NINJA SIMS Flashcards
The bank’s confirmation reply regarding the company’s line of credit indicated that the December, Year 2, interest was unpaid at year-end. Accruals for monthly interest expense have been made for 11 months in Year 2 by the company.
Dr. Interest expense Cr. Accrued liabilities
Without accruing the final month’s interest expense, interest expense and accrued liabilities would be understated for Year 2. In this case, the auditor would compare the balance in the line of credit (which would be a type of accrued liabilities account) with the balance per confirmation. The auditor would also compare the interest expense total for the year to any 1099-INTs received by the company. In order to match the documentary evidence received from outside sources, the company must make an adjusting entry to debit (or increase) interest expense and credit (or increase) accrued liabilities.
Employee overtime pay for hours worked before year-end, but paid in the following year, were not recorded in Year 2.
Dr. Operating expenses Cr. Accrued liabilities
Regardless of whether the overtime from Year 2 (paid in Year 3) is quantitatively material, the company will not have a complete picture of its costs of production (or costs of sales) if it does not record the accrual for overtime. It is possible that without this overtime, the financial statements could be misleading. The auditor would suggest a journal entry to record the overtime in Year 2. This entry would involve increasing a wage account (a type of operating expense) by debiting it, as well as increasing an accrued wages account (a type of accrued liability) by crediting it.
In the last week of Year 2, the company recorded revenue for services rendered to some clients in Year 3.
Dr. Revenues Cr. Accounts Receivable
Revenues should not be recognized until they are earned. Since the services were not performed until Year 3, the auditor should suggest an adjusting entry that lowers (or debits) revenues and lowers (or credits) accounts receivable. This entry reverses the original entry to record the revenue. Auditors must operate under the assumption that improper revenue recognition is a fraud risk, and premature recognition of revenue (which would overstate the revenues for the year under audit) could result in a material misstatement.
During Year 2, a former client sued the company for inappropriate work. Legal counsel has advised that it is “reasonably possible” that the company will be assessed damages. An amount can be estimated.
Dr. Disclosure but no entry required Cr. Disclosure but no entry required
A loss contingency should only be accrued if it is BOTH probable that the loss will occur AND the amount of the loss can be reasonably estimated. In this example, the company’s attorney believes that it is reasonably possible that a loss will occur. Reasonably possible is less likely to happen than “probable.” This situation does not meet the criteria for accrual. However, a loss contingency should be disclosed if it is EITHER probable that the loss will occur OR the amount of the loss can be reasonably estimated. In this case, the disclosure should indicate the nature of the contingency, as well as an estimate of the possible loss or range of loss, or state that an estimate cannot be made.
At the end of Year 2, a major customer filed for bankruptcy.
Dr. Operating expenses Cr. Allowance for doubtful accounts
If a major customer files for bankruptcy, the assumption is that the company under audit will most probably not receive all or any of the receivable from the customer. A major customer would have a larger balance than others. This situation would be considered a loss contingency.
In this circumstance, the loss is probable and the amount of the loss (the receivable) can be estimated. An adjusting entry should be made when both these criteria are met. The auditor would suggest increasing (or debiting) a bad debt account (a type of operating expense) and increasing (or crediting) the allowance for doubtful accounts. The allowance account is a contra account to the accounts receivable and allows the presentation of the accounts receivable at its net realizable value.
