Valuation and Verification of Assets and Liabilities | Business | Auditing

In this article we will discuss about the valuation and verification of assets and liabilities of a business.

Valuation of Assets and Liabilities of a Business:

The processes of routine checking and vouching would only substantiate transac­tions as they occur from day to day and confirm the acquisition of assets or assump­tion of liabilities at the first instance but the value thereof may change by the end of a financial period when the balance sheet is prepared.

The vital significance of correct valuation of assets and liabilities for the purpose of closing of accounts is amply demonstrated in the undernoted chart:

Evidently, in the last analysis, variation in the inter-relation assets and liabilities is the most important factor determining profit or loss through its influence on the differ­ence between capitals at the commencement and at the close of a particular financial period.

Such variation may be the result of genuine factors operating in course of nor­mal business activities or it may be inten­tionally engineered by manipulation or fal­sification of accounts. Besides, any inappro­priate valuation of assets and liabilities, whether inadvertently or fraudulently done, would vitiate the financial state of affairs of a business by exhibiting a wrong picture in the balance sheet.

Basis of Valuation of Assets:

In view of the importance of valuation an auditor should always be careful to see whether assets are valued on some reason­able and appropriate basis.

The standard methods of valuation that are usually followed in respect of different classes of assets are enumerated below:

Nature and purpose of acquisition:

1. Fixed:

Stable in nature. Acquired for permanent or long-term reten­tion and use in the business for earning income.

2. Intangible:

Semi-Stable in nature. Acquired as a non-monetary identifiable asset, for use in business to augment earnings or as a class of fixed assets with no physical or tangible existence but valu­able all the same e.g. goodwill intellectual property, or license rights.

3. Fictitious:

Semi-stable or temporary assets without any tangible form, usu­ally expenditure or losses of unusual nature not realisable in cash e.g. preliminary expenses, loss on issue of securities or special advertisement cost.

4. Floating:

Subject to constant movement or changes. Acquired for tempo­rary retention and conversion into cash as early as possible.

Basis of valuation:

1. Fixed:

Going concern value i.e. historical cost or original cost of acquisition (including ad­justments for additions including all ex­penses of bringing an asset into a reason­able condition or disposals) minus proper depreciation on a consistent basis irrespec­tive of the market value.

2. Intangible:

Usually on the same basis as fixed assets i.e. written down value according to the policy on amortisation or fair value of benefits enjoyable on future. As per new norms from ICA, intangible assets will have to be written-off in a maximum of 10 years.

3. Fictitious:

Cost/expenditure incurred or balance thereof less amount written-off from year to year depending on financial policy.

4. Floating:

Realisable value, i.e. market value (net realisable value) or cost price whichever is lower.

Revaluation of Assets:

There may be periodical revaluation of assets (i.e., revision of book values) by a sys­tematic assessment so as to show a more realistic value of assets based on the physical condition and estimated future working life of assets, trend of market prices, etc. It may be noted that reserve created on revaluation, if any, would not be available for distribution.

Revaluation may be done on basis of:

(a) A number of factors like technical up gradation, replacement cost, productivity and efficiency of the assets; or

(b) Historical cost, which does not reflect a true and fair view of the affairs, suitably revised to indicate realistic value.

Revaluation is made on the basis of- (a) replacement cost (net realisable value having regard to market trends) as reduced by accumulated depreciation; or (b) indexa­tion method based on industrial indices; or (c) appraisal method i.e. valuation by expert valuers or appraisers like architects, engi­neers, certified valuers.

Accounting Standard AS 10 issued by the Institute of Chartered Accountants of India provides that the revalued amount of a fixed asset should be shown in the finan­cial statement by restating both the gross book value and the accumulated deprecia­tion to give the net revised book value, or by restating the net book value by adding the net increase thereof.

The selective re­valuation processes as above are not avail­able under instructions for making out as­sets contained in Schedule VI to the Com­panies Act, 1956, which require that in case of any writing up of the asset(s) it must be shown at its increased figure in the Balance Sheet subsequent to such writing up.

