Financial statement assertions: auditors can use a framework built around five types of assertions to help assure financial statements are fairly presented

Internal Auditor, April, 2004 by Paul M. Clikeman

THERE ARE ONLY THREE CONditions that can cause an account balance to be misstated: missing entries, erroneous entries, and the presence of entries that do not belong in the account. Testing an account balance, therefore, requires verifying that the recorded transactions occurred and belong in the account (existence or occurrence), searching for omitted items or transactions that should have been recorded in the account (completeness), and testing whether the entries have been recorded for the correct dollar amounts (valuation). Following this simple process can help auditors design appropriate audit procedures for any account or class of transactions.

TYPES OF ASSERTIONS

The American Institute of Certified Public Accountants' Statement on Auditing Standards No. 31: Evidential Matter provides a logical framework for designing audit procedures. The framework is built around five financial statement assertions. The first three assertions--existence or occurrence, completeness, and valuation--address whether accounts contain valid entries that are recorded accurately. The last two assertions--rights and obligations and presentation and disclosure--focus on whether the entity's legal rights and obligations are presented properly and described adequately in the financial statements.

EXISTENCE OR OCCURRENCE Assertions regarding existence or occurrence address whether assets and liabilities exist at a given date and whether recorded transactions occurred during a given period. For example, all items in the inventory account must physically exist and be available for sale, and all entries in the sales account must represent actual exchanges occurring within the period examined.

When testing existence or occurrence assertions, auditors search for overstatements. As shown in "Testing for Assertions" on page 24, existence or occurrence testing should begin with the accounting records and progress toward the supporting evidence. For example, to test the occurrence of recorded sales, auditors may select entries in the sales journal and trace the transactions to supporting documents such as sales invoices, shipping records, and customer purchase orders. To test the existence of accounts receivable, auditors could confirm customer balances from the aged receivables trial balance.

COMPLETENESS Management's completeness assertions address whether all transactions and accounts that should be presented in the financial statements are so included. For example, all expenses incurred during a given period must be recorded, and all amounts owed to vendors must be included in the accounts payable balance.

When conducting tests to verify the completeness assertion, auditors search for understatements. Testing begins with the supporting source documents and progresses toward the accounting records (see "Testing for Assertions" on page 24). For example, an auditor may search for unrecorded purchases by selecting a sample of receiving reports and tracing the transactions to the purchases journal and the accounts payable records. Because unrecorded transactions are difficult to discover through substantive tests, it is essential that organizations develop adequate controls, such as the use of prenumbered documents, to ensure that all transactions are captured by the accounting system.

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VALUATION OR ALLOCATION Assertions regarding valuation or allocation address whether assets and liabilities are valued properly and whether costs are allocated reasonably among products and time periods. For example, accounts receivable must be reported at net realizable value, and manufacturing overhead must be allocated among the various products produced.

Valuation often represents a high-risk assertion because of the wide variety of methods used to value assets. Short-term marketable securities, for example, are valued at current market value, whereas fixed assets are valued at historical cost minus accumulated depreciation. For inventory items, valuation is based on the lower of cost or market value, with several alternative methods for calculating cost.

Determining the proper value of liabilities can be equally challenging. Bonds payable are reported at face value plus or minus the unamortized premium or discount, for instance, whereas employee post-retirement health benefit obligations are reported at the present value of estimated future costs.

Another factor adding to the risk level of valuation assertions is that many values need to be estimated. Depending on the account tested, auditors may have to evaluate a host of estimates and assumptions, such as the useful life of fixed assets, the frequency and cost of future warranty claims, the long-term average return on pension plan assets, and the default rate on past due receivables.

RIGHTS AND OBLIGATIONS Management's rights and obligations assertions focus on whether assets and liabilities constitute the rights and liabilities of the entity on a given date. For example, an item should not be reported as an asset unless the entity owns it or, in the case of a leased asset, possesses a non-cancelable right to its use. Liabilities should be reported only if they represent obligations of the reporting organization--not owners' or officers' personal obligations.