Introduction to Audit

Purpose & Objectives of Auditing

Financial Statements
Topic Contents:
1. Objective
2. Accountability
3. Reliability
4. Scope

Objective
The objective of external audit is for the auditor to express an opinion on the truth and fairness of financial statements.

Accountability
The main necessity for conducting the audit of financial statements stems from the fact that the persons responsible for the preparation of financial
statements are often different from the owners of large corporations.
Whereas in small owner managed companies, the owners have firsthand knowledge of the affairs of their business, management and ownership is
normally separate in the case of large companies that often have thousands of shareholders. In large corporations, shareholders appoint directors to
run the enterprise on their behalf. This separation of ownership and control creates the need for external audit.
Financial statements are the main source of accountability of management performance by the shareholders. However, as the management is
responsible for the preparation of financial statements, shareholders have to rely on external verification by auditors in order to gain reasonable
assurance that the accounts are free from material misstatements and can therefore be relied upon to be presenting true and fair view of the affairs of
the company.

Reliability
Apart from the needs of owners, other users of financial statements may need to place reliance on the financial statements. External audit is a means
of providing a reasonable basis for the users to place reliance on financial statements.
Examples of stakeholders (other than shareholders) that rely on audited financial statements include the following:
Tax authorities rely on audited financial statements to determine the accuracy of tax returns filed by the companies.
Financial institutions require audited accounts of prospective borrowers for assessing the credit risk by analyzing their liquidity and financial position.
Management uses the audit exercise to re-evaluate the company's risk management processes and internal control system by considering the
feedback given by external auditors during the course of the audit in this regard.

Scope
Financial audit is intended to provide a 'reasonable' assurance over the accuracy of financial statements. It therefore does not provide absolute
assurance that the financial statements are free from all misstatements. The purpose of audit is confined to provide reasonable assurance in order to
avoid excessive time and cost in the performance of the audit that may outweigh any benefit that may be derived from the enhanced assurance.
Absolute assurance is also impossible to guarantee in most cases due to the inherent limitations of audit.

Limitations of Audit of Financial

Statements
Contents:
1. Inherent Limitations
2. Use of Professional Judgment
3. Use of Sampling
4. Management Representations
5. Risk of Fraud
6. Time Constraints
7. Independence Threats
8. Scope

Inherent Limitations
 Due to the inherent limitations of audit, auditors are only able to offer 'reasonable assurance' over the truth and fairness of the financial statements
rather than absolute assurance. Inherent limitations of audit are discussed below.

Use of Professional Judgment

Audit involves the use of judgment in the identification of audit risks, selection of appropriate auditing procedures and the interpretation of audit
evidence. Although auditing standards provide guidelines to assist auditors in forming sound professional judgments, it is inevitable that an auditor may
at times misjudge a situation which may cause the auditor to overlook a misstatement in the financial statement.

Use of Sampling
Auditors apply sampling techniques to limit the number of transactions and balances selected for audit testing in order to perform the audit efficiently
and cost effectively. The results derived from the selected transactions and balances may not however be representative of the entire population.
There is therefore an inherent risk that the audit procedures may fail to detect a material misstatement in the financial statements due to the inability of
auditors to perform detailed testing of the entire population of transactions and balances.

Management Representations
Generally, external evidence is considered to be a more reliable form of audit evidence than internal evidence produced by the management. Although
auditors collect audit evidence from a range of sources, too often they have to rely on the representations of management in order to assess the
reasonableness of the matters concerning financial statements. This is particularly the case in matters that involve the use of judgment by the
management as it is usually difficult to corroborate management representations about the appropriateness of their judgments with external evidence.

Risk of Fraud
By their very nature, frauds are intended to be concealed by the perpetrators and therefore pose a very high risk of remaining undetected by the
auditors even in spite of the application of sound audit methodology and procedures.

Time Constraints
In practice, auditors face strict time constraints within which they have to provide their opinion on the financial statements. Auditors tend to prioritize
tasks that are essential for the effective performance of the audit. In some cases, particularly where there is legal requirement for companies to publish
their financial reports within a certain time frame, the auditors may, in a bid to meet the assignment deadlines, fail to consider an important matter in
the finalization of the audit report.

Independence Threats
Whereas the ethical guidelines issued by IFAC and other professional bodies attempt to minimize the instances of loss of objectivity of auditors, certain
level of conflicts of interest are inevitable in practice. The perceived independence of an auditor is for instance impaired where a client accounts for a
significant portion of the revenue of the audit firm.

