During an audit, income statement items warrant close attention due to their complexity, possible effect on balance sheet items and the potential for manipulation. Auditors tend to focus on particular income statement categories as outlined below.
Revenue recognition can be complex. Under current accounting rules, companies follow a patchwork of industry-specific guidance. So, companies in different industries may record revenue for similar transactions differently.
However, more than 180 industry-specific revenue recognition rules will soon be replaced by Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The new standard goes into effect in 2018 for public companies and 2019 for private companies and not-for-profit entities. It calls for a single principles-based approach for recognizing revenues from long-term contracts.
As you implement the updated guidance, expect your auditor to give more attention to how you report revenue than in previous years. For example, your auditor might analyze revenue-related balance sheet accounts (such as accounts receivable) to uncover over- or understatement of revenue. Your auditor might also conduct tests to verify the legitimacy of accounts receivable balances recognized as revenue during the reporting period.
In the case of complex contract sales, testing includes reading the contract and verifying that the company earned the right to recognize revenue. For simpler transactions, a review of relevant documents such as invoices, bills of lading and payment information may suffice.
Cost of goods sold (COGS)
There are three components of COGS: raw materials, labor and overhead costs. COGS is a major line item for many companies, so auditors spend significant time verifying these costs.
They may review purchase orders, shipping documents and employee time records to verify specific amounts claimed for labor and materials. In addition, these costs tend to change in tandem with revenue. So, if labor as a percentage of revenue changes over time, it’s likely to raise a red flag during your audit.
Calculating and allocating overhead costs calls for a high degree of subjectivity. Auditors often turn to analytical procedures to test COGS. For example, they may use the inventory balance to help confirm the amount and cost of inventory consumed during the reporting period.
Companies incur various expenses — such as sales commissions, office supplies, rent and utilities — to support their general business operations. Auditors typically review vendor acceptance and payment approval processes to determine whether the amounts reported appear reasonable and timely. To uncover anomalies, auditors also analyze operating expenses over time and against other line items.
Operating expenses for services, such as advertising and professional fees, can be an easy place for dishonest employees to hide fraud. So, auditors tend to scrutinize these accounts. For example, they’re likely to review invoices and inquire about prepaid retainers. Auditors also send letters to their clients’ attorneys to assess the risk of pending litigation that may need to be reported as a liability on the balance sheet.
Auditors spend a significant amount of time determining whether amounts claimed on the income statement capture the company’s financial performance during the reporting period. For more information about what to expect as auditors review your revenues and expenses this audit season or if you need assistance with your company’s audit, call us at 972-931-6803 or click here to contact us.