Using Procurement Card to Simplify Invoice Processing

Accounts Payable (A/P) accountants very well know how the supplier invoice processing sucks most of their working hour. Consider the following common routines carried on daily basis:

  • Registering and setting up new vendors on the system and physical filing folders;
  • Receiving work papers (PO, receiving slip, invoice);
  • 3-way matching the work papers;
  • Routing invoices for approvals;
  • Entering data into the system;
  • Separating and expediting invoices that have discounts;
  • Creating month-end accruals;
  • Processing checks;
  • Obtaining check signatures;
  • Mailing payments to vendors; and
  • Filing the check copies.

The routines leave the accounts with no time for analytic works. Not to mention the important expenses audit that are often left behind. Such situation is especially common in the small and medium business environment.

So, Putra, what is the easy way to speed up the invoice processing without imposing the company to any risks?” a client once asked.

The answer is unfortunately “there is no easy way”. All of the above listed tasks are must done in that way to ensure sufficient control. EXCEPT, small purchases that the cost of carrying all those tasks exceeds the amount of the invoice, often referred to as “low-risk purchase” or “low-risk invoice.”  The good news is that, in many instances, up to 1/3 of all payment transactions fall into the category, including my client’s. A company can change the approach on how to handle low-risk purchases to speed up the process thus results in lower cost of invoice processing in the company-wide level.

“How?” You may ask.

As far as I know, using “procurement card”—instead of issuing PO and write a check—is the most effective way to process such small purchases.

What is a Procurement Card?

A “procurement card,” also known as a “purchasing card” (abbreviated as “P-Card), is simply like a consumer credit card but numbers of extra features on it.

So, instead of using a purchase order or check to purchase something (which demands the traditional long-listed tasks above), purchasers instead use a procurement card for small and frequent purchases.

The procurement card is issued to those people who make frequent purchases, with instructions to keep on making the same purchases, but to do so with the card. This eliminates the plethora supplier invoices by consolidating them all into a single monthly credit card statement.

According to Bizdoz, the use of procurement cards has seen a dramatic rise in recent years with many government organizations now using them to reduce costs. For example In 2001 the Department of Defense (DOD) had 230,000 card holders with an annual spend of $6.1 Billion.

Another report titled “2005 Purchasing Card Benchmark Survey” by Palmer and Gupta (2007) notes:

  • 2003 procurement card spend = $80 billion
  • 2005 procurement card spend = $110 billion
  • 43% of e-procurement transactions are paid via check
  • By 2008 over 70% of all organizations will have a procurement card program, up from 60% in 2005.

The study also highlights that, “although these cards currently are not in widespread use, their popularity is growing.”

Traditional purchasing card transactions below $2000, the report reveals, grew 1.4% from 2003 to 2005. The most dynamic growth was in transactions from $2000 – $10,000 representing a 6.1% growth. A/P transactions fall within this range and can extend into the hundreds of thousands of dollars.

An organizations can use procurement card as a strategic form of payment in its accounts payable (A/P), instead of issuing PO and write a check for low risk purchase. Using the approach, the company can cut the cost of invoice processing in the company-wide level.

Why Using Procurement Card?

The use of procurement card is for sure attractive. Here are why:

1. It decreases numbers of purchasing transaction – A whole range of purchasing activities are reduced in volume, including contacting suppliers for quotes, creating and mailing purchase orders, resolving invoicing differences, and closing out orders.

2. It results in fewer invoice reviews and signatures – Managers no longer have to review a considerable number of invoices for payment approval, nor do they have to sign so many checks addressed to suppliers.

3. It minimizes petty-cash transactions – If employees have procurement cards, they will—somehow—no longer feel compelled to buy items with their own cash and then ask for a reimbursement from the company’s petty-cash fund. So, the use of procurement card reduces such tendency.

4. It results in less frequent cash advances – Employees often request cash advances and the accounting staff must create a manual check for that person, record it in the accounting records, and ensure that it is paid back by the employee. This can be a very time-consuming process. A credit card can avoid this entire process, because employees can go to an automated teller machine and withdraw cash, which will appear in the next monthly card statement from the issuing bank—no check issuances required.

5. It reduces supplier list – The number of active vendors in the purchasing database can be greatly reduced, which allows the buying staff to focus on better relations with the remaining ones on the list.

6. A/P staff is available for other tasks – Having fewer A/P transactions, when start using procurement card, some of the staffs may be redirected to other tasks—particularly analytical works.

7. It reduces mailroom volume – Even the mailroom will experience a drop in volume, since there will be far fewer incoming supplier invoices and outgoing company checks.

In addition, the payable staffs can contact a supplier, just before an invoice is due for payment, and see whether the supplier will accept payment of the invoice with a procurement card. By doing so, the company has just extended its payment interval (depending on the cutoff period for the procurement card), since it can now wait an additional period until the monthly procurement card statement arrives before making a payment.

Knowing the Procurement Card’s Features

A worth questioning on the use of procurement card probably is the possibility of getting misused by bad purchasers.

As there is always a risk of having bad purchasers purchase personal items (for personal use) with a cash advances or excessively expensive purchases by using credit card, the procurement card adds a few features to control precisely what is purchased. Here are two built-in controls a procurement card offers:

  • Purchase Limitations – For example, it can have a limitation on the total daily amount purchased, the total amount purchased per transaction, or the total purchased per month. It may also limit purchases to a specific store or to only those stores that fall into a specific Standard Industry Classification (SIC code) category, such as a plumbing supply store and nothing else. These built-in controls effectively reduce the risk that procurement cards will be misused.
  • Expenses Statement – Once the card statement arrives, it may be too jumbled, with hundreds of purchases, to determine the expense accounts to which all the items are to be charged. To help matters, a company can specify how the credit card statement is to be sorted by the credit card processing company. For example, it can list expenses by the location of each purchase, by Standard Industrial Classification (SIC) code, or by dollar amount, as well as by date. It is even possible to receive an electronic transmission of the credit card statement so that a company can do its own sorting of expenses.

Note: The purchasing limitations and expense statement changes are the key differences between a regular credit card and a procurement card.

In addition to the basic features, certain procurement card providers (issuers) even offer more detail data through which the company is able to do control activities on the transaction using the card, such as followings:

  • Vendors’ Status Data – Certain procurement card providers (issuers) even provide what is called “Level II” data; this includes a supplier’s minority supplier status, incorporated status, and its tax identification number.
  • Transaction Details – Another features to look into when reviewing the procurement card option is the existence of “Level III” reporting, which includes such line-item details as quantities, product codes, product descriptions, and freight and duty costs—in short, the bulk of the information needed to maintain a detailed knowledge of exactly what is being bought with a company’s procurement cards.

Though the use of procurement card is so much convincing to many organizations, but Thich Nhat Hanh ever said that, “good-and-bad, is an inter-are” which means, in this context, the benefit of using procurement card comes with the issues that require solution.

Overcoming the Challenge of Using Procurement Card

Susan Avery, in 2005, has stated that according to the Aberdeen Group purchasing card benchmark report, best practice purchasing card programs “do not confine” purchasing to the traditional spending of low-dollar, high-transaction goods and services, due to numbers of reason.

One hurdle in the A/P procurement card payment conversion is in the area of what is called “supplier enablement”—often referred as to “purchasing card supplier enablement” or “p-card supplier enablement”—on which every supplier must be contacted and informed of the payment change from check to the procurement card, even if the supplier is already a purchasing card supplier.

A collaborative research study by the First Annapolis Consulting and the National Association of Purchasing Card Professionals (NAPCP), in 2010, suggests:

“In terms of impeding an organization’s card program growth, 61% of end-user respondents reported that suppliers’ resistance to (or non-acceptance of) card payments is, at a minimum, somewhat of a problem. Not surprising, the transaction acceptance fee factor is overwhelmingly the number-one reason suppliers give end-users for resisting or not accepting card payments. Further, nearly 50% of respondents stated they sometimes or frequently encounter suppliers that impose a surcharge in conjunction with card acceptance. End-users employ varying approaches in response to the challenges; for example, educating suppliers on the benefits of card payments—a task that is often completed by program management and/or procurement staff.”

As of today, in 2013, banks offer help in the procurement card supplier enablement and many other software companies provide technology to make the conversion efficient and easy for the users.

The procurement card supplier enablement is mostly solved but, in a controller (like me) sight, the following issues must be carefully considered by the business owner in order to ensure that the procurement card program operates as it is expected:

1. Overcoming Procurement Card Misuse – When procurement cards are handed out to a large number of employees, there is always the risk that someone will abuse the privilege and use up valuable company funds on incorrect or excessive purchases. There are several ways to prevent this problem and reduce its impact. One approach is to hand out the procurement cards only to the purchasing staff, who can use them to pay for items for which they would otherwise issue a purchase order. However, this does not address the large quantity of very small purchases that other employees may make, so a better approach is a gradual rollout of procurement cards to those employees who have shown a continuing pattern of making small purchases. Also, the features of the procurement card itself can be set up either by limiting the dollar amount of purchases per transaction, per time period, or even per department.

2. Purchasing on Capital and Special Inventory Items – Capital purchases typically have to go through a detailed review and approval process before they are acquired; since a procurement card offers an easy way to buy smaller capital items, it represents a simple way to bypass the approval process. Thus, procurement card are not a good choice for capital purchases. The use of a procurement card can actually interfere with existing internal procedures for the purchase of some items, rendering those systems less efficient. For example, the use of an automated system linked to the inventory system that does not allow manual intervention, such as an automated materials planning system—adding inventory items to this situation that were purchased through a different methodology can interfere with the integrity of the database, requiring more manual reconciliation of inventory quantities. Thus, the use of procurement cards is not a good idea when buying inventory items.

3. Summarizing General Ledger Accounts – The summary statements that are received from the procurement card processor will not contain as many expense line items as are probably already contained within a company’s general ledger. For example, the card statements may only categorize by shop supplies, office supplies, and shipping supplies. If so, then it is best to alter the general ledger accounts to match the categories being reported through the procurement cards. This may also require changes to the budgeting system, which probably mirrors the accounts used in the general ledger.

4. Purchases from Unapproved Suppliers – A company may have negotiated favorable prices from a few select suppliers in exchange for making all of its purchases for certain items from them. It is a simple matter to ensure that purchases are made through these suppliers when the purchasing department is placed in direct control of the buying process. However, once purchases are put in the hands of anyone with a procurement card, it is much less likely that the same level of discipline will occur. Instead, purchases will be made from a much larger group of suppliers. Though not an easy issue to control, the holders of procurement cards can at least be issued a “preferred supplier yellow pages,” which lists those suppliers from whom they should be buying. Their adherence to this list can be tracked by comparing actual purchases to the yellow pages list and giving them feedback about the issue.

5. Paying Sales and Use Taxes – Occasionally, a state sales tax auditor will arrive on a company’s doorstep, demanding to see documentation that proves it has paid a sales tax on all items purchased. The requirement becomes a serious issue when procurement cards are used, because the sales tax noted on a procurement card payment slip shows only the grand total sales tax paid, rather than the sales tax for each item purchased. Please take a note. This is an important issue, for some items are exempt from taxation, which will result in a total sales tax that appears to be too low in comparison to the total dollar amount of items purchased. One way to address this issue is to obtain sales tax exemption certificates from all states with which a company does business; employees then present the sales tax exemption number whenever they make purchases so that there is no doubt at all—no sales taxes have been paid. Then the accounting staff can calculate the grand total for the use tax (which is the same thing as the sales tax, except that the purchaser pays it to the state, rather than to the seller) to pay, and forward this to the appropriate taxing authority.

6. Overcoming the Reluctance on the Banker Side – If one think that a procurement card is easy to implement (just hand it out to employees), she might be wrong. It is better to keep a significant difficulty in mind. In fact, the banks that issue credit cards must expend extra labor to set up a procurement card for a company, since each one must be custom designed. Consequently, they prefer to issue procurement cards only to those companies that can show a significant volume of credit card business—usually at least $1 million per year. This volume limitation makes it difficult for a smaller company to use procurement cards. This problem can be partially avoided by using a group of supplier-specific procurement cards. For example, a company can sign up for a credit card with its office supply store, another with its building materials store, and another with its electrical supplies store. This results in a somewhat larger number of credit card statements per month, but they are already sorted by supplier, so they are essentially a “poor man’s procurement card.”

7. Negotiating Procurement Card Rebates – Last but not least. If a company has shifted a large part of its purchases to procurement cards, then this represents a significant revenue source for procurement card companies. Once a company has built up a sufficient volume of procurement card business, it is in a position to negotiate for better terms with its procurement card supplier. One of the best such deals is to obtain a rebate percentage that is tied to the volume of payments made with a specific procurement card. Such opportunity is particularly available for a company that can surpass about $5 million per year in procurement card purchases. If so, then such company can bargain for a small rebate percentage that can increase as its purchases increase.

Although the problems are minor in relation to the possible benefits of using procurement card, they can lead into a failure. Therefore, realizing and then preparing the company to overcome the issue is the best.

Accounting for Business Acquisition Using Purchase Method

In brief, a business acquisition, from the accounting standpoint, is a transaction in which both the acquiring and acquired company are still left standing as separate entities at the end of the transaction. If the acquiring company spreads the acquisition price over the assets being bought at their fair market value, with any remaining portion of the acquisition price being recorded in a goodwill account, the “purchase method” is used to account the transaction. So, how do you account transaction of a business acquisition using purchase method?

This post provides you with step-by-step guide on how to account transaction of business acquisition using purchase method.

There are three primary steps involved on the accounting for business acquisition using purchase method.

Step-1. Determine the Purchase Price

How do you determine the purchase price? You would determine purchase value based on fair market value. For example:

  • If the purchase is made with stock, the stock must be valued at its fair market value.
  • If treasury stock is used as part of the consideration, then this must also be valued at its fair market value.
  • If the buyer’s stock is thinly traded or closely held, then it may be necessary to obtain the services of an investment banker or appraiser, who can use various valuation models and industry surveys to derive a price per share.

Step-2. Allocate Price Among the Various Assets of the Company Being Purchased

The second step in the purchase method is to allocate the purchase price among the acquired company’s assets and liabilities, which are then recorded in the buyer’s accounting records.

The main issue on the second step is that the method of valuation varies by line item on the acquired company’s balance sheet. Here are the key valuation rules:

1. Accounts Receivable – Record A/R at its present value, less the allowance for bad debts. For example, if present value of the A/R is $250,000 with $5000 bad debt allowance sitting underneath, then the value of the A/R is 245,000. Given the exceedingly short time frame over which the A/R is outstanding, there is generally no need to discount this valuation, unless there are receivables with very long collection terms. Also, since the acquisition transaction is generally not completed until several months after the acquisition date (given the effort required to make the accounting entry), the amount of the allowance for bad debts can be very precisely determined as of the acquisition date.

2. Marketable Securities – You would record marketable securities at their FAIR MARKET VALUE. If you are under the U.S jurisdiction, this could be an opportunity for the buyer to mark up a security to its fair market value (if such is the case)—since the GAAP normally only allows for the recognition of reductions in market value. For this reason, this is an area in which there is some opportunity to allocate an additional portion of the purchase price beyond the original cost of the asset. However, since most companies only invest in short-term, highly liquid securities, it is unlikely that there will be a large amount of potential appreciation in the securities.

3. Inventory—Raw Materials – You would record raw material inventories at their REPLACEMENT COST. Though, this can be a problem if the acquiree is in an industry, such as computer hardware, where inventory costs drop at a rapid pace as new products rapidly come into the marketplace. Consequently, the buyer may find itself with a significantly lower inventory valuation as a result of the purchase transaction than originally appeared on the accounting records of the acquiree.

4. Inventory—Finished Goods – You would record FG inventories at their SELLING PRICE, less their AVERAGE PROFIT MARGIN + DISPOSITION COSTS. This can be a difficult calculation to make, though, if the finished goods have variable prices depending upon where or in what quantities they are sold—in such cases, the determination of selling price should be based on a history of the most common sales transactions. For example, if 80% of all units sold are in purchase quantities that result in a per-unit price of $1.50, then this is the most appropriate price to use.

Note: The above rule can be avoided if the acquiree has firm sales contracts as of the date of the acquisition with specific customers that can be used to clearly determine the prices at which the finished goods will actually be sold.

5. Inventory—Work-In-Process – You would record WIP inventories by using the same valuation treatment as finished goods, except that the cost of conversion into finished goods must also be subtracted from their eventual sale price.

6. Property, Plant, and Equipment (PP&E) – You would record PP&Es at their REPLACEMENT COST. This can be a difficult task that lengthens the interval before the acquisition journal entry is completed, because some assets may be so old that there is no equivalent product currently on the market, or equipment may be so specialized that it is difficult to find a reasonable alternative on the market. This valuation step frequently calls for the services of an appraiser.

7. PP&E to be Sold – If buyer intends to sell off assets as of the acquisition date, then these assets should be recorded at their FAIR MARKET VALUE. This most accurately reflects their disposal value as of the acquisition date.

8. Capital Leases – If the acquiree possesses assets that were purchased with capital leases, then you would value the asset at its FAIR MARKET VALUE, while valuing the associated lease at its NET PRESENT VALUE.

9. Research and Development Assets (R&D) – If any assets associated with specific R&D projects are part of the acquiree, you would then charge the R&D assets off to expense if there is no expectation that they will have an alternative future use once the current R&D project has been completed. The precise allocation of assets to expense or asset accounts can be difficult, though, since the existing projects may be expected to last well into the future, or the future use of the assets may not be easy to determine. Consequently, one should carefully document the reasons for the treatment of R&D assets.

10. Intangible Assets – You would record intangible assets at their APPRAISED VALUES. If the buyer cannot reasonably assign a cost to them or identify them, you would then assign no cost.

11. Accounts and Notes Payable – You can typically record A/P at their CURRENT AMOUNTS as listed on the books of the acquiree. However, if the A/Ps are not to be paid for some time, you would then record them at their DISCOUNTED PRESENT VALUES. The same logic applies to notes payable; since all—but the shortest-lived notes—will have a significantly different present value, they should be discounted and recorded as such. Note, however, that this treatment is used on the assumption that the buyer would otherwise be purchasing these liabilities on the date of the acquisition, not on a variety of dates stretching out into the future, and so must be discounted to show their value on the acquisition date.

12. Accruals – Accruals are fall under the short-term (or current) liabilities. These liabilities are typically very short-term ones that will be reversed shortly after the current accounting period. Accordingly, they are to be valued at their PRESENT VALUE (discounting is rarely necessary).

13. Pension Liability – If there is an unfunded pension liability, even if not recognized on the books of the acquiree, it must be recognized by the buyer as part of the purchase transaction.

14. Stock Option Plan (SOP) – If the buyer decides to take over an existing stock option plan of the acquiree, then it must allocate part of the purchase price to the incremental difference between the price at which shares may be purchased under the plan and the market price for the stock as of the date of the acquisition. However, if the buyer forced the acquiree to settle all claims under the option plan prior to the acquisition, then this becomes a compensation expense that is recorded on the books of the acquiree.

The company being purchased can be bought with any form of consideration, such as stock, cash, or property.

Let’s construct a case example:

Lie Dharma Corporation acquires Robinson Ma Corporation by spreading the acquisition price over the assets being bought at their fair market value—with any remaining portion of the acquisition price being recorded in a goodwill account, so we use purchase method for the case.

If the acquiring company (Lie Dharma Corporation) buys the acquiree’s (Robinson Ma Corporation) stock with $500,000 of cash, the entry on Lie Dharma’s books would be:

[Debit]. Investment in Robinson Ma Corporation = $500,000
[Credit]. Cash = $500,000

Alternatively, if Lie Dharma were to make the purchase using a mix of 20% cash and 80% for a note, the entry would be:

[Debit]. Investment in Robinson Ma Corporation = $500,000
[Credit]. Cash = $100,000
[Credit]. Note payable = $400,000

Another approach would be to exchange 5,000 shares of Lie Dharma’s $1 par value stock for that of Robinson Ma as a form of payment. Under this method, the entry would be:

[Debit]. Investment in Robinson Ma Corporation = $500,000
[Credit]. Common stock—par value = $ 5,000
[Credit]. Common stock—additional paid-in capital = $495,000

The result of all the preceding valuation rules is shown below—where I show the calculation that would be required to adjust the books of an acquiree in order to then consolidate it with the results of the acquiring company:

Accounting for Business Acquisition

The above table shows the initial book cost of each account on the acquiree’s balance sheet, followed by a listing of the required valuation of each account under the purchase method, the adjustment required, and the new account valuation. The new account valuation on the right side of the table can then be combined directly into the records of the acquiring company.

Note, under the “Purchase Method Valuation” column, that:

  • a designation of “NPV” means that the net present value of the line item is shown,
  • a designation of “FMV” means that the fair market value is shown (less any costs required to sell the item, if applicable)
  • “RC” designates the use of replacement cost
  • “SLM” designates the use of sale price less the gross margin
  • “AV” designates an asset’s appraised value.

In the above table, debits and credits are specified for each adjusting entry listed in the “Required Adjustment” column.

The amount of goodwill shown in the “Required Adjustment” column is derived by subtracting the purchase price of $15,000 from the total of all fair market and other valuations shown in the “Purchase Method Valuation” column. In this case, we have a fair market valuation of $18,398 for all assets, less a fair market valuation of $8,075 for all liabilities, which yields a net fair market value for the acquiree of $10,323. When this fair market value is subtracted from the purchase price of $15,000, we end up with a residual of $4,677, which is listed in the goodwill account.

Please note that the “Adjusted Acquiree Records” column on the right side of the table still must be added to the acquirer’s records to arrive at a consolidated financial statement for the combined entities.

Step-3. Account for the First Year Partial Results of the Purchased Entity

The third step in the acquisition process is to account for the first year partial results of the acquired company on the buyer’s financial statements. Here the rules of thumb:

  • Only the income of the acquiree that falls within its current fiscal year, but after the date of the acquisition, should be added to the buyer’s accounting records.
  • The buyer must charge all costs associated with the acquisition to current expense—they cannot be capitalized. These acquisition costs should be almost entirely for outside services, since any internal costs charged to the acquisition would likely have been incurred anyway, even in the absence of the acquisition.
  • The only variation from this rule is the costs associated with issuing equity to pay for the acquisition; these costs can be recorded as an offset to the additional paid-in capital account.
  • An additional item is that a liability should be recognized at the time of the acquisition for any plant closings or losses on the dispositions of assets that are planned as of that date; this is not an expense that is recognized at a later date, since we assume that the buyer was aware at the purchase date that some asset dispositions would be required.
  • If the acquirer chooses to report its financial results for multiple years prior to the acquisition, it does not report the combined results of the two entities for years prior to the acquisition.

A reverse acquisition is one in which the company issuing its shares or other payment is actually the acquiree, because the acquiring company’s shareholders do not own a majority of the stock after the acquisition is completed. Though rare, this approach is sometimes used when a shell company with available funding buys an operating company, or when a publicly held shell company is used to buy a non-public company, thereby avoiding the need to go through an initial public offering (IPO) by the non-public company. In this case, the assets and liabilities of the shell corporation are revalued to their fair market value and then recorded on the books of the company being bought.

If you are an accountant, your main interest in your company’s merger and acquisition activities is how to account for the transactions. The main approach you would use probably is the purchase method, which has been described on this post. An alternative is the pooling of interests method, however, the FASB is continually reviewing the need for this method, and was close to eliminating it as of I made this post. The IASB has prohibited the use of pooling of interest method, completely.