Scope
Audit procedures are designed to detect material misstatements in the financial statements and focus on the financial aspects of transactions and
events. Non financial matters are generally not considered in the performance of the audit unless they have relevance to the financial statements.
Stakeholders often misinterpret the role and scope of an external audit

Types of Audit Engagements

Audit is an appraisal activity undertaken by an independent practitioner (e.g. an external auditor) to provide assurance to a principal (e.g. shareholders)
over a subject matter (e.g. financial statements) which is the primary responsibility of another person (e.g. directors) against a given criteria or
framework (e.g. IFRS and GAAP).
Main types of audit engagements
and services include:
 External Audit
 Internal Audit
 Forensic Audit
 Public Sector Audit
 Tax Audit
 Information System Audit
 Environmental & Social Audit
 Compliance Audit
 Value For Money Audit

External
External audit, also known as financial audit and statutory audit, involves the examination of the truth and fairness of the financial statements of an
entity by an external auditor who is independent of the organization in accordance with a reporting framework such as the IFRS. Company law in most
jurisdictions requires external audit on annual basis for companies above a certain size.
The need for an external audit primarily stems from the separation of ownership and control in large companies in which shareholders nominate
directors to run the affairs of the company on their behalf. As the directors report on the financial performance and position of the company,
shareholders need assurance over the accuracy of the financial statements before placing any reliance on them. External audit provides reasonable
assurance to the owners of the company that the financial statements, as reported by the directors, are free from material misstatements.
External auditors are required to comply with professional auditing standards such as the International Standards on Auditing and ethical guidelines
such as those issued by IFAC in order to maintain a level of quality and trust of all stakeholders in the auditing exercise.

Internal
Internal audit, also referred as operational audit, is a voluntary appraisal activity undertaken by an organization to provide assurance over the
effectiveness of internal controls, risk management and governance to facilitate the achievement of organizational objectives. Internal audit is
performed by employees of the organization who report to the audit committee of the board of directors as opposed to external audit which is carried
out by professionals independent of the organization and who report to the shareholders via audit report.
Unlike external audit, whose scope is primarily restricted to matters that concern the financial statements, the scope of work of an internal audit is very
broad and can encompass any matters which can affect the achievement of organizational objectives. Internal audit is typically centered around certain
key activities which include:
 Monitoring the effectiveness of internal controls and proposing improvements
 Investigating instances of fraud and theft
 Monitoring compliance with laws and regulations
 Reviewing and verifying where necessary the financial and operating information
 Evaluating risk management policies and procedures of the company
 Examining the effectiveness, efficiency and economy of operations and processes

Forensic
Forensic Audit involves the use of auditing and investigative skills to situations that may involve legal implications. Forensic audits may be required in
the following instances:
 Fraud investigations involving misappropriation of funds, money laundering, tax evasion and insider trading
 Quantification of loss in case of insurance claims
 Determination of the profit share of business partners in case of a dispute
 Determination of claims of professional negligence relating to the accountancy profession
Findings of a forensic audit could be used in the court of law as expert opinion on financial matters.

Public Sector
State owned companies and institutions are required by law in several jurisdictions to have their affairs examined by a public sector auditor. In many
countries, public sector audits are conducted under the supervision of the auditor general which is an institute responsible for strengthening public
sector accountability and governance and promoting transparency.
Public sector audit involves the scrutiny of the financial affairs of the state owned enterprises to assess whether they have been operated in way which
is in the best interest of the public and whether standard procedures have been followed to comply with the requirements in place to promote
transparency and good governance (e.g. public sector procurement rules). Public sector audit therefore goes a step further than the financial audit of
private organizations which primarily focuses on the reliability of financial statements
Audits of public sector companies are becoming increasingly concerned with the efficiency, effectiveness and economy of resources used in state
organizations which has given way for the development of value for money audits.

Tax
Tax audits are conducted to assess the accuracy of the tax returns filed by a company and are therefore used to determine the amount of any over or
under assessment of tax liability towards the tax authorities.
In some jurisdictions, companies above a certain size are required to have tax audits after regular intervals while in other jurisdictions random
companies are selected for tax audits through the operation of a balloting system.
Information System
Information system audit involves the assessment of the controls relevant to the IT infrastructure within an organization. Information system audits may
be performed as part of the internal control assessment during internal or external audit.
Information system audit generally comprises of the evaluation of the following aspects of information system:
 Design and internal controls of the system
 Information security and privacy
 Operational effectiveness and efficiency
 Information processing and data integrity
 System development standards

Environmental & Social

Environmental & Social Audits involve the assessment of environmental and social footprints that an organization leaves as a consequence of its
economic activities. The need for environmental auditing is increasing due to higher number of companies providing environment and sustainability
reports in their annual report describing the impact of their business activities on the environment and society and the initiatives taken by them to
reduce any adverse consequences.
Environmental auditing has provided a means for providing assurance on the accuracy of the statements and claims made in such reports. If for
example a company discloses the level of CO2 emissions during a period in its sustainability report, an environment auditor would verify the assertion
by gathering relevant audit evidence.

