Auditing is the systematic process of obtaining and evaluating evidence about an entity’s financial information to determine whether it has been prepared, in all material respects, in accordance with an applicable financial reporting framework. Auditing major transactions and account balances requires more than checking arithmetic. The auditor must understand how transactions arise, identify risks of material misstatement, connect those risks to management’s assertions, and design procedures that provide sufficient appropriate audit evidence.

This chapter focuses on revenue, purchases, inventory, cash, receivables, payables, payroll, non-current assets, and related disclosures. These areas are common sources of error and fraud because they involve high transaction volumes, estimates, cut-off judgments, or opportunities for management bias. The procedures described are general principles; actual audit work must be adapted to the entity, its systems, applicable auditing standards, materiality, and assessed risk.

Learning Objectives

1. Assertions: The Foundation of Audit Testing

Management makes implicit or explicit assertions when presenting financial statements. The auditor obtains evidence to evaluate those assertions. Assertions are commonly grouped as follows.

Assertion	Meaning	Typical audit question
Occurrence	Recorded transactions and events actually occurred and relate to the entity.	Did this recorded sale really take place?
Completeness	All transactions and balances that should be recorded have been recorded.	Have any liabilities or purchases been omitted?
Accuracy	Amounts and other data have been recorded correctly.	Was the invoice entered for the correct amount?
Cut-off	Transactions are recorded in the correct accounting period.	Was a December purchase recorded in December rather than January?
Classification	Items are recorded in the proper accounts.	Was equipment incorrectly charged to repairs expense?
Existence	Assets, liabilities, and equity interests exist at the reporting date.	Does the recorded inventory physically exist?
Rights and obligations	The entity controls the rights to assets and is responsible for liabilities.	Does the entity own the goods held in its warehouse?
Valuation and allocation	Items are recorded at appropriate amounts, including adjustments and estimates.	Is obsolete inventory written down?
Presentation and disclosure	Items are appropriately described, classified, and disclosed.	Are related-party transactions disclosed?

Assertions differ in importance by audit area. For revenue, occurrence and cut-off are often significant because fictitious or prematurely recorded sales can inflate profit. For payables, completeness is usually especially important because omitted liabilities understate expenses and obligations. For inventory, existence and valuation are central.

Audit Evidence and Procedure Selection

Audit evidence may include inspection of documents, observation, external confirmation, recalculation, reperformance, analytical procedures, and inquiry. Inquiry alone is generally weaker than evidence obtained from independent sources or direct auditor observation. Evidence is more persuasive when it is relevant to the assertion, reliable in origin, and obtained directly by the auditor.

A test of controls evaluates whether a control operated effectively. A substantive procedure detects material misstatements directly and may consist of tests of details or substantive analytical procedures. When controls are weak or risks are high, the auditor generally increases substantive work.

Materiality affects audit planning and evaluation. A misstatement is material if it could reasonably influence users’ economic decisions. Materiality is not solely a numerical threshold; qualitative factors such as fraud, covenant breaches, regulatory compliance, or concealment of a loss may make a small amount important.

2. The Audit Approach to Transaction Cycles

Sampling is frequently used. A sample should be selected so that every item in the population has a chance of selection consistent with the audit design. The auditor should define the population, sampling unit, objective, tolerable misstatement or deviation, and method of selection. A sample result cannot be interpreted without considering the population and the risk of sampling error.

3. Revenue

Revenue may arise from cash sales, credit sales, service contracts, subscriptions, long-term arrangements, or multiple-performance-obligation contracts. Revenue is often a presumed fraud risk because management may have incentives to report higher sales or meet targets.

Common Risks and Assertions

Typical Procedures

The auditor may inspect customer orders, dispatch records, invoices, and proof of delivery. A sample of recorded sales may be vouched from the ledger back to source documents, testing occurrence. A sample of dispatch documents may be traced forward to invoices and the ledger, testing completeness. Sales just before and after year-end should be examined for cut-off.

The auditor may confirm receivable balances and inspect subsequent cash receipts. Credit notes issued after year-end can identify returns or pricing disputes relating to the audited period. Analytical procedures may compare sales by month, customer, product, or location and investigate unusual trends.

Revenue contracts should be reviewed when arrangements are complex. The auditor considers when control transfers, whether variable consideration is constrained, and whether the entity acts as principal or agent. The correct accounting depends on the applicable reporting framework; the auditor does not simply accept management’s label for a transaction.

