Journal entry testing is required in all audits. Why? The use of journal entries to manipulate financial statements is always present–even in accounting systems with good internal controls. Thus the journal entry test requirement in AU-C 240, Consideration of Fraud in a Financial Statement Audit.
In this article, I explain how auditors can understand and test journal entries to ensure management is not cooking the books.
First, auditors should gain an understanding of the journal entry process. Ask questions such as:
Inspect sample documents and journal entries. Also, observe who is doing what. Then document your inquiries, the records inspected, and your observations as a part of your walkthrough process. Also, document who you talked with and on what date.
Consider downloading all journal entries for a particular month and scanning those. Doing so will enable you to see the typical entries made. Most accounting systems differentiate journal entries from other transactions, so it’s usually easy to segregate all journal entries for review.
Scanning a month’s journal entries is not a required procedure, but one that I suggest.
So, as you scan the journal entries, what are you looking for? What types of entries might imply that fraud is present?
The following are potential indicators of fraud risk:
Plan to test journal entries based on your risk assessment procedures. If you notice particular risks, then audit those areas.
Here are examples of risks and responses:
Journal entries may be appropriate throughout the year because they are subject to good controls. Even so, someone might inflate the numbers in the financial statement creation process (after exporting the original numbers to a spreadsheet, for example).
AU-C 240, Consideration of Fraud in a Financial Statement Audit, requires auditors to test journal entries in every audit. Why? There is always a possibility that management might override controls, and journal entries are an easy way to make the company look better than it is. Think about it: one journal entry in the last month of the year can increase revenues and receivables by millions.
It is wise to test journal entries made late in the year. As management approaches year-end, they might realize the company needs to meet specific targets (e.g., a certain level of net income) for them to earn bonuses. If true, management has a potential motivation to manipulate the numbers, especially at year-end.
See my article about management override of controls for more information about manipulation of financial statements and potential theft.
Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty-five years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention, The Why and How of Auditing, Audit Risk Assessment Made Easy, and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles consults with other CPA firms, assisting them with auditing and accounting issues.
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