Journal Entry Testing

Journal Entry Testing is one of the significant audit testings as it can affect many financial line items in both income statement and balance sheet. Journal Entry refers to the adjustments transactions which outside of the normal recording process.

Financial statements are the result of the recording of daily business processes such as purchase, sale, cash receipt, borrowing, pay off, and so on. These types of transactions are the normal course of business and they are usually recorded into accounting software by their own module. Most accounting software has separate modules for sale, purchase, inventory, and so on.

At the same time, the company may need to make some adjustments such as wrong records, accrued expenses, unearned revenue, and others. These adjustments will be made in the form of journal entries or journal vouchers. The journal entry module will be able to adjust with all of the accounts in the chart of account. That why it is very risky if the accountants have made any mistake with a journal entry, the transaction will impact the whole report. Most of the company has a strict policy regarding posting through a journal entry, they need to review, check and approved by the authorized person who knows exactly what they are doing.

Moreover, journal entry becomes commonplace for management to commit fraud due to its abilities. Management wants to make the financial statement look good for their own benefits, so they are looking to adjust some accounts such as sales, assets, expenses…etc. Journal entry is the best place for them to do so.

Due to the risk of fraud and error, journal entry testing is very significant for auditors to ensure the financial statement are presented true and fair.

Journal Entry Testing Process

Understand the nature of journal entries: We have to understand the nature of transactions which is posted as journal entries. Some transactions are normal for the company and they are very low risk such as depreciation, interest expense and income, inventory provision, accrued expense, and unearned revenue. These transactions will happen again and again every month. Auditors have to understand how the journal entries are recorded and posted. How many people involved in the process such as posting, review, and approval. If the company has a strict policy regarding the posting, it will reduce the risk of error.
Extract all Journal Entries: Some companies use special references such as “JE####” or “JV####” and so on. So we have to extract all of the journal entries posted within the month. We have to ensure that the listing is complete.

Ensure completeness: After receiving the listing, auditors have to ensure that it is completed, there is no transactions are excluded for any reason. We can simply run through the reference sequential number. They should be sequential, if any number is missing, we should check with the accountant. Moreover, we need to check for the debit and credit side is equal. If not, it means something wrong.
Separate Recurring and Non-recurring transaction: Base on our understanding in step one, we should be able to separate the recurring adjustments which are considered as low risk. Non-recuring transactions refer to other adjustments besides the recuring, they include correction, reversing entry, and others.
Test recurring adjustment: recuring adjustments should be group together by their type. The auditor can go through the accounting treatment of each group transaction. If they are correct we can simply scan through for the unusual transaction amount.
Test non-curing adjustment: It is very subjective to test the non-recurring adjustment as they do not fall into any group. First, we can target them by high-risk accounts. Based on our understanding of the client’s business, we already know which accounts are high risk. So we simply filter the high-risk accounts and check them. One more thing, we can target by the amount of transaction. It would be less material if the transaction is only $ 100 compared to another adjustment of $ 1,000,000. So we should target the high amount first. Finally, when the remaining transactions are huge and the total amount still significant. We can perform a sampling test by select the random sample to reduce the risk of material misstatement.

Important of Journal Entry Testing

One significant risk for auditor: As we have mentioned, a journal entry is a high-risk area. Without testing it, the auditor will not be able to get comfort from the whole financial statement.
Detect error and fraud: It is a good place for management to commit fraud as it can override internal control. Moreover, it also a high risk of error area.
Test Internal control: Internal control is very important as it helps to reduce the risk of error. If the company does not perform it properly, it is highly likely to increase the risk of error and fraud.