4. Purchases and Trade Payables

The purchases cycle normally includes requisition, authorization, purchase order, receipt of goods, supplier invoice, recording in the purchases journal, and payment. Segregation of duties should ideally separate ordering, receiving, invoice approval, recording, and payment authorization.

Risks and Procedures

The major risk for purchases and payables is understatement. Procedures therefore emphasize completeness and cut-off. The auditor may:

A supplier statement is useful evidence, but it is not conclusive. Differences may arise from timing, credit notes, disputed invoices, or transactions omitted from the entity’s records. The auditor must investigate rather than merely agree the balance.

5. Inventory

Inventory commonly includes raw materials, work in progress, and finished goods. It may be held at several locations or by third parties. Inventory auditing combines physical verification with valuation and ownership testing.

Existence and Completeness

Attendance at a physical inventory count enables the auditor to observe management’s counting procedures, inspect inventory condition, perform independent test counts, and identify damaged or obsolete items. The auditor records test counts and reconciles them to the final inventory listing. Items counted should be identified clearly to reduce the risk of double counting or omission.

The auditor should also consider goods in transit, goods held on consignment, inventory at external warehouses, and inventory belonging to customers or suppliers. Floor-to-sheet testing, selecting items from the warehouse floor and tracing them to the listing, supports completeness. Sheet-to-floor testing, selecting listing items and locating them physically, supports existence.

Valuation

Inventory is generally measured at the applicable cost and net realisable value rule under the reporting framework. Net realisable value is the estimated selling price in the ordinary course of business less estimated costs of completion and costs necessary to make the sale.

The formula applies when inventory valuation requires comparison with net realisable value. All amounts must relate to the same units and relevant measurement date. The auditor tests purchase invoices, labour records, production overhead calculations, and costing methods. Slow-moving, damaged, expired, or technologically obsolete goods require special attention.

Cut-off

The auditor examines the last and first goods-received notes and dispatch documents around year-end. Goods received before year-end should generally be included in inventory and a payable, while goods dispatched before year-end may have been sold, depending on the transfer-of-control terms. Cut-off errors can affect inventory, revenue, purchases, profit, receivables, and payables simultaneously.

6. Cash and Bank

Cash is highly liquid and vulnerable to theft, unauthorized payments, and manipulation. The principal assertions are existence, completeness, rights, and presentation.

The auditor obtains bank reconciliations and checks the arithmetic, agrees the book balance to the ledger, and agrees the bank balance to an external bank statement or confirmation. Outstanding lodgements and unpresented cheques should be traced to subsequent bank activity. Long-outstanding reconciling items may indicate errors or fraud.

The auditor should confirm bank accounts, loans, security arrangements, guarantees, and restrictions directly with banks where appropriate. A surprise cash count may test the existence of petty cash and reveal unrecorded shortages. The auditor also tests transfers between bank accounts around year-end to detect window dressing, in which one transfer is recorded in both accounts or omitted from one account.

Cash equivalents and restricted cash must be classified and disclosed correctly. A positive bank balance does not necessarily mean that all funds are available for general use.

7. Trade Receivables and Allowances

Trade receivables arise when customers owe the entity for goods or services delivered. Key risks include fictitious balances, disputed amounts, unrecorded credit notes, and inadequate allowances for expected credit losses.

External confirmation is a powerful procedure for existence and rights. Positive confirmation requests ask the customer to respond whether the stated balance is correct; negative confirmations request a response only if the customer disagrees. Positive confirmations are generally more persuasive when risk is high, balances are material, or records are unreliable.

When a customer does not respond, alternative procedures may include inspecting subsequent cash receipts, invoices, dispatch evidence, and correspondence. The auditor should control the confirmation process, including selecting recipients, preparing requests, sending them directly, and receiving responses directly.

An aged receivables analysis helps identify overdue balances. The auditor tests the mathematical accuracy of the aging, investigates disputes, reviews subsequent receipts, and evaluates management’s allowance methodology. A simple aging model may apply different loss rates to age categories, but assumptions must be supported by historical experience, current conditions, and reasonable forecasts where required by the reporting framework.

8. Payroll and Employee-Related Liabilities

Payroll involves employee records, wage rates, time records, deductions, approvals, payment, and remittance of taxes or social contributions. Risks include fictitious employees, unauthorized pay-rate changes, inflated hours, duplicate payments, and failure to record payroll liabilities.

