Auditing 4
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A pp e n d i x III
Adjusting Journal Entries
I.OVERVIEW
Journal entries may be on any accounts that appear in the financial statements. These questions
often require basic knowledge of journal entries. (For example, revenue related to Year 2 should not
be included in Year 1 revenue.) Some methods the examiners may use to test adjusting entries can
be found below (but this is not meant to be a comprehensive list).
A.
Correct Accounts That Are Overstated or Understated
1.
2.
For questions related to adjusting accounts that are overstated or understated, it is
important to be familiar with the natural debit or credit balance of an account. With the
exception of contra-accounts, the general rule is:
a.
Assets have a natural debit balance.
b.
Liabilities and stockholder equity have a natural credit balance.
c.
Sales have a natural credit balance.
d.
Expenses have a natural debit balance.
Knowing the natural balance of accounts will help you understand how to adjust journal
entries. For example, if sales made "on account" are overstated, this means that the
auditor thinks sales and the related receivable are too large and need to be smaller. To
decrease these accounts, the auditor would propose:
DR
CR
Sales
$XXX
Accounts receivable
$XXX
(To adjust sales and accounts receivable to correct amounts.)
Rationale: Sales has a natural credit balance, so sales should be debited to decrease
it. Accounts receivable has a natural debit balance, so accounts receivable should be
credited to decrease it.
B.Contingencies
Questions may ask about contingencies and whether the financial statements should be
adjusted. Contingencies are discussed in more detail in the F10 lecture, but a high level
summary is:
Can Estimate Loss Amount
Probable
C.
Cannot Estimate Loss Amount
Accrue and disclose
Disclose
Reasonably possible
Disclose
Disclose
Remote
May ignore or may disclose
Purchases and Inventory
1.Purchases
Questions related to purchases may require knowledge of free on board (FOB) shipping
point and FOB destination. It is important to note whether the client is the buyer or seller
to help determine whether purchases (such as inventory) should be included or excluded
from a balance.
a.
If the Client Is the Buyer
(1) FOB shipping point: An item shipped FOB shipping point should be included
in the client's inventory as soon as the item is with the carrier (e.g., in a
FedEx truck).
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Auditing 4
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(2) FOB destination: An item shipped FOB destination should be included in the
client's inventory as soon as the item has reached the destination (e.g., the
client's place of business).
b.
If the Client Is the Seller
(1) FOB shipping point: An item shipped FOB shipping point should be excluded
from the client's inventory as soon as the item is with the carrier (e.g., in a
FedEx truck).
(2) FOB destination: An item shipped FOB destination should be excluded from
the client's inventory as soon as the item has reached the destination (e.g., the
buyer's place of business).
2.Inventory
a.
Perpetual Inventory
In a perpetual inventory system the journal entries to record the sale of
inventory are:
DR
CR
Cash or accounts receivable
Sales
$XXX
$XXX
(To record the sale of an item.)
AND
DR
CR
Cost of goods sold
Inventory
$XXX
$XXX
(To record the relief of inventory.)
b.
Periodic Inventory System
In a periodic inventory system, sales are recorded after every sale is made, while
inventory is adjusted at the end of the period through a periodic count. The formula
to calculate cost of goods sold is:
Beginning inventory
+ Purchases
= Cost of goods sold available for sale
– Ending inventory (based on physical inventory count)
= Cost of goods sold
The journal entry to record a sale under the periodic method is:
DR
CR
Cash or accounts receivable
Sales
$XXX
$XXX
(To record the sale of inventory.)
Cost of goods sold are recorded at period end. The journal entry at the end of the
period (based on the formula above) would be:
DR
CR
Cost of goods sold
Inventory
$XXX
$XXX
(To record the relief of inventory.)
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Auditing 4
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Example
The auditor is auditing ABC Company, which utilizes a periodic inventory system. The auditor discovered
that inventory stored at a distribution center on December 31, Year 2, was inadvertently omitted during
the Year 2 physical inventory count. This inventory was valued at $20,000. What should the adjusting
journal entry be?
DR Inventory
CR
Cost of Goods Sold
$20,000
$20,000
(To correct inventory and cost of goods sold for inventory held at off-site location.)
The company needs to increase inventory by $20,000. In addition, when the company computed cost
of goods sold, the ending inventory was lower by $20,000, which resulted in a higher cost of goods sold
of $20,000. To decrease cost of goods sold, the auditor would propose a credit to cost of goods sold
for $20,000.
c.Consignment
(1) Audit client is the consignee (holding another company's goods): This
inventory should be excluded from the client's financial statements.
(2) Audit client is the consignor (goods are held at consignee's place of business):
This inventory should be included in the client's financial statements.
D.
Subsequent Events
1.
2.
Type I events require adjustment of the financial statements. Type I events provide
additional evidence with respect to conditions that existed at the date of the balance
sheet and affect the estimates inherent in the process of preparing financial statements.
All information that becomes available prior to the issuance of the financial statements
should be used by management in its evaluation of the conditions on which the estimates
were based. Examples include:
a.
Loss on an uncollectible trade account receivable as a result of a customer's
deteriorating financial condition leading to bankruptcy subsequent to the balance
sheet date. This event gives more information about the customer's condition that
existed at the balance sheet date. Note that the customer's condition was already
deteriorating as of the balance sheet date; therefore, the balance sheet should be
adjusted to reflect this.
b.
Settlement of litigation for an amount different from the liability recorded in the
accounts would require adjustment of the financial statements if the event that gave
rise to the litigation took place prior to the balance sheet date.
Type II events require disclosure only in the financial statements. These events provide
evidence with respect to conditions that did not exist at the date of the balance sheet but
arose subsequent to that date. Examples include:
a.
Sale of a bond or capital stock issue subsequent to the balance sheet date.
b.
Purchase of a business subsequent to the balance sheet date.
c.
Settlement of litigation when the event giving rise to the claim took place
subsequent to the balance sheet date.
d.
Loss of plant or inventories as a result of fire or flood subsequent to the balance
sheet date.
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