How to Audit Interest Income?

Audit interest income is the method that auditors use to evaluate the material misstatements which may include in the interest income balance on the income statement.

The main objective of auditors is to ensure that interest income balance is correct. There is no misstatement within this financial statement line item.

Interest income is the revenue that company generates from the interest from loans, fixed deposits, investments in bonds, and saving accounts. In general, its balance is mostly very low compared to the other line items. The company may record it in the other income which is not the main revenue for the company. The auditor may not include the interest income in the testing procedure as it is below the materiality level and does not have any significant risk to the financial statement.

However, the interest income is very significant for some businesses such as banks and microfinance institutes. It is the main revenue source of the enity as they are the one that lends money to other corporations and individuals. It is the primary item on the company’s income statement.

In such a case, auditors will consider it as a significant line item in their scope. Anything wrong with the interest income will have a huge impact on the whole financial statement. It has a huge influence on the user of financial statements.

Audit Assertion for interest income

Audit assertions are the financial characteristic that auditors must test before claiming the account is true and fair. The assertion will be separate between the transaction and account balance line items.

The auditing process for interest income requires certain audit assertions to ensure that all necessary ground has been covered and the financial statements are accurate. We have to test the following assertion such as:

  • Cut-off: The interest income must be accounted for in the correct accounting period. Interest income is based on the principle, interest rate, and cover period. It is necessary for the company to record the income for the current period only.
  • Accuracy: The interest income record must be properly calculated. As the amount is based on calculation, there is no invoice bill or cash receipt. Auditors must carefully recalculate the interest income to ensure accuracy.
  • Completeness: All interest income that occurs within the accounting period must be included in the financial statement. There is no elimination of transactions from the income statement.
  • Classification: Auditor has to ensure that the balance is recorded in the correct classification. If the interest income is the main source of business, it must be recorded as sale revenue at the beginning of income statement. If the interest income is not the main revenue, it may be recorded as the other incomes on the income statement.
  • Occurrence: The financial statement records only the transaction which really occurs. The interest income will only record if it really earned from the borrowers.

Risk of Material Misstatement for Interest Income

Risk of material misstatements is the risk that material misstatements exist within the account balance and the internal control cannot detect or prevent. This risk may or may not exist in the interest income depending on the inherent risk and control risk.

Inherent Risk of Interest Income

Inherent risk is the nature of account which could cause the material misstatement. It depends on the account balance, the complexity of the business, and the business environment.

As mentioned, interest income may not be a high risk if company just receives it from a saving account that does not include a large balance.

The interest income will become a huge risk when it represents a large portion of company revenue. The interest income is always a high risk for the bank, microfinance.

It is a high risk due to the nature of business of bank which is very complex. It faces the error of calculation using the banking software. Anything wrong with the software will lead to a material misstatement in the whole financial report.

Control Risk of Interest Income

Control risk is the risk that company internal control can not detect and prevent the risk of material misstatements. When the financial statement line item is considered a high inherent risk, auditor has to check if the management has performed any internal control. Management is usually aware of the risk and set the company policy to prevent and detect the risk of error or fraud.

If the company has such kind of internal control, auditor must perform internal control testing to see if it really helps to reduce the risk of material misstatement.

Effective internal control will help the auditor to reduce the risk as well as the testing required. We believe that effective internal controls are able to prevent, detect and correct the material misstatement that occurred in the account nature.

Risk of Material Misstatement of Interest Income

The risk of material misstatement of interest income will depend on the inherent risk and control risk. Inherent risk depends on the auditor’s judgment over the account’s nature, business complexity, and other environmental surroundings. The control risk depends on the effectiveness of the company’s internal control.

The high inherent risk of interest income will require the auditor to test the internal control to reduce the risk. If effective control exists, the risk is lower and it will reduce the substantive test perform in the next steps.

The internal control may not exist or it is not effective, the auditor will not plan to rely on the internal control. They will go straight to the substantive testing. Auditors will require to test a huge sample size as there is a high risk and lack of effective internal control.

Substantive Audit Procedure for Interest income

To ensure the corrected interest income balance, auditor has to perform various tests. Test of detail is one of the significant tests that auditor use to gather audit evidence to support their opinion on accounts balance as well as the whole financial statement.

Auditors have to provide reasonable assurance regarding the accuracy and reliability of these numbers. There is a setlist or criteria that auditing firms use when performing an audit on this type of financial statement line, so it’s important not only to cover all aspects but to double-check your work by checking against these standards as well.

Substantive Analytical Procedures for Interest Income

Substantive analytical procedure is the testing that auditor performs by evaluating the relationship between financial line items, the connection between financial and non-financial data, and other information on the financial statement.

The substantive analytic is very suitable for the interest income as this account is supposed to be less fluctuating. As we know, the interest income arrives from the principal, interest rate, and coverage date. If we have the interest rate, principle, and coverage date, we will be able to recalculate the interest income during the period. It will not require checking the supporting document of interest income each month. It is also more reasonable to perform the comparison of balance from one month to another.

For the interest income from the fixed deposit, the auditor can perform the calculation base on the amount of deposit, interest from the bank, and coverage period. The interest income from the deposit will change according to the deposit balance during the year.

The analytical procedure will follow the trend in the connection between all accounts in the financial statement. As the accounting record use double entry, so all the transaction will impact two accounts or more.

For example, interest income will increase and align with the loan disbursement to the customer. As the interest income is automatically calculated by the system, it will not be related to the cash collection. The client has to record interest income after disbursing loan to customers even if cash is not yet collected. So when the loan balance increase, we expect the interest income to increase as well. It will increase align with the average interest rate and the coverage month.

Besides accounting records, analytical procedures also look at the non-financial data as well. If the company is expanding and increasing new branches, we expect the revenue will increase as well.

Test of Details for Interest Income

Test of detail is the test that auditor uses to validate the financial assertion base on the nature of account. As the name suggests, the auditor will perform a detailed review of the supporting document of the transaction recorded and other testing which look at the individual transaction.

Auditor perform tests of detail in addition to the analytical procedure as they are not satisfied with the testing. It is the additional test that auditor performs

  • Completeness: Before testing, auditor has to ensure that the listing is completed. Auditor asks the client to extract the interest income listing and reconcile it with the trial balance. The balance should be the same unless there are some adjustments. It can ensure that all the interest income in the bank software is recorded in the financial statement.
  • Cut off: It is one of the most common errors that can happen to the transaction that does not depend on the invoice issued. Interest income recognition depends on the system calculation. If the loan term covers more than one accounting period, it has to separate based on the coverage months. Auditor can recalculate the interest and focus on the cut-off date. They should pay attention to the new loan disbursement and pay-off.
  • Occurrence: The company is only allowed to record the interest income as they really happen during the period. It can be a fraud for that banks to use fake/ghost loan to increase the interest income. The auditor can review the loan application to make sure that the company really lends money to the customer to earn interest.
    If the interest arrives from the deposit in bank, auditor can review the original bank statement attached with bank reconciliation. It is also reconciled with bank reconciliation and bank confirmation.
  • Accuracy: Auditor has to test the accuracy of the recorded amount. The interest income arrives from the calculation, so it is important to recalculate the ensure accuracy. For the bank, auditor can recalculate the interest income which extracts from the banking system.
  • Classification: The interest income has to record in the correct classification on the income statement. The testing is very straightforward as we have to review the classification of interest income on the financial statement.