Auditor’s Duty towards Valuation of Assets:

An auditor should inquire into the basis of valuation of all assets and liabilities used or adopted by client with the greatest care before finally passing any item.

He should be thoroughly satisfied that they have been prop­erly valued or revalued on scientific princi­ples so as to represent their true and fair worth to the business at the date of the balance sheet. It is, however, no part of an auditor’s normal duty to value assets or liabilities himself.

That work is usually done either by a responsible officer of the business or by some independent and expert valuer and, in such circumstances, an auditor’s re­sponsibility is confined to the acceptance of certificates of value from the management or the valuer, as the case may be, subject, of course, to suitable personal inquiries made by himself to establish that the values appear to be reasonable having regard to the nature of the business and of the assets or liabilities concerned.

In any case, an auditor is not res­ponsible for valuation of assets and liabilities provided he exercises reasonable skill and care in scrutinising the basis of valuation (London & General Bank case; Kingston Cotton Mills case; Westminster Road Construc­tion Co. case.

Verification of Assets and Liabilities of a Business:

Verification of assets means substantia­tion of the actual existence of assets under the legal ownership and/or possession of the clients on the date of balance sheet. This is as important as valuation of assets, if not more; because the balance sheet should include only such items as are genuinely owned by the clients and an auditor should never pass an asset unless he is fully satisfied about the bona fide ownership of the same by his clients. 

Verification of Liabilities:

Gen­erally liabilities are valued at face value. Verification of liabilities is as important as that of assets because any under-statement or omission thereof would vitally affect the result of business and also the financial state of affairs. Usually liabilities are small in number and more or less fixed in nature and, as such, they offer less difficulties to an auditor than assets.

An auditor should see that all liabilities or obligations genu­inely outstanding on the closing date even those omitted accidentally or deliberately are duly accounted for, that all credit bal­ances shown by books are real liabilities and that there is no manipulation in regard thereto.

An auditor must be satisfied that liabilities recorded in books are real, omis­sion, if any, of liabilities are accounted for and duly disclosed. In fact, an auditor would be liable for negligence if he fails to detect omission of liabilities [Westminster Road Construction Co. case. Audi­tor’s report should be qualified for any omission of liability.

Important points regarding verification of liabilities are enumerated below. It may, however, be noted that a major portion of such verification would have already been done at the time of routine checking and vouching of the books of account. As an additional safeguard the auditor may obtain a certificate from some responsible officer stating that all liabilities have been fully taken into account.

Contingent Liabilities:

A contingent liability is an incidence which is conditional or contingent on the happening’ of certain events. There is an element of uncertainty about this group of liabilities, which may or may not occur. Such a liability, if it even­tually arises, involves payment of money in future.

The following are the main types of contingent liabilities:

(i) Liability in respect of bills discounted or accepted on behalf of other par­ties, but not matured.

(ii) Liability under guarantee or surety arrangements in favour of others.

(iii) Liability under incomplete contracts for which compensation may or may not have to be paid under forward contracts.

(iv) Liability under pending law suits, claims or taxation appeals.

(v) Liability in respect of unpaid calls on partly paid shares held.

(vi) Liability for accumulated arrear divi­dends on cumulative preference shares.

(vii) Liability for claims not acknowledged as debts.

(viii) Liability of members of a company limited by guarantee.

(ix) Possible personal liabilities of part­ners in a firm.

(x) Liability under guarantee(s) for loans taken by others.

(xi) Other uncertain financial liability.

If any liability under the aforesaid heads does not actually accrue on the date of the balance sheet it should be mentioned by way of a separate note on the liabilities side of the balance sheet, compulsorily in case of a company and preferably in other cases also—but the figures should not be extended to the money column.

The maturity of any contingent liability may arise from either acquisition of asset or incurring of loss. If, however, any of these liabilities is expected to cause an actual loss, adequate reserve should be provided for the same.