Compliance
In many countries, companies are required to conduct specific audit engagements other than the statutory audit to comply with the requirements of
particular laws and regulations. Examples of such audits include:
 Verification of reserves available for distribution to shareholders before the declaration of interim dividend
 Audit of the statement of assets and liabilities submitted by a company at the time of liquidation
 Performance of cost audit of manufacturing companies to verify the cost of production in order for a regulator to determine the maximum price
to be allowed after allowing a reasonable profit margin to companies operating in a sensitive sector (e.g. pharmaceuticals industry)

Value For Money

Value for money audits involves the assessment of the efficiency, effectiveness and economy of an organization's use of resources.
Value for money audits are increasingly relevant to sectors which do not have profit as their main objective such as the public sector and charities.
They are usually performed as part of internal audit or public sector audit.

True and Fair View of Financial

Statements | Audit Concept
Contents:
1. Definition
2. Explanation
3. Application & Importance

Definition
True and fair view in auditing means that the financial statements are free from material misstatements and faithfully represent the financial
performance and position of the entity.

Explanation
Although the expression of true and fair view is not strictly defined in the accounting literature, we may derive the following general conclusions as to its
meaning:
True suggests that the financial statements are factually correct and have been prepared according to applicable reporting framework such as the
IFRS and they do not contain any material misstatements that may mislead the users. Misstatements may result from material errors or omissions of
transactions & balances in the financial statements.
Fair implies that the financial statements present the information faithfully without any element of bias and they reflect the economic substance of
transactions rather than just their legal form.

Application & Importance

Preparation of true and fair financial statements has been expressly recognized as one of the responsibilities of the directors of companies in the
corporate law of several countries such as in the Companies Act 2006 in the UK. Auditors must therefore consider whether directors have fulfilled their
responsibility for the preparation of true and fair financial statements when providing an audit opinion.
Company law of certain jurisdictions require the auditors to expressly state in their audit report whether in their opinion the financial statements present
a true and fair view of the financial performance and position of the entity.

Audit Risk Model

Inherent Risk, Control Risk & Detection
Risk
Contents:
1. Definition
2. Explanation
3. Model
4. Components
5. Inherent Risk
6. Control Risk
7. Detection Risk
8. Application
9. Example

Definition
Audit Risk is the risk that an auditor expresses an inappropriate opinion on the financial statements.

Explanation
Audit risk is the risk that an auditor issues an incorrect opinion on the financial statements. Examples of inappropriate audit opinions include the
following:
 Issuing an unqualified audit report where a qualification is reasonably justified;
 Issuing a qualified audit opinion where no qualification is necessary;
 Failing to emphasize a significant matter in the audit report;
 Providing an opinion on financial statements where no such opinion may be reasonably given due to a significant limitation of scope in the
performance of the audit.

Model
Audit Risk = Inherent Risk x Control Risk x Detection Risk
Audit risk may be considered as the product of the various risks which may be encountered in the performance of the audit. In order to keep the overall
audit risk of engagements below acceptable limit, the auditor must assess the level of risk pertaining to each component of audit risk.

Components
Explanation of the 3 elements of audit risk is as follows:

Inherent Risk
Inherent Risk is the risk of a material misstatement in the financial statements arising due to error or omission as a result of factors other than the
failure of controls (factors that may cause a misstatement due to absence or lapse of controls are considered separately in the assessment of control
risk).
Inherent risk is generally considered to be higher where a high degree of judgment and estimation is involved or where transactions of the entity are
highly complex.
For example, the inherent risk in the audit of a newly formed financial institution which has a significant trade and exposure in complex derivative
instruments may be considered to be significantly higher as compared to the audit of a well established manufacturing concern operating in a relatively
stable competitive environment.