There are also many situations in which a company merely makes a small investment in another company, rather than making a big and outright purchase. This requires three possible types of accounting—depending upon the size of the investment and the degree of control attained over the subject company—which are: the cost method, equity method, and consolidation method, I would plan to discuss on the coming post, one-by-one.

What Are Roles and Responsibilities of Audit Committee?

Audit committee, in the real corporate world, has been existed for long time and the perception of its roles and responsibilities are evolved time-by-time. This post aims to highlight roles and responsibilities of audit committee in the past and recent years.

There were varied views on audit committee’s roles and responsibility in the United States and European Union—which then followed by the rest of the countries—before 2000s, but a certain consensus has emerged in recent years following the promotion of audit committee function in corporate governance by market regulators and professional bodies.

What is Audit Committee?

In short words, audit committee can be described as a group of minimum 3 persons who oversee quality and integrity of the company’s accounting and reporting practices.

Searching offline and online auditing literature, one may find various descriptions about audit committee. A common term consistently appeared among the descriptions is the “oversight responsibility.” Because of this oversight responsibility, audit committee members must be independent with no connection to company management.

Therefore, in longer words, an audit committee can be described as a group of minimum 3 independent directors with no connection to the company management, which are an operating component of the board of directors, with responsibility for internal controls and financial reporting oversight.

In the real corporate world, an audit committee often invites members of management or others to attend committee meetings and even to join in on the deliberations. However, any such invited outside guests cannot be full voting members. And the roles of the committee is much more than overseeing financial reporting practices, depending on sizes of the company, such as: legal and regulatory compliance; risk management, corporate governance practices.

Who Does Establish Audit Committee and How?

Audit committee is established by the board of director (BOD)—which is a formal entity given the responsibility for the overall governance of that company for its owner investors or lenders.

Because all members of the board can be held legally liable through their actions on any issue, and a board and its committees enact most of its formal business through resolutions, which become matters of company record.

The company of the board’s various committees, including the audit committee, is established through such a resolution. Such resolution is an example of corporate governance setting the rules by which a corporation operates. This type of resolution is documented in the records of the board and not generally revised unless some circumstances require a change.

While not published in annual reports and the like, the existence of appropriate board resolutions becomes issues in matters of regulation and litigation only when a board needs to rely on an authorizing resolution. After SOx became U.S. law in 2002, many corporate board audit committee–authorizing resolutions were updated to make them compliant. Otherwise, such resolutions are often almost one-time things.

Here is an example company board resolution authorizing their audit committee:

Board Resolution Example That Authorizes the Audit Committee

LDP Company Corp Board of Directors

Board Resolution No. 25, January 23, 2013

The Board of Directors authorizes an audit committee to consist of five directors who are not officers of LDP Company. The Board will designate one member of the Audit Committee as a Financial Expert, per the requirements of the Sarbanes-Oxley Act, and elect one member to serve as its chair for a term of three years. The LDP Company Chief Executive Officer may attend Audit Committee meetings as a nonvoting member at the invitation of the Audit Committee.

The LDP Company Audit Committee is responsible for:

  • Determining that LDP Company internal controls are effective and formally reporting on the status of those controls on an annual basis with quarterly updates.
  • Recommending an external auditor to be selected on an annual basis through a vote by the shareholders.
  • Taking action, where appropriate, on significant control weaknesses reported by internal audit, the external auditors, and others.
  • Approving an annual plan and budget submitted by the external auditor.
  • Approving annual audit plans to be submitted by the outside auditor as well as by internal audit.
  • Approving the appointment and ongoing service of Internal Audit’s Chief Audit Executive.
  • Approving the annual internal audit plan and recommending areas for additional internal audit work as appropriate.
  • Reviewing and distributing the audited financial statements submitted by the outside auditor.
  • Establishing an LDP Company whistleblower program that allows officers, employees, and other stakeholders to report financial accounting errors or improper actions and to investigate and resolve those whistleblower calls without any retribution to the original whistleblower.
  • Circulating a Code of Ethics to senior officers and obtaining their assent on a quarterly basis.
  • Initiating appropriate actions based on any recommendations by the outside auditor or the Director of Internal Audit.
  • Maintaining records on other consulting activities as mandated by the Sarbanes-Oxley Act.

An Audit Committee meeting will be held at least concurrently with each scheduled Board meeting and at other times as required.

The Audit Committee will meet privately with the outside auditor or the Chief Audit Executive to assess the overall internal control environment and to evaluate the independence of the audit function.

Composed: Jessica Dharma Putra/Corporate Secretary

The New York Stock Exchange (NYSE) suggested proposed board audit committee charters in December 1999 but with no requirement that an audit committee should have such a charter. The Sarbanes Oxley (SOx) Act, however, has now mandated that each board audit committee must develop its own formal audit charter to be published as part of the annual proxy statement.

The purpose of a board audit committee charter is to define the audit committee’s responsibilities regarding:

  • Identification, assessment, and management of financial risks and uncertainties
  • Continuous improvement of financial systems
  • Integrity of financial statements and financial disclosures
  • Compliance with legal and regulatory requirements
  • Qualifications, independence, and performance of independent outside auditors
  • Capabilities, resources, and performance of the internal audit department
  • Full and open communication with and among the independent accountants, management, internal auditors, counsel, employees, the audit committee, and the board

The audit committee is required to go before its overall board of directors and obtain authorization, through this charter document, for board audit committee activities. Though there is no single required format or mandated contents for this charter document, but the NYSE has published a model charter that has been adopted by many public corporations today. Formats vary from one company to another, but audit committee charters generally include:

1. Purpose and authority of audit committee

2. Audit committee composition

3. Meetings schedule

4. Audit committee procedures

5. Audit committee primary activities:

  • Corporate governance
  • Public reporting
  • Independent accountants
  • Audits and accounting
  • Other activities

6. Audit committee discretionary activities:

  • Independent accountants
  • Internal audits
  • Accounting
  • Controls and systems
  • Public reporting
  • Compliance oversight responsibilities
  • Risk assessments
  • Financial oversight responsibilities
  • Employee benefit plans investment fiduciary responsibilities

7. Audit committee limitations

A good example of an easy-to-follow charter, can be found online, is Accenture Plc’s audit committee charter, found on its Web site (http::/accenture,com/us-en/company/governance/committees/Pages/corporate-governance-audit-committee.aspx), which will be used as an example to explain each of the audit committee’s roles on this post.

Not every corporation is a Accenture in terms of size and resources and not every company registered in the U.K, of course, but all corporations in the U.S. with SEC registration must conform to SOx rules. Smaller entities will not have the resources or need to release a Web-based audit committee charter. But they still must have an independent directors’ audit committee, as mandated by SOx, as well as an audit committee charter. This is the type of board of directors’ resolution document that would be part of corporate records.

Audit Committees in the Past

The description of audit committee presented on the above section is what it is today. In past years, many audit committees met only quarterly for brief sessions in conjunction with regular board meetings; those meetings often were limited to little more than approving the external auditor’s annual plan and their quarterly and year-end reports and reviewing internal audit activities in what appeared to be little more than a perfunctory basis.

While NYSE rules, even prior to SOx, required that audit committees consist of only outside directors, in the past many audit committee directors often appeared to be buddies of the chief executive officer (CEO) with apparently little evidence of true independent actions.

Internal audit’s Chartered Audit Executive (CAE) has always had a direct reporting relationship to the audit committee, but often this was little more than a theoretical relationship where the CAE had limited contact with the audit committee beyond scheduled board meetings. SOx has now changed all of that.

During the first years of this millennium, a major issue that evolved from the collapse of Enron and the related financial scandals was the fact that boards and their audit committees were not exercising a sufficient level of independent corporate governance.

The Enron audit committee was highlighted as an example of what was wrong. It was reported to have met some 30 minutes per calendar quarter prior to the company’s fall. Given the size of Enron at that time and the many directions it was pursuing, the audit committee’s attention appeared to be limited at best.

Even before the fall of Enron, the SEC was becoming interested in seeing audit committees acting as more independent, effective managers of a company’s external and internal auditors. In 1999 the Blue Ribbon Committee on “Improving the Effectiveness of Corporate Audit Committees” was formed by the NYSE, SEC, AICPA, and others. It issued a series of recommendations on improving the independence, operations, and effectiveness of audit committees.

The stock exchanges then adopted new independent director audit committee standards as listing requirements to be phased in over the next 18 months, and the Auditing Standards Board  (ASB)of the AICPA raised standards for external auditors with respect to their audit committees. The subsequent financial failures of Enron and others showed these initiatives were not enough. The result was the legislative work that led to SOx.

Today, since the passage of SOx, audit committees have expanded responsibilities and internal audit has a greater responsibility to best serve its audit committee. Although an audit committee typically has regular contacts primarily with the CAE, all internal auditors should have an understanding of this very important relationship.

Next, let’s discuss the current audit committee roles and responsibilities in more detail

Current Roles and Responsibilities of Audit Committee

Many literatures have highlighted the roles and responsibilities of audit committee. Lin et al. (2008) for example, notes that audit committee oversight roles and responsibilities is for improving internal control, rules compliance, sound corporate financial reporting and auditing processes.

Chen et al. (2008) notes that while the primary responsibilities of the audit committees are to assist the board with its duties in overseeing the corporation’s reporting and audit requirements, it also:

  • monitors the integrity of the company’s financial statements and reporting system;
  • ensures that the company complies with legal and regulatory requirements;
  • monitors independent auditors’ qualifications and independence;
  • monitors the performance of the company’s internal and external auditors; and
  • monitors compliance with corporate legality and ethical standards, including the maintenance of preventive fraud controls.

Chambers (2005) discussed four responsibilities of audit committees, which are:

  • advising board on the reliability of financial information;
  • advising board in risk management and internal control;
  • dealing with external auditors; and
  • overseeing the internal audit process.

Among many areas of audit committee roles and responsibilities, next we will see five main areas where audit committees perform specific roles:

1. Roles in the Financial Reporting Area

The financial process and ensuring reliable financial information is one of the most important functions of the audit committee. While the audit committee should not become involved in day-to-day operations, there is pressure from the oversight role for the audit committee to get more involved in ensuring the integrity of the financial reporting process. Experts and educators have studied about effective audit committee processes for overseeing financial reporting. These studies generally noted that audit committees are expected to:

  • Review all financial statements, whether interim or annual, before they are approved by the Board of Directors and publicly disseminated to ensure their objectiveness, accuracy, and timeliness.
  • Review all existing accounting policies, and concentrate on the impact on the financial statements of any changes in accounting policies including the likely impact of any contemplated changes.
  • Evaluate exposure to fraud.
  • Appraise key management estimates, judgments, and valuations where they are thought to be material to the financial statements.
  • Evaluate the adequacy of financial statement disclosures.
  • Review adequacy of organization’s structure, including management’s implementation of internal controls.
  • Review all significant transactions, especially those that are nonroutine and those that might be illegal, questionable, or unethical.

If you check on the Accenture Plc’s charter documents, you will find the following roles:

  • Review, in consultation with the independent auditors and the internal auditors, the integrity of the Company’s internal and external financial reporting processes and controls. In this regard, the Committee should obtain and discuss with management and the independent auditors all reports from management and the independent auditors regarding: (i) all critical accounting policies and practices to be used by the Company; (ii) analyses prepared by management and/or the independent auditors setting forth significant financial reporting issues and judgments made in connection with the preparation of the financial statements, including all alternative treatments of financial information within generally accepted accounting principles that have been discussed with the Company’s management, the ramifications of the use of the alternative disclosures and treatments, and the treatment preferred by the independent auditors; (iii) major issues regarding accounting principles and financial statement presentations, including any significant changes in the Company’s selection or application of accounting principles; (iv) major issues as to the adequacy of the Company’s internal controls and any special audit steps adopted in light of material control deficiencies; and (v) any other material written communications between the independent auditor and the Company’s management;
  • Review periodically the effect of regulatory and accounting initiatives, as well as off-balance sheet structures (if any), on the financial statements of the Company;
  • Establish regular systems of reporting to the Committee by each of management, the independent auditors and the internal auditors regarding any significant judgments made in management’s preparation of the financial statements and any significant difficulties encountered during the course of the review or audit, including any restrictions on the scope of work or access to requested information
  • Review any significant disagreement between management and the independent auditors or the internal auditing department in connection with the preparation of the financial statements and management’s response to such matters;
  • Review and discuss with the Company’s internal auditors: (i) the internal audit function, including its authority, responsibilities, independence and reporting obligations; (ii) the proposed audit plan for the coming year; (iii) the coordination of that proposed audit plan with the Company’s independent auditors; and (iv) the results of the internal audit program, and perform a specific review of any significant issues; and
  • Review and discuss with the independent auditors the responsibilities, budget and staffing of the Company’s internal audit function.

2. Roles in the Internal Audit Area

The audit committee can strengthen the entity’s internal audit function by ensuring that management has established and is maintaining an adequate and effective internal audit structure. Also, after discussion in the Treadway Commission’s Report identified the interaction between the internal audit function and the AC that should ensure the internal audit function’s effectiveness and objectivity.

Here are specific roles, in the internal audit area, expected to be done by the audit committee:

  • Appointment of the Chief Audit Executive – The CAE typically reports administratively to company management, but the audit committee is responsible for the hiring and dismissal of this internal audit executive. The objective here is not to deny company management the right to name the person who will administer the internal audit department, which serves the combined needs of company management and the audit committee. Rather, the significance of the audit committee’s participation is to ensure the independence of the internal audit function when there is a need to speak out regarding issues identified in the review and appraisal of internal controls and other company activities.
  • Approval of Internal Audit Charter – An internal audit charter serves as a basis or authorization for every effective internal audit program. An adequate charter is particularly important to define the roles and responsibilities of internal audit and its responsibility to serve the audit committee properly. It is here that the mission of internal audit must clearly provide for service to the audit committee as well as to senior management. The audit committee is responsible for approving this internal audit charter, just as the full board is responsible for approving the audit committee’s charter.
  • Approval of Internal Audit Plans and Budgets – Ideally, the audit committee should have developed an overall understanding of the total internal audit needs of the company. This high-level appraisal covers various special control and financial-reporting issues, allowing the audit committee to determine the portion of audit or risk assessment needs to be performed by either internal audit or other providers. As part of this role, the audit committee is responsible for reviewing and approving all internal audit higher-level plans and budgets. This responsibility is consistent with the audit committee’s role as the ultimate coordinator of the total audit effort. The committee’s review of all internal audit plans is essential if the policies and plans for the future are to be determined most effectively.
  • Audit Committee Review and Action on Significant Audit Findings – An audit committee’s most important responsibility is to review and take action on significant audit findings reported to it by the internal and external auditors, management, and others. While the audit committee has responsibility for all of these areas, our focus here is on the importance of internal audit to report all significant findings to the audit committee regularly and promptly. Part of this reporting will occur through internal audit’s distribution of all audit reports to the audit committee as part of the SOx requirements. Reacting to significant audit findings requires a combination of understanding, competence, and cooperation by all of the major parties of interest: internal audit, management, external auditors, and the audit committee itself.

3. Roles Related to External Auditors’ Activities

The audit committee is a valuable instrument for initiating direct contact with the independent/external auditor, participating in the selection of the external auditor, and promoting effective communication between the independent auditor and corporate directors. Audit committee members dependency on external auditors in performing their oversight.

An audit committee has a major responsibility for hiring the external audit firm, approving its proposed budget and audit plan, and releasing the audited financial statements. While many aspects of this arrangement have remained unchanged over time, SOx has caused some significant changes here.

External auditors no longer can both perform and then approve their internal controls assessments, nor are any consulting arms of public accounting firms allowed to install financial applications that would be subject to external audit review. The major public accounting firms no longer have these consulting divisions, and, as discussed, public accounting firms are prohibited from outsourcing the internal audit services for the companies they audit.

Audit committees should be aware and sensitive to these changes. SOx requires that the audit committee approve all external audit services, including comfort letters, as well as any nonaudit services provided by the external auditors.

External auditors are still allowed to provide tax services as well as certain de minimis service exceptions, but they are prohibited from providing these nonaudit services contemporaneously with their financial statement audits:

  • Bookkeeping and other services related to the accounting records or financial statements of the audit client
  • Financial information technology design and implementation
  • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
  • Internal audit outsourcing services
  • Management function or human resource support activities
  • Broker or dealer, investment advisor, or investment banking services
  • Legal services and other expert services unrelated to the audit
  • Any other services that the Public Company Accounting Oversight Board determines to be not permitted

Even though their external auditors are prohibited from performing these activities, corporations still will need to contract for and acquire many of these types of services. These must be treated as special contracting arrangements, reported as part the annual financial reports. It is in the best interests of the external audit firm not to get involved with such nonaudit services.

If you check on the Accenture Plc’s charter documents, you will find the following roles are expected from the committee, in the external auditors’ activities:

  • Retain or change the Company’s independent auditors and approve all audit engagement fees and terms;
  • Oversee the work of any registered public accounting firm employed by the Company, including the resolution of any disagreement between management and the independent auditor regarding financial reporting, for the purpose of preparing or issuing an audit report or related work;
  • Approve, in advance, any audit and any permissible non-audit engagement or relationship between the Company and the independent auditors;
  • Review, at least annually, the qualifications, performance and independence of the independent auditors and present its conclusions with respect to the independent auditor to the Board. In conducting its review and evaluation, the Committee should:
  • Obtain and review a report by the Company’s independent auditors describing: (i) the auditing firm’s internal quality-control procedures; (ii) any material issues raised by the most recent internal quality-control review, or peer review, of the auditing firm, or by any inquiry or investigation by governmental or professional authorities within the preceding five years, respecting one or more independent audits carried out by the auditing firm, and any steps taken to deal with any such issues; and (iii) all relationships between the independent auditors and the Company (so as to enable the assessment of the independent auditors’ independence).
  • Ensure the rotation of the lead audit partner and reviewing partner on at least that schedule required by the Securities and Exchange Commission, the Public Company Accounting Oversight Board or any other applicable authority. As part of its review, the Committee shall confirm with any independent auditors retained to provide audit services in any fiscal year that the lead (or coordinating) audit partner (having primary responsibility for the audit), or the audit partner responsible for reviewing the audit, has not performed audit services for the Company in any of the five previous fiscal years of the Company prior to his or her appointment.
  • Take into account the opinions of management and the Company’s internal auditors (or of other personnel responsible for the internal audit function).
  • Receive from the independent auditors such written statements as required by the Public Company Accounting Oversight Board Rule 3526 or any other applicable rules, and recommend to the Board and/or management such actions it deems appropriate to ensure the independence of the external auditors;
  • Review with the independent auditors any audit problems or difficulties and management’s response.
  • Set clear hiring policies to be implemented by the Company for employees or former employees of the independent auditors to ensure the independence of the Company’s outside auditors is not compromised under the rules of the Securities and Exchange Commission.
  • Discuss with management and the independent auditors the Company’s guidelines and policies with respect to risk assessment and risk management. The Committee should discuss the Company’s major financial risk exposures and the steps management has taken to monitor and control such exposures. Such reviews shall include the following:
  • A quarterly review with the Chief Operating Officer (or such other executive or executives with primary responsibility for risk oversight) of the Company’s company risks and risk management;
  • An annual review (or more frequently as appropriate) with such person or persons of the process by which the Company manages its company risks; and
  • An annual review with the chair of each of the Compensation Committee and the Finance Committee of the risk assessment process undertaken by those committees with respect to the risks overseen by those committees.

4. Roles in the Risk Management and Corporate Governance Areas

Audit committees play significant role in managing risk of the business. Apart from the above discussed four key roles, audit committees presume some corporate governance responsibilities for the firm. In the case of corporate governance responsibilities, audit committees are expected to:

  • Facilitate and enhance communication between the external auditors and the BoDs
  • Review corporate policies and practices in the light of ethical considerations
  • Monitor the manner in which the company’s affairs are conducted and, where applicable, compliance with the company’s code of corporate conduct
  • Review significant transactions outside entity’s normal business
  • Review adequacy of management information systems

If you check on the Accenture Plc’s charter documents, you will find the following roles in the external auditors’ activities:

Discuss with management and the independent auditors the Company’s guidelines and policies with respect to risk assessment and risk management. The Committee should discuss the Company’s major financial risk exposures and the steps management has taken to monitor and control such exposures. Such reviews shall include the following:

  • A quarterly review with the Chief Operating Officer (or such other executive or executives with primary responsibility for risk oversight) of the Company’s company risks and risk management;
  • An annual review (or more frequently as appropriate) with such person or persons of the process by which the Company manages its company risks; and
  • An annual review with the chair of each of the Compensation Committee and the Finance Committee of the risk assessment process undertaken by those committees with respect to the risks overseen by those committees.

5. Roles in the Whistleblower Programs and Codes of Conduct Areas

SOx rules state the audit committee must establish procedures for the receipt, retention, and treatment of complaints regarding accounting, internal accounting controls, or auditing matters, including procedures for the confidential, anonymous submission by employees of concerns regarding questionable accounting or auditing matters.

The CAE as well as the legal counsel often are the only non-CEO and CFO links between the audit committee and the corporation. Internal audit often offer its services to the audit committee—often to the designated financial expert—to establish documentation and communication procedures in these areas:

  • Documentation logging whistleblower calls – SOx mandates that the audit committee establish a formal whistleblower program where employees can raise their concerns regarding improper audit and controls matters with no fear of retribution. A larger company may already have an ethics function, where these matters can be handled in a secure manner. When a smaller company does not have such a resource, internal audit should offer its facilities to log in such whistleblower communications, recording the date, time, and name of the caller for investigation and disposition.
  • Disposition of whistleblower matters – Even more important than logging in initial whistleblower calls, documentation must be maintained to record the nature of any follow-up investigations and related dispositions. Although the SOx-mandated whistleblower program does not have any cash reward program, complete documentation covering actions taken as well as any net savings should be maintained.
  • Codes of ethics – SOx makes the audit committee responsible for implementing a code of ethics or conduct for a corporation’s senior officers (CEO and CFO).

The audit committee must to outline a set of rules for proper conduct and have those senior officers acknowledged that they have read and understand and agree to abide by them. Audit committee, if the company has the program, is expected to make sure the program is effectively running, not just for a limited set of senior officers but for the entire company.

How Auditors Treat Uncorrected Misstatements under US GAAP

Misstatements sometimes left uncorrected, particularly when the financial statements preparer detects them after the statements have been produced and distributed. Using an auditor perspective, how do you treat uncorrected misstatements?

Before discussing type of misstatements, how to evaluate and treat uncorrected misstatements, let us have a look at why uncorrected misstatements occur.

Why Do Uncorrected Misstatements Occur?

A common reason for leaving a misstatement uncorrected is that the preparer judges the figure as “immaterial”. Consider this:

A Financial statement preparer, by the accounting standard, is expected to exercise professional judgment in determining the level of materiality to apply, while on other side she is also expected to be able to cost-effectively prepare full and complete financial statements without delay. With high degree of pressure, during the year end, the financial statements are finally completed and distributed. Back to her desk, she finds some misstatements on the statement and consider, “no time to make correction, they are not material anyway”.

The preparer catches up timeliness at the cost of financial statement users—having inaccurate statements.

