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Sometimes the sales and purchases figures are altered towards the year-end. Cut-off errors arise when companies recognize revenue and purchases based on the date on which the sales invoices/purchase invoices are generated rather than the date on which the risk and reward are transferred to the buyer. This can ultimately lead to an improper recording of revenue and purchases in the books, resulting in misstatements in financial statements. Therefore, proper cut-off procedures are extremely important to test the transactions immediately before and after the year-end. In this blog, we are discussing, with examples, why and how these cut-off procedures are performed in an audit. An understanding of Cut-off procedures and testingWe know that auditors examine the financial statements of a company independently and present a report of their findings. They need to see whether the companies have prepared their financial statements in accordance with the generally accepted accounting principles or not. Now in the preparation of such financial statements, the management of a company implicitly or explicitly makes certain claims (also known as assertions) with regard to the completeness, valuation, existence, cut-off, rights and obligations, and presentation of assets, liabilities, income and expenses. The management asserts that all the items of financial statements are recorded and disclosed as per the applicable accounting standards. It is up to the auditor to examine whether each of these assertions made by the client’s management is correct or not. For this, he draws a proper audit program and obtains sufficient and appropriate audit evidence. Now, one of these assertions relates to “cut-off”. Let us understand that. “Cut-off” is a key assertion that signifies that all assets, liabilities, income and expenses are reported in the appropriate period. To verify this assertion, the auditor has to assure that all transactions are recorded in the correct period. In other words, the auditor has to verify whether all assets, liabilities, income and expenses recorded in a particular period actually pertain to that period or not. For example, do employee benefit expenses recognized during the current year belong to this year only? No such item which does not relate to the current financial year finds a place in the profit or loss. Further, with cut-off procedures, one can separate the transactions and events of one accounting period from another. Say, the transactions that pertain to the year ending 31st March 20XX and the transactions post 31st March. Cut-off procedures in audit – ExamplesLet us understand this with the help of some examples. I. Trade receivable balances and SalesAn auditor needs to satisfy himself with the cut-offs to check whether trade receivable balances that were supposed to be recorded have been recognized in the financial statements. Without a cut-off, sales can be understated or overstated, thus, cut-off tests should be performed. Following are a few examples:
II. Trade payable balances and PurchasesJust like debtors, it is also important to verify that the trade payable and other liability balances that were supposed to be recorded have been recognized in the financial statements. Some examples of cut-off procedures that an auditor can perform during his audit are:
III. InventorySimilarly, for cut-off testing of inventory items, the auditor should trace shipping documents (such as bill of lading, goods receiving reports, warehouse records, inventory records, etc.) to accounting records immediately before and after the year-end. It would enable the auditor to ensure that the inventory balance at year-end does not contain any element of the next financial year. Conclusion (Cut-off testing in audit)The year-end cut-off testing or cut-off procedures in audit play a significant role in determining if the transactions are correctly recorded in the appropriate period or not. For sales, the date of invoice and the date of dispatch must fall in the same period in which the entries are recognized in the Sales Book. Likewise, for purchases, the date of material inward and invoice date must correspond to the period in which entries are made in the Purchases Book. Unless the risk and reward are transferred from the seller to the buyer, no entry of Sales or Purchases should be recognized, as the case may be. You might also like:
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