Control Risk
Control Risk is the risk of a material misstatement in the financial statements arising due to absence or failure in the operation of relevant controls of
the entity.
Organizations must have adequate internal controls in place to prevent and detect instances of fraud and error. Control risk is considered to be high
where the audit entity does not have adequate internal controls to prevent and detect instances of fraud and error in the financial statements.
Assessment of control risk may be higher for example in case of a small sized entity in which segregation of duties is not well defined and the financial
statements are prepared by individuals who do not have the necessary technical knowledge of accounting and finance.

Detection Risk
Detection Risk is the risk that the auditors fail to detect a material misstatement in the financial statements.
An auditor must apply audit procedures to detect material misstatements in the financial statements whether due to fraud or error. Misapplication or
omission of critical audit procedures may result in a material misstatement remaining undetected by the auditor. Some detection risk is always present
due to the inherent limitations of the audit such as the use of sampling for the selection of transactions.
Detection risk can be reduced by auditors by increasing the number of sampled transactions for detailed testing.

Application
Audit risk model is used by the auditors to manage the overall risk of an audit engagement.
Auditors proceed by examining the inherent and control risks pertaining to an audit engagement while gaining an understanding of the entity and its
environment.
Detection risk forms the residual risk after taking into consideration the inherent and control risks pertaining to the audit engagement and the overall
audit risk that the auditor is willing to accept.
Where the auditor's assessment of inherent and control risk is high, the detection risk is set at a lower level to keep the audit risk at an acceptable
level. Lower detection risk may be achieved by increasing the sample size for audit testing. Conversely, where the auditor believes the inherent and
control risks of an engagement to be low, detection risk is allowed to be set at a relatively higher level.

Example
ABC is an audit and assurance firm which has recently accepted the audit of XYZ. During the planning of the audit, engagement manager has noted
the following information regarding XYZ for consideration in the risk assessment of the assignment:
 XYZ is a listed company operating in the financial services sector
 XYZ has a large network of subsidiaries, associates and foreign branches
 The company does not have an internal audit department and its audit committee does not include any members with a background in finance
as suggested in the corporate governance guidelines
 It is the firm's policy to keep the overall audit risk below 10%

Inherent risk in the audit of XYZ's financial statements is particularly high because the entity is operating in a highly regularized sector and has a
complex network of related entities which could be misrepresented in the financial statements in the absence of relevant financial controls. The first
audit assignment is also inherently risky as the firm has relatively less understanding of the entity and its environment at this stage. The inherent risk
for the audit may therefore be considered as high.
Control risk involved in the audit also appears to be high since the company does not have proper oversight by a competent audit committee of
financial aspects of the organization. The company also lacks an internal audit department which is a key control especially in a highly regulated
environment. The control risk for the audit may therefore be considered as high.
If inherent risk and control risk are assumed to be 60% each, detection risk has to be set at 27.8% in order to prevent the overall audit risk from
exceeding 10%.
Working
Audit Risk = Inherent Risk x Control Risk x Detection Risk
0.10 = 0.60 x 0.60 x Detection Risk
0.10 = Detection Risk = 0.278 = 27.8%
0.36

Audit Risks & Business Risks

The complexities of modern day businesses and accounting practices have necessitated the consideration of business risks during the course of the
audit.
Topic Contents
1. Definition of business risk
 2. Differences between audit risk and business risk
3. Example of use of business risk in audit planning
4. Importance of considering business risks in audit

Business Risk - Definition

Business risks are the factors that could prevent or hinder the achievement of organizational goals and objectives.

Difference between Audit Risk and Business Risk

Business risks facing an organization can be wide-ranging and diverse. The ultimate business risk any organization faces is the risk that it seizes to be
a going concern. Business risks therefore comprise any factors that may contribute towards business failure.
Examples of business risks include:
 Loss of customers
 Increase in production costs
 Cash flow problems
 Decline in product demand
 Litigations and claims
 Technological obsolescence
 Increase in market competition
 Decrease in profitability
 Political and economic instability
 Over trading
 Inadequate financing
 High financial risk
 Risk of fraud and theft

Audit risk is the risk that the auditor expresses an inappropriate audit opinion on the financial statements. Audit risk therefore includes any factors that
may cause a material misstatement or omission in the financial statements.
Whereas business risks relate to the organization and its stakeholders, audit risk relates specifically to an auditor. Although audit risks and business
risks are dissimilar in nature, it is often the case that identification of significant business risks lead to the detection of audit risks as we shall see in the
following example.