In worst cases, which are truly happened, the materiality concept has been used to rationalize the non-correction of errors that should have been dealt with, indeed, even to excuse errors known when first committed. The fact that the concept of materiality has sometimes been abused led to the promulgation of further guidance relative to error corrections.

What is Materiality?

Materiality, defined by the FASB, as:

“the magnitude of an omission or misstatement in the financial statements that makes it probable that a reasonable person relying on those financial statements would have been influenced by the omitted information or made a different judgment if the correct information had been known.”

Despite many efforts to develop a firm definition of materiality that have been made by academicians and the profession over the decades, a universally agreed-upon definition of materiality remains elusive, and thus a matter for professional judgment.

[box type=”note”]

Materiality According to SEC

The Securities and Exchange Commission has, in various of its pronouncements, defined materiality as:

  • 1% of total assets for receivables from officers and stockholders;
  • 5% of total assets for separate balance sheet disclosure of items; and
  • 10% of total revenue for disclosure of oil and gas producing activities


Although materiality judgments have traditionally been primarily based on quantitative assessments, the nature of a transaction or event can affect a determination of whether that transaction or event is material.

Example: Transaction that, if recorded, changes a profit to a loss or changes compliance with ratios in a debt covenant to noncompliance would be material even if it involved an otherwise immaterial amount.

Also, a transaction that might be judged immaterial if it occurred as part of routine operations may be material if its occurrence helps meet certain objectives.

Example: Transaction that allows management to achieve a target or obtain a bonus that otherwise would not become due would be considered material, regardless of the actual amount involved.

The individual accountant, therefore, must exercise professional judgment in evaluating information and concluding on its materiality.

Materiality—as a criterion—has both quantitative and qualitative aspects, and items should not be deemed immaterial unless all potentially applicable quantitative and qualitative aspects are given full consideration and found not relevant.

[box type=”note”]Although independent auditors are charged with obtaining sufficient evidence to enable them to provide the financial statement user with reasonable assurance that management’s financial statements are free of material misstatement, the financial statements are primarily the responsibility of the preparers.[/box]

Types of Misstatements

Preparers of financial statements obviously will need to have control procedures to reduce the risk of accounting errors being committed and not detected. From the auditors’ perspective, it is required that the examination be conducted in a manner that will provide reasonable assurance of detecting material misstatements, including those resulting from errors.

In evaluating misstatements, an auditor would classify them into two categories: (a) known misstatements; and (b) likely misstatements.

The “known misstatements” could arise from:

  • Incorrect selection or application of accounting principles
  • Errors in gathering, processing, summarizing, interpreting, or overlooking relevant data
  • An intent to mislead the financial statement user to influence their decisions
  • To conceal theft

The “likely misstatements” could arise from:

  • Differences in judgment between management and the auditor regarding accounting estimates where the amount presented in the financial statements is outside the range of what the auditor believes is reasonable
  • Amounts that the auditor has projected (the statistical term “extrapolated” is also used in this context) based on the results of performing statistical or nonstatistical sampling procedures on a population.

An auditor, following on the SAS 107, would evaluate both known and likely misstatements. Under the auditing standards, auditors are responsible for accumulating all known and likely misstatements except those that, in the auditors’ judgment, are trivial or inconsequential.

[box type=”note”]In forming judgments regarding the triviality of misstatements, auditors consider whether the misstatement individually or when aggregated with other similar amounts would be considered immaterial to the financial statements.[/box]

How Should Auditors Treat Misstatements?

Auditors are expected to communicate known and likely misstatements to management in a timely manner, distinguishing between these categories. Timely communication is important in order to provide management the opportunity to evaluate whether they concur that the items are misstatements and to determine whether to adjust the financial statements or request that the auditor obtain additional evidence.

Auditors are obligated by professional standards to request that management record adjustments to correct all known misstatements, other than those deemed to be trivial. Because some of these may be based on audit sampling results, some management may either resist because there is inherent distrust of projections, or because it will not be clear how corrections can be recorded when the error items cannot be specifically identified.

Likely misstatements are treated as follows:

1. If the likely misstatement results from a projection to the population from examination of a sample, auditors will request management to examine the relevant population from which the sample was drawn. This might be a class of transactions, an account balance, or the information required to be presented in a disclosure. The purpose of the requested examination is for management to identify and correct misstatements in the remaining population.

Example: The auditor may identify a misstatement caused by an error in inventory pricing relative to raw materials. Management would be requested, in this case, to reexamine the entire raw materials inventory to determine whether it includes other misstatements and to correct any other misstatements found as a result of the reexamination.

2. If the likely misstatement results from differences in estimates (e.g. the amount needed for the allowance for uncollectible accounts receivable), the auditors should request that management review the methods and assumptions used to develop their estimate.

Ultimately, management is responsible for deciding how to respond to auditors’ requests and whether it wishes to correct some or all of the misstatements brought to its attention by the auditors.

Both the auditors and management, in assessing the impact of uncorrected misstatements, are required to assess materiality both quantitatively and qualitatively, from the standpoint of whether a financial statement user would be misled if a misstatement were not corrected or if, in the case of informative disclosure errors, full disclosure was not made.

Qualitative considerations include (but are not limited to) whether the misstatement:

  • Arose from estimates or from items capable of precise measurement and, if the misstatement arose from an estimate, the degree of precision inherent in the estimation process
  • Masks a change in earnings or other trends
  • Hides a failure to meet analysts’ consensus expectations for the reporting entity
  • Changes a loss to income or vice versa
  • Concerns a segment or other portion of the reporting entity’s business that has been identified as playing a significant role in operations or profitability
  • Affects compliance with loan covenants or other contractual commitments
  • Increases management’s compensation by affecting a performance measure used as a basis for computing it
  • Involves concealment of an unlawful transaction

Misstatements from Prior Years

Management, with the concurrence of the reporting entity’s auditors, may have decided to not correct misstatements that occurred in one or more prior years because, in their judgment at the time, the financial statements were not materially misstated.

Two methods of making that materiality assessment have been widely used in practice:

1. Rollover Method – This method quantifies a misstatement as its originating or reversing effect on the current period’s statement of income, irrespective of the potential effect on the balance sheet of one or more prior periods’ accumulated uncorrected misstatements.

  • Focus on: Current period income statement.
  • Strength: Focuses on whether the income statement of the current period is materially misstated assuming that the balance sheet is not materially misstated.
  • Weakness: Material misstatement of the balance sheet can accumulate over multiple periods.

2. Iron Curtain Method – This method quantifies a misstatement based on the accumulated uncorrected amount included in the current, end-of-period balance sheet, irrespective of the year (or years) in which the misstatement originated.

  • Focus on: End of period balance sheet
  • Strength: Focuses on ensuring that the balance sheet is not materially misstated irrespective of the year or years in which a misstatement originated
  • Weakness: Does not consider whether the effect of correcting a balance sheet misstatement that arose in one or more periods is material to the current period income statement

For a publicly held corporation, the SEC staff issued SAB 108, in order to address how publicly held corporations are to evaluate misstatements. SAB 108 prescribes that if a misstatement is material to either the income statement or balance sheet, it is to be corrected in a manner set forth in the bulletin.

In addition, the SEC provided transition relief for certain reporting entities initially adopting SAB 108. The SEC staff indicated in SAB 108 that in the following circumstances the ASC 250 requirement for prior period restatement would be waived:

1. The reporting entity’s initial registration statement was effective on or before November 15, 2006, and

2. Management had, in the past, properly applied its pervious method of evaluating misstatements (either iron curtain or rollover), including consideration of all relevant qualitative factors (set forth in SAB 99, “Materiality”). Registrants that meet these criteria are permitted to reflect the results of initial application of SAB 108 as a cumulative effect adjustment to retained earnings as of the beginning of the fiscal year. Disclosures are required of:

  • The nature and amount of each individual error correction included in the cumulative effect adjustment;
  • When and how each error arose; and
  • The fact that the errors had been previously considered to be immaterial.

The SEC encouraged early adoption of this guidance in any report for an interim period ending in the first fiscal year ending after November 15, 2006, that is filed after September 13, 2006, the publication date of SAB 108.

If the cumulative effect adjustment occurs in an interim period other than the first interim period, the SEC waived the requirement that previously filed interim reports for that fiscal year be amended. Instead, comparative information presented for interim periods of the first year subsequent to initial application are to be adjusted to reflect the cumulative effect adjustment as of the beginning of the fiscal year of initial application. The adjusted results are also required to be included in the disclosures of selected quarterly information that are required by Regulation S-K, Item 302. Entities that do not meet the criteria to use the cumulative effect adjustment are required to follow the provisions of ASC 250 that require restatement of all prior periods presented in the filing.

Financial Statements Disclosures Required Under IFRS

Though I have posted about balance sheet’s disclosures required under the US’s accounting standard codification, in the past. This post discusses financial statements disclosures required under IFRS, dedicated for those who implement IFRS.

As it is required under the US-GAAP, a supplemental disclosure for financial statements is also required under the IFRS—generally shown as notes to the accounts.

To help users to understand the financial statements and to compare them with financial statements of other entities, an entity normally should present notes in the following order:

1. Statement of compliance with IFRS
2. Summary of significant accounting policies applied
3. Supporting information for items presented in the financial statements
4. Other disclosures

More detailed explanations are presented below. Read on…

1. Statement of Compliance with IFRS

An entity might refer to IFRS in describing the basis on which its financial statements are prepared without making this explicit and unreserved statement of compliance with IFRS.

Financial statements, however, should not be described as complying with IFRS unless they comply with all the requirements of IFRS. A reporting entity may only claim to follow IFRS if it complies with every single IFRS in force as of the reporting date.

IAS 1 requires an entity whose financial statements comply with IFRS to make an explicit statement of such compliance in the notes.

2. Accounting Policy Disclosures

Basically, entities should make financial statement users become aware of the accounting policies used by reporting entities—so that they can better understand the financial statements and make comparisons with the financial statements of others.

Financial statements should include clear and concise disclosure of all significant accounting policies that have been used in the preparation of those financial statements. The policy disclosures should identify and describe the accounting principles followed by the entity and methods of applying those principles that materially affect the determination of financial position, results of operations, or changes in cash flows. IAS 1 requires that disclosure of these policies be an integral part of the financial statements.

IAS 8 provides criteria for making accounting policy choices. Policies should be relevant to the needs of users and should be reliable (representationally faithful, reflecting economic substance, neutral, prudent, and complete).

The policy note should begin with a clear statement on the nature of the comprehensive basis of accounting used.

Management must also indicate the judgments that it has made in the process of applying the accounting policies that have the most significant effect on the amounts recognized. The entity must also disclose the key assumptions about the future and any other sources of estimation uncertainty that have a significant risk of causing a material adjustment to later be made to the carrying amounts of assets and liabilities.

IAS 1 also requires an entity to disclose in the summary of significant accounting policies:

  • The measurement basis (or bases) used in preparing the financial statements; and
  • The other accounting policies applied that are relevant to an understanding of the financial statements.

[box type=”note” ]

Note: Measurement bases may include historical cost, current cost, net realizable value, fair value or recoverable amount.


Other accounting policies should be disclosed if they could assist users in understanding how transactions, other events and conditions are reported in the financial statements.

3. Supporting Information for Financial Statement’s Items

Basically, supporting information is required for nearly all items presented on the financial statements. There is, though, a degree of fluidity between showing information “on the face of the accounts” (=directly in the statement of financial position or income statement) and in the notes (= the main categories have to be preserved, but the detail underlying the reported amounts may be shown in the notes).

The two basic techniques, for the purpose, are:

1. Parenthetical explanations – Supplemental information is disclosed by means of parenthetical explanations following the appropriate statement of financial position items. For example:

“Equity share capital ($10 par value, 150,000 shares authorized, 100,000 issued) = $1,000,000”

Parenthetical explanations have an advantage over both footnotes and supporting schedules, as they place the disclosure in the body of the statement, where their importance cannot be overlooked by users of the financial statements.

2. Footnotes – If the additional information cannot be disclosed in a relatively short and concise parenthetical explanation, a footnote should be used, with a cross-reference shown in the statement of financial position. In accordance with IAS 1 the notes should:

  • present information about the basis of preparation of the financial statements and the specific accounting policies used;
  • disclose the information required by IFRS that is not presented elsewhere in the financial statements; and
  • provide information that is not presented elsewhere in the financial statements, but is relevant to an understanding of any of them.

An entity should present notes in a systematic manner and should cross-reference each item in the statements of financial position and of comprehensive income, in the separate income statement (if presented), and in the statements of changes in equity and of cash flows to any related information in the notes. For example:

“Inventories (see Note 2) = $2,550,000”

The notes to the financial statements would then contain the following:

“Note 2: Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method, and market is determined on the basis of estimated net realizable value. As of the date of the statement of financial position, the market value of the inventory is $2,620,000.”

To present adequate detail regarding certain statement of financial position items, or move complex detail from the face of the accounts, a supporting schedule may be provided in the notes. For example:

Current receivables may be a single line item in the statement of financial position, as follows:

“Current receivables (see Note 3) = $2,300,000”

A separate schedule for current receivables would then be presented as follows:

Financial Statements Disclosures

Valuation accounts are another form of schedule used to keep detail off the balance sheet. For example, accumulated depreciation reduces the book value for property, plant, and equipment, and a bond premium (discount) increases (decreases) the face value of a bond payable as shown in the following illustrations. The net amount is shown in the statement of financial position, and the detail in the notes.

In addition, an entity should disclose the judgments that management has made in the process of applying the entity’s accounting policies and that have the most significant effect on the amounts recognized in the financial statements. For example: when making decisions whether investments in securities should be classified as trading, available for sale or held to maturity, or whether lease transactions transfer substantially all the significant risks and rewards of ownership of financial assets to another party.

Determining the carrying amounts of some assets and liabilities requires estimating the effects of uncertain future events on those assets and liabilities at the end of the reporting period in measuring, for example, the recoverable values of different classes of property, plant, and equipment, or future outcome of litigation in progress.

The reporting entity should disclose information about the assumptions it makes about the future and other major sources of estimation uncertainty at the end of the reporting period—which have a significant risk of resulting in a material adjustment to the carrying amount of assets and liabilities within the next financial year.

The notes to the financial statements should include the nature and the carrying amount of those assets and liabilities at the end of the period.

4. Other Required Disclosures

IFRS also requires entities to include other disclosures such as related party, contingent liabilities and unrecognized contractual commitments; and nonfinancial disclosures (e.g., the entity’s financial risk management objectives and policies).

a. Related-party Disclosures

A related party is essentially any party that controls or can significantly influence the financial or operating decisions of the company to the extent that the company may be prevented from fully pursuing its own interests. Such groups would include:

  • Associates
  • Investees accounted for by the equity method
  • Trusts for the benefit of employees
  • Principal owners
  • Key management personnel
  • Family members of owners or management

According to IAS 24, financial statements should include disclosure of material related-party transactions that are defined by the standard as

transfer of resources or obligations between related parties, regardless of whether a price is charged.”

Disclosures should take place even if there is no accounting recognition made for such transactions (e.g., a service is performed without payment). Disclosures should generally not imply that such related-party transactions were on terms essentially equivalent to arm’s-length dealings.

Additionally, when one or more companies are under common control such that the financial statements might vary from those that would have been obtained if the companies were autonomous, the nature of the control relationship should be disclosed even if there are no transactions between the companies.

The disclosures generally should include:

  • Nature of relationship
  • Description of transactions and effects of such transactions on the financial statements for each period.
  • Financial amounts of transactions for each period for which an income statement is presented and effects of any change in establishing the terms of such transactions different from that used in prior periods.
  • Amounts due to and from such related parties as of the date of each statement of financial position presented together with the terms and manner of settlement

b. Comparative Amounts For The Preceding Period

IAS 1 requires that financial statements should present corresponding figures for the preceding period. When the presentation or classification of items is changed, the comparative data must also be changed, unless it is impracticable to do so.

When an entity applies an accounting policy retrospectively or makes a retrospective restatement of items in its financial statements, or when it reclassifies items in its financial statements, at a minimum, three statements of financial position, two of each of the other statements, and related notes are required. The three statements of financial position presented are as at:

  • The end of the current period;
  • The end of the previous period (which is the same as the beginning of the current period); and
  • The beginning of the earliest comparative period

When the entity changes the presentation or classification of items in its financial statements, the entity should reclassify the comparative amounts, unless reclassification is impractical. In reclassifying comparative amounts, the required disclosure includes:

  • The nature of the reclassification;
  • The amount of each item or class of items that is reclassified; and
  • The reason for the reclassification. In situations where it is impracticable to reclassify comparative amounts, an entity should disclose (a) the reason for not reclassifying the amounts; and (b) the nature of the adjustments that would have been made if the amounts had been reclassified.

The related footnote disclosures must also be presented on a comparative basis, except for items of disclosure that would be not meaningful, or might even be confusing, if set forth in such a manner.

Although there is no official guidance on this issue, certain details, such as schedules of debt maturities as of the year earlier statement of financial position date, would seemingly be of little interest to users of the current statements and would be largely redundant with information provided for the more recent year-end.

Accordingly, such details are often omitted from comparative financial statements. Most other disclosures, however, continue to be meaningful and should be presented for all years for which basic financial statements are displayed.

Many companies include in their annual reports five- or ten-year summaries of condensed financial information—to increase the usefulness of financial statements. This is not required by IFRS. The presentation of comparative financial statements in annual reports enhances the usefulness of such reports and brings out more clearly the nature and trends of current changes affecting the entity.

c. Subsequent Event Disclosures

The statement of financial position is dated as of the last day of the fiscal period, but a period of time will usually elapse before the financial statements are actually prepared and issued. During this period, significant events or transactions may have occurred that materially affect the company’s financial position. These events and transactions are usually referred to as subsequent events. IAS 10 refers to these as “events after the date of the statement of financial position.”

If not disclosed, significant events occurring between the date of the statement of financial position and the financial statement issuance date could make the financial statements misleading to others not otherwise informed of such events.

IAS 10 describes two types of subsequent events, as follows :

  • Adjusting Events – These are events that provide additional evidence with respect to conditions that existed at the date of the statement of financial position and which affect the estimates inherent in the process of preparing financial statements; these are called.
  • Non-adjusting Events – These are events that do not provide evidence with respect to conditions that existed at the date of the statement of financial position, but arose subsequent to that date (and prior to the actual issuance of the financial statements); these are called.

The principle is that the statement of financial position should reflect as accurately as possible conditions that existed at date of the statement of financial position, but not changes in conditions that occurred subsequently, even though they have the potential to influence investors’ decisions. In the latter case disclosure is to be made.

Examples of post-balance-sheet date events:

(1). A loss on an uncollectible trade account receivable as a result of a customer’s deteriorating financial condition leading to bankruptcy subsequent to the date of the statement of financial position.

(2). A loss arising from the recognition after the date of the statement of financial position that an asset.

(3). Nonadjusting events, which are those not existing at the date of the statement of financial position, require disclosure but not adjustment. These could include:

  • Sale of a bond or share capital issue after the date of the statement of financial position, even if planned before that date.
  • Purchase of a business, if the transaction is consummated after year-end.
  • Settlement of litigation when the event giving rise to the claim took place subsequent to the date of the statement of financial position.
  • Loss of plant or inventories as a result of fire or flood.
  • Losses on receivables resulting from conditions (such as a customer’s major casualty) arising subsequent to the date of the statement of financial position.
  • Gains or losses on certain marketable securities.

d. Contingent Liabilities and Assets

Provisions are recognized as liabilities (if reliably estimable), inasmuch as these are present obligations with probable outflows of resources embodying economic benefits needed to settle them. Provisions are accrued by a charge against income if:

  • The reporting entity has a present obligation as a result of past events;
  • It is probable that an outflow of the entity’s resources will be required; and
  • A reliable estimate can be made of the amount.

If an estimate of the obligation cannot be made with a reasonable degree of certitude, accrual is not prescribed, but rather disclosure in the notes to the financial statements is needed.

For a provision to be made, the entity has to have incurred a constructive obligation. This may be an actual legal obligation, but it may also be only an obligation that arises as a result of an entity’s stated polices. However, to preclude the use of reserves for manipulative purposes, provisions for restructuring are subject to additional restrictions, and a provision may only be made once a detailed plan has been agreed and its implementation has commenced.

Contingent liabilities are not recognized as liabilities under IFRS because they are either only possible obligations or they are present obligations that do not meet the threshold for recognition.

IAS 37 defines provisions, contingent assets, and contingent liabilities. Importantly, it differentiates provisions from contingent liabilities.

At the present date, the key recognition issue for contingent liabilities is the probability of a future cash outflow. The probability of this occurring is the threshold condition for recognition: a probable outflow triggers recording a provision, while an unlikely or improbable outflow creates only the need for a disclosure.

In its ongoing business combinations project, the IASB appears likely to conclude that a contingency is usually a combination of an unconditional right or obligation which is linked to a conditional right or obligation.

The unconditional element is always to be recognized, although its value will be a function of the probability of the conditional element occurring. For Example:

If a company is being sued for $10 millions, and it considers that it has a 10% chance of losing, under the existing financial reporting rules, NO provision would be made. If the new approach under consideration were to be adopted, this could be analyzed as an unconditional obligation to pay what the court decides, and this obligation would be measured as 10% of $10 millions. The probability of the loss then shifts from being a recognition criterion to being a measurement tool.

Following the general guidelines on constructive obligations, instead of recognizing one major restructuring provision at a specific time, entities would need to recognize different liabilities relating to the different costs occurring in the restructuring, which costs can occur at different points in time.

e. Share Capital Disclosures

An entity is required to disclose information that enables users of its financial statements to evaluate the entity’s objectives, policies, and processes for managing capital. This information should include a description of what it manages as capital, the nature of externally imposed capital requirements, if there are any, as well as how those requirements are incorporated into the management of capital.

Additionally, summary quantitative data about what it manages as capital should be provided as well as any changes in the components of capital and methods of managing capital from the previous period.

The consequences of noncompliance with externally imposed capital requirements should also be included in the notes. All these disclosures are based on the information provided internally to key management personnel.

An entity should also present either in the statement of financial position or in the statement of changes in equity, or in the notes, disclosures about each class of share capital as well as about the nature and purpose of each reserve within equity.

Information about share capital should include:

  • The number of shares authorized and issued;
  • Par value per share or that shares have no par value;
  • The rights, preferences and restrictions attached to each class of share capital;
  • Shares in the entity held by the entity or by its subsidiaries or associates; and
  • Shares reserved for issue under options and contracts

Classifying Asset and Liability Transactions under IAS 1

Classifying transactions into accounts is a crucial step in the accounting process. Asset and liability transactions are the biggest portion of the whole accounting data. Classifying transactions into asset and liability group, under the IAS 1, is a big challenge, for those who implement IFRS for the first time. This post helps starters to understand the process of classifying asset and liability transactions, under the IAS 1.

But before the main topic, let us have a look at a quick overview of statement of financial position.

How is a Statement of Financial Position Presented?

Assets and liabilities are presented on a statement of financial position—which is known as “balance sheet” in the past—and tells financial statements’ users about entity’s resources and claims to resources, at a moment in time.

[box type=”note”]Incase you haven’t noted it yet, the revised IAS 1 has changed the title of “balance sheet” to “statement of financial position”—which, according to the IASB, better reflects the function of the statement.

While the title “balance sheet” well reflects the accounting equation (Assets = Liabilities + Shareholder) that always in balance position, it does not identify the content or purpose of the statement.

