Key income statement figures: revenue, purchases, payroll, interest and expenses

A client has strong controls over sales, purchases and payroll, and the auditor has tested them. Is that enough? No. Some substantive work is still needed on the income statement, but where controls are strong it may be limited to analytical procedures. The income statement is mostly tested through its links to the balance sheet: revenue links to receivables, purchases to payables and inventory, and payroll to headcount.

Knowing which test fits which figure saves time and finds errors.

This topic covers the substantive procedures for revenue, purchases, payroll costs, interest and other expenses. The previous topics covered the balance sheet, and the next covers written representations and completion.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence and substantive procedures (25% of marks). It covers:

• substantive procedures for key income statement figures
• analytical procedures
• tests of details

CAMA 2020 and income statement figures

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

The place of substantive work on the income statement

Tests of controls on the main income statement figures were covered earlier. Whatever the results, some substantive procedures must be performed. For clients with strong controls, the work may be limited to analytical procedures. Other procedures are set out below.

Revenue

Revenue is often tested through controls. It is also possible to get strong evidence through analytical procedures, because revenue is closely related to other figures, such as receivables, for which the auditor can get strong third-party evidence through confirmations. Revenue can also be tested by vouching transactions.

If the major risk is overstatement, the auditor selects a sample of entries from the revenue account in the nominal ledger and traces them back through sales invoices to dispatch notes, which gives evidence that the recorded sales occurred.

Typical analytical procedures for revenue are comparisons of monthly sales with the previous year and the budget; of sales per product line, branch or sales representative; of the gross profit margin by product; and of sales to units dispatched or to the production capacity. Revenue in a business with prices and volume records can be estimated as units times average price, and compared with the recorded amount.

ISA 240 presumes that there is a fraud risk in revenue recognition, so the auditor does not rely on analytical procedures alone when the risk is high. For significant risks, tests of detail are required, such as cut-off tests around the year end, review of credit notes after the year end, and confirmation of unusual terms.

Purchases

Like revenue, purchases are often tested through controls. Strong evidence also comes from analytical procedures because of the relationships with other figures, for example revenue through the gross profit percentage, and trade payables. Purchases can also be tested by vouching. If the main risk is understatement, the auditor tests completeness and checks that:

• all purchase orders are recorded and the order details are correct;
• for every purchase order, the goods were actually received; and
• all goods received were properly recorded in the inventory system.

Substantive procedures other than analytical procedures are:

1. Obtain a sample of copies of purchase orders and trace them to the purchasing IT system. Check the accuracy of the details recorded.
2. Obtain a sample of purchase orders in the purchasing system and trace them to the signed copies of goods received notes in the goods inward department.
3. For the same sample, check that the details of goods received were properly recorded in the inventory system.

Tests on purchase invoices make sure that:

• the details have been correctly entered in the payables ledger
• entries are made only for goods actually received
• the liability was recorded in the correct supplier's account

Methods are:

• take a sample of invoices in the purchases day book and agree supplier and price with the entry in the ledger
• for a sample of invoices in the day book, agree the details to the corresponding goods received note
• do arithmetical checks on a sample of supplier invoices, multiplying quantities delivered by price, checking totals and checking prices to the original orders

Payroll costs

As with other expenses, the key risk for payroll is understatement, so the auditor tests completeness. Analytical procedures are often used, because there is a strong relationship between rates of pay and numbers of employees for gross pay, and between gross pay and deductions such as employer's pension contributions. For a department where employees receive fixed salaries, compare salary costs for the year with the previous year.

Unless staff numbers changed significantly, the totals should be similar apart from inflationary increases. Compare also total salary payments for the same department from one month to the next: they should be constant except in a month where a pay rise is applied.

Other substantive procedures are to select a sample of payroll records and check that:

• the employee exists, by reference to personnel records
• gross pay is correctly calculated, by reference to personnel records for salaries or to time worked multiplied by documented pay rates
• deductions are correct, by reperforming the calculation on a sample of payments

Interest paid and received

Interest paid and received is usually verified through the bank statements and a "proof in total", which means multiplying the average interest rate for the period by the average balance outstanding and comparing the result with the amount in the accounts. Differences are investigated, for example for unrecorded loans, unrecorded deposits or capitalised borrowing costs.

Other expenses

Other expenses can be tested through analytical procedures, such as comparison with the previous year and budget and ratio of expenses to revenue, or by vouching transactions to purchase invoices. The auditor pays attention to the unusual: round amounts, payments to related parties, expenses with no clear business purpose, large items at the year end, and expense accounts where a large increase or decrease cannot be explained.

Choosing between analytical procedures and tests of detail

The auditor sets an expectation, a threshold for investigation and a record of the explanations obtained, as in the earlier topic on analytical procedures.

Linking income statement tests to the balance sheet

Income statement items are tested with the balance sheet because of double entry. Revenue ties to receivables and cash; purchases to payables and inventory; payroll to accrued wages and cash; interest to loans and deposits; depreciation to assets. For example, a cut-off error in sales will show up in both receivables and inventory.

Evidence on one side gives comfort about the other, and the auditor avoids duplicating work by planning the tests together.

The auditor also pays attention to income statement presentation: that items are classified in the right headings (cost of sales, distribution costs, administrative expenses), that revenue is disclosed as required, that finance costs are shown separately and that exceptional or unusual items are disclosed.

Worked examples

1. The sales may not have occurred, or the goods may have been delivered without a signature.
2. The auditor checks further evidence, such as customer confirmation or later cash, and considers the error rate.

1. The 25% jump needs an explanation, such as a pay rise, a bonus or an error.
2. The auditor checks to the payroll and authorisation for the increase.

1. Proof in total gives ₦80 million.
2. The difference of ₦28 million suggests interest is understated or has been capitalised, and the auditor investigates.

1. Two are not recorded until January.
2. Purchases and payables are understated, and the auditor proposes an adjustment.

How to score full marks

• State the direction: ledger to documents for overstatement, documents to ledger for understatement.
• Use analytical procedures where relationships are strong.
• Give the test for existence, gross pay and deductions for payroll.
• Mention proof in total for interest.

Common mistakes in the exam

• Testing expense completeness from the ledger.
• Relying on analytical procedures alone for revenue fraud risk.
• Forgetting employer costs in payroll.
• Missing the proof in total for interest.

Quick revision

• Revenue: analytical procedures; vouch ledger to dispatch notes.
• Purchases: orders to receipt to inventory; invoices to ledger.
• Payroll: analytics; sample for existence, gross pay and deductions.
• Interest: bank statements and proof in total.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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