Example
AM is the audit manager of Energy PLC, a company operating in the energy exploration and production sector. As part of the risk assessment
procedures during the planning for audit of Energy PLC, AM identified the following significant matters while examining the minutes of a meeting of the
Company's Board of Directors held at the start of the year.
Matter Business Risks Audit Risks
The CFO apprised the Board of the initiation of legal The litigation may result in a significant Liabilities of Energy PLC might be
proceedings against Energy PLC regarding damage outflow of economic resources in the future. understated as a result of non recognition of
caused to a customer's pipelines as a result of the the provision in respect of the litigation.
supply of low quality gas by the Company. Significant management time will also need
to be expended over the course of the Alternatively, the disclosure regarding
litigation. contingencies may not adequately disclose
the effects of the pending litigation.
The Board accepted the proposal of the Finance The full worth of the subsidiary may not be Financial results of the subsidiary might be
Director to sell off a low performing subsidiary of the realized by Energy PLC through the sale manipulated to influence the market value of
Company after two year. transaction. its shares prior to the sale transaction.

The Finance Director remarked that the current Related party transactions with the
market price of the subsidiary's shares is too low. subsidiary may be misrepresented in order to
improve the market perception of financial
performance of the subsidiary.
CFO informed the Board about the progress towards The finalization of the gas sales agreement Sales revenue is currently being recognized
the finalization of the gas sales agreement in respect may result in a significant cash outflow in the on an estimate basis in respect of the
of a gas field which commenced production in the form of a price differential adjustment if the mentioned gas field. The estimate may be
preceding year. final price determined is lower than the price biased and not based on realistic
currently charged to the customer. assumptions regarding the sales price.
CFO explained the basis of the provisional price being
charged to the customer at the moment and that any The effect of provisional pricing and any
price differential arising on the determination of the future revisions in price may not be
final price will be subsequently settled with the adequately disclosed in the financial
customer upon the finalization the gas sales statement.
agreement.
The managing director apprised the Board regarding The cost to be incurred on drilling of the Exploration and evaluation assets of the
plans to drill a second exploratory well in an area. second exploratory well may not be company may be overstated as a result of
recoverable if a similar rock formation to the the unsuccessful exploratory well whose cost
The drilling of the first exploratory well in the same first well is discovered. must be immediately expensed in the income
area in the previous period could not be successful statement.
due to unsuitable rock formation.
The cost incurred in the current period, if
any, on the second well may also not be
recoverable in which case the assets of
Energy PLC may be overstated.

Importance of considering business risks in audit planning

In view of the high profile accounting scandals in recent times, the role and responsibilities of auditors has been questioned. In the particular instance
of Enron, the company auditors, Arthur Anderson, were alleged to have lacked sufficient understanding of the business, risks and exposures of the
Company which ultimately caused them to overlook the effects of Enron's aggressive accounting practices.
It is in view of such scandals that the adoption of a top down approach in auditing has been emphasized where the auditor proceeds by gaining an
understanding of the entity, its environment, significant business risks and how these risks might translate into audit risks.
ISA 315 requires auditors to obtain an understanding of the entity and its environment in order to assess the risks of material misstatement of financial
statements. This reinforces the importance of obtaining a bird's eye view of the entity's business and significant business risks by the auditor at the
audit planning stage.

Accounting for Convertible Bonds

Convertible Bonds entitle bondholders to convert their bonds into a fixed number of shares of the issuing company usually at the time of their maturity.
Convertible bonds are a type of compound financial instrument with characteristics of both liability and equity.

Accounting Problem
It is argued that a convertible bond has a similar economic effect on the issuing company as issuing debt and share warrants (options) at the same
time.
Prior to introduction of IAS 32, IAS 39 and IFRS 9, entities used to account for compound debt instruments in a similar way to ordinary financial
liabilities, i.e. a liability was recorded for the entire amount of proceeds from the issue of convertible bonds while interest was charged at the nominal
rate. This distorted the financial performance and position of the issuing company in two ways. Firstly, as convertible bonds usually carried lower
interest rate than ordinary debt because of the conversion option, the true opportunity cost of financing the debt was not being recognized. Secondly,
the financial position of the entity did not present the fact that the entity had in effect issued share options as part of the convertible debt arrangement.