These items would usually be discov­ered in course of routine checking and vouching. It is also useful to check contracts, notices, lawyers’ bills, minute books, bank letters, correspondence etc. and to hold discussions with clients.

As additional meas­ure an auditor may secure from the client’s solicitors, legal advisers or tax consultants particulars of pending suits, claims, appeals etc. and obtain a schedule of contingent liabilities certified by a responsible officer to the effect that all probable liabilities- under this head have been taken into account, as it may not be possible for the auditor to gain in the normal course of audit knowl­edge of all items of contingent liabilities. An auditor should see that proper notes re: contingent liabilities are incorporated in the balance sheet.

The above exercise by an auditor would ensure disclosure of ‘true and fair view’ of the profit or loss and of the state of affairs of an enterprise by the Profit and Loss Account and the Balance Sheet.

(ii) Auditor’s duties re: Contingent Liabili­ties:

(1) Collect a schedule of contingent liabili­ties certified by a responsible officer.

(2) Check the items in the list with notes taken in course of routine checking and vouching.

(3) Gather copies of bills discounted, if any, from banks or other parties.

(4) Check bills receivable book with entries in bank pass book.

(5) Check payments against partly paid shares.

(6) Mention in report insufficient provi­sion, if any, for any contingent liability

(7) Check computation of and reasons for unpaid dividend on cumulative pref­erence shares.

(8) Ascertain all facts, justification and amount of contingent liabilities for pending law suits.

(9) Check correspondence, certificates from solicitors’ lenders regarding contingent liability under guarantee(s) for loan(s).

(10) In case of a company verify compli­ance with provisions of Schedule VI to the Companies Act, 1956.

(11) Verify disclosure of contingent liabili­ties in the balance sheet.

Auditor’s Duties towards Events taking Place after the Balance Sheet Date:

1. Analyse all relevant events to find out those relating to the balance sheet date in question.

2. Eliminate events not related to balance sheet date.

3. Correct the balance sheet by incorporat­ing changes in value of assets and liabili­ties caused by events occurred after the balance sheet date according to the concept of “materiality”.

4. Suitably revise the profit and loss ac­count by altering provisions and re­serves due to events occurred after the balance sheet dates.

5. Prepare and authenticate a special state­ment of reconciliation covering the above points.

Valuation and Verification of Particular Assets:

Subject to the general principles of valuation and verification discussed above an auditor should always take into full consideration special points in regard to the valuation and verification of individual items of assets on the basis of their precise nature and utility.

Cash, book debts and stock-in- trade constitute three important assets re­quiring very careful attention and, as such, their valuation and verification aspects are fully discussed below followed by the enu­meration of main points in relation to other assets in a tabular form:

(i) Cash Balance:

There can be no separate basis of valu­ation in respect of cash balance except that the actual balance in hand must be the same as indicated by the cash book; in other words, an auditor is required to verify the existence of cash balance in hand on the closing date.

For this purpose the matter is to be handled separately in respect of vari­ous types of cash balance as under:

(a) Cash at bank:

As the balance remains with the bank no physical verification is possible; only a documentary verification has to be con­ducted. For this purpose the bank bal­ance, as shown by the ‘bank column’ of the cash book, should be compared with the corresponding figure of the bank pass book.

The bank reconciliation state­ment should also be checked. If a dis­crepancy still persists, casting and bal­ancing of the pass book itself may be checked. It is desirable to obtain a cer­tificate or confirmation from the bank about the balance held by it. In case of fixed deposits, deposit receipts from the bank should be seen; if such receipts are pledged, certificates from pledgees should be obtained.

(b) Cash in hand including petty cash:

Physical verification is the only effective method of verification, i.e., if possible, cash in hand should be actually counted by an auditor on the closing date. As, however, it is not practicable to attend offices of all clients on the closing date, for this purpose, verification is usually done after that date.

