How to Audit Interest Expense?
Interest expense is the amount of cost that company pays to borrow cash from a bank or other creditors.
The amount of interest expense will depend on the cash that company borrows from others and the agreed interest rate. The borrowed cash will record as debt on the borrower’s financial statement. If a company relies on debt rather than equity, the interest expense will become a significant account.
On the other hand, it will be insignificant if the company has small debt on the balance sheet. The interest expense will be very small, it will not have any huge impact on the income statement.
During the planning, auditor must access the risk associated with all the accountant balances. They also evaluate the risk of interest expense on the income statement. If the amount is small and the risk is low, they may exclude from the audit scope.
If the amount of interest expense is huge as the company has many long-term debts, auditor has to review it very carefully. They will perform internal control testing to ensure the company has proper control to prevent and detect risk. It can reduce the inherent risk that attaches to the account balance. It also reduces the number of substantive testing which will increase the efficiency.
Auditors can use the substantive analytical procedure to get a view of the overall balance. It is the result of the debt that represents the risk position of the company. The interest expenses have a close connection with the amount of debt on balance sheet.
To ensure the applicable assertions, auditor has to use various tests which will be further discussed in the following sections.
Audit Assertion for Interest Expense
- Occurrence: The company has to record only the transaction that is really incurred during the accounting period. Interest expense is recorded for the expense related to the cost of obtaining debt.
- Cut-off: The income statement balance needs to be split between each accounting period. Interest expense is recorded only the portion that incur in this period only, not the previous year and the next year. The interest expense for a debt may cover several periods, company need to separate it between accounting period.
- Completeness: All interest expense must be recorded in the account even if it is not yet paid to the creditor. The interest expense record based on the accrued basic, not cash paid.
- Accuracy: The transactions have to be record base on the accurate supporting document. Interest expense must be calculated based on loan principal, interest rate, and the number of months.
- Classification: The interest expense has to record in the proper account.
Substantive Analytical Procedure for Interest Expense
The substantive analytical procedure is the audit testing that focuses on the total balance rather than the detailed transaction. It helps auditors to ensure the reasonableness of account balance by comparing them with other accounts, trending and non-financial data.
Based on the review of relevant accounts, auditors have built an independent expectation. After that, they have to compare the total account with expectations. Any significant variance needs to investigate. After that, the auditor can make a conclusion on the material misstatements of the account balance.
The interest expense depends on the company debt and the agreed interest rate. The monthly interest expense is highly likely to be the same while the debt remains the same. It is the auditor’s expectation regarding the monthly interest expense.
Auditors can request the monthly interest expense during the year. Then they have to inspect the debt principal and interest rate and calculate one interest expense for a month. Next month’s interest expense should be the same unless the company obtains a new debt or paid off the existing debt.
Auditors have to compare the interest expense from one to another. It supposes to be the same from month to month and it aligns with the balance of the debt.
So if the company debt remains the same over the year, the interest expense should be consistent as well.
If the company obtains new debt, it will increase interest from the receiving date. Auditors have to check if the company records interest expenses on new debt in the proper time frame.
When the company paid off some debts, it will lead to a decrease in interest expenses. So the interest expense in the following months will be decreased based on the debt paid off.
Auditors must investigate any unusual variance that is higher than expected. It is fine if the vriance is reasonable. If it is not explainable, the auditor has to propose an adjustment based on the materiality.
Test of Detail for Interest Expense
- Occurrence: The company record only the interest expense transaction that is really incurred during the accounting period.
The auditor can validate the occurrence of interest expense by inspecting the loan agreement between company and the creditor. Auditor has to ensure that the loan incurs so it really creates the interest expense.
- Cut-off: The interest expense needs to be split between each accounting period.
It mostly happens when the loan covers more than one accounting period. The company may record the total interest expense correctly, however, they fail to separate the expense to the proper period. Auditor can perform testing by recalculating the interest from beginning to year-end. It should be taken into account the new loan and paid-off loan during the year.
- Completeness: All interest expense must be recorded in the account even it is not yet paid to the creditor.
Auditor has to obtain the interest expense listing from the client and reconcile it with the balance on the income statement. In addition, the listing may contain the loan amount of loan principal that use as the basis for calculation.
Auditors can reconcile the loan principle balance between the listing and balance sheet balance. They should reconcile both beginning and ending balance. It helps to ensure that company takes into account all the loans which are the source of interest expense.
- Accuracy: The transactions have to be record base on the accurate supporting document.
There is no invoice from creditor to charge for the monthly interest. It will base on the calculation by using principal balance and the interest rate. Auditor can ensure accuracy by recalculating the interest expense from the listing. With the help Excel spreadsheet, it can be done almost immediately. However, we have to ensure that the loan balance and interest rate are correct.
- Classification: Interest expense is only recorded in one account and presented properly on the income statement.
Auditors can review the classification of interest expenses that are present on the income statement.