Accounting Treatment
IFRS propose that the issuing company must separately identify the liability and equity components of convertible bonds and treat them accordingly in
the financial statements.
Initially, the liability component is calculated by discounting the future cash flows of the bonds (interest and principle) at the rate of a similar debt
instrument without the conversion option. The value of the equity component is the difference between the present value of the liability component of
the convertible bond (as mentioned above) and the total proceeds from the issue of bonds. This is known as the residual approach to calculation of
equity component which assumes that value of the share option is equal to the difference between the total issue proceeds of the convertible bonds
and the present value of future cash flows using the interest rate of a similar debt instrument without the option to convert into shares.
Subsequently, Interest is charged to the income statement based on the effective interest rate, which is usually higher than the nominal rate, to reflect
the true opportunity cost of the financial liability.
Upon maturity of the convertible bonds, the accounting treatment depends on whether the conversion option is exercised or lapsed. If the conversion
option is not exercised, the company will have to pay the principal amount of the convertible bonds. Therefore, the outstanding liability may be simply
de-recognized. If however, the conversion option is exercised, the company will have to issue shares to the bondholders. Hence, both liability and
equity components of the convertible bonds will need to be de-recognized and replaced by share capital reserves as they are treated as consideration
for the new shares issue.
Next page contains illustration showing accounting treatment upon "Initial Recognition", "Subsequent Measurement" and "Treatment Upon
Maturity" of convertible bonds.

Accounting for Convertible Bonds

Illustration - Example
ABC LTD issues 1 million convertible bonds of $1 each carrying nominal interest of 10%. Bondholders are entitled to convert their bonds into $1
ordinary shares of the company on the date of their maturity in three years time instead of receiving principle repayment.
Interest rate of a similar bond without the conversion option is 15%.
How must ABC LTD account for the convertible bonds upon initial recognition, subsequent measurement and maturity assuming all bonds are
converted after three years?

Initial Recognition
Following accounting entries must be recorded upon initial recognition:
 Dr - Cash/Bank $1,000,000 (Total Proceeds)
Cr - Liability $885,839 (Note 1)
Cr - Share Options (Equity) $114,161 (Balancing Figure)
Note 1:
Present value of future interest payments and principal using 15%:
Year1: $100,000 (interest) x [1/1.15] = $ 86,956.5

Year2: $100,000 (interest) x [1/1.15^2] = $ 75,614.4

Year3: $100,000 (interest) x [1/1.15^3] = $ 65,751.6

Year3: $1,000,000 (principal) x [1/1.15^3] = $ 657,516.0

Total $ 885,839.0

Subsequent Measurement
Interest expense will be charged using 15%. The difference between interest paid and interest charged will be added to the liability component as
follows:
Interest Expense Liability

$ $

Year1: [885,839 x 15%] 132,876 [885,839 + 132,876 - 100,000*] 918,715

Year2: [918,715x 15%] 137,807 [918,715+ 137,807 - 100,000] 956,522

Year3: [956,522x 15%] 143,478 [956,522+ 143,478 - 100,000] 1,000,000

*$100,000 is the 10% nominal interest.

Maturity
Following accounting entry will be required to account for the conversion of bonds into shares after three years:
Dr - Liability $1,000,000
Dr - Share Options (equity) $114,161

Cr - Share Capital $1,000,000

Cr - Share Premium $114,161

Accounting Treatment of
Stolen or Lost Assets &
Insurance Compensation
Question
How should lost or stolen assets covered by insurance be accounted for?
How shall the insurance compensation in respect of the lost or stolen asset be accounted for?

Answer
Accounting treatment for lost or stolen assets depends on the nature of assets. For the purpose of
accounting of lost or stolen assets, the accounting treatment may be classified into the following
categories:
1. Accounting for lost / stolen tangible fixed assets
2. Accounting for lost / stolen stores and inventory
3. Accounting for lost / stolen cash and other valuable assets
In all instances, the lost or stolen asset must be de-recognized from the balance sheet as no future
economic benefits from the asset can be realized or controlled by the entity. Any insurance claim
receipts must be accounted for separately rather than being adjusted in the carrying amount of the
asset.
The treatment of loss varies slightly according to the nature of the asset as explained below. If the
amount of loss is material, it may be necessary to present the loss separately in the income
statement.