The auditor may test a sample of employees from the payroll register to personnel files and independently verify employment, pay rate, and approved deductions. A sample selected from personnel files can be traced to payroll to test completeness. Joiners and leavers around year-end require particular attention. Payroll totals may be reconciled to the general ledger, and statutory deductions may be agreed to payroll reports and subsequent remittances.

Analytical procedures compare payroll expense with headcount, average wages, overtime, and prior periods. Unexpected changes should be investigated rather than automatically treated as errors. Access to payroll master data should be restricted, and changes should be independently reviewed.

Payroll testing must respect privacy and data-protection requirements. Auditors should access only information necessary for the audit and protect sensitive employee data.

9. Non-Current Assets

Non-current assets include property, plant and equipment, right-of-use assets, intangible assets, and long-term investments. Audit risks include capitalizing repairs, failing to record disposals, incorrect depreciation, impairment issues, and lack of ownership.

For additions, the auditor inspects purchase invoices, authorization, contracts, title documents, and evidence that the asset is in use or available for use. Physical inspection may establish existence and condition. For disposals, the auditor examines approval, disposal proceeds, removal from the asset register, and calculation of gain or loss.

Depreciation is commonly calculated using a systematic allocation of depreciable amount over useful life. Under a straight-line method:

Cost is the amount recognized for the asset, residual value is the estimated amount recoverable at the end of its useful life, and useful life is the estimated period or capacity of use. The formula is applicable only when a straight-line pattern appropriately represents consumption of benefits and the relevant accounting framework permits or requires that method. The auditor checks dates placed in service, useful lives, residual values, and consistency with policy.

Impairment indicators include physical damage, technological obsolescence, declining demand, adverse legal developments, and underperformance. Management’s impairment assessment should be challenged through review of budgets, external evidence, sensitivity analysis, and comparison with actual results.

10. Related Disclosures and Presentation

An audit conclusion covers both recognized amounts and disclosures. Important disclosures may relate to accounting policies, commitments, contingencies, related parties, guarantees, restricted cash, leases, borrowing arrangements, significant estimates, and subsequent events.

The auditor should read the financial statements as a whole and consider whether classifications are understandable and consistent with the underlying evidence. A transaction may be correctly recorded but inadequately disclosed. For example, a loan secured against property may require disclosure of the security arrangement even if the loan balance is correctly stated.

Related-party transactions deserve special attention because they may not occur at arm’s length or may be used to conceal obligations or transfer profits. The auditor reviews minutes, declarations by management, registers of interests, unusual journal entries, and significant contracts. Inquiry should be corroborated with other evidence.

11. Illustrative Case: Northfield Traders

Background

Northfield Traders sells electrical equipment and closes its financial year on 31 December. Sales increased by 28% in December, while cash collections did not increase proportionately. The finance manager received a performance bonus based on reported annual profit.

Problem

The audit team identifies three concerns: several large sales were recorded on 31 December, inventory records include goods stored at a third-party warehouse, and supplier statements show balances greater than the payables ledger.

Analysis

The December sales create occurrence and cut-off risks. The warehouse arrangement creates existence, rights, and completeness risks. The supplier differences create a completeness risk for payables and expenses. The manager’s bonus creates a possible management-bias or fraud incentive.

Audit approach

The auditors inspect orders, dispatch notes, delivery acknowledgements, and customer correspondence for the large December sales. They confirm selected receivable balances and inspect January cash receipts. They attend the warehouse count, obtain a direct confirmation of quantities held, and inspect the storage agreement to determine ownership. They reconcile supplier statements, examine January payments, and search for unrecorded liabilities.

The work shows that two December invoices were recorded before goods were dispatched. The sales and receivables are reversed and recognized in January. A quantity of damaged inventory is identified and written down under the applicable valuation requirement. The supplier reconciliation reveals invoices received before year-end that were omitted from the ledger; payables and expenses are recorded.

Outcome and learning points

The audit procedures were effective because they were linked directly to assertions and identified risks. The case demonstrates that one event may affect several accounts: premature revenue affects sales, receivables, profit, inventory, and tax-related balances. It also shows why auditors must consider incentives, external evidence, cut-off, third-party holdings, and subsequent transactions together.

12. Professional, Ethical, and Technological Considerations

Auditors must maintain independence, professional competence, confidentiality, professional skepticism, and integrity. Familiarity with management, financial dependence on a client, or pressure to reduce procedures can threaten independence. Ethical safeguards may include removing affected personnel, independent review, or declining an engagement where threats cannot be reduced to an acceptable level.