In addition, according to the IASB, the term “financial position” is a well-known and accepted term—auditors’ opinions, internationally, have used the term to describe what “the balance sheet” presents.[/box]

The IASB Framework, in general, describes the basic concepts by which financial statements are presented. To be included in the financial statements, an event or transaction must meet definitional, recognition, and measurement requirements, all of which are set forth in the Framework.

In the United States, a statement of financial position, generally, is consisted of 3 major categories which are presented in the following manner:

Assets = xxx

Liabilities = xxx

Stockholders’ Equity = xxx


Assets = Liabilities + Stockholders’ Equities

Assets, liabilities, and stockholders’ equity are separated in the statement of financial position.

Entities, according to IAS 1, should make a distinction between current and noncurrent assets and liabilities, except when a presentation based on liquidity provides information that is more reliable or relevant.

Next let’s have a look how you should classify assets and liabilities under the IAS 1.

Classifying Assets under IAS 1 (IFRS)

Following on the IAS 1 requirement, assets is classified into two major categories: (a) current assets; and (b) noncurrent assets.

A. Current Assets – An asset is classified as a current asset when it meets any one of the following:

  • It is expected to be realized in, or is held for sale or consumption in, the normal course of the entity’s operating cycle;
  • It is held primarily for trading purposes;
  • It is expected to be realized within twelve months of the statement of financial position date;
  • It is cash or a cash equivalent asset that is not restricted in its use.

Any assets does not meet any of the above criterions should be classified as noncurrent assets. Therefore, assets that can be expected to be realized in cash or sold or consumed during one normal operating cycle of the business, are classified to “Current Assets”.

[box type=”note”]Note: The operating cycle of an entity is the time between the acquisition of materials entering into a process and its realization in cash or an instrument that is readily convertible into cash.[/box]

That said, inventories and trade receivables should still be classified as current assets in a classified statement of financial position EVEN if these assets are not expected to be realized within twelve months from the statement of financial position date.

Note, however, that if a current asset category includes items that will have a life of more than twelve months, the amount that falls into the next financial year should be disclosed in the notes, according to IAS 1.

Based on the above criterion and notes, the following items would be classified as current assets:

1. Cash and Cash Equivalents – These include cash on hand, consisting of coins, currency, and undeposited checks (money orders and drafts; and deposits in banks). Anything accepted by a bank for deposit would be considered cash. Cash must be available for a demand withdrawal; thus, assets such as certificates of deposit would not be considered cash because of the time restrictions on withdrawal. Also, to be classified as a current asset, cash must be available for current use. According to IAS 1, cash that is restricted in use and whose restrictions will not expire within the operating cycle, or cash restricted for a noncurrent use, would not be included in current assets. According to IAS 7, cash equivalents include short-term, highly liquid investments that (1) are readily convertible to known amounts of cash, and (2) are so near their maturity (original maturities of three months or less) that they present negligible risk of changes in value because of changes in interest rates. Treasury bills, commercial paper, and money market funds are all examples of cash equivalents.

2. Trading Investments – Included on this category are those that are acquired principally for the purpose of generating a profit from short-term fluctuations in price or dealer’s margin. A financial asset should be classified as held-for-trading if it is part of a portfolio for which there is evidence of a recent actual pattern of short-term profit making. Trading assets include debt and equity securities and loans and receivables acquired by the entity with the intention of making a short-term profit. Derivative financial assets are always deemed held-for-trading unless they are designed as effective hedging instruments.

3. Trade Receivables (Receivables) – Included under this category are: accounts and notes receivable, receivables from affiliate companies, and officer and employee receivables. The term “accounts receivable” represents amounts due from customers arising from transactions in the ordinary course of business. Allowances due to expected lack of collectibility and any amounts discounted or pledged, however, should be disclosed clearly.

4. Inventories – Inventories are defined as assets held, either for sale in the ordinary course of business or in the process of production for such sale, or in the form of materials or supplies to be consumed in the production process or in the rendering of services—according to IAS 2. The basis of valuation and the method of pricing—which is now limited to FIFO or weighted-average cost—should be disclosed properly. In the case of a manufacturing entity, raw materials, work in process, and finished goods should be disclosed separately on the statement of financial position or in the footnotes.

5. Prepaid Expenses – These are assets created by the prepayment of cash or incurrence of a liability. Prepaid expenses expire and become expenses with the passage of time, use, or events, for example: prepaid rent, prepaid insurance and deferred taxes.

B. Noncurrent Assets – IAS 1 uses the term “noncurrent” to include tangible, intangible, operating, and financial assets of a long-term usage. It does not prohibit the use of alternative descriptions, as long as the meaning is clear. The EU may use the term “fixed assets”—which draws a distinction between fixed and circulating assets. Noncurrent assets include the followings:

1. Held-to-maturity Investments – These are financial assets with fixed or determinable payments and fixed maturity that the entity has a positive intent and ability to hold to maturity. Examples of held-to-maturity investments are: debt securities and mandatorily redeemable preferred shares. This category excludes loans and receivables originated by the entity, however, as under IAS 39 these represent a separate category of asset. Held-to-maturity investments are to be measured at amortized cost.

2. Investment Property – This denotes property being held to earn rentals, or for capital appreciation, or both, rather than for use in production or supply of goods or services, or for administrative purposes or for sale in the ordinary course of business. Investment property should be initially measured at cost. Subsequent to initial measurement an entity is required to elect either the fair value model or the cost model.

3. Property, Plant, and Equipment (PP&E) – These, essentially, are tangible assets that are held by an entity for use in the production or supply of goods or services, or for rental to others, or for administrative purposes—and which are expected to be used during more than one period. Included are such items as land, buildings, machinery and equipment, furniture and fixtures, motor vehicles and equipment. PP&E should be disclosed, with the related accumulated depreciation, as follows:

Machinery and equipment = xxx
Less accumulated depreciation (xxx) = xxx


Machinery and equipment (net of $xxx accumulated depreciation) = xxx

[box type=”note”]Note: Accumulated depreciation should be shown by major classes of depreciable assets.[/box]

In addition to showing this amount in the statement of financial position, required by the IAS 16, the notes to the financial statements should contain balances of major classes of depreciable assets, by nature or function, at the date of the statement of financial position, along with a general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets.

4. Intangible Assets – These are noncurrent assets of a business, without physical substance, the possession of which is expected to provide future benefits to the owner. Included in this category are the unidentifiable asset goodwill and the identifiable intangibles trademarks, patents, copyrights, and organizational costs. IAS 38 stipulates that where an intangible is being amortized, it should be carried at cost net of accumulated amortization.

5. Assets Held for Sale. Where an entity has committed to a plan to sell an asset or group of assets, these should be reclassified as assets held for sale and should be measured at the lower of their carrying amount or their fair value less selling costs—set forth by IFRS 5.

6. Other Assets – An all-inclusive heading for accounts that do not fit neatly into any of the other asset categories (e.g., long-term deferred expenses that will not be consumed within one operating cycle, and deferred tax assets).

Classifying Liabilities under IAS 1 (IFRS)

As the assets do, liabilities are classified into two major categories: (a) current lliabilities and (b) noncurrent liabilities.

A. Current Liabilities – A Liability, according to IAS 1, should be classified as a “current liability” when:

  • It is expected to be settled in the normal course of business within the entity’s operating cycle; or
  • It is due to be settled within twelve months of the date of the statement of financial position; or
  • It is held primarily for the purpose of being traded; or
  • The entity does not have an unconditional right to defer settlement beyond twelve months

Otherwise, they should be classified as noncurrent liabilities.

Current liabilities also include:

1. Obligations arising from the acquisition of goods and services entering into the entity’s normal operating cycle, for example:

  • Accounts Payable
  • Short-term Notes Payable
  • Wages Payable
  • Taxes Payable
  • Miscellaneous Payable

2. Collections of money in advance for the future delivery of goods or performance of services, for example:

  • Rent Received in Advance
  • Unearned Subscription Revenues

3. Other obligations maturing within the current operating cycle, for example:

  • Current Maturity of Bonds
  • Long-term Notes

As these are happened to receivable and inventories on the asset’ side, certain liabilities (on the liability’s side) which is form part of the working capital used in the normal operating cycle of the business, are to be classified as current liabilities EVEN if they are due to be settled after more than twelve months from the date of the statement of financial position, fall under these criteria are:

  • Trade Payables
  • Accruals for Operating Costs

Other current liabilities which are not settled as part of the operating cycle, but which are due for settlement within twelve months of the date of the statement of financial position, such as dividends payable and the current portion of long-term debt, should also be classified as current liabilities. However, interest-bearing liabilities that provide the financing for working capital on a long-term basis and are not scheduled for settlement within twelve months should not be classified as current liabilities.

Note: obligations that are due on demand or are callable at any time by the lender are classified as current regardless of the present intent of the entity or of the lender concerning early demand for repayment.

[box type=”note”]

Important Notes On Classifying Liabilities

IAS 1 provides another exception to the general rule that a liability due to be repaid within twelve months of the date of the statement of financial position should be classified as a current liability. If the original term was for a period longer than twelve months and the entity intended to refinance the obligation on a long-term basis prior to the date of the statement of financial position, and that intention is supported by an agreement to refinance, or to reschedule payments, which is completed before the financial statements are approved, then the debt is to be reclassified as noncurrent as of the date of the statement of financial position.

However, an entity would continue to classify as current liabilities its long-term financial liabilities when they are due to be settled within twelve months, if an agreement to refinance on a long-term basis was made after the date of the statement of financial position.

Similarly if long-term debt becomes callable as a result of a breach of a loan covenant, and no agreement with the lender to provide a grace period of more than twelve months has been concluded by the date of the statement of financial position, the debt must be classified as current. (This is different than under US GAAP, which permits a determination to be made as of the date of issuance of the financial statements, which may be months after the date of the statement of financial position.)


B. Noncurrent Liabilities – Obligations that are not expected to be liquidated within the current operating cycle, including:

  • Obligations arising as part of the long-term capital structure of the entity, such as the issuance of bonds, long-term notes, and lease obligations;
  • Obligations arising out of the normal course of operations, such as pension obligations, decommissioning provisions, and deferred taxes; and
  • Contingent obligations involving uncertainty as to possible expenses or losses. These are resolved by the occurrence or nonoccurrence of one or more future events that confirm the amount payable, the payee, and/or the date payable.

For all long-term liabilities, the maturity date, nature of obligation, rate of interest, and description of any security pledged to support the agreement should be clearly shown.

Also, in the case of bonds and long-term notes, any premium or discount should be reported separately as an addition to or subtraction from the par (or face) value of the bond or note. Long-term obligations which contain certain covenants that must be adhered to are classified as current liabilities if any of those covenants have been violated and the lender has the right to demand payment. Unless the lender expressly waives that right or the conditions causing the default are corrected, the obligation is current.

Is It Allowed, under IFRS, to Offset Assets and Liabilities?

In general, assets and liabilities may not be offset against each other.

However, the reduction of accounts receivable by the allowance for doubtful accounts, or of property, plant, and equipment by the accumulated depreciation, are acts that reduce these assets by the appropriate valuation accounts and are not considered to be the result of offsetting assets and liabilities.

Only where there is an actual right of setoff is the offsetting of assets and liabilities a proper presentation.

This right of setoff exists only when all the following conditions are met:

  • Each of the two parties owes the other determinable amounts (although they may be in different currencies and bear different rates of interest).
  • The entity has the right to set off against the amount owed by the other party.
  • The entity intends to offset.
  • The right of setoff is legally enforceable.

In particular cases, laws of certain countries, including some bankruptcy laws, may impose restrictions or prohibitions against the right of setoff. Furthermore, when maturities differ, only the party with the nearest maturity can offset because the party with the longer maturity must settle in the manner determined by the earlier maturity party.

Final Notes On Classifying Assets and Liabilities Under IAS 1

The distinction between current and noncurrent liquid assets generally rests upon both the ability and the intent of the entity to realize or not to realize cash for the assets within the traditional one-year concept.

Intent is not of similar significance with regard to the classification of liabilities, however, because the creditor has the legal right to demand satisfaction of a currently due obligation, and even an expression of intent not to exercise that right does not diminish the entity’s burden should there be a change in the creditor’s intention.

Thus, whereas an entity can control its use of current assets, it is limited by its contractual obligations with regard to current liabilities, and accordingly, accounting for current liabilities (subject to the two exceptions noted above) is based on legal terms, not expressions of intent.

Does a Services Company Include Cost of Goods Sold On the Income Statements?

Hi, I am a small business that provides clients with computer repair services; do I need to include cost of goods sold on my income statement?” I know it sounds obvious but, can be tricky for starters and non-accountants. I fact, people still asks—in the forums, blogs and social media ponds—whether or not a services company includes cost of goods sold, since long time ago. So, I would like to address the question through this post.

Does Accounting Standard Rule Cost of Goods Sold Presentation?

Addressing accounting issues, whatever they are, first thing you want to do is seeking answer on the accounting standard (US/Local-GAAP or IFRS.) Unfortunately, you won’t find any procedures for cost of goods sold, on the standard. Why?

Because the standard rules Financial Accounting only—it does not address management nor cost accounting issues. And cost of goods sold is fallen under the Cost Accounting area.

IAS 1 requires an entity to, at minimum, present “cost of sales” (= another expression for “cost of goods sold”) on its income statement, separated from the operation expenses, without any further details about:

  • how cost of goods sold should be presented;
  • what items should be included on the category;
  • how it is calculated;  and
  • whether or not a service company has to present cost of goods sold

That said, cost of goods sold presentation, in detail, is under the management discretion. It makes sense since Cost of Goods Sold, in detail, is more often used for internal rather than external analyses.

What is Cost of Goods Sold, How Is It Determined?

Cost of Goods Sold is the cost of the inventory items sold during the period.” (IAS 1)

In the case of a merchandising company, COGS is computed this way:

Inventory Beginning Balance            = xxx
Plus: Net purchases                               = xxx
Cost of Goods Available for Sale       = xxx
Minus: Inventory Ending Balance   = (xxx)
Cost of Goods Sold                                  = xxx

Net Purchase = purchases + freight-in – less discounts – returns – allowances

Determination of COGS in a manufacturing company is little bit different: to arrive at cost of goods available for sale, “Cost of Goods Manufactured” is added to the beginning inventory balance. And to arrive at cost of goods sold, the ending finished goods inventory balance is then deducted from the cost of goods available. Here how COGS, in manufacturing businesses, is calculated:

FG inventory beginning balance                    = xxx
Plus: Cost of goods manufactured       = xxx
Cost of goods available for sale                       = xxx
Minus: FG inventory ending balance            = (xxx)
Cost of goods sold                                                 = xxx

While “Cost of Goods Manufactured” is calculated as follows:

Beginning direct materials inventory balance           = xxx
Net purchases of materials                                                 = xxx
Total direct materials available for manufacturing = xxx
Direct materials inventory ending balance                = (xxx)
Direct materials used                                                           = xxx
Direct labor                                                                              = xxx

Factory overhead:
Depreciation of factory equipment = xxx
Utilities                                                        = xxx
Indirect factory labor                           = xxx
Indirect materials                                   = xxx
Other overhead items                           = xxx
Factory overhead                                                                  = xxx
Manufacturing cost incurred                                            = xxx
Plus: Work in process beginning balance                     = xxx
Minus: Work in process ending balance                       = (xxx)
Cost of goods manufactured                                              = xxx

But those are for merchandising and manufacturing companies. What is it in the case of a services company? Read on…

Common Misconception: a Services Company Has No Inventory

I often find misconception suggesting that, any services company definitely has no inventory. That is true in the case of a company ‘purely’ sell services but, how many businesses, today, does stay a live by selling services only? Not many.

  • A computer repairer is a good example. Is it a services business? Yes but, it sells its clients computer spare parts and peripherals, occasionally, in addition to the computer repair services. So it has inventory.
  • An airline company is another good example. Airline companies sell air transportation services as their main business but, they also sell merchandises such as: gift and souvenir items—in wide range of selection—to their passengers. So airline companies also have inventory.
  • Next is hotel. Hotels sell accommodation services (room and its facilities) but, they also sell foods, beverages, to snacks (in the mini-bar unit installed on each room). So a hotel is a services company but usually has inventory.

Therefore, assuming services companies have no inventory, without having a look at their revenue sources, is premature and could lead to mistakes. For a services company that sells merchandises, in addition to services, cost of good sold should be included on its income statement.

How about a services business ‘purely’ sells services (no merchandise at all)?” You may ask.

Incase if you haven’t heard about it yet, let me introduce you with “Cost of Services” or “Cost of Revenue” that can be seen as the “cost of goods sold” of companies sell pure services.

Cost of Services (Cost of Revenue) for Services Business

A pure services business—such as accounting firms, law firms, business appraisers and the like—of course, does not accumulate cost of goods sold, since they don’t sell goods but, it accumulates typical costs to proceed and deliver services to the clients.

The costs incurred to deliver services to the clients, in a services company, are accumulated and included in a group of costs called “Cost of Services.” In the case of such costs that are in an ongoing contract services (e.g. a contractor that implement completion contract method,) it is called “Cost of Revenue”.

What expenditures are included in the cost of services?

Here are expenses, commonly included in the cost of services:

  • Sales commissions
  • Wages for part timer or freelancers that work to deliver the services
  • Fees for professionals paid by projects
  • Transportation cost to deliver the services
  • Rental cost for equipment and tools that occurs only when services is sold

Depending on type services sold, expenditures included to the cost of services vary from a services company to another. A good way to determine whether or not an expense should be included in the ‘cost of services’, is by asking yourself one of the following questions:

Does this expense occur ONLY when services are sold?” If the answer is “YES,” you would then include the expense in the cost of services, and vice versa.


Does this expense up-and-down as the sales up-and-down too?” If the answer is “YES,” include the expense in the cost of services, and vice-versa.

[box type=”note”]

Summing Up

Cost of good sold, according to IAS 1, is the cost of the inventory items sold during the period.

The accounting standard (IAS 1) requires that an entity should, at minimum, present “cost of sales” on its income statement, separated from the operation expenses. However, it does not address cost of goods sold in detail—thus is on the management discretion, as long as it helps the financial statement’s users with reliable and relevant information.

In the case of a services business that sells merchandises, in addition to services, it would need to present cost of goods sold on its income statement. But in the case of a services business that sells services only, it would present Cost of Services or Cost of Revenues, instead.[/box]

What Are Major Functions of Internal Audit Workpapers?

Internal audit workpapers can be seen as a “link” between actual internal audit procedures and the reports issued as results of an internal audit process, created to fit particular internal audit tasks, have to support and document the purposes and activities of an internal auditor, regardless of their specific form. But that is the short story.

This post discusses major functions of internal audit workpapers. Before going into the topic, let us have a look, first, at a short-summarized process of an internal audit. Read on…

How Does An Internal Audit Process Work?

Internal auditing is an objective-directed process of reviewing selected business documentation as well as interviewing members of the enterprise to gather information about an activity to support an audit objective.

In short, an internal auditor examines those materials and information gathered from interviews to determine if:

  • the objectives of the audit are being met; and
  • whether or not appropriate standards and procedures are being followed.

Based on the evaluation, the internal auditor forms an audit conclusion and opinion that is reported to the management of the organization.

The conclusion and opinion—usually in the form of audit findings and recommendations published in an internal audit report—should be supported by legitimate and strong and well-documented audit evidences, popularly known as “the evidential matter”, which are essentially series of internal audit workpapers.

The audit evidence, documented in the auditor’s workpapers, must be sufficient to support the internal auditor’s report. These form the documented record of who performed the audit and who reviewed the work, as well.

Major Functions of the Internal Audit Workpapers

Other than for internal management reporting purpose, the internal audit workpapers maybe—in some situations—submitted to some legal institutions, regulatory authorities, or governments, through court orders, as supporting evidence.

The major functions of auditor workpapers include:

Function#1. As Basis for planning Of an Internal Audit

Workpapers from a prior audit provide an auditor with background information for conducting a current review in the same overall area. They may contain descriptions of the entity, evaluations of internal control, time budgets, audit programs used, and other results of past audit work.

Function#2. As Record of Audit-Work Performed

Workpapers describe the current audit work performed and also provide a reference to an established audit program. Even if the audit is of a special nature, such as a fraud investigation where there may not be a formal audit program, a record should be kept of the auditing work carried out. This workpaper record should include a description of activities reviewed, copies of representative documents, the extent of the audit coverage, and the results obtained.

Function#3. Use During the Audit

In many instances, the workpapers play a direct role in carrying out the specific audit effort. A flowchart might be prepared and then used to provide guidance for a further review of the actual activities in some process. Each of these elements would have been included in the workpapers in a previous audit step.

Function#4. As Description of Situations of Special Interest

As the audit work is carried out, situations may occur that have special significance in such areas as compliance with established policies and procedures, accuracy, efficiency, personnel performance, or potential cost savings.

Function#5. As Support for Specific Audit Conclusions

The final product of most internal audits is a formal audit report, containing audit findings and recommendations. The documentation supporting the findings may be actual evidence, such as a copy of a PO lacking a required signature, or derived evidence, such as the output report from a computer-assisted procedure against a data file or notes from an interview. The workpapers should provide sufficient evidential matter to support the specific audit findings that would be included in an audit report.

Functions#6. As Reference Source

Workpapers can answer additional questions raised by management or by external auditors. Such questions may be in connection with a particular audit report finding or its recommendation, or they may relate to other inquiries. For example, management may ask internal audit if a reported problem also exists at another location that is not part of the current audit. The workpapers from that review may provide the answer. Workpapers also provide basic background materials that may be applicable to future audits of the particular entity or activity.

Functions#7. For Audit Coordination

An internal auditor may exchange workpapers with external auditors, each relying on the other’s work. In addition, government auditors, in their regulatory reviews of internal controls, may request to examine the internal auditor’s workpapers.

Internal audit workpapers acts as principal record of an internal audit work performed but, overall, these are to document that an adequate audit was conducted following professional standards.

How Transfer Pricing Techniques Improve Profitability

There are five transfer pricing techniques a corporation can choose from to improve profitability of not only business unit level, but the corporate-wide level. Each of the technique has strengths and weaknesses that, any incorrect transfer pricing can cause considerable dysfunctional purchasing behavior and could suffer profitability on corporate-wide level—thus selecting the most suitable transfer pricing techniques is critical.

First, here s a quick comparison of the five transfer pricing techniques, each shows four variables: profitability enhancement, performance review process required, ease of use and common problems.


Five Transfer Pricing Techniques Summarized

A comparison of five transfer pricing methods can be summarized as follows:

1. Market Pricing

  • Profitability Enhancement: Creates highest level of profits for entire company.
  • Performance Review: Creates profits centers for all divisions.
  • Ease of Use: Simple applicability.
  • Problems: Market prices not always available; may not be large enough external market; does not reflect slight reduced internal selling costs; selling divisions may deny sales to other divisions in favor of outside sales.

2. Adjusted Market Pricing

  • Profitability Enhancement: Creates highest level of profits for entire company.
  • Performance Review: Creates profits centers for all divisions.
  • Ease of Use: Requires negotiation to determine reductions from, market price.
  • Problems: Possible arguments over size of reductions; may need headquarters’ intervention.

3. Negotiated Prices

  • Profitability Enhancement: Less optimal result than market-based pricing, especially if negotiated prices vary substantially from the market.
  • Performance Review: May reflect manager negotiating skills more than division performance.
  • Ease of Use: Easy to understand but requires substantial preparation for negotiations.
  • Problems: May result in better deals for divisions if they buy or sell outside the company; negotiations are time consuming; may require headquarters’ intervention.