In such cases, an auditor should attend as early as possi­ble after the closing, carefully vouch cash transactions from the date of clos­ing up to the date of the visit and count the actual cash in hand on the latter date. Sometimes a system of depositing the closing cash balance with the bank on the closing date and withdrawing the same on the next day may be followed when the bank pass book will provide the only reliable source of verification.

In case of organisations like banks etc. holding large cash balances at any time, complete physical checking is not practica­ble and test checking has to be adopted, provided a good system of internal control is in operation. Bundles of notes may be counted, checking some of them in detail. Bullion or coins may be verified by taking the average weight of bags containing the coins, actually counting some of the bags picked up at random.

An auditor should insist on the produc­tion of all cash balances at a time to prevent substitution with a view to covering up defalcations. According to the decision of the London Oil Storage Co. case an auditor will be liable for negligence if he fails to verify cash balance.

(c) Cash held by officers:

An auditor should not ordinarily accept a certificate from an official about large cash balance held by him. When such a practice is unavoidable the auditor should see that it is properly authorised and is absolutely necessary for the genuine purpose of business and that the balance is within the limit fixed, if any, and is not allowed to remain with the officer concerned indefinitely.

(d) Cash with branches and agents or in transit:

It is not possible for an auditor to personally count cash balances at differ­ent branches or lying with various agents or in transit; he has, therefore, to be satisfied with proper documentary evi­dence.

Where a system of depositing branch or agents’ balances on the last working day of a financial year with banks is followed, an auditor should see the bank pass book and also obtain certificates from the banks concerned about the balances held by them. In case of cash in transit, the respective advices from branches or agents should be scru­tinised.

(ii) Book Debts:

An auditor’s primary duty is to see that book value of sundry debtors has been correctly ascertained. The basis of valuation should be net realisable value after deduct­ing bad and doubtful debts.

The schedule of debtors’ accounts extracted from the debtors’ ledger and certified by the manage­ment should be compared with the balance of the total debtors’, account in the general ledger when the self-balancing system is in operation. Checking of the items appearing in the said schedule of debtors with indi­vidual statements of accounts and/or con­firmation of balances received from custom­ers is also a useful method of verification.

A very important matter about verifica­tion of book debts is the checking of ad­equacy or otherwise of the provision for bad and doubtful debts.

In this connection an auditor should obtain a certified schedule of bad and doubtful debts from the manage­ment and he should thoroughly check the same paying special attention to the follow­ing points:

(a) Checking year-end balances and subse­quent realisations.

(b) Age of the debtor’s balances. See if there is any debt which is already time-barred or is nearing the end of the period of limitation.

(c) Whether regular payments are being made as per terms of credit allowed. Particularly look out for overdue pay­ments.

(d) If cheques or bills of any customer have been dishonoured.

(e) If there is any history of bankruptcy or attachment of the funds and properties of any debtor.

(f) If any suit had to be instituted against any debtor for recovery of dues.

(g) Whether the balances of-individual debt­ors are stable, increasing or diminishing.

(h) Checking provisions for allowances, discounts, bad and doubtful debts, if any.

(i) Checking Debtors’ Ledger Trial Balance with Control A/cs.

(j) Particularly enquire about suppression of sales leading to suppression of debtors.

On a careful consideration of the afore­said information an auditor should make his own estimate of probable bad or doubtful debts and compare the same with the pro­vision made by the management. If he is not satisfied with the provision he should, in the first instance, discuss the matter fully with the management trying to persuade them to correct the position, failing which he should mention the fact in his report.

Arthur E. Green & Co. case clearly established that an auditor will be liable for negligence if he accepts a schedule of bad debts without being able to detect time- barred debts included therein.

(iii) Stock-in-Trade or Inventory:

This is one of the most important items in respect of which frauds are perpetrated and, as such, it should receive the most careful attention of an auditor. It comprises stores and spares, loose tools, raw materials and components, work-in-process and fin­ished goods.

