In this lesson, I want to describe to you the concept of management assertions.
In our previous lesson, we talked about cycles.
Cycles are simply a grouping of accounts that use similar processes within the organization.
For instance, the sales cycle involves sales, receivables, and cash receipts.
The acquisition cycle involves the accounts for inventory, capital assets, accounts payable, and cash disbursements.
As so on and so forth until all the accounts in the financial statements have been grouped within one or more cycles to which they relate.
The diagram presented here shows how the cycles interact with one another.
This is the first step and we do this simply for audit efficiency so that we can audit like accounts simultaneously.
Keep in mind that every journal entry has both a debit and a credit.
So if you are able to substantiate either the debit or the credit, you are indirectly proving the other side of the entry.
Does that make sense?
But what exactly are we proving?
Getting back to our income statement, we need to form an opinion on whether each,
and every one of these numbers is fairly presented.
That means, that the amount is neither higher nor lower than what has been represented,
and that management has got the dollars recorded in the right accounts.
Let’s flip over to the balance sheet for a moment, because there are other things we need to substantiate here.
Not only do we need to ensure that the number are appropriately valued,
we also need to ensure that the company owns its assets and is obligated to pay its liabilities.
Think of it this way, when management puts these statements in front of the auditors,
management is “asserting” to us that these are the numbers
and that they don’t have a second set of books hidden away in the back of the closet.
Management's assertions are multi-faceted and can be dissected to help focus our audit procedures.
So let’s take inventory for example.
What is management asserting about this balance.
Well, first of all, management is asserting that the balance of inventory exists, and that is it physically present.
Secondly, management asserts that it has the rights to the inventory and that it hasn’t been sold or is owned by someone else,
say in a consignment arrangement.
This is called the rights (for assets) and obligations (for liabilities) assertion or “ownership” assertion.
Thirdly, management is asserting that all the inventory that it owns has been recorded,
and there isn’t another hotel storeroom full of unrecorded inventory somewhere in its operations.
In other words, the balance reported is complete.
Fourthly, managemet is asserting that the inventory balance was accurately measured,
both in terms of the quantities, the prices, and the calculations that determine the carrying value.
Fifthly, that management has considered the appropriate valuation of inventory.
As we know, GAAP requires inventory to be carried at the lesser of cost and net realizable value.
So management’s assertion is that they have made this determination for us by considering obsolescence and ultimate selling prices.
Sixthly, that the inventories have been appropriately classified as required by GAAP,
say between raw materials, work in progress, and finished goods.
Other assertions exist for the detailed tie in with the general ledger and the achievement of an appropriate cut off.
The tie in is a representation that the balance inventory comes from the general ledger.
The general ledger is the foundation of the financial system.
Cut-off speaks to ensuring that transactions that occur near the period end date get reported in the proper year.
For example, if you are a company that ships product on the last day of the year with the goods are still in transit at the year end date,