4. Contribution Margins

  • Profitability Enhancement: Allocates final profits among cost centers; divisions tend to work together to achieve large profit
  • Performance Review: Allows for some basis of measurement based on profits, where cost center performance is only other alternative.
  • Ease of Use: Can be difficult to calculate if many divisions involved.
  • Problems: A division can increase its share of the profit margin by increasing its costs; a cost reduction by one division must be shared among all divisions; requires headquarters’ involvement.

5. Cost Plus

  • Profitability Enhancement: May result in profit buildup problem, so that division selling externally has no incentive to do so.
  • Performance Review: Poor for performance evaluation, since will earn a profit no matter what cost is incurred.
  • Ease of Use: Easy to calculate profit add-on.
  • Problems: Margins assigned do not equate to market-driven profit margins; no incentive to reduce costs.


This post further discusses each of the transfer pricing techniques in greater details and provides guidance on how to make use of each technique—and improve profitability on the corporate-wide level, instead of department-or-business unit level. But let us start with the basic first. Read on…

What is Transfer Pricing, When Is It Important?

Simply put, transfer pricing is a task of determining prices at which products (or could be components) will be sold between divisions (or department or business units) in a corporation. It is most common in vertically integrated companies, where each division in succession produces a component that is a necessary part of the product being created by the next division in line.

So, if an organization sells its own products internally—from one division to another—then transfer pricing is important.

Next, let us take a look at each transfer pricing techniques and how each technique can be used to improve profitability in the corporate-wide level.

Technique#1. Using External Market Price

Using external market price as transfer pricing technique is the most common. Under this approach, the selling division matches its transfer price to the current market rate. By doing so, a company can achieve four goals:

  • Goal#1. Maximize profits – A company can achieve the highest possible corporate-wide profit. This happens because the selling division can earn just as much profit by selling all of its production outside of the company as it can by doing so internally—there is no reason for using a transfer price that results in incorrect behavior of either selling externally at an excessively low price or selling internally when a better deal could have been obtained by selling externally.
  • Goal#2. Profit center structure – Using the market price allows a division to earn a profit on its sales, no matter whether it sells internally or externally. By avoiding all transfers at cost, the senior management group can structure its divisions as profit centers, thereby allowing it to determine the performance of each division manager.
  • Goal#3. Simplified information sources – The market price is simple to obtain—it can be taken from regulated price sheets, posted prices, or quoted prices, and applied directly to all sales. No complicated calculations are required, and arguments over the correct price to charge between divisions are kept to a minimum.
  • Goal#4. Outside shopping – A market-based transfer price allows both buying and selling divisions to shop anywhere they want to buy or sell their products. For example, a buying division will be indifferent as to where it obtains its supplies, for it can buy them at the same price, whether that source is a fellow company division or not. This leads to a minimum of incorrect buying and selling behavior that would otherwise be driven by transfer prices that do not reflect market conditions.

However, market prices are not always available. This happens when the products being transferred do not exactly match those sold on the market, or if they are intermediate- level products that have not yet been converted into final products, so there is no market price available for them.

Another problem with market-based pricing is that there must truly be an alternative for a selling division to sell its entire production externally. This is a common problem for specialty products, where the number of potential buyers is small, and their annual buying needs are limited in size. A final issue is that market-based pricing can drive divisions to sell their production outside of the company.

Technique#2. Using Adjusted Market Pricing

Adjusted market pricing involves price setting in order to simplify transfer prices and adjust for the absence of sales-related costs. For example, if market prices vary considerably by the unit volume ordered, there may be a broad range of transfer prices in use, which can be very complicated to track.

A single adjusted market price can be used instead, which is based on the average shipment or order size. If a buying division turns out to have purchased in significantly different quantities from the ones that were assumed at the time prices were set, a company can retroactively adjust transfer prices at the end of the year; or it can leave the pricing alone and let the divisions do a better job of planning their inter-divisional transfer volumes in the next year.

As another example, there should be no bad debts when selling between divisions, as opposed to the occasional losses incurred when dealing with outside firms; accordingly, this cost can be deducted from the transfer price.

The same argument can be made for the sales staff, whose services are presumably not required for interdepartmental sales. However, these price adjustments are subject to negotiation, so more aggressive division managers are more likely to resist reductions from their market-based prices while those managing the buying divisions will push hard for excessively large price deductions. The result may be pricing anomalies that do not yield the optimum profit for the company as a whole.

Technique#3. Using Negotiated Transfer Prices

The managers of buying and selling divisions can negotiate a transfer price between themselves, using a product’s variable cost as the lower boundary of an acceptable negotiated price and the market price (if one is available) as the upper boundary. The price that is agreed on, as long as it falls between these two boundaries, should give some profit to each division, with more profit going to the division with better negotiating skills.

The method has the advantage of allowing division managers to operate their businesses in a more independent manner, not relying on preset pricing. It also results in better performance evaluations for those managers with greater negotiation skills.

However, it also suffers from these flaws:

  • Sub-optimal behavior – If the negotiated price excessively favors one division over another, the losing division will search outside the company for a better deal on the open market and will direct its sales and purchases in that direction; this may result in sub-optimal company-wide profitability levels.
  • Negotiation time – The negotiation process can take up a substantial proportion of a manager’s time, not leaving enough for other management activities. This is a particular problem if prices require constant renegotiation.
  • Brokered deals – Interdivisional conflicts over negotiated prices can become so severe that the problem is kicked up corporate headquarters, which must step in and set prices that the divisions are incapable of determining by themselves.

For all these reasons, the negotiated transfer price is a method that is generally relegated to special or low-volume pricing situations.

Technique#4. Using Contribution Margin

What if there is no market price at all for a product? A company then has no basis for creating a transfer price from any external source of information, so it must use internal information instead.

One approach is to create transfer prices based on a product’s contribution margin. Under this pricing system, a company determines the total contribution margin earned after a product is sold externally and allocates this margin back to each division, based on their respective proportions of the total product cost.

There are several good reasons for using this approach, which:

  • Converts a cost center into a profit center – By using this method to assign profits to internal product sales, divisional managers are forced to pay stricter attention to their profitability, which helps the overall profitability of the organization.
  • Encourages divisions to work together – When every supplying division shares in the margin when a product is sold, it stands to reason that it will be much more eager to work together to achieve profitable sales rather than bickering over the transfer prices to be charged internally. Also, any profit improvements that can be brought about only by changes that span several divisions are much more likely to receive general approval and cooperation under this pricing method, since the changes will increase profits for all divisions. These arguments make the contribution margin approach popular as a secondary transfer pricing method, after the market price approach.

Despite its useful attributes, there are a number of issues with it that a company must guard against in order to avoid behavior by divisions that will lead to less-than optimal overall levels of profitability. The contribution margin approach:

  • Can increase assigned profits by increasing costs – When the contribution margin is assigned based on a division’s relative proportion of total product costs, the divisions will realize that they will receive a greater share of the profits if they can increase their overall proportion of costs.
  • Must share cost reductions – If a division finds a way to reduce its costs, it will receive an increased share of the resulting profits that is in proportion to its share of the total contribution margin distributed. For example, if Division A’s costs are 20% of a product’s total costs and Division B’s share is 80%, then 80% of a $1 cost reduction achieved by Division A will be allocated to Division B, even though it has done nothing to deserve the increase in margin.
  • Requires the involvement of the corporate headquarters staff – The contribution margin allocation must be calculated by somebody, and since the divisions all have a profit motive to skew the allocation in their favor, the only party left that can make the allocation is the headquarters staff. This may increase the cost of corporate overhead.
  • Results in arguments – When costs and profits can be skewed by the system, there will inevitably be arguments between the buying and selling divisions, which the corporate headquarters team may have to mediate. These issues detract from an organization’s focus on profitability.

The contribution margin approach is not a perfect one, but it does give companies a reasonably understandable and workable method for determining transfer prices. It has more problems than market-based pricing but can be used as an alternative or as the primary approach if there is no way to obtain market pricing for transferred products.

Technique#5. Using Cost-Plus Method

The cost-plus approach is an alternative when there is no market from which to determine a transfer price. This method is based on its name—just accumulate a product’s full cost and add a standard margin percentage to the cost; this is the transfer price. This approach has the singular advantage of being very easy to understand and calculate, and can convert a cost center into a profit center, which may be useful for evaluating the performance of a division manager.

The cost-plus method’s flaw is that the margin percentage added to a product’s full cost may have no relationship to the margin that would actually be used if the product were to be sold externally. If a number of successive divisions were to add a standard margin to their products, the price paid by the final division in line—the one that must sell the completed product externally—may be so high that there is no room for its own margin, which gives it no incentive to sell the product. Because of this issue, the cost-plus method is not recommended in most situations.

Words of Caution

A company must set its transfer prices at levels that will result in the highest possible levels of profits, not for individual divisions but rather for the entire organization. Otherwise a division may enjoy maximum profit while the corporate-wide level does not.

For example, if a transfer price is set at a product’s cost, the selling division would rather not sell the product at all, even though the buying division can sell it externally for a profit that more than makes up for the lack of profit experienced by the division that originally sold it the product. The typical division manager will select the product sales that result in the highest level of profit only for his or her division, since the manager has no insight (or interest) in the financial results of the rest of the organization.

Only by finding some way for the selling division to also realize a profit will a company have an incentive to sell its products internally, thereby resulting in greater overall profits.

An example of such a solution is when a selling division creates a by-product that it cannot sell but that another division can use as an input for the products it manufactures. The selling division scraps the by-product, because it has no incentive to do anything else with it. However, by assigning the selling division a small profit on sale of the byproduct, it now has an incentive to ship it to the buying division. Such a pricing strategy assists a company in deriving the greatest possible profit from all of its activities.

Another factor is that the amount of profit allocated to a division through the transfer pricing method used will impact its reported level of profitability—therefore the performance review for that division and its management team.

If the management team is compensated in large part through performance-based bonuses, its actions will be heavily influenced by the profit it can earn on inter-company transfers. For example, an excessively low transfer price will result in low production priority for that item, as long as the selling division has some other product available that it can sell for a greater profit.

Finally, altering the transfer price used can have a dramatic impact on the amount of income taxes a company pays, if it has divisions located in different countries that use different tax rates.

Companies that are frequent users of transfer pricing must create prices that are based on a proper balance of the goals of overall company profitability, divisional performance evaluation, and (in some cases) the reduction of income taxes. The attainment of all these goals by using a single transfer pricing method should not be expected. Instead, focus on the attainment of the most critical goals, while keeping the adverse affects of not meeting other goals at a minimum. This process may result in the use of several transfer pricing methods, depending on the circumstances surrounding each inter-divisional transfer.

Seven Internal Audit Core Competencies Auditors Should Have

Internal audit role, performed by internal auditors, requires core competencies. This post lists seven internal audit core competencies internal auditors should have—beyond internal audit standards—for planning and performing effective internal audits.

I, in this post, do not aim to explain how an internal auditor should conduct data analyses for example, but would give you solid knowledge about core competencies an internal auditor should has—as many of you may aspire to be come one, in the near future.

Also, I hope, this post can be a friendly reminder to fellow internal auditors of subjects that are professionally important to the practice of today’s internal auditing.

Importance of Internal Audit Key Competencies

What competencies are essential to be a successful internal auditor?” You may ask—as others asked me through email (Sorry I can’t personally reply you one-by-one).

The answer to the question is: There are many. And they include having attained at least a four-year college degree in the area of Financial Accounting, Management Accounting, Financial Management and Operational Management—that will give the new auditor an understanding of the importance of business processes as well as the ability to observe areas of operations and to describe them through written and verbal approaches.

More important and even more fundamentally, though, an internal auditor must have strong personal ethics and a work-related commitment. That is, when sent to some location to perform a review, the internal auditor must maintain a professional attitude and conduct his or her work in an honest and ethical manner. These things are really fundamental and necessary to build a set of internal auditor key competencies.

As I have mentioned on the preface, internal audit core competencies are essential skill to conduct effective internal audits—thus are indispensable. While some professionals may look at the selections differently, adding or deleting some, my personal recommendation for internal audit key competencies includes the followings.

Core Competency#1. Internal Auditor Interview Skills

Internal auditor interviews with members of auditee management and staff are an important first step in the internal audit process. As a key part of these interview skills, the assigned in-charge internal auditor then meets with designated members of the auditee organization for an initial internal audit interview.

That initial interview and all others that follow are key steps in the internal audit process. They are valuable first steps to launch an internal audit and to gather information, but a poorly prepared or organized auditee interview can throw the internal audit so off that it may be difficult to complete the audit as planned.

All internal audit interview meetings, whether with auditee management or team associates, should be based on some internal audit planning and preparation before launching the meeting.

Once an auditee interview has been scheduled, the auditor should begin to focus on interview preparation. An internal auditor should never be fooled into thinking that she can simply walk into an auditee interview and inform them of the planned audit. An internal auditor’s goal must be to demonstrate the objectives of the planned review and his or her knowledge and qualifications for the planned internal audit. Adequate preparation is key.

The next snippet is a list outlining issues to consider when launching a new internal audit in some area that may have been reviewed in a past period. The list has been prepared with assumption that management on both sides is new participants in this review, and thus introductions and explanations all around are necessary.

Internal Auditor Preliminary Auditee Interview Checklist

1. After introductions all around, internal audit should outline the timing and objectives of the planned internal audit.

2. Introduce internal auditors who will be doing actual review as well as expected auditee participants.

3. If this is the first planned audit in this area or if there have been significant changes since the last review, arrange for a walk-through of the operations area to be reviewed.

4. If there had been a past internal audit in this area, check on the status of past findings and recommendations as well as any system changes since.

5. Outline the planned timing of the audit review steps.

6. Request or make arrangements to audit materials, including:

  • Access rights to files and IT systems resources
  • Temporary passwords, access right to key files, and physical libraries
  • Internal audit working space and telecommunication connections
  • Plant parking, guard desk badges, and other facility access issues

7. For extended time period reviews, schedule periodic status meetings.

8. Schedule tentative planned audit completion as well as preliminary wrap-up meetings.

9. Make arrangements for resources available to resolve any questions or problems during the course of the review.

10. Explain the expected internal audit process, including any planned draft report, expected response times to audit recommendations, and delivery of the final report.

11. Throughout the interview and certainly here, allow sufficient time for questions.

12. Follow-up interview with a detailed summary memo outlining the potential audit timing and any matters yet to be resolved.

Internal auditors will be involved with auditee and other management group meetings or interviews on a regular, ongoing basis. These meetings are the contact points to launch new internal audits as well as to review the status and continuing progress of ongoing internal audits.

Such meetings are generally not formal. Often they involve an internal auditor just meeting a manager at a nearby office desk or in a canteen over coffee. The real skill and competency need here is that an internal auditor should carefully plan objectives and even expected outcomes from such sessions and should conduct them in a planned, orderly manner.

The last thing a professional internal auditor should do is to burst in on an auditee manager with no warning and just blurt out some concerns. The internal auditor’s objectives will not be met in that situation, and internal audit will lose credibility in the eyes of entity management.

Core Competency#2. Analytical Skills

According to Wikipedia, analytical skills refers to the ability to visualize, articulate, and solve complex problems and concepts and to make decisions that make sense based on available information. Such skills include demonstration of an internal auditor’s ability to apply logical thinking to gathering and analyzing information, designing and testing solutions to problems, and formulating plans.

To test for analytical skills, an internal auditor might be asked to look for inconsistencies in some production report, to put a series of events in proper order, or to critically read a project status report and identify potential errors.

An analytical review usually requires an internal auditor to review some audit evidence materials and then to use logic to pick apart a problem and come up with a solution. Internal auditors are required to use such analytical processes on a regular basis in the course of their audits. The idea is not to jump into an audit with an already assumed conclusion but to break down the elements of whatever data or series of events is being analyzed in order to reach a conclusion. This conclusion may very well not always be the one the internal auditor expected to reach.

To be truly analytical, internal auditors need to think about all of the factors involved in a situation and then evaluate pluses and minuses in order to develop a recommended solution.

Many audit decisions are fairly easy to make. For example, a voucher either is or is not approved or an account either does or does not balance. However, sometimes other decision criteria are not that clear cut. Here an internal auditor should develop establish kind of decision criteria.

Internal audit decisions should be made in a consistent, organized manner. It is for this reason that internal auditors should view analytical skills as a key competency. Too often, some professionals think of the terms analytics or analytical analysis as a detailed, mathematical-oriented process. Internal auditors should use an analytical approach to describe their use of well-documented, well-reasoned processes to arrive at decisions in their internal audit activities.

Core Competency#3. Testing and Analysis Skills

While internal auditors should develop their initial decision approaches analytically, their next challenge and a required key competency is to have the ability to test, review, and assess the materials.

As a key internal audit competency, testing or sampling should be viewed in a broader perspective. For example, the next snippet describes some alternative audit testing approaches.

Audit Testing Approaches

  • Physical Observation – Testing approach is used for processes that are difficult to formally document or control. For example, stockroom cleanliness or customer service practices are important to the entity’s image but usually are not formally controlled. These factors can be especially important to organizational success when considered in broader contexts, such as assessments of employee morale or the professional tone of an office. Because these areas are somewhat subjective, developing internal audit recommendations can be difficult.

  • Independent Evaluations – Audit confirmations are an example of independent confirmations. While this technique is more common with external auditors, internal auditors sometimes find it useful as well. For example, confirmation letters can be sent to the entity’s vendors to verify their compliance with some matter.

  • Compliance Tests – Compliance testing helps determine whether controls are functioning as intended. When conducting compliance tests, internal auditors often use one broad sample to test several items concurrently. However, multiple samples are sometimes very effective. As an example, for disbursement testing, an auditor can use one sample to test documentation and approval of disbursements, another to assess contract approvals and agreement to payments, and a third to test personal reimbursements. Such targeted tests can yield much clearer results than using one sample to test all three items.

  • Exception or Deficiency Testing – If a reporting system shows deficient performance, exceptions can be reviewed in detail to understand root causes and determine possible resolutions. Many process improvements require coordination with other departments or persons involved in the process; internal audit involvement in deficiency resolution frequently facilitates such coordination.

  • Accuracy Testing – Tests for accuracy help determine whether a reviewed processes are measuring or assessing the right things and calculating results correctly. Much of today’s reporting contains significant black box elements, where the underlying calculations are embedded in computer programs and intermediate files. By using CAATT procedures and gaining an understanding of the reporting objectives, internal auditors can effectively verify systems reporting accuracy.

On the first point of the above list, “Physical Observation,” is often not thought of in terms of the concept of testing. But if an analytical approach, with established review and acceptance criteria, is used to organize an observation-based testing process, organized physical observations can be viewed as a valid testing process as well.

No matter what method is selected, internal auditors should always take appropriate steps to make certain that the samples they are testing are representative of the overall population they are analyzing.

A related requirement for this key internal audit competency is the analysis of the test results. Once an internal auditor has selected a sample and performed an internal audit test, the results should be analyzed. Having performed a sample per the established audit objectives, an internal auditor should review results for any possible errors detected in the sample to determine whether they are actually errors and, if appropriate, the nature and cause of the errors.

For those that are assessed as errors, the errors should be projected as appropriate to the population, if a statistically based sampling method is used. Any possible errors detected in the sample should be reviewed to determine whether they actually are errors. Internal auditors should consider the qualitative aspects of the errors, including the nature and cause of the errors and their possible effect on other phases of the audit.

Internal auditors should also realize that errors that are the result of the breakdown of an information technology process ordinarily have wider implications for error rates than human error.

Internal auditors should always take care to analyze and document their test sample results. They should devote every effort to making sure that the test results are representative of the overall population of items reviewed.

When audit results just do not “smell” right, as sometimes happens, an internal auditor should take any follow up procedures as necessary. However, the process of establishing audit objectives, pulling a sample of items of interest to ascertain if audit objectives are being met, and then reporting these results is a key internal audit internal audit competency.

Core Competency#4. Recommending Results and Corrective Actions

A very important role—perhaps the most important—of an internal auditor is reporting the results of audit work and developing and making strong recommendations for corrective actions, as appropriate. Internal auditors go through this exercise via their audit reports or when serving as enterprise internal consultants

In all cases, internal auditors need to have the key skills to summarize the results of audit work, to discuss what was wrong, and to develop some recommendations for effective corrective action.

While audit reports and their recommendations are often the responsibility only of senior, in-charge internal auditors or the chief audit executive, all members of the audit team should be able to describe an audit finding and to make a recommendation for improvement.

In some cases, a staff auditor will go through this exercise only as part of a workpaper note, but all internal auditors should think of much of their audit work in terms of these questions:

  • What were the objectives of this audit or exercise?
  • What was found?
  • Why were those audit findings incorrect or not in compliance?
  • What can be done to correct this error or control breakdown?
  • What are internal audit’s recommendations for corrective action?

This process is very much part of internal auditing. Internal auditors at all levels should develop competencies to think of much of their work along those lines. Of course, it is always important for internal auditors to answer these questions clearly and simply enough that recipients can understand the issue and the nature of the suggested corrective action.

Reviewing evidence and making appropriate audit recommendations can become particularly difficult if the audit finding covers a complex or potentially obscure area. For example, many people will find it difficult to understand an audit finding describing an internal control weakness caused by an incorrect setting in an IT operating system software. Using analogies or other mechanisms, internal auditors should strive to prepare findings and recommendations in a manner that they can be easily understood.

Core Competency#5. Internal Auditor Communication Skills

The preparation of effective internal audit reports, with meaningful findings and recommendations, is a very important competency area for all internal auditors. Internal auditors at all levels should develop the skills to discuss and present audit findings and the related internal audit recommendations. These communications can take place in the workplace at all levels.

Internal auditors typically receive, review, and have access to a large amount of potentially confidential information. For that reason, it is very important that strong security controls be placed over all internal audit files and any retained data. However, internal auditors at all levels should develop the skills and ability to communicate with others in the entity about their work as appropriate and to help others to understand the value of internal auditing.

Whether presenting the results of an internal audit to local management or dealing with others on a day-to-day basis, all internal auditors should develop strong communication skills. This is another internal audit key competency.

Core Competency#6. Internal Auditor Negotiation Skills

If you ever thought of negotiation skill as an essential skill to marketing people, that is not wrong at all but, also not true all the ways. The truth is that negotiation is something that we do all the time, not only for business or internal audit purposes.

In general, negotiation is usually as a compromise method to settle an argument or issue. Internal auditors should communicate in order to negotiate issues/arguments as they often encounter differences of opinion during a review. Auditors can sometimes be wrong, but they always need to have the background and support to explain a proposed audit finding.

Whether it concerns recommendations developed in an audit report or while reviewing audit evidence on the shop floor, internal auditors will encounter many areas where management and others will disagree with their assumptions or potential findings.

Internal auditors at all levels should learn negotiation skills as they complete audit reports and prepare recommendations. Internal auditors should recognize that any type of audit finding, no matter how seemingly inconsequential, may be viewed as a criticism by auditee management.

Sometimes an internal auditor will encounter a situation where auditee management wants to fight internal audit on every point, no matter how trivial or how solid the audit finding. Internal auditors should develop skills to negotiate and compromise on some items or areas but should always reserve the right to say that something is wrong and needs to be reported.