Fixed Assets
Accounting treatment for lost or stolen tangible fixed assets such as motor vehicles is similar to
the accounting for disposal of such assets without any sale proceeds.
 The fixed asset must be de-recognized from the statement of financial position and a loss must be
recognized for the carrying amount of the lost or stolen asset.
Insurance compensation received or receivable on the asset may either be offset against the loss or
presented separately as other income.
The accounting entries may therefore be summarized as follows:
Debit Loss on asset theft
Debit Accumulated Depreciation
Credit Property, plant and equipment (cost)

Debit Bank / Insurance compensation receivable

Credit Other income - Insurance compensation*
*This may instead be set off against the loss on asset theft

Inventory & Stores

Accounting for stolen or lost inventory depends on whether periodic or perpetual system is being
used by the entity.
Under periodic system, inventory balance is computed at the period end and a single accounting
entry for the closing stock is posted. If the computation of the closing balance of inventory under
such system excludes the amount of inventory lost or stolen, no separate accounting entry would be
necessary as the cost of goods sold would increase as a result of the reduction in closing stock
thereby reflecting the impact of lost or stolen goods.
Under perpetual system however, inventory balance is updated regularly throughout the accounting
period. Any inventory pilferage will need to be accounted for in a similar manner to the normal
inventory issues during the period. The following journal entry may therefore be recorded to account
for the loss or theft of inventory, stores and spares:
Debit Cost of goods sold
Credit Inventory

Debit Bank / Insurance compensation receivable

Credit Other income - Insurance compensation*
*This may instead be set off against the loss on asset theft
The amount of inventory de-recognized must include all elements of cost which are ordinarily
included in the valuation of inventory and should not just consist of the purchase cost of direct
materials (e.g. fright charges, direct labor, allocation of production overheads, etc).

Cash and other assets

The loss on theft of cash and any other assets may be simply be expensed to the income statement
net of any insurance claim received or receivable. Following accounting entries would therefore be
required:
Debit Loss on asset theft (balancing amount)
Debit Accumulated Depreciation
Credit Asset (carrying amount)

Derecognition & Write Off of Accounts

Payables | Accounting | Entries
Question
Should long outstanding trade creditors and other account payables be written off or derecognized in a similar way to the write-off of account
receivables considered irrecoverable?
What are the circumstances under which accounts payable balances may be written off or reversed?

Answer
Trade creditors and other accounts payables constitute financial liabilities of the company which are payable to the respective creditors according to
the terms of contracts.
The liability of the entity does not extinguish by the mere passage of time. IFRS 9 Financial Instruments states that financial liabilities should only be
de-recognized by an entity when the related contractual obligation is 'discharged, cancelled or expired'.
Therefore, long outstanding trade and other payables should not be written off from the statement of financial position simply because they have not
been paid long after their due date although receivables may be written off immediately in the accounting period in which they are considered as
irrecoverable. This is an application of the prudence concept which requires a degree of caution in the preparation of financial statements in order to
avoid the overstatement of income and assets and the understatement of liabilities and expenses.
Trade creditors and other payables may be de-recognized in the following circumstances:
1. Discharge of liability
The payment of liability results in the discharge of contractual obligation. The liability must be reduced to the extent of the payment by cash or the
transfer of other assets.
Where payment is made through the transfer of any assets other than cash, it may be necessary to recognize gain or loss for the difference in carrying
value of those assets and the amount of liability offset.
Payment of liability within the certain duration specified in the contract may entitle the payer to a cash discount which is accounted for by reducing the
payables balance and the recognition of discount received.
It may also be necessary to recognize gain or loss on the settlement of foreign currency payables.
Following accounting entries may be recorded to account for the payment of accounts payables:
Debit Payables balance This represents the gross amount of liability to be de-recognized from the balance sheet
Credit Cash / Bank / Other asset Net cash payment or the carrying value of assets other than cash for the settlement of liability
Credit Discount received Early settlement cash discount received
Debit Exchange loss In case of appreciation of a foreign currency payable balance
Credit Exchange gain In case of depreciation of a foreign currency payable balance
Debit Loss on transfer of other In case of transferred asset other than cash having carrying value higher than the amount agreed for
assets settlement
Credit Gain on transfer of other In case of transferred asset other than cash having carrying value lower than the amount agreed for
assets settlement

2. Cancellation of liability
Liability in respect of trade creditors and other payables may be cancelled or reduced as a result of the operation of law or an agreement with the
creditor to waive the contractual liability.
Liability may be cancelled through the operation of law where for instance the creditor fails to fulfill a term of the contract which entitles the debtor to
offset the resulting liquidated damages against the outstanding payable.
Liability may also be reduced or waived as a result of negotiation with the creditor.
The cancellation of liability results in savings to the entity and should therefore be recognized as other income since the saving of cash outflows are not
attained through the ordinary course of business operations.
Following journal entry shall be recognized to account for the cancellation of liability:
Debit Payable
Credit Other Income

3. Expiry of term
Agreement may specify a term over which the creditor has to claim the outstanding amount at the expiry of which the debtor seizes to be liable for the
amount due towards the payable.
As with the cancellation of liability, following accounting entry shall be recognized to account for the expired liability:
Debit Payable
Credit Other Income

Entity in Accounting
Definition
In accounting, entity refers to any organization or part thereof for which separate financial statements are prepared.

