How to Audit Loan and Advance?

Loan and advance is the amount that financial institutions lend to the customers. When the bank or microfinance disburses money to the customers, they will record them as loans which are the assets on balance sheet.

The entity generates the most of the income from loans to the customers. It is the main account for the entity as they invest most of their capital on loans rather than other assets. When the company disburses cash to the customer, they will reduce cash balance and record loans on balance sheet.

The company expects to collect back the loan principal and interest based on the loan schedule. The interest will depend on the agreed rate.

Loan is the main account for the bank and its link to the source of income as well, so auditors most of the time consider it as a significant risk. If anything goes wrong with this account balance it will cause a material impact on the financial statement.

Auditor has to verify the effective internal control to ensure the company’s control is able to prevent and detect risk. With strong internal control, the auditors can reduce the sample size for testing. Without effective control, it means the risk of material misstatement is very high. The auditor requires to increase the sample size to detect the error within the account.

In the substantive test, the auditor uses both substantive analytical procedure and test of detail to ensure the true and fair loan balance. The analytical procedure will help the auditor to view the full connection between loans and interest income. The test of detail will ensure the detailed support of each transaction.

In addition, auditor has to engage the IT team to verify the loan software that company use. With the big size of the loan, company is highly likely to use the software to control the loan and interest income. So auditors have to engage the IT audit specialist to verify the software and ensure its effectiveness.

Audit Assertion for Loan and Advance

  • Existence: The company record loan when the company had provide them to the customers. The company expects to collect it back from customers on the due date.
  • Right and Obligation: The company has the right to demand the customer payback otherwise they will face lawful action.
  • Completeness: When the company provides loan to customers, they have to record decreased cash and debit loans on balance sheet. All of them must be included in the loan and advance account.
  • Accuracy: The amount recorded must reflect the cash that company lends to customers. However, some customers may have repaid the partial balance, so it has to reflect this balance as well.
  • Classification & Presentation: The loan and advance have to be classified in the correct account. Moreover, the entity such as bank and microfinance requires a lot of disclosure related to the loan and advance.

Substantive Analytical Procedure for Loan and Advance

For bank and microfinance, loan is a very significant account due to the balance compared to the entity’s total assets. Interest income is the main revenue for bank and it generates from the loan balance.

In each bank, the loan account is very big and contain so many loan application. It is very time-consuming to use a test of detail to detect the material misstatement of loan balance. The auditor has to use the analytical procedure to validate the balance.

Auditor has to obtain loan listing and reconcile the balance with the trial balance. They should observe the process of exporting listing to prevent any modification and increase the reliability of data.

Auditor has to reconcile the loan movement from the opening balance to the year-end balance.

Year-end loan balance = opening balance + New loan – Loan paid

Opening balance loan can be reconciled to the prior year’s balance. If it is a new company, auditor has to test the opening balance for all balance sheet accounts.

The new loans have to be reconciled with cash movement. When company disburses loans to customer, they have to record loan and credit cash.

Loan paid will increase the cash balance on the balance sheet. So auditor has to reconcile with balance with cash inflow as well.

Test of Detail for Loan and Advance

  • Existence: The company can only record the loan or advance which really exists with the real customers. The loan will be recorded after cash disbursement from company, so the loan and cash must be connected with each other. They can just record loan from thin air. Moreover, each loan must include many supporting documents which depends on company policy.

Auditors can perform loan reviews to ensure the money really disbursed to the real customers. They can inspect the loan agreement, cash disbursement slip, loan application form, and so on.

  • Right and Obligation: The company has the legal right to collect the cashback from the customer on the due date.

By reviewing the term and conditions in the loan contract or agreement, we will be able to ensure if the company has this right or not.

  • Completeness: All the loans provided to customers must be properly recorded on the balance sheet.

Auditors have to ask for the loan listing from company and reconcile it with the loan balance. The new loan will be added to the listing. The paid-off loan is also required to remove from the listing as well.

Most client will use the computer software to control the loan listing, so they can test the computer software. Auditors have to be an eyewitness while clients export the listing. They have to ensure it is the raw data from the system without any modification.

  • Accuracy and valuation: After loan disbursement, the amount of the loan will be reduced due to payments from customers. Company has to decrease the loan balance after the cash collection each month. The balance on balance sheet only presents the cash that the customer has not yet paid.

Comparing each loan to the agreement will allow auditors to ensure the disbursement balance only. So they have to check the cash collection from customers to ensure the carrying amount is correct. To ensure this assertion, auditors have to inspect both loan contracts and cash collection documents.

  • Classification & Presentation: The loan and advance transactions have to be recorded in the right accounts. The classification has to be consistent from one year to another. In addition, there is much information need to disclose to prevent misunderstanding.