Audit adjustment is the entry that the auditor proposes to correct the financial statement base on the evidence acquired during the audit work.
Auditors review the client’s financial statements and issue audit independent opinion reports. The audit report will show if the financial statements are true and fair or not. Most of the time, the auditors will try their best to correct the report to ensure it is free from material misstatements. They correct it by proposing the audit adjustments.
Not all financial statements are correct in the first place. There are some mistakes that happen due to errors or fraud. Auditors use professional judgment to evaluate such mistakes. Some mistakes are very small and it is not impact the whole financial statement and decision-making of the user. So the auditors only inform the clients about the nature or put in the management letter if it is related to the internal control weakness.
If the error is significant, the auditors will propose an audit adjustment to correct the financial statement. The adjustment is made based on the evidence collected during the fieldwork.
Auditors have to discuss with the clients’ management before proposing adjustments. They have to explain the nature of the transaction, the evidence collected, and the applicable accounting standards. If it involves judgment, auditors have to provide more detailed explanations to support such adjustment.
The adjustment will be put into the financial statement after the client and auditors agreed. It will correct the report to ensure a true and fair view to the users.
The purpose of audit adjustment is to ensure that the financial statement is free from material misstatement. The auditors will be able to issue an opinion on the report.
If the client does not agree to adjust the financial statement, they may try to challenge back with their own reasons. For a serious case, it can lead to a qualified opinion from the auditors. It depends on the issue and auditors’ judgment.
How to Record Audit Adjustment?
During the fieldwork, auditors will discuss all the audit adjustments with the management teams. After the agreement, the audit adjustment will be reflected on the financial statements. It will only adjust with the financial statement, not the accounting system.
The company has to include the audit adjustment into the accounting system, so it is easy to keep track of next year’s audit.
Most of the audits will be performed after the year-end, so it means that the audit adjustments are identified after the year-end closing. It will be a problem if the adjustment is related to the revenue and expense account. We cannot propose adjustments to the revenue/expense of the current year as the transaction is related to the audited year. We have to adjust with retained earnings accounts. To learn more about this kind of adjustment, please refer to the prior-year adjustment.
Audit Adjustment Vs Adjusting Entry
Audit adjustment is the adjustment proposed by the auditor to correct the financial statement before issuing the audit opinion. The adjustment is raised due to the error or mistake made by the company. There is no exact type of audit adjustment as they depend on the mistake made by the company. The objective is to correct these kinds of mistakes.
Adjusting entry is the adjustment that an accountant made to prepare the financial statement. They are the normal entry that an accountant has to record to reflect the nature of the business transaction.
Type of Adjusting Entry
- Prepaid Expense
Prepaid expenses are classified as current assets on a company’s balance sheet. These assets result from making payments for goods or services in advance. Common examples of prepaid expenses include rent, prepaid insurance, and advance purchase.
For example, if a company paid its 12-month insurance premium in January, that premium would be considered a prepaid expense. At the end of January, the company would report the prepaid expense as an asset on the balance sheet. As the insurance coverage is used throughout the year, the asset is gradually converted into an expense.
Therefore, prepaid expenses are initially reported as assets, but eventually, they are reversed to expenses. Although they may seem small, prepaid expenses can have a significant impact on a company’s financial statements. Therefore, it is important for businesses to keep track of their prepaid expenses and to properly record them in their accounting records.
Depreciation is an accounting method used to allocate the cost of a fixed asset, such as a building or equipment, over its useful life. This process allows businesses to expense the cost of the asset on their financial statements over time, rather than recognizing the entire cost upfront.
Depreciation is often used when computing income taxes, as it can provide a tax deduction for the business. There are several methods that can be used to calculate depreciation, including the straight-line method, declining balance method, and units of production method. The choice of depreciation method can have a significant impact on a business’s financial statements and tax liability.
At the end of the accounting period, the company has to make an adjusting entry to allocate the cost of the fixed asset to depreciation expense.
- Accrued Revenue
If you provide a service to a customer but do not bill them until the following month, the revenue is considered accrued. The company has earned the revenue, but it has not yet been issued an invoice.
This can occur often with businesses that provide services on a regular basis, such as monthly cleaning or lawn care. While the customer has not yet paid for the service, the business has still performed the work and is entitled to payment.
Accrued revenues are reported as assets on a company’s balance sheet. This is because they represent money that the company is owed and will eventually receive. Therefore, it is important for businesses to keep track of all services provided so that they can correctly account for all accrued revenues.
- Accrued Expense
Accrued expenses are those that have been incurred but not yet paid. This includes things like electricity used this month but not billed until next month, or salaries earned by employees in the current pay period but not paid until the following pay period. In accounting, accrued expenses are recorded as liabilities, since they represent money that the company owes.
Accrued expenses can be significant, it’s important for companies to track them carefully and include them in their financial reporting. Accrued expenses can have a major impact on a company’s cash flow, so it’s crucial to keep them in mind when making decisions about spending.
- Unearned Revenue
Unearned revenues are funds that a company has received but has not yet earned. This can happen when a customer pays for goods or services in advance. For example, if you pay for a year-long gym membership upfront, the gym will recognize this as unearned revenue until the year is up and you have actually used the services. Unearned revenues are classified as current liabilities on a company’s balance sheet.
This is because the company does not yet have a legal right to keep the money, and it may need to refund the customer if it is unable to provide the promised goods or services. While unearned revenue can provide a short-term boost to a company’s finances, it can also create difficulties if customers demand refunds or if the company is unable to meet its obligations. As a result, businesses need to carefully consider whether unearned revenue is right for them.