If the auditee disagrees, it can be covered in the responses to the audit report and interactions with the audit committee if necessary. As a cautionary note, when an internal auditor agrees to modify a suggested recommendation or even drop an audit finding, the matter should always be documented in as much detail as possible and with an emphasis on why the internal auditor decided to change the disputed matter.

Core Competency#7. Internal Auditor Documentation Skills

Internal auditors have a major challenge in preparing meaningful and helpful documentation covering all of their work, whether informal notes from a meeting, to audit workpapers, to the final issued audit report. Internal auditors have an ongoing need to develop strong audit work documentation skills.

The next snippet contains some best practice standards for documentation. Internal auditors should always keep in mind that their documentation, at all levels, may be subject to other reviews or disclosures.

Internal Audit Documentation Best Practices

Best practices for increasing the quality of internal audit documentation:

A. Writing Narratives and Descriptions:

  • Describe all work in a narrative fashion such that an outsider can review some materials here and understand the activities or processes.
  • Document the audit concepts observed or performed but do not describe assumptions or speculative ideas.
  • Generate systems-related documentation with use of hyperlinks where appropriate.

B. Simplification:

  • Keep documentation just simple enough but not too simple—this is often an internal audit challenge.
  • Write the fewest documents with least overlap.
  • Put information in the most appropriate places—that is, allow the reader quickly to grasp the main elements of a documentation package without having to go through multiple addendums.
  • Display key information publicly by including summaries and brief descriptions where appropriate.
  • Use a whiteboard or internal Web site—whatever is necessary to promote the transfer of information and thus communication.

C. Determining What to Document:

  • Document with a purpose. For example, documentation describing test results will have a whole different focus and content from material designed for the audit staff.
  • Focus on the needs of the actual intended users(s) of the documentation who would determine its sufficiency.

D. Determining When to Document:

  • Iterate, iterate, iterate. Take evolutionary (iterative and incremental) approaches to gain feedback for materials under.
  • Find better ways to communicate, recognizing that documentation supports knowledge transfer but it is only one of several options available.
  • Keep documentation current. Materials that are not kept up to date are of little value to most users.
  • Update documentation regularly but only when it hurts. That is, documentation preparation resources must be balanced with other key internal audit activities.

E. In General:

  • Always recognize that documentation is a requirement. It should not be postponed as a “when time is available” activity.
  • Require users to justify documentation requests. Check-out and back-in processes should be established.
  • Build a recognition throughout internal audit of the need for strong supporting documentation.
  • Provide documentation preparation training to all members of the internal audit team

Whether it is a request from an audit committee member, external auditors, court order, or even government action, poorly prepared or inaccurate documentation could embarrass or even endanger the enterprise and professionally damage both the internal audit function and the individual internal auditor

In our electronic world of powerful word processing and database systems, that documentation sometimes can get out of hand. Perhaps every internal auditor has received a documentation-oriented word processing message, describing some area of audit interest with some supporting message attached.

Documentation becomes a challenge when that first supporting attachment has its own attachments, several of which have even more attachments, and on and on. Perhaps this type of a stream of attached documents provides the necessary and supporting information, but all too often such trails of attachments lead to ambiguities and problems.

An internal audit function should establish some best practice standards for its own internal electronic documentation. In some cases, the major office automation software tools—such as Microsoft Office—will make this easy, but in other situations, there is a need to work around vendor-supplied software.

The next snippet describes some internal audit digital documentation best practices that may help (I am using the term “computer-based” to refer to the many word processing, spreadsheet, e-mail, and other forms of electronic documentation that an internal audit function will need to support its internal audit work beyond formal workpaper binders)

Internal Audit Digital Documentation Best Practices

A substantial amount of internal audit supporting documentation and other activities takes place on computer systems, whether auditor laptops, desktop machines tied to an audit office local area network (LAN), or even on terminals connected to a central server processor.

All of those comprise the e-Office—the use of email, word processing, spreadsheet, database, graphics, and other tools. The following are some best practices that internal audit should consider when implementing an effective internal audit e-office:

  • Establish hardware and software standards – Whether internal audit is located in a more remote, developing country regions or at corporate headquarters, all members of internal audit should use the same general hardware and software product suite.
  • Use password-based security rules with regular updates – Because of the sensitive information that internal audit encounters, password controls, with requirements for frequent changes, should implemented on all systems—even auditor personal laptops.
  • Build a security awareness – All members of the audit team should be instructed in the sensitive nature of audit documents. For example, when documents are printed on a remote office printer, establish rules that the initiator must be present during the printing process. Even better, avoid printing internal audit documents at a remote location.
  • Backup, backup and backup – Strong procedures should be established for at least 100% daily backups of internal audit file folders, a rotating stream of several cycles of backups should be established.
  • Establish file revision control procedures – Through the use of file naming conventions or software system controls, conventions should be established to identify all documents with a date created and revision number.
  • Build templates and establish style protocols – All memos, audit programs, audit plans, and other key internal audit documents should be required to use the same common formats.
  • Establish e-mail style rules – While there are many needs and requirements for email messages, some general style rules should be established. In addition, define and recognize areas that should be released as controlled documents rather than e-mail messages subject to forwarding.
  • Establish e-mail attachment rules – Attached documents are an easy way to convey information, but the process can get out of hand with attachments attached to attachments and so on. Guidance rules should be established here.
  • Actively implement and monitor antivirus and firewall tools – Effective software should be installed, regularly updated, and violations monitored, as appropriate.
  • Limit personal use – Whether a laptop brought to the auditor’s home, downloaded music files, or a night school paper written in the office, personal use of e-office resources should be limited, if not prohibited.
  • Establish locks and security rules for portable machines – All auditor laptop machines should be configured with locking devices as well as guidance in their use. In addition, security audit guidance should be established for all portable machines.
  • Monitor compliance – A member of the internal audit team should periodically review and monitor compliance with auditor e-office procedures. Process and performance improvements should be installed as appropriate.

Whenever possible, these standards should be consistent with IT department standards, but the objective should always be to support the overall internal audit effort.

If all members of the internal audit team use standard practices, such as Word document revision controls, internal audit will have a greater success in controlling its own automation processes. Internal audit standards in such areas as office documentation should try to be at least as good as if not better than their enterprise’s overall standards.

Going beyond effective internal audit digital documentation described above, an internal auditor should develop strong skills and competencies in documenting every aspect of their work.

Internal Auditor’s Commitment to Learning

Some professionals probably include it into the core competencies group while others not. I would rather put it separately for a reason. Not because of it is less important compare to the described competencies but, it is the most important.

I personally (perhaps others too) would recommend that all internal auditors should develop is a strong commitment to learning beyond the 40 hours continuing education requirement for certified internal auditors.

Business and technology are always changing, as are the political and regulatory climates in which entities operate. All internal auditors should embrace this commitment to constant and ongoing learning as a very key competency.

For example, the International Financial Reporting Standards (IFRS) are becoming a substitute for the US-GAAP. International standards have been growing in acceptance around the world, country by country and region by region, with the United States as the only major holdout. Although many internal auditors probably will not need to understand the details of many of these accounting standards rules, they should at least understand their high-level impact on the reporting of financial results in the United States.

All of the outlined internal audit core competencies—including the commitment to learning—are essential to perform effective internal audits, no matter what industry, geographic area, or type of internal audit.

Three Steps to Proper Receipt of Goods Entry and Control

Receipt of goods is typical to those who work for a retailer or manufacturer. If you do too, having solid system for the task is a must. A system that ensure a proper receipt of goods entry and control is on the place. Other wise the task could become cumbersome yet results in mess inventory and accounts payable records. This post provides three steps to proper receipt of goods entry and control.

It may sound easy, the truth is not. Proper receipt of goods, in this post, means you are required to make sure about two things: (1) proper receipt of goods entry; and (2) proper control for the both inventory and accounts payable accounts. How do you perform these functions?

A big company surely has different staffs to take care of accounting treatment and internal control, separately. But if you are working for small-medium business, you will most likely end up doing both functions. Either ways, a Controller or Accounting Manager is required to make sure the purchases are correctly recorded and a sound internal control system is on the place.

Case Example

For the sake of this example, you are working for a shop that sells kids wear. So, today, a package just arrived at the front of the shop’s door, shipped by one of your supplier in China. What are you going to do with the package?

Take the following three steps:

Step#1. Perform Receipt of Goods Inspection

A package from supplier should always come with packing slip and shipping invoice—either they are attached on the package or separately delivered by the courier/shipping agent.

The packing slip contains the following information, regarding items on the package (more on s invoice a little bit later):

  • Codes of each items (be they are generic or SKU codes)
  • Description of each item
  • Specifications of each item (materials, color, sizes)
  • Quantity of each item

Your first task is to perform receipt of goods inspection—to verify each of the above information with the actual items on the package.

You may have an assistant or staff to do the task, under your supervision. In a big corporation, such task is performed by the Purchasing or Warehouse section (under the finance department). If you are a controller, overseeing and making sure the process is done correctly your responsibility.

An effective way to make sure the task done correctly and completely is by using a receipt of goods inspection work paper. If such work paper is not available, you can alternatively make a simple a check list. The staff then would need to fill the inspection work paper (or check list), as well as writing down necessary notes for any discrepancies found during the inspection, and sign the paper.

[Info_Box]Note: In the clothing businesses, buyers usually perform a quality inspection on the goods. The task is usually done by a quality assurance specialist—who has a special skill to conduct quality inspection on textiles. Big clothing retailers have quality assurance departments to make sure any merchandises received—and accepted—meets the quality standard they have.[/Info_Box]

The next task you would not forget is to communicate any discrepancies found to the seller/supplier. If a purchasing section is available then this task is also performed by a staff in the section. You may ask a replacement or discount for defects or broken merchandise. If discrepancy is happened on the quantity, then you would need to inform seller with the actual quantity—so that they can update their own record.

Step#2. Compare Shipping Invoice Vs Purchase Order

The shipping invoice also contains list of items but has unit price of each item and total value of the merchandise, without specification of each items. Other than prices, a well prepared invoice usually comes with the following information:

  • Invoice Number – This is a reference number generated by the seller, for communication purpose. You would then need to indicate/mention the number every time talking about the invoice with the seller. Most importantly is to always put the number on the bank slip when making payment for the invoice.
  • PO Number – This is usually a unique serial number that refers to the Purchase Order (PO) you (or purchasing section) issued when making the purchase.
  • Tax – Whether or not the sales tax is included on the selling price
  • Sales Term – An FOB term means you are the one who should pay the shipping, handling and clearing cost (if the shipment is covered with insurance, the insurance premium is also on your account). A C&F term means the shipping, handling and clearance cost is covered by the seller, but you still have to pay the insurance premium (if any). A CIF term means that you only need to pay the goods purchase without any additional costs.
  • Due Date – A well prepared invoice usually indicates specific due date (e.g. Due Date: October 15’ 2012). Or, at least a payment term, such as: A COD term means you have to make the payment once you receive the goods. A “Net 30 days’ means the due date is 30 days after merchandise is received.
  • Payment Instruction – A seller may require special arrangement of payment, such as: they want it to be telex transfer instead of check.

Your task on this step is to compare all of the above information to the Purchase Order (PO) you have issued (to the seller) for the merchandise. Make sure that all the above information is matched to information on the PO. You can implement the same approach as you do on the first task. Do not forget, though, to communicate any discrepancies to the seller.

Step#3. Record Receipt of Goods and Accounts Payable

Unless the goods (in the package) are completely returned to the seller, the next task is to record receipt of goods and accounts payable at whatever quantity is acceptable, by referring to the first and second steps above.

For the sake of making the step sound practical, let us assume that 10 of 500 pcs kids jacket, on the package, come with defect. Unit price of the jacket is $9. The shipment is covered with insurance premium of 1% of amount on the invoice. The purchase term according to the PO and invoice is an FOB, so you’re the one who will pay all cost related to the delivery of $260. For simplification, we don’t involve sales tax.

Ho will you record the receipt goods?

It depends on whether or not you accept the 10 pcs jacket with defects:

(a) If you accept the defected goods, then you will make the following entry:

[Debit]. Inventory – Finished Goods = $4500 (=500 pcs x $9)
[Debit]. Inventory – Shipping = $260
[Debit]. Inventory – Insurance Coverage = $45 (=1% x $4500)
[Credit]. Accounts Payable – SunCo China = $4500
[Credit]. Accounts Payable – UPS = $260
[Credit]. Accounts Payable – Insurance Provide = $45

Note: As you can see on the above entry, all of related costs to the delivery of the goods are added up to the inventory accounts—thus increase the inventory value).

(b) If you decide to return the defected goods, you will only record receipt of goods as whatever you accept:

[Debit]. Inventory – Finished Goods = $4410 (=490 pcs x $9)
[Debit]. Inventory – Shipping = $260
[Debit]. Inventory – Insurance Coverage = $45 (=1% x $4500)
[Credit]. Accounts Payable – SunCo China = $4410
[Credit]. Accounts Payable – UPS = $260
[Credit]. Accounts Payable – Insurance Provide = $45

Note: Despite of any return merchandise you make, the shipping cost and insurance premium remain the same.

(c) Instead of returning the defected jackets, you may ask for a 10% discount for example, and the seller confirmed to give the discount. Here is the entry you will make:

[Debit]. Inventory – Finished Goods = $4500 (=500 pcs x $9)
[Debit]. Inventory – Shipping = $260
[Debit]. Inventory – Insurance Coverage = $45 (=1% x $4500)
[Credit]. Inventory – Discount on Defect FG = $9 (=10% x (10pcs x $9))
[Credit]. Accounts Payable – SunCo China = $4491
[Credit]. Accounts Payable – UPS = $260
[Credit]. Accounts Payable – Insurance Provide = $45

Alternatively, you can make the following entry—which results in the same inventory value and accounts payable:

[Debit]. Inventory – Finished Goods = $4410 (=490 pcs x $9)
[Debit]. Inventory – Finished Goods = $81 (=(10 pcs x $9) – (10% x (10pcs x $9))
[Debit]. Inventory – Shipping = $260
[Debit]. Inventory – Insurance Coverage = $45 (=1% x $4500)
[Credit]. Accounts Payable – SunCo China = $4491
[Credit]. Accounts Payable – UPS = $260
[Credit]. Accounts Payable – Insurance Provide = $45

A Final Note

If the receipt goods inspection is conducted by others (the purchasing or warehouse staff), for proper control, you would always demand packing list slip, shipping invoice, receipt of goods inspection sheet and PO copy, bound together, as supporting documents, before and after making receipt of goods entry—to record the delivery.

In addition, you would need to make sure that all documents are properly signed off by a supervisor or manager. You won’t make receipt of goods and accounts payable entries if any of the supporting documents isn’t available or lack of signature. That way; not only proper entry has been made, but you also have performed proper control for receipt of goods.

Four Accounting Issues Related to Inventory Ownerships

Inventory accounting is an important topic with complex issues that can causes confusion even to well-experienced accountants. But in this post, I focus on the most basic issue which is often overlooked; proper inventory ownerships. There are four issues that may cause confusion about proper inventory ownership: (1) goods in transit; (2) consignment sales; (3) product financing arrangements; and (4) sales with right to return given to customers, which are discussed, with case examples, on this post.

In spite of complexities an accountant may face in recognizing-classifying-measuring company’s inventory, the only matter financial statement’s users concern about is whether or not the inventory numbers, on the balance sheet, is correct (accurate).

From the accountant point of view, the question probably is: what point in time should inventory items be included in (through purchases) and excluded of (through sales) the company’s ownership?

IAS 2 defines inventories as items that are

held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.”

In general, a company should record purchases and sales of inventory when legal title passes. For accounting purposes, it is necessary to determine when title has passed—so that you’re able to obtain an accurate measurement of inventory quantity and corresponding monetary representation of inventory and cost of goods sold in the financial statements.

If you think that everything in the company’s warehouse/storage is inventory belong to the company—thus should be recognized on company’s book—you are probably right but can be wrong too. “Why?” You may ask.

Consider these:

  • Today, a loyal customer couldn’t afford to loose the chance of buying your new hot product but she has no more space to store the product at her own shop. So, she purchased your product, eventually paid you right away, and asked you favor to not ship the product yet, until a week later. Who own the inventory?
  • Another case; you just shipped 50 pairs of hand-crochet gloves out to a store belong to your friend, today. You will get payment for any gloves sold later on and your friend get 20 percent commission of it. Who own the 50 pairs gloves?

Instead of a company owner, you are an accountant who works for the company; how would you treat such inventory situations?

Inventory Ownership Issue#1. Goods in Transit

Simply put; “goods in transit” are goods being shipped from seller to buyer at year-end.

At year-end, any goods in transit from seller to buyer may properly be includable in one, and only one, of those parties’ inventories—based on the terms and conditions of the sale.

Under traditional legal and accounting interpretation, goods are included in the inventory of the firm financially responsible for transportation costs. This responsibility may be indicated by shipping terms such as ‘free on board’ (FOB), ‘free alongside’ (FAS), ‘cost-insurance-freight’ (CIF), ‘cost-and-freight’ (C&F).

Let us talk about this one-by-one. Read on…

(a) FOB Term – The term FOB can come in two ways:

  • FOB shipping point – Transportation costs are paid by the buyer and title passes when the carrier takes possession; thus these goods are part of the buyer’s inventory while in transit.
  • FOB destination – transportation costs are paid by the seller and title does not pass until the carrier delivers the goods to the buyer; thus these goods are part of the seller’s inventory while in transit.

[Info_Box] If an FOB destination (or FOB shipping point) indicates a specific location at which title to the goods is transferred, such as “FOB California,” this means that the seller retains title and risk of loss until the goods are delivered to a common carrier in California who will act as an agent for the buyer.[/Info_Box]

(b) FAS Term – A sale transaction with FAS (free alongside) terms means the seller—who ships—must bear all expense and risk involved in delivering the goods to the dock next to (alongside) the vessel on which they are to be shipped. The buyer bears the cost of loading and of shipment; thus title passes when the carrier takes possession of the goods.

(c) CIF Term – In a CIF (cost, insurance, and freight) contract the buyer agrees to pay in a lump sum the cost of the goods, insurance costs, and freight charges. In a C&F contract, the buyer promises to pay a lump sum that includes the cost of the goods and all freight charges. In either case, the seller must deliver the goods to the carrier and pay the costs of loading; thus both title and risk of loss pass to the buyer upon delivery of the goods to the carrier.

(d) C&F Term – As same as the CIF term, except that it is without insurance premium coverage by the seller.

Keep in mind that these are meant only to define normal terms and usage; actual contractual arrangements between a given buyer and a given seller can vary widely. The accounting treatment, however, should in all cases strive to mirror the substance of the legal terms established between the parties.

For the sake of making it into more practical manner, let us construct a case example

Accounting for Goods in Transit Case Example

The Lie Dharma Apparel Inc is located in Costa Mesa, California, and obtains winter clothes from a supplier in Singapore. The delivery term is free alongside (FAS) a container ship in the harbor in Singapore, so that Lie Dharma Apparel takes legal title to the delivery once possession of the goods is taken by the carrier’s dockside employees for the purpose of loading the goods on board the ship. When the supplier delivers goods with an invoiced value of $250,000 to the wharf, it e-mails an advance shipping notice and invoice to Lie Dharma Apparel via an electronic data interchange (EDI) transaction, itemizing the contents of the delivery.

Lie Dharma’s computer system receives the EDI transmission, notes the FAS terms in the supplier file, and therefore automatically logs it into the company computer system with the following entry:

[Debit]. Inventory = $250,000
[Credit]. Accounts payable = $250,000

The goods are assigned an “In Transit” location code in Lie Dharma’s perpetual inventory system. When the clothes delivery eventually arrives at Lie Dharma’s receiving dock, the receiving staff records a change in inventory location code from “In Transit” to a code designating a physical location within the warehouse, CA for example.

[Info_Box]An overland shipping contract usually uses FOB term, since it takes such short time until the inventory is actually arrived at the buyer’s shipping dock. For such term a buyer only records inventories when inventory is received.[/Info_Box]

Inventory Ownership Issue#2. Consignment Sales

Consignment” is defined as a marketing method in which the consignor ships goods to the consignee, who acts as an agent for the consignor in selling the goods. The inventory remains the property of the consignor until sold by the consignee.

In consignments, the consignor (seller) ships goods to the consignee (buyer), which acts as the agent of the consignor in trying to sell the goods, and get payment for every merchandizes (inventories) sold. On other hand, the consignee receives a commission. In other words, the consignee “purchases” the goods simultaneously with the sale of the goods to the final customer.

Goods out on consignment are included in the inventory of the consignor and excluded from the inventory of the consignee—thus, until they are actually sold to end customers.

A disclosure may be required of the consignee, however, since common financial analytical inferences, such as days’ sales in inventory or inventory turnover, may appear distorted unless the financial statement users are informed.

Consignment Transaction Case Example

The Lie Dharma Inc ships a consignment of its kids wear clothes to a retail outlet of the Kidz Store Inc. Lie Dharma’s cost of the consigned goods is $3,700, Lie Dharma shifts the inventory cost into a separate inventory account to track the physical location of the goods. The entry follows:

[Debit]. Consignment Out Inventory – Kidz Store Inc. = $3,700
[Credit]. Finished Goods Inventory = $3,700

A third-party shipping company ships the clothes inventory from Random Gadget to Kidz Store. Upon receipt of an invoice for this $550 shipping expense, Lie Dharma charges the cost to consignment inventory with the following entry:

[Debit]. Consignment out inventory – Shipping = $550
[Credit]. Accounts payable = $550
(To record the cost of shipping goods from Lie Dharma’s warehouse to Kids Store)

Kidz Store sells half the consigned inventory during the month for $2,750 in credit card payments, and earns a 22% commission on these sales, totaling $605. According to the consignment arrangement, Lie Dharma must also reimburse Kidz Store for the 2% credit card processing fee, which is $55 (=$2,750 × 2%).

The results of the sale, on Lie Dharma’s book, are summarized as follows:

Sales price to Kidz Store’s customer earned on behalf of Lie Dharma = $2,750

Less: Amounts due to Kidz Store in accordance with arrangement 22% sales commission = $605

Less Reimbursement for credit card processing fee = $55

Due to Lie Dharma = $2,090

Upon receipt of the monthly sales report from Kidz Store, Lie Dharma records the following entries:

[Debit]. Accounts receivable = $2,090
[Debit]. Cost of goods sold = $55
[Debit]. Commission expense = $605
[Credit]. Sales = 2,750

(To record the sale made by Kidz Store acting as agent of Lie Dharma, the commission earned by Kidz Store and the credit card fee reimbursement earned by Kidz Store in connection with the sale)

[Debit]. Cost of goods sold = $2,125
[Credit]. Consignment out inventory = $2,125

(To transfer the related inventory cost to cost of goods sold, including half the original inventory cost and half the cost of the shipment to Kidz Store [($3,700 + $550= $4,250) × ½ =$2,125])

Inventory Ownership Issue#3. Product Financing Arrangements

Simply put; product financing arrangement is an arrangement whereby a company buys inventory for another company that agrees to purchase the inventory over a certain period at specified prices which include handling and financing costs.

Alternatively, a company can buy inventory from another company with the understanding that the seller will repurchase the goods at the original price plus defined storage and financing costs.

How does a product financing arrangement work? What is the accounting treatment?