(a) Valuation of stock:

The fundamen­tal basis of valuation in respect of stock is ‘cost or market value, whichever is lower’. Cost includes cost of purchase/acquisition or conversion, other costs in bringing the items to present location or condition.

The exact implication of the terms cost and market price which should be clearly under­stood, are outlined below:

(i) Chief Types of Cost:

1. First-in-first-out method:

It is assumed that the materials or stocks are used or despatched in the chronological order of their receipt so that the closing balance in hand would consist of the items acquired towards the end of the year. The prices of such latter purchases are, therefore, taken as the basis of ascer­taining cost of the closing stock.

2. Last-in-first-out method:

Just a reverse order is followed assuming that items received last are used or disposed of first so that the balance in hand would represent earlier purchases; its cost is, therefore, assessed on the basis of earlier purchase prices.

3. Average cost method:

Average is taken of the different rates at which particular items have been bought at different times during a year and that is taken as the basis of cost in respect of the stock in hand at the close of the year. In view of the practical difficulties in calculating cost strictly according to the first two methods the average cost method is the most popular and common due to its simplicity.

4. Standard cost method:

Stock is valued at a fixed cost per unit which may be regarded as a cost-budget for each item.

(ii) Chief types of market value:

Description:

1. Realisable value

2. Replacement value

Nature:

Value that the stock is expected to realise if sold at the market price ruling on the closing date minus selling cost. Amount that would be necessary to replace an existing stock or to acquire similar stock at the prevailing market price

N.B. Although both realisable and replacement values are based on market prices there is a fine technical distinction between the two. The chief idea behind the former is the sale or disposal of stock, whereas that behind the latter is the purchase or acquisition of similar stock in replacement of an existing one.

Usually the prices at which a particular item can be bought or sold at any particular time differ and this variation must be taken into account in assessing market values under the ‘realisable’ and the ‘replacement’ methods.

The precise applications of the aforesaid criteria for ascertaining cost or market value of different groups of stock items are indicated in the undernoted table:

(b) Verification of stock:

Physical ex­istence of stock items represented by the stock figure in the balance sheet is usually verified by actual annual or half-yearly stock­taking arranged by the management and necessary reconciliation is made with book figures as per bin cards or store ledger accounts.

An inventory or schedule of all items is prepared at the time of stock-taking and each item is valued on one of the accepted principles as discussed above and such a schedule is usually certified by an engineer or other expert, a director, manager or high official for authentication.

Sometimes a system of continuous stock-taking is adopted instead of periodical stock-taking to cover substantial part, if not whole, of the inventory. This inventory forms the basic document for inclusion of stock-in-trade in the balance sheet. Separate inventories for stocks on consignment, on hire-purchase and on sale or return should also be simi­larly prepared.

(c) Auditor’s position re: stock-in- trade:

‘It is an accepted principle that an auditor is not a valuer of stock as he is not supposed to possess expert knowledge re­garding the nature and utility of various stock items nor is he in a position to count or verify the physical existence of each and every item of the inventory, particularly in the case of a big manufacturing or trading concern holding a large variety of items in stock.

In practice, an auditor is obliged to depend on the system of internal control and to accept the certified inventory as the basic documents for checking the valuation of and also verifying the stock.

The Kingston Cotton Mills Co.’s case established that an auditor is entitled to accept and rely on stock-sheets certified by a responsible officer in the absence of suspi­cious circumstances and that he is not to take stock himself. Evidently, acceptance of a certified inventory is condi­tional upon the ‘absence of suspicious cir­cumstances’; an auditor should not blindly accept a certificate of stock provided by the management.

To be sure that there is no ground for suspicion he should carry out proper independent checking of the stock- sheets as far as circumstances permit; other­wise he may be held liable for negligence in duty.

The Westminster Road Construction Co. Ltd. case established that an auditor would be negligent in duty if he accepted from management a certificate re: work-in- progress without proper enquiries; according to the decision in McKessan