Examples
Examples of accounting entities include the following:
 Individuals
 Sole proprietorships
 Partnerships
 Companies
 Trusts and NGOs
 Clubs and societies
 Divisions of companies
 Group of companies
 Government institutions

Concept
Accounting entities do not necessarily equate to legal entities.
So whereas law may not differentiate between a sole proprietorship business and the sole trader himself, accounting principles require that expenses
of the business (accounting entity) be accounted for separately from the personal expenses of the business owner. This is often referred to as
the business entity concept.
Conversely, distinct legal entities may be combined and treated as a single accounting entity for the preparation of financial statements. This is most
evident in the preparation of the consolidated financial statements of a group of companies whereby separate companies, which are related to each
other, are absorbed into a single entity for the purpose of financial reporting. This is an application of the single entity concept.

The Missing File - Forensic Audit of ABC

Co.
You have been assigned as the Forensic Auditor of ABC Co. to assist in the investigation of a missing file from the company's premises containing
trade secrets.
During investigation, you find out that on the day of the incident three employees entered the room where the file was being held.
While interviewing the three employees, you are informed that one of them is truthful while the remaining two are liars. This is what they tell you:
Employee 1: I entered the room first or second. File was not present when I left.
Employee 2: I entered the room second or third. File was present when I left. None of us stole the file.
Employee 3: I entered the room third. File was present when I left.
Which of the employees stole the file?

Solution
The file was stolen by the second employee.
Here's how:
First we need to identify the liars. Employee 2 is a liar since he claimed that none of them stole the file. Employee 3 is a liar because he claims that the
file was present when he left which is not possible if he entered the room last. As employees 2 and 3 are liars, this also implies that employee 1 is
truthful.
However, looking at statement of employee 1 alone, we cannot conclude who the culprit is. In order to make any sense of the statements of employees
2 and 3, we will have to reverse them to know the truth. This is how their statements would look like if we reverse them:
Employee 2: I entered the room first. File was not present when I left. Someone from among us stole the file.
Employee 3: I entered the room first or second. File was not present when I left.
It is clear from above that employee 2 was the first one and that is when the file went missing. Employee 3 and employee 1 only entered the room later
when the file was already gone.

Calculate Opening Reserves For Bakers

Co.
Bakers Co started trading as a small chain of bakeries three years ago.
Owners of the business are considering applying for a loan to expand their current operations. However, financial statements of the company have not
been prepared yet which are essential for obtaining a bank loan.
Bakers Co's owners have hired you to prepare the first financial statements of Bakers Co for the year ended 31 December 2011.
You are required to calculate the Net Assets of Bakers Co at the START of the year (ie. 1st January 2011) for the purpose of presenting opening
reserves in the Statement of Changes in Equity.
Following information is available relating to the last year:
1. Net Assets as at 31 December 2011 are $100,000
2. Bakers Co incurred expenses of $3,000 each month which were settled after a 2 month credit period.
3. Bakers Co's average sale for a month was $8000. All sales were made for cash.
4. Bakers Co also paid rent of $2,500 every 3 months.
5. Bakers Co purchased a piece of land for $20,000 during the year.
What were the Net Assets of Baker Co at the start of the year?

Solution
Net Assets of Bakers Co at 1st January 2011 were $50,000.
[100,000 + 36,000(3000 x 12) - 96,000(8000 x 12) + 10,000(2500 x 4)] = $50,000
As only closing net assets of Bakers Co are available, we need to work backwards to arrive at the opening net assets for the year 2011.
Therefore, expenses need to be added to the closing net assets to arrive at the net assets at the start of the period. Credit period for payment of
expenses is irrelevant because expenses are recorded on accrual basis rather than cash basis. Similarly, sales need to be deducted from the closing
net assets as they did not contribute to net assets at the start of the period.
The purchase of land does not affect the calculation of net assets as it does not result in an increase or decrease in Bakers Co's net assets. If for
example the land was purchased for cash, the transaction would have caused a decrease in cash and a corresponding increase in the fixed asset. The
purchase of land therefore does not result in a change in the value of net assets but simply causes its composition to change which is why it must be
ignored in the calculation above.