You can read other post of mine, in accounting topic, which specifically address the issue, with more detail explanation and case examples: Accounting for Product Financing Arrangements

Inventory Ownership Issue#4. Right to Return Purchases

A related inventory accounting issue that requires special consideration is the situation that exists when the buyer holds the right to return the merchandise acquired.

Keep in mind that it is not meant to address the normal sales terms found throughout commercial transactions—where buyer can return goods—whether found to be defective or not, within a short time after delivery, such as five days. Rather, this connotes situations where the return privileges are well in excess of standard practice, so as to place doubt on the veracity of the purported sale transaction itself.

When the buyer has the right to rescind the transaction under defined conditions and the seller cannot, with reasonable confidence, estimate the likelihood of this occurrence, the retention of significant risks of ownership makes this transaction not a sale, according to IAS 18.

The US GAAP, particularly FAS 48 (“Revenue Recognition When Right of Return Exists“) usefully elaborates on this situation and provides additional insight.

Under both standards:

  • The sale is to be recorded if the future amount of the returns can reasonably be estimated.
  • If the ability to make a reasonable estimate is precluded, the sale is not to be recorded until further returns are unlikely.
  • Although legal title has passed to the buyer, the seller must continue to include the goods in its measurement and valuation of inventory.

In some situations, a “side agreement” may grant the nominal customer greatly expanded or even unlimited return privileges, when the formal sales documents (air way bill, bill of sale, bill of lading, etc.) make no such reference. These situations would be highly suggestive of financial reporting irregularities, in an apparent attempt to overstate revenues in the current period (not to mention the risk reporting high levels of sales returns in the following period, if customers do indeed avail themselves of the generous terms).

In such circumstances, these sales should in all likelihood not be recognized, and the goods nominally sold should be returned to the reporting company’s inventories.

Four inventory accounting issues, related to goods ownerships, have just been discussed. At the end of the period, however, the inventory balance on the balance sheet should be mechanically linked with cost of goods sold on the income statements. To achieve the goal, you would need to carefully record every single inventory transactions (whatever it is), along the inventory cycle—i.e. raw material received, raw material moved to the line of production, finished goods moved to the finished good warehouse, obsolescence, stolen, and finished goods sold out or moved to other warehouses—without failures. What is journal entry of each transaction? I have posted a good Summary of Journal Entry since the beginning until the end of the inventory cycle: Journal Entry for Inventory Transactions.

Learning Accounting the First Time, Where to Start

Learning accounting, the first time, is so much exciting. And it is suffice to say that, writing about it is also so much exciting to me. But our world isn’t as pleasant as it is in our dream; there are always challenges which make our life even more worth living. So does it in the accounting learning-curve. A constant question I get from readers (through email) is, “where to start?

This post answers the question.

Where You Should Start Learning Accounting

If you have the same question, here is a single advice I repeat time-by-time: start with the basic.


Accounting is a technical skill with dynamic characteristic. Being an accountant, you are specialized, thus need to be darn good at it. And, to get into such skill-level, you need two things:

1. A strong foundation; and
2. A constant learning –curve, overtime

To be able to fly, even a supersonic jet would need a strong ground. To be able to master the accounting, you would at least sense the ground; get use to the basic. Else, you could loss in the middle of the process of mastering it. (More on this a little bit later)

The next question, probably, is: “Where should I get the basic accounting materials?

Where You Can Get Basic Accounting Materials

Here are your best bets:

1. Accounting Teachers/Mentors

If you are an accounting student, your professor is the main source. If you are a clerk or junior accountant, the chief/senior accountant—who supervises your works on daily basis—is the main source.

Either one, expect her/him as a mentor that is able to give you the sense of the ground. Listen to her/him carefully and follow, then you are good to go.

2. Accounting Books/e-Books

There are plenty of basic accounting books or e-book you can start with. But reading too many different books may results in confusion, instead of enrichment.

If I ever asked to recommend a good basic accounting book, I would say Keiso’s is good, while other may argue it. A better approach is to compare different books (written by different authors), then choose one or two of them that you can understand easily.

Don’t forget, though, that the only way to master accounting is by practicing whatever you’ve learnt, as often and as many as possible. So, getting a book that has quizzes/problems (and its solution) at the end of every chapter, is extremely important.

3. The Internet

I have to describe it carefully since internet can be a ‘double-edge-sword’; it can be an effective tool—thus makes you really productive person—in one side, but also a monster time-sucker on the other side, when you use it unwisely.

Here is another challenge comes; getting accounting material isn’t easy, particularly on the internet. I mean a serious accounting material that enriches your knowledge and skill (not mere accounting terms and definitions.) This was the reason why is available for the public.

At, you can get most (if not all) of the materials; from the very basic to the advance accounting topics. As of today, hosts 1160 articles. You can browse the materials you are looking for in many different ways:

  • Browse it by category (main menu above this article)
  • Use the “advance search” feature (on the top menu), for a specific article/topic, in certain range of time, in within a category.
  • Find them out through the “Accounting Archive” (on the top menu).
  • Go the basic way by making use of the search feature (on the top-right of the site)

Millions of accounting people like you, around the globe, have enjoyed comprehensive accounting materials available at Many of them, in various skill-levels, have joined me since the first time I wrote, in 2007. Through email subscription, they get notification for every new article published here right on their inbox—so they can always jump right onto it and never missed any. If you haven’t done so, I encourage you to do the same. is surely not the only place where you can find accounting materials. Looking for IFRS/IAS guidelines for example, you can browse IASPlus (powered by the PwC) for free. If budget is not an issue, you can even enroll online accounting courses, at a small cost, which unfortunately has not been offered here yet. You can find one elsewhere for the time being.

The next question, probably, is: “what topic should I start with?

Basic Accounting Topic You Can Start With

I really want to say that accounting is an easy skill that everybody can learn and master in a matter of days, to boost your enthusiasts. But, then I become a big liar—which I don’t want to be. The truth is that learning accounting takes lot of sweats and probably tears too, to make it sounds worst.

To be safe and at an ideal condition, one would need at least enough interest to be able to master accounting faster. This is the only factor that will keep you up, overtime. As a checklist, ask yourself the following questions:

  • Do I have enough interest in business thingy in general?
  • Do I love to work with numbers, particularly money?

Accounting is all about business and numbers. To sense it, you can start reading the following articles:

The list can goes on, but I am pretty much sure a starter gets enough sense whether or not accounting is for him/her, after reading the above three posts.

In addition, either you’re completely new to accounting OR you have been learning accounting but need some basic refreshers, the following posts maybe useful for you:

  • Basic Accounting: Assumptions, Principles, and Constraints – It post explains assumptions principles and constraints used in the accounting.
  • Qualitative Characteristic of Accounting Information [Hierarchy of Accounting Qualities] – Although the accounting is much about numbers—which is quantitative, there are qualitative measures accountant should respect to. You can learn the hierarchies on this post.
  • Basic Accounting: Debit and Credit – Double Entry System – This post provides you with basic ‘debit-and-credit’ concept famously known as “double entry accounting system” (a.k.a the modern accounting).
  • Bookkeeping Fundamentals – This is an extremely long post. It explains the first three elements of the bookkeeping fundamental: debit-and-credit (again), chart of accounts, and initial entries to the books
  • Accounting Records And Its Flow Process [Basic] – This post helps you understand the role and function of accounting record as source documents (such as: bills, invoices) and introduces the books of prime entry and the ledgers. You then are able to look at the link between source documents and books of prime entry and the accounting ledgers.
  • Chart Of Accounts – This post covers the types of account numbering formats that can be used to construct a chart of accounts, and eventually lists sample charts of accounts that use each of the formats for both balance sheets and income statements.
  • Accounting Term And Definitions For Chart Of Accounts – This post describes terms and definitions used on the chart of accounts, thus (hopefully) helps you understand the chart even better. Not only for starters, may even seniors (management-level) find it useful, particularly when setting up chart of accounts and its procedure for the first time.

The next list by no mean complete, but is a good start to learn the basic:

These are some of the basic accounting materials. As I said in the beginning of this post, hosts over one thousand posts ranging from basic, intermediate to advance accounting, from accounting to financial and taxation topic. Browse accounting materials as you need.

Getting Used to Accounting Common Terms and Definitions

Last but not least, learning accounting the first time, you would need to get used to the lingo commonly used in the accounting. Here are common accounting terms and definitions you can start with:
 Happy learning accounting. All the best.

Download Bank Reconciliation Template in Excel

Are you looking for bank reconciliation template, in excel, you can use easily? Now you can download it, at, for f.ree.

How to Use the Bank Reconciliation Template

This template is intuitive, means that, it has self-explanatory features; a pop up instruction is shown up when clicking on cells you want to fill, and has build-in formulas on it.

Important Notes

This is a simple (but useful) template that surely helps you in the process of reconciling cash.

Here are two goals the template aims to achieve:

1. Introducing you with a clear and effective bank reconciliation worksheet.

2. With its simple structure, it helps you to speed up the process of reconciling your cash.

However, keep in mind that it can’t change an inaccurate cash ledger into more accurate one. You’re the one who should do the job. This is why a simple build-in control cell (called “Difference“) is included at the bottom of the template;

  • If the control cell shows zero (0), means your reconciliation is correct, as well as your book
  • If the control cell shows other than zero (either minus or plus value), means your reconciliation has not been correct yet, and you would need to figure out reasons for the difference.

Here are steps you can take to address the difference (on the latter case):

Step-1. Make sure, the following items have been included on your book:

– Interest you earn from the bank
– Tax on interest expense
– Transfer charges
– Check book charges
– Other bank charges
– Other auto-debited expenses

Make journal entry for any items that has not included yet.

Step-2. Re-run reconciliation process – Once the step-1 has been completed, your cash balance is changed accordingly,  you then are able to re-run the reconciliation process. Though you don’t need to re-type the ‘Deposit-in-Transit‘ and ‘Outstanding Check‘, again. Instead, just key in  the new cash balance onto the ‘Per Your Book‘ field, and see if the ‘Difference‘ cell is now showing zero (0). I hope so. Otherwise, go on next step…

Step-3. Perform cash ledger review – Arriving on this step clearly says that, you’re facing a serious problem, thus a more efforts are required. If this is the case, you would need to perform an in-depth cash ledger review, find out cash transactions that either has not been keyed yet, keyed twice or wrongly keyed (wrong amount or wrong account). A good way to perform the task is by comparing the cash ledger with the check stabs, cash receipt, and supporting documents.

Tracing error transactions can be tedious, but you don’t have other choices.  A better approach to prevent such issue is by performing regular ledger review on daily (or at least a weekly) basis. By doing so, you can catch erroneous right when they are occurring and fix them faster, not a month later when everybody have forgetten what those transactions were exactly about.

Here is a screenshot of the template shows the pop-up instruction:

Bank Reconciliation Template in Excel
Screenshot: Bank Reconciliation Template in Excel

Download Bank Reconciliation Template

Now, you can download the bank reconciliation template which I store at a public sharing site called Zippyshare.  Happy downloading:


~Updated: Sept 08′ 2012


Note: Since this is a free storage service, you may see a lot of ads in there,  when accessing the site, but there is no pop-up ads as far as I observe it. The download button is right by right-side of the file name (BankReconciliationTemplate) shown up on the page.

Auditing: Internal Control Over Financial Reporting (FAQ)

Internal control over financial reporting is essential information an auditor supposed to be able to draw during an audit session. Why? A client’s internal control state (be it is strong, somewhat strong or weak) implies 3 conditions about the company:

(1) Whether the company’s financial reporting is reliable or unreliable;

(2) Whether the company operates in effectively or ineffectively manner; and

(3) Whether the company is laws regulation compliant or incompliant.

These are super-important information to all stakeholders. Therefore, the PCAOB requires all public companies, in the United States, to file annual report with its management’s assessment of the effectiveness of the company’s internal control over financial reporting.

Specifically, what is a client responsibility, in term with internal control over financial reporting? And, what is an auditor’s responsibility for that matter?” You may ask.

This post provides the most frequently asked questions around internal control over financial reporting. If you have a question or two in the particular area, read on…

Question#1. What is a client’s reporting responsibility in connection with internal control over financial reporting?

Answer: A client’s annual report must include a management report that contains management’s assessment of the effectiveness of the company’s internal control over financial reporting as of the end of the company’s most recent fiscal year, including a statement as to whether the internal control is effective.

Question#2. What is an auditor’s reporting responsibility in connection with internal control over financial reporting?

Answer: An auditor is required to attest to (audit) and report on management’s assessment of internal control over financial reporting if the auditor audits the company’s financial statements included in the company’s annual report. The auditor’s attestation report must then be included in the annual report.

[Info_Box]Note: The auditor may make an independent estimate of fair value to corroborate the entity’s fair value measurement.[/Info_Box]

Question#3. What is the objective of the audit of internal control over financial reporting?

Answer: The objective of the audit of internal control over financial reporting is to obtain reasonable, but not absolute, assurance that no material weaknesses exist as of the date specified in management’s assessment. To achieve this objective, an auditor must evaluate management’s assessment and obtain and evaluate evidence regarding the design and operating effectiveness of internal control.

Question#4. What is the definition of a “material weakness?”

Answer: The definition of a material weakness is slightly different from the definition included in SAS 60. Under AS2, a material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

Question#5. What established criteria should management use in assessing the effectiveness of its internal control?

Answer: Management is required to base its assessment on a suitable recognized framework. Generally, in the United States, the framework to be utilized is the framework contained in Internal Control—Integrated Framework (the COSO Report), published by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission.

[Info_Box]Note: The criteria contained in the COSO Report served as the basis for developing the SASs relevant to internal control issued by the Auditing Standards Board of the AICPA.[/Info_Box]

Question#6. What are management’s responsibilities in an audit of internal control over financial reporting?

Answer: Management’s responsibilities in an audit of internal control are essentially the same as those specified in the Statements on Standards for Attestation Engagements issued by the AICPA.

Question#7. How should an auditor evaluate management’s assessment process?

Answer: An auditor is required to obtain an understanding of, and evaluate, management’s process for assessing the effectiveness of internal control over financial reporting. Accordingly, an auditor needs to determine whether management has considered the following elements:

  • Determining which controls should be tested, including controls over all relevant assertions related to all significant accounts and disclosures.
  • Evaluating the likelihood that failure of the control could result in a misstatement, the magnitude of such a misstatement, and the degree to which other controls, if effective, achieve the same control objectives.
  • Determining the locations or business units to include in the evaluation for a company with multiple locations or business units.
  • Evaluating the design effectiveness of controls.
  • Evaluating the operating effectiveness of controls based on procedures sufficient to assess their operating effectiveness. To evaluate the effectiveness of the company’s internal control over financial reporting, management must have evaluated controls over all relevant assertions related to all significant accounts and disclosures.
  • Determining the deficiencies in internal control over financial reporting that are of such a magnitude and likelihood of occurrence that they constitute significant deficiencies or material weaknesses.
  • Communicating findings to the auditor and to others, if applicable.
  • Evaluating whether findings are reasonable and support management’s assessment.

[Info_Box]Note: In order to obtain a sufficient understanding of management’s process for assessing internal control, an auditor should perform at least one walkthrough for each major class of transactions. A walkthrough involves tracing a transaction from its initiation through its reporting in the company’s financial reports.[/Info_Box]

Question#8. When auditing internal control over financial reporting, may an auditor use the work of others?

Answer: While an auditor is required to perform enough of the audit testing himself or herself so that his or her own work provides the principal basis for the opinion, an auditor is allowed to use the work of others to modify the nature, extent, and timing of the work he or she would have performed.

Question#9. When may an auditor issue an unqualified opinion?

Answer: An unqualified opinion may be issued only when there are no identified material weaknesses and when there have been no scope restrictions.

Question#10. What type of opinion should be issued if a material weakness is identified?

Answer: An adverse opinion must be issued if a material weakness is identified.

Question#11. What type of opinion should be issued if the scope of the auditor’s work has been restricted?

Answer: Depending on the significance of the scope restriction, a qualified opinion or a disclaimer of opinion should be issued.

Question#12. What should be included in management’s assessment of the effectiveness the company’s internal control over financial reporting?

Answer: The items required to be included in management’s assessment of the effectiveness the company’s internal control over financial reporting are:

  • A statement of management’s responsibility for establishing and maintaining adequate internal control over financial reporting
  • A statement identifying the framework used by management to conduct the required assessment of the effectiveness of the company’s internal control over financial reporting.
  • An assessment of the effectiveness of the company’s internal control over financial reporting as of the end of the company’s most recent fiscal year, including an explicit statement as to whether that internal control over financial reporting is effective.
  • A statement that the registered public accounting firm that audited the financial statements included in the annual report has issued an attestation report on management’s assessment of the company’s internal control over financial reporting

Question#13. What should an auditor consider in evaluating management’s report on its assessment of internal control over financial reporting?

Answer: In order to properly evaluate management’s report on its assessment of internal control over financial reporting, an auditor should consider whether:

  • Management has properly stated its responsibility for establishing and maintaining adequate internal control over financial reporting
  • The framework used by management to conduct the evaluation is suitable
  • Management’s assessment of the effectiveness of internal control over financial reporting, as of the end of the company’s most recent fiscal year, is free of material misstatement
  • Management has expressed its assessment in acceptable form; that is, management must state whether the company’s internal control over financial reporting is effective
  • Material weaknesses identified in the company’s internal control over financial reporting, if any, have been properly disclosed, including material weaknesses corrected during the period

Question#14. What should be included in the auditor’s report on management’s assessment of internal control over financial reporting?

Answer: The following elements must be included in the auditor’s report:

  • A title that includes the word independent
  • An identification of management’s conclusion about the effectiveness of the company’s internal control over financial reporting as of a specified date based on the control criteria [for example, criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)]
  • An identification of the title of the management report that includes management’s assessment (The auditor should use the same description of the company’s internal control over financial reporting as management uses in its report.)
  • A statement that the assessment is the responsibility of management
  • A statement that the auditor’s responsibility is to express an opinion on the assessment and an opinion on the company’s internal control over financial reporting based on his or her audit.
  • A definition of internal control over financial reporting
  • A statement that the audit was conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States)
  • A statement that the standards of the Public Company Accounting Oversight Board require that the auditor plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects
  • A statement that an audit includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as the auditor considered necessary in the circumstances
  • A paragraph stating that, because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements and that projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate
  • The auditor’s opinion on whether management’s assessment of the effectiveness of the company’s internal control over financial reporting as of the specified date is fairly stated, in all material respects, based on the control criteria
  • The auditor’s opinion on whether the company maintained, in all material respects, effective internal control over financial reporting as of the specified date, based on the control criteria
  • The manual or printed signature of the auditor’s firm
  • The city and state (or city and country, in the case of non-U.S. auditors) from which the auditor’s report has been issued
  • The date of the audit report, which should coincide with the date of the audit report on the company’s financial statements (This is required because an audit of internal control over financial reporting cannot be performed without auditing the company’s financial statements)

Question#15. When is it appropriate to modify the standard report?

Answer: The standard report should be modified if:

  • Management’s assessment is inadequate or management’s report is inappropriate. (The auditor should qualify or disclaim an opinion.)
  • There is a material weakness in the company’s internal control over financial reporting. (In this, an adverse opinion should be expressed.)
  • There is a restriction on the scope of the engagement. (The issuance of a qualified opinion or a disclaimer of opinion is appropriate; withdrawal from the engagement might need to be considered.)
  • The auditor decides to refer to the report of other auditors as the basis, in part, for the auditor’s own report. (The auditor should consider the appropriateness of dividing responsibility with another auditor.)
  • A significant subsequent event has occurred since the date being reported on. (If the effectiveness of internal control is adversely affected, an adverse opinion should be issued.)

[Info_Box]Note: Instead of issuing separate reports on the company’s financial statements and on internal control, the auditor may issue a combined report that contains both an opinion on the financial statements and an opinion on internal control over financial reporting.

A separate report on internal control over financial reporting necessitates the inclusion of the following paragraph to the auditor’s report on the company’s financial statements:

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of W Company’s internal control over financial reporting as of December 31, 2013, based on [identify control criteria] and our report dated [date of report, which should be the same as the date of the report on the financial statements] expressed [include nature of opinions].

In addition, the following paragraph must be added to the report on internal control over financial reporting:

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the [identify financial statements] of W Company and our report dated [date of report, which should be the same as the date of the report on the effectiveness of internal control over financial reporting] expressed [include nature of opinion].[/Info_Box]

Question#16. What are an auditor’s responsibilities for evaluating management’s Quarterly Certification Disclosures about internal control over financial reporting?

Answer: An auditor is required only to perform the following limited procedures on a quarterly basis to become aware of any material modifications that should be made to the disclosures about changes in internal control over financial reporting in order for management’s certification to be accurate:

  • Inquire of management about significant changes in the design or operation of internal control as it relates to the preparation of annual as well as interim financial information that could have occurred since the preceding annual audit or prior review of interim financial information.
  • Evaluate the implications of misstatements identified during the required review of interim financial information.
  • Determine, through inquiry and observation, whether any change in internal control has materially affected, or is reasonably likely to materially affect, internal control.

Question#17. What communications are required in an audit of internal control over financial reporting?

Answer: All identified significant deficiencies and material weakness must be communicated in writing to management and the audit committee before the auditor’s report on internal control over financial reporting is issued. It is important that the communication distinguish the significant deficiencies from the material weaknesses.

The communication should be made directly to the board of directors if the auditor determines that the matters identified were based on the ineffectiveness of the oversight of the audit committee. All deficiencies in internal control over financial reporting other than those considered to be significant deficiencies should be communicated, in writing, to management. The audit committee should be notified that this type of communication occurs. Any of the communications described above should include a statement restricting the use of communication to the board of directors, audit committee, management, and others within the organization.

Items Should Be Included In Management Representation Letter

A constant question I get from fellow junior auditors is “what items should be included in a management’s representation letter?” If you are questioning the same thing, then this post is for you. In addition, I also address other important questions related to management’s representation letter.

Five Fundamental Questions Related with Management Representation Letter

Question#1. What is management’s representation letter in a financial audit engagement?

Answer: This is a letter issued by the management of the client (auditee), confirming oral and written representations or assertions made by the client during the course of the audit.

Question#2. When should I (an independent auditor) obtain management’s representation letter?

Answer: At the conclusion of the audit process.

Question#3. Who sign the representation letter?

Answer: Chief Executive Officer (CEO) and Chief Financial Officer (CFO)

Question#4. What is the scope of the representation letter?

Answer: The representation letter should cover all financial statements and periods covered by the audit report.

Question#5. What is the date of the representation letter?

Answer: It should be dated no earlier than the audit report date—which is usually the conclusion of the fieldwork.

Main Question: What Items Included in the Representation Letter?

