• Purchase and Sale of goods
• Operating expense
• Non-operating expenses
• Other Income
• Asset Purchases and Sales
• New Liability or Settlement of Existing Liability
• Profits or Gains relating to Sale of Asset or Extinguishment of Liability

The above list is not exhaustive. In other words, it includes all the transactions of GLs which are part of balance sheet and statement of profit & loss.

Why to perform Journal Entry Testing?

The Major risks attributable to the Journal entries are 

• Fraudulent Entries (Misappropriation of Funds)
• Management Override of Controls 

Let’s understand this with a Practical Example of Supermarkets. Do you remember seeing security personnel checking the Super Market Staff before leaving the store?

These checks are to ensure that employees will not resort to theft. Consider an individual of high authority, like a manager leaving the store with some goods hidden in a bag and asking the security guy not to check him. The Security Staff needs to obey the orders of his superior. Further, he is under the fear of job security.

Management override of controls is a scenario where the individuals of respected authority use their capacity to gain undue advantages.

• Employee Frauds (For Example, creating fake vendor profiles and paying off the liability against fictitious purchase orders)
• Recording Non-business transactions (Like Director Personal Expenses recorded within the books of accounts)
• Recording the transactions as per the applicable GAAP and best practices

How to Perform the Journal Entry Testing?

There are a couple of different ways to perform Journal Entry Testing. Let’s look into those.

New Accounts Test:

Identify the new accounts and review all the journal entries posted during the year. Check if there are any unusual business entries. If there are any such infrequent journal entries, then understand the nature and purpose of such entry.

How about an example here?

Ruin Company is in the Marketing business of FMCG goods. The entity created a Legal Expenses GL account to record the charges for the lawsuit filed against Ruin Company.

Performing a Check for this kind of new accounts helps the Auditor to know that there is a lawsuit against the company. So, the audit team will investigate further to understand 

• if there are any questions or ongoing concern 
• Check if the lawsuit is against the Major buyer or Seller
• Inquiry with the entity management and in-house legal counsel for any other such lawsuits.
• Check whether the disclosures made in the notes of the financials are in line with the progress of lawsuits.

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Keywords Test:

Keyword test is different kind of journal entry testing. This test does not have any specific formula that works for any engagement audit. It needs to be tailored based on the entity which is in audit, previous audit experience, historical errors and industry in which entity operates.

Before moving into understanding this Keyword test, let’s see an example of an inappropriate business expense. ABC Entity is in the business of Construction and shows some director personal expenses as a business. The accountant adds a description of Mr. A’s (Director) Marriage expenses. 

 The audit team needs to brainstorm for such keywords to find those entries and understand if it’s a valid business transaction.

In General, the Accounting team will record the entries along with narration. So, the nature will be evident either in journal line description, account description, and narration.

We have added a couple of keywords that will help audit team find unusual entries

• Director, Auditor, Names of Director and Audit firms
• Cover up, Penalty, Extra Payments,
• Settlement, Court, Litigations 

Infrequent Used Accounts Test:

Fraudulent Entries can also be seldom used. Every seldom-used account does not mean something isn’t right. There can be a valid reasons for not using a GL account frequently. For example, there will be one journal entry to record the building purchase for the administrative office. It’s not conclusive of some suspicious nature unless there are no other related journal entries for – Registration charges, Interior design expenses, Makeover charges, legal expenses, etc.

Let’s look at the different example.

Every entity wants to be successful and self-sufficient regarding the availability of funds so that there will not be any finance charges. So, managing working capital is essential.

For example, DEF Company allows a credit period of 30 days to its customer. It has more than 1,000 customers. Company has a discount policy to encourage quick receipts.

If the payments are made within ten days, the entity provides a discount of 5%. So, the discount helps in the quicker inflow of funds and thereby lower interest costs on the working capital loans.

The audit team performs the Journal entry testing and finds only one discount entry. Then Auditor needs to understand why there is only one entry out of 1,000 Customers. 

Is the policy favouring only one customer?

The audit team needs to check if such a customer is a related party. If so, then auditor need to check whether the transactions occur at an Arms-length price.

Year-End Entries Test:

Auditors need to give more attention to the closing journal entry testing. There can be some entries recorded during the close to show up good financial position of the company, and later those are reversed.

Top Management Bonus and Incentives might depend on the value of the business which the company did for that year. So, there might be window dressing of accounts during the close. 

Every business needs to accrue and reverse the specific transaction as per the accrual and matching concepts. So, those are part of the accounting. But there can be entries which are posted with personal objectives. Therefore, the Auditor needs to review all those for business validity and shall obtain reasonable audit evidence.

Are you wondering what evidence can audit team can get for accruals?

Probably that’s a great question. The answer is not a one-word or a sentence. Well, it depends. For example, entity records the utility accruals, then there might be some basis for it, like taking an average of the entire year and projecting it for that last month.

Let’s take another example, recording sales or something substantial GL transaction. Then we can consider the following facts

• The history of those balances and add up inflation,
• Refer to the contracts entered,
• Ask for email communication, and
• Check for the general approach in the industry in which the entity operates.

The key take away here is robust audit documentation.

Frequently Asked Questions

Is journal entry testing required?

Journal testing is the primary area of audit. It helps to check for any management override of controls and confirm if the transaction is within the ordinary course of business and to conclude that there are no fraudulent entries.

What is an example of a journal entry?

Let’s see the depreciation Journal Entry. The GL accounts involved here are depreciation and fixed assets.

Depreciation is a non-cash expense and will be on the debit side of the entry as its increasing. The value of a fixed asset decreases due to the normal wear and tear, which we call depreciation. So, we will credit the asset

How do you audit a journal voucher?

The audit team can review all the Journal Entries. But in the interest of time and considering engagement economics, Auditor can filter transactions as per the above tests. For example, the audit team will not consider immaterial transactions. Here the term Immaterial is defined as a percentage of materiality. The common practice for the immaterial value is 5% on materiality.

If there is any entry that’s triggered due to the above tests and its less than immaterial value, then we can ignore it and need not perform testing.

What management assertions may be covered by journal entry testing?

Journal entries involve recording all kind of transaction (both Balance sheet and Profit & Loss account) . So, almost all the assertions are covered by the journal entry testing. Those Management assertions are

• Valuation
• Cut off
• Rights and Obligation
• Accuracy
• Occurrence

Conclusion:

Journal entry testing tests all the transactions recorded in the books of accounts. It’s not possible to test for 100% population. So, we will apply different tests like new accounts, seldom used accounts, Closing entries, and Keywords test on the entire journal entries population. These tests help to filter out the unusual entries. For such entries, the Auditor needs to obtain an understanding by performing inquiries and asking for support to validate the business need for such transactions. Hope this article provided some good understanding of journal entry testing.

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