Technology can improve audit quality. Enterprise-resource-planning data, automated exception reports, duplicate-invoice searches, continuous monitoring, and computer-assisted audit techniques can test large populations. Artificial intelligence may identify unusual patterns in journals, payments, customer behavior, or vendor master files. However, technology does not remove the need to define the audit objective, validate data completeness, understand algorithms, protect confidential information, and exercise professional judgment. An anomaly is an indicator for investigation, not proof of misstatement.

Contemporary audits increasingly address cybersecurity incidents, electronic evidence, cloud systems, automated controls, and third-party service organizations. The auditor should understand whether system-generated reports are complete and accurate and whether access controls and change-management controls support reliance on automated processing.

13. Challenges and Limitations

Audit evidence has limitations. Confirmations may be intercepted, inventory may change after counting, management estimates may be uncertain, and sophisticated fraud may involve collusion. Sampling creates a risk that the selected items are not representative. Time pressure can lead to overreliance on inquiry or prior-year working papers.

Auditing provides reasonable assurance, not absolute assurance. The auditor’s responsibility is to plan and perform procedures to reduce audit risk to an acceptably low level, not to guarantee that every error or fraud will be detected. Effective documentation should show the risk, assertion, procedure, evidence obtained, exceptions found, and conclusion reached.

Best-Practice Checklist

Chapter Summary

Auditing major transactions and balances requires a risk-based connection between financial statement assertions, internal controls, substantive procedures, and audit conclusions. Revenue testing emphasizes occurrence, cut-off, and the validity of performance and delivery. Purchases and payables require strong completeness and unrecorded-liability procedures. Inventory auditing combines count observation, ownership testing, cut-off, condition assessment, and valuation. Cash work relies heavily on bank reconciliations and external confirmations. Receivables require confirmation, subsequent-receipt testing, and evaluation of credit losses. Payroll procedures address employees, pay rates, deductions, and liabilities. Non-current asset testing covers additions, disposals, depreciation, ownership, and impairment.

Reliable auditing also requires attention to presentation, related parties, estimates, ethics, privacy, technology, and fraud incentives. No single procedure is sufficient in every circumstance. The quality of an audit depends on whether procedures are appropriately designed for the assessed risks and whether evidence is critically evaluated rather than merely collected.

Key Terms

Assertion: A representation by management about recognition, measurement, presentation, or disclosure in the financial statements.

Completeness: Inclusion of all transactions, balances, and disclosures that should be included.

Occurrence: A recorded transaction or event actually happened and relates to the entity.

Existence: An asset, liability, or equity interest is present at the reporting date.

Rights and obligations: The entity controls an asset or has responsibility for a liability.

Substantive procedure: An audit procedure designed to detect material misstatement directly.

Test of controls: A procedure evaluating whether a control operated effectively.

Unrecorded liability: An obligation existing at the reporting date but omitted from the records.

Net realisable value: Estimated selling price less completion and selling costs.

External confirmation: Audit evidence obtained directly from an independent third party.

Bank reconciliation: A comparison explaining differences between bank and accounting records.

Professional skepticism: An attitude involving a questioning mind and critical assessment of evidence.

Impairment: A condition in which an asset’s recorded amount may not be recoverable.

Related party: A person or entity with a relationship that may influence transactions or reporting.

Subsequent receipt: Cash collected after the reporting date, used as evidence about receivables.

Audit trail: The sequence of records linking a transaction from origin to financial statement presentation.

Review Questions

Short Answer Questions

Long Answer Questions

Analytical / Application Questions

Multiple Choice Questions with Answers

Question 1

Which assertion is most directly tested by tracing receiving reports to the purchases journal?

Question 2

Which procedure provides especially strong evidence about the existence of a receivable?

Question 3

Question 4

A sale recorded before goods are dispatched primarily creates a risk relating to:

Question 5

Correct Answer: A. Inspecting invoices received after year-end and subsequent cash payments

Question 6

Under straight-line depreciation, an asset costs 50,000, has a residual value of 5,000, and a useful life of 5 years. What is annual depreciation?

Question 7

Which assertion concerns whether the entity controls an asset or is responsible for a liability?

Question 8

Question 9

Correct Answer: A. Tracing approved personnel records to the payroll register

Question 10

An audit anomaly identified by an artificial-intelligence tool should generally be treated as:

Chapter 7 Auditing Major Transactions and Account Balances

Auditing Major Transactions and Account Balances

Introduction and Context