The items included in the client representation letter will vary depending on the engagement and the nature and basis of financial statement presentation. Some commonly included items are:

  • Management’s acknowledgment of its responsibility for the fair presentation in the financial statements of financial position, results of operations, and cash flows in conformity with generally accepted accounting principles
  • Management’s belief that the financial statements are fairly presented in conformity with generally accepted accounting principles
  • Availability of all financial records and related data
  • Completeness and availability of all minutes of meetings of stockholders, directors, and committees of directors
  • Communication from regulatory agencies concerning noncompliance with or deficiencies in financial reporting practices
  • Absence of unrecorded transactions
  • Management’s belief that the effects of any uncorrected financial statement misstatements aggregated by the auditor during the current engagement and pertaining to the latest period presented are immaterial, both individually and in the aggregate, to the financial statements taken as a whole (Note: a summary of such items should be included in or attached to the letter.)
  • Management’s acknowledgment of its responsibility for the design and implementation of programs and controls to prevent and detect fraud
  • Knowledge of fraud or suspected fraud affecting the entity involving (1) management, (2) employees who have significant roles in internal control, or (3) others where the fraud could have a material effect on the financial statements
  • Knowledge of any allegations of fraud or suspected fraud affecting the entity received in communications from employees, former employees, analysts, regulators, short sellers, or others
  • Plans or intentions that may affect the carrying value or classification of assets or liabilities.
  • Information concerning related-party transactions and amounts receivable from or payable to related parties
  • Guarantees, whether written or oral, under which the entity is contingently liable
  • Significant estimates and material concentrations known to management that are required to be disclosed in accordance with the AICPA’s Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties
  • Violations or possible violations of laws or regulations whose effects should be considered for disclosure in the financial statements or as a basis for recording a loss contingency
  • Unasserted claims or assessments that the entity’s lawyer has advised are probable of assertion and must be disclosed in accordance with Financial Accounting SAS 85—Management Representations 551 Standards Board (FASB) Statement No. 5, Accounting for Contingencies
  • Other liabilities and gain or loss contingencies that are required to be accrued or disclosed by FASB Statement No. 5
  • Satisfactory title to assets, liens, or encumbrances on assets, and assets pledged as collateral
  • Compliance with aspects of contractual agreements that may affect the financial statements
  • Information concerning subsequent events

Note: For better understanding, you may want to look at this standardized representation letter example (of the SAS 85, AU333).

Other Important Questions about Representation Letter

Question#6. Can a representation letter replace audit procedures?

Answer: Although the management representation letter is a form of evidential matter, it is not a substitute for the application of auditing procedures.

Question#7. What if the management refuses to issue representation letter?

Answer: Management’s refusal to furnish the representation letter to you—as an independent auditor—is tantamount to a scope limitation sufficient to preclude the issuance of an unqualified opinion. However, the refusal should lead you to doubt the integrity of management. You should reconsider your ability to rely on other assertions or representations the management ever made. This will usually result in a disclaimer of opinion.

Financial Statement Reporting Under Regulation S-X (SEC)

Financial statement reporting under Regulation S-X is a very important regulation for a publicly held company; the Securities and Exchange Commission (SEC) uses this regulation as principal one to oversee the form and content of financial statements submitted by the securities issuers. If you are in the United States and working for a public company, knowing the regulation can be as important as knowing your parent’s name.

Though you can access the complete text on the for more detail regulation, this post is a light overview that can be a good start. If the regulation is applicable to your company, then I strongly suggest you to peruse the complete text, in there.

The SEC exerts a considerable amount of control over the financial reporting activities of publicly held companies, particularly in the areas of new securities issuance and the ongoing release of financial information to the public. One, among all-important regulations, is the Reg S-X, about financial statement reporting.

SEC’s Regulation S-X is comprised of the following sections:

Qualifications and Reports of Accountants (Article 2)

The SEC will not recognize as a CPA any person who is not currently registered to practice in the state where his or her home or office is located.

SEC will also not recognize a CPA as being independent if the CPA has a financial interest in the entity being audited, or was a manager or promoter of an auditee at the time of the audit.

SEC requires a CPA’s report be dated and manually signed, state that GAAP was followed, state an audit opinion, and clearly itemize any exceptions found.

General Instructions as to Financial Statements (Article 3)

Balance sheets must be submitted for the last two year-ends, as well as statements of income and cash flow for the preceding three years.

If interim financial statements are provided, then standard year-end accruals should also be made for the shorter periods being reported upon.

Changes in stockholders’ equity shall be included in a note or a separate statement.

The financial statements of related businesses can be presented to the SEC in a single consolidated format if the companies are under common control and management during the period to which the reports apply. There are a number of tests to determine whether or not consolidated results are required, as well as for how many time periods over which the combined financial statements must be reported.

If a registrant is inactive (revenues and expenses of less than $100,000, and no material changes in the business or changes in securities) during the period, then its submitted financial statements can be unaudited.

There are also special reporting requirements for foreign private issuers, real estate investment trusts, and management investment companies.

Consolidated and Combined Financial Statements (Article 3a)

For financial statement reporting purposes, a registrant shall consolidate financial results for business entities that are majority owned, and shall not do so if ownership is in the minority.

A consolidated statement is also possible if the year-end dates of the various companies are not more than 93 days apart.

Inter-company transactions shall be eliminated from the consolidated reports. If consolidating the results of a foreign subsidiary, then the impact of any exchange restrictions shall be made.

Rules of General Application (Article 4)

Financial statements not created in accordance with GAAP will be presumed to be misleading or inaccurate. If the submitting entity is foreign-based, it may use some other set of accounting standards than GAAP, but reconciliation between its financial statements and those produced under GAAP must also be submitted.

Footnotes to the statements that duplicate each other may be submitted just once, as long as there are sufficient cross-references to the remaining footnote. The amount of income taxes applicable to foreign governments and the United States government shall be shown separately, unless the foreign component is no more than 5% of the total.

There must also be reconciliation between the reported amount of income tax and the amount as computed by multiplying net income by the statutory tax rate. This article also contains an extensive review of the manner in which oil and gas financial results must be reported.

Balance Sheet of Commercial and Industrial Companies (Article 5)

This article describes the specific line items and related footnotes that shall appear in the financial statements.

On the balance sheet, this shall include:

  • Cash.
  • Marketable securities.
  • Accounts and notes receivable.
  • Allowance for doubtful accounts.
  • Unearned income.
  • Inventory.
  • Prepaid expenses.
  • Other current expenses.
  • Other investments.
  • Fixed assets and associated accumulated depreciation.
  • Intangible assets and related amortization.
  • Other assets.
  • Accounts and notes payable.
  • Other current liabilities.
  • Long-term debt.
  • Minority interests (footnote only).
  • Redeemable and non-redeemable preferred stock.
  • Common stock.
  • Other stockholder’s equity.
  • On the income statement, this shall include:
  • Gross revenues.
  • Costs applicable to revenue.
  • Other operating costs.
  • Selling.
  • General and administrative expenses.
  • Other general expenses.
  • Non-operating income.
  • Interest.
  • Non-operating expenses.
  • Income or loss before income taxes.
  • Income tax expense.
  • Minority interest in income of consolidated subsidiaries.
  • Equity in earnings of unconsolidated subsidiaries.
  • Income or loss from continuing operations.
  • Discontinued operations.
  • Income or loss before extraordinary items.
  • Extraordinary items.
  • Cumulative effect of changes in accounting principles.
  • Net income or loss.
  • Earnings per share data.

Balance Sheet of Registered Investment Companies (Article 6)

SEC requires this type of company to file a balance sheet that contains the following line items:

  • Investments in securities of unaffiliated issuers.
  • Investments in and advances to affiliates.
  • Investments other than securities.
  • Total investments.
  • Cash.
  • Receivables.
  • Deposits for securities sold short and open option contracts.
  • Other assets.
  • Total assets.
  • Accounts payable and accrued liabilities.
  • Deposits for securities loaned.
  • Other liabilities.
  • Notes payable, bonds, and similar debt.
  • Total liabilities.
  • Commitments and contingent liabilities.
  • Units of capital.
  • Accumulated undistributed income or loss.
  • Other elements of capital.
  • Net assets applicable to outstanding units of capital.

The statement of operations for issuers of ‘face-amount’ certificates shall include the following line items:

  • Investment income.
  • Investment expenses.
  • Interest and amortization of debt discount and expense.
  • Provision for certificate reserves.
  • Investment income before income tax expense.
  • Income tax expense.
  • Investment income—net.
  • Realized gain or loss on investments—net.
  • Net income or loss.

Employee Stock Purchase, Savings, and Similar Plans (Article 6A)

These types of plans must present a statement of financial condition that includes the following line items:

  • Investments in securities of participating employers.
  • Investments in securities of unaffiliated issuers.
  • Investments.
  • Dividends and interest receivable.
  • Cash.
  • Other assets.
  • Liabilities.
  • Reserves and other credits.
  • Plan equity and close of period.
  • These plans must include in their statements of income and changes in plan equity the following line items:
  • Net investment income.
  • Realized gain or loss on investments.
  • Unrealized appreciation or depreciation on investments.
  • Realized gain or loss on investments.
  • Contributions and deposits.
  • Plan equity at beginning of period.
  • Plan equity at end of period.

Balance Sheet of Insurance Companies (Article 7)

An insurance company must present a balance sheet that includes the following line items:

  • Investments.
  • Cash.
  • Securities and indebtedness of related parties.
  • Accrued investment income.
  • Accounts and notes receivable.
  • Reinsurance recoverable on paid losses.
  • Deferred policy acquisition costs.
  • Property and equipment.
  • Title plant.
  • Other assets.
  • Assets held in separate accounts.
  • Total assets.
  • Policy liabilities and accruals.
  • Other policyholders’ funds.
  • Other liabilities.
  • Notes payable, bonds, mortgages and similar obligations, including capitalized leases.
  • Indebtedness to related parties.
  • Liabilities related to separate accounts.
  • Commitments and contingent liabilities.
  • Minority interests in consolidated subsidiaries.
  • Redeemable preferred stock.
  • Non-redeemable preferred stock.
  • Common stock.
  • Other stockholders’ equity.
  • Total liabilities and stockholders’ equity.

Balance Sheet of Bank Holding Companies (Article 9)

A bank holding company must present a balance sheet that includes the following line items:

  • Cash and cash due from banks.
  • Interest-bearing deposits in other banks.
  • Federal funds sold and securities purchased under resale or similar agreements.
  • Trading account assets.
  • Other short-term investments.
  • Investment securities.
  • Loans.
  • Premises and equipment.
  • Due from customers on acceptances.
  • Other assets.
  • Total assets.
  • Deposits.
  • Short-term borrowing.
  • Bank acceptances outstanding.
  • Other liabilities.
  • Long-term debt.
  • Commitments and contingent liabilities.
  • Minority interest in consolidated subsidiaries.
  • Redeemable preferred stock.
  • Non-redeemable preferred stock.
  • Common stock.
  • Other stockholders’ equity.
  • Total liabilities and stockholders’ equity.
  • A bank holding company’s income statement must include the following line items:
  • Interest and fees on loans.
  • Interest and dividends on investment securities.
  • Trading account interest.
  • Other interest income.
  • Total interest income.
  • Interest on deposits.
  • Interest on short-term borrowings.
  • Interest on long-term debt.
  • Total interest expense.
  • Net interest income.
  • Provision for loan losses.
  • Net interest income after provision for loan losses.
  • Other income.
  • Other expenses.
  • Income or loss before income tax expense.
  • Income tax expense.
  • Income or loss before extraordinary items and cumulative effects of changes in accounting principles.
  • Extraordinary items.
  • Cumulative effects of changes in accounting principles.
  • Net income or loss.
  • Earnings per share data.

Interim Financial Statements (Article 10)

An interim statement does not have to be audited. Only major line items need be included in the balance sheet, with the exception of inventories which must be itemized by raw materials, work-in-process, and finished goods either in the balance sheet or in the accompanying notes.

Any assets comprising less than 10% of total assets, and which have not changed more than 25% since the end of the preceding fiscal year, may be summarized into a different line item.

If any major income statement line item is less than 15% of the amount of net income in any of the preceding three years, and if its amount has not varied by more than 20% since the previous year, it can be merged into another line item.

Disclosure must also be made in the accompanying footnotes of any material changes in the business since the last fiscal year end.

Pro forma Financial Information (Article 11)

Pro forma information is required in cases where a business entity has engaged in a business combination or roll-up under the equity method of accounting, or under the purchase or pooling methods of accounting, or if a company’s securities are to be used to purchase another business.

It is also required if there is a reasonable probability of a spin-off, sale, or abandonment of some part or all of a business.

The provided information should consist of a pro forma balance sheet, summary-level statement of income, and explanatory notes.

The presented statements shall show financial results on the assumption that the triggering transaction occurred at the beginning of the fiscal year, and shall include a net income or loss figure from continuing operations prior to noting the impact of the transaction.

Form and Content of Schedules (Article 12)

This article describes the format in which additional schedules shall be laid out in submitted information, including layouts for valuation and qualifying accounts. It also itemizes formats for the display of information for management investment companies, which include the following formats:

  • investments in securities of unaffiliated issuers;
  • investments in securities sold short;
  • open option contracts written;
  • investments other than securities;
  • investments in and advances to affiliates;
  • summary of investments;
  • supplementary insurance information;
  • reinsurance; and
  • supplemental information.

How Do I Calculate Fixed Assets Depreciation Under IFRS?

IAS 16 (of the IFRS) provides for two acceptable alternative approaches to accounting for fixed assets. The first of these is the cost model, under which an item of fixed asset is carried at its cost minus its accumulated depreciation. “So, how do I calculate fixed assets depreciation under the IFRS?” you may ask.

Before answering the question, let’s first have a look at what depreciation is, according to IFRS.

Depreciation under the IAS 16

Simply put. A company uses fixed asset (also known as “property, plant and equipment” abbreviated as “PP&E”) to run its business. Since they’re used overtime, the function of the fixed assets got declined as well as their value. The declined value (of the fixed asset) is called “depreciation”.

IAS 16 describes depreciation as,

Both the decline in value of an asset over time as well as the systematic allocation of the depreciable amount of an asset over its useful life.”

Another way to see depreciation that, it is designed to spread an asset’s cost over its entire useful service life. At the end of the service life, the asset is no longer expected to be economically usable, or when it no longer has a sufficient productive capacity for ongoing company production needs, thus rendering it essentially obsolete.

Note: The ‘service life’ is the period of time over which the product is anticipated to be used, after which it is expected to have been worn out).

What can I depreciate?” you may ask further.

You can, literally, depreciate anything that has a business purpose, has a productive life of more than one year, gradually wears out over time, and whose cost exceeds the corporate capitalization limit.

Note: Since land does not wear out, it cannot be depreciated.

Here are some terms and definitions that will be happily used in this post (Source: IAS 16):

  • Depreciable amount – Cost of an asset, or another amount that has been substituted for cost, minus the residual value of the asset.
  • Residual value – Estimated amount of what the entity would currently obtain upon disposal of the asset, net of estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.
  • Useful life – Period over which an asset is expected to be available for use by an entity; or the number of production, or similar units, expected to be obtained from the asset by an entity.
  • Cost – Amount of cash or cash equivalent paid, the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction, or (where applicable) the amount attributed to that asset when initially recognized in accordance with the specific requirements of other IFRS—for example, IFRS 2, Share-Based Payment.

How To Calculate Fixed Assets Depreciation Based on IFRS

There are several methods you can choose alternative ways to calculate depreciation. IAS 16, however, states that,

the depreciation method should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity and that appropriateness of the method should be reviewed at least annually in case there has been a change in the expected pattern.”

Beyond that, the standard leaves the choice of method to the entity, even though it does cite ‘straight-line’, ‘diminishing balance’, and ‘units of production’ methods.

Straight-line depreciation provides for a depreciation rate that is the same amount in every year of an asset’s life, whereas diminishing balance depreciation methods are oriented toward the more rapid recognition of depreciation expenses, on the grounds that an asset is used most intensively when it is first acquired.

There are, also, depreciation methods based on compound interest factors, resulting in delayed depreciation recognition. But, since these methods are rarely used, however, they are not presented here.

Perhaps the most accurate depreciation methods are those that are tied to actual asset usage (such as the units of production method), though they require much more extensive recordkeeping in relation to units of usage.

Below are rules you should consider, in calculating fixed assets depreciation based on IFRS:

If an asset is present but is temporarily idle, then its depreciation should be continued using the existing assumptions for the usable life of the asset. Only if it is permanently idled should the accountant review the need to recognize impairment of the asset.

Please note, however, that an asset is rarely purchased or sold precisely on the first or last day of the fiscal year, which brings up the issue of how depreciation is to be calculated in these first and last partial years of use. Although IAS 16 does not go to such detail, one would need to be aware of this:

When an asset is either acquired or disposed of during the year, the full-year depreciation calculation should be prorated between the accounting periods involved. This is necessary to achieve proper matching.

It may so happen that individual assets in a relatively homogeneous group are regularly acquired and disposed of; in this case, there are a number of alternatives available, all of which are valid as long as they are consistently applied.

One option is to record a full year of depreciation in the year of acquisition and no depreciation in the year of sale. It is also possible to record a half-year of depreciation in the first year and a half-year of depreciation in the last year. One can even prorate the depreciation more precisely, making it accurate to within the nearest month (or even the nearest day) of when an acquisition or sale transaction occurs.

Next, let’s have a look at methods available to depreciate fixed assets…

Using Straight-Line Depreciation Method

This is the simplest method available, and is the most popular one when a company has no particular need to recognize depreciation costs at an accelerated rate (as would be the case when it wants to match the book value of its depreciation to the accelerated depreciation used for income tax calculation purposes), and it is used for all amortization calculations.

This method is calculated by subtracting an asset’s expected residual value from its capitalized cost and then dividing this amount by the estimated useful life of the asset.

Case Example:

A machine has a cost of $40,000 and an expected residual value of $8,000. It is expected to be in service for eight years. Given these assumptions, its annual depreciation expense is:

= (Cost – residual value) / number of years in service
= ($40,000 – $8,000) / 8 years
= $32,000 / 8 years
= $4,000 depreciation per year

Remember: “cost”, in general, could be the amount of cash or cash equivalent paid; or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction; or the amount attributed to that asset when initially recognized.

Using Accelerated Depreciation Methods

In brief, using this method, the depreciation expense is higher in the early years of the asset’s useful life and lower in the later years.

IAS 16 mentions only one accelerated method, the diminishing balance method, but other methods have been employed in various national GAAP under earlier or contemporary accounting standards. Let’s have a look one-by-one

1. Diminishing balance – the depreciation rate is applied to the net book value of the asset, resulting in a diminishing annual charge. There are various ways to compute the percentage to be applied. The next formula provides a mathematically correct allocation over useful life.


where n = the expected useful life in years.

Case Example:

A machine costing $20,000 is estimated to have a residual value of $1,000, and a useful life of four years. The depreciation rate under the diminishing balance, applying the preceding formula, is approximately 44%. Consequently, the depreciation expense during each of the four years is:

Year 1 = 44% × $10,000 =$4,400
Year 2 = 44% × $5,600 = $2,464
Year 3 = 44% × $3,136 = $1,380
Year 4 = $10,000 – $4,400 – $2,464 – $1,380 – $1,000 = $756

However, companies generally use approximations or conventions influenced by tax practice, such as a multiple of the straight-line rate times the net carrying value at the beginning of the year.

Straight-line rate = 1/Estimated useful life

Case Example

A machine costing $20,000 is estimated to have a useful life of six years. Under the straight-line method, it would have depreciation of $3,333 per year. Consequently, the first year of depreciation under the 200% DDB method would be double that amount, or $6,667. The calculation for all six years of depreciation is below:

Straight-Line Depreciation Method

Note that there is still some cost left at the end of the sixth year that has not been depreciated. This is usually handled by converting over from the DDB method to the straight-line method in the year in which the straight-line method would result in a higher amount of depreciation; then the straight-line method is used until all of the available depreciation has been recognized.

2. Sum-of-the-years’ digits method – This is another method to accomplish a diminishing charge for depreciation is the sum-of-the-years’ digits method—which is commonly used in the United States and certain other venues.

Sum-of-the-years’ digits (SYD) depreciation = Cost less salvage value × Applicable fraction


‘Applicable fraction’ = (number of years of estimated life remaining as of the beginning of the year) / SYD


SYD = [n(n + 1)] / 2

n = estimated useful life

This depreciation method is designed to recognize the bulk of all depreciation within the first few years of an asset’s depreciable period, but does not do so quite as rapidly as the double-declining balance method described previously.

Its calculation can be surmised from its name. For the first year of depreciation, one adds up the number of years over which an asset is scheduled to be depreciated and then divides this into the total number of years remaining. The resulting percentage is used as the depreciation rate. In succeeding years, simply divide the reduced number of years left into the same total number of years remaining.

Case Example:

A tool costing $24,000 is scheduled to be depreciated over five years. The sum-of-the-years’ digits is 15 (Year 1 + Year 2 + Year 3 + Year 4 + Year 5). The depreciation calculation in each of the five years is:

Year 1 = (5/15) × $24,000 = $   8,000
Year 2 = (4/15) × $24,000 = $   6,400
Year 3 = (3/15) × $24,000 = $   4,800
Year 4 = (2/15) × $24,000 = $   3,200
Year 5 = (1/15) × $24,000 = $    1,600
Accum. Deprec                         = $24,000

In practice, unless there are tax-reasons to employ accelerated methods, large companies tend to use straight-line depreciation. This has the merit that it is simple to apply, and where a company has a large pool of similar assets, some of which are replaced each year, the aggregate annual depreciation charge is likely to be the same, irrespective of the method chosen.

Using Units of Production Depreciation Method

The units of production depreciation method can result in the most accurate matching of actual asset usage to the related amount of depreciation that is recognized in the accounting records. Its use is limited to those assets for which some estimate of production can be attached, but it is a particular favorite of those who use activity-based costing systems because it closely relates asset cost to actual activity.

To calculate it, estimate the total number of units of production that are likely to result from the use of an asset. Then divide the total capitalized asset cost (less residual value, if this is known) by the total estimated production to arrive at the depreciation cost per unit of production.

The recognized depreciation is derived by multiplying the number of units of actual production during the period by the depreciation cost per unit. If there is a significant divergence of actual production activity from the original estimate, the depreciation cost per unit of production can be altered to reflect the realities of actual production volumes.

Case Example:

A machine, at an oil company, is assembled at a cost of $350,000. It is expected to be used in the extraction of 1 million barrels of oil, which results in an anticipated depreciation rate of $0.35 per barrel. During the first month, 23,500 barrels of oil are extracted. Using this method, the depreciation cost is counted as follows:

= (Cost per unit of production) × (Number of units of production)
= ($0.35 per barrel) × (23,500 barrels)
= $8,225

This calculation also can be used with service hours as its basis rather than units of production. When used in this manner, the method can be applied to a larger number of assets for which production volumes would not be otherwise available.

The Challenge of Determining Residual Value (and the solution)

As you should do it on the useful life of an asset, the residual value should be reviewed at least at each financial year-end; if expectations differ from previous estimates, the change should be accounted for as a change in an accounting estimate.

However, the residual value can be difficult to determine, for several reasons:

  • First, there may be a removal cost associated with the asset, which will reduce the net residual value that will be realized. If the equipment is especially large or if it involves environmental hazards, then the removal cost may exceed the residual value. In this latter instance, the residual value may be negative; in that case, it should be ignored for depreciation purposes.
  • Second, the lack of a ready market for the sale of used assets in many instances.
  • Finally, the cost of conducting an appraisal in order to determine a net residual value may be excessive in relation to the cost of the equipment being appraised.

For all these reasons, you should certainly attempt to set a net residual value in order to arrive at a cost base for depreciation purposes, but it will probably be necessary to make regular revisions in a cost-effective manner to reflect the ongoing realities of asset resale values. In the case of low-cost assets, it is rarely worth the effort to derive residual values for depreciation purposes; as a result, typically these items are fully depreciated on the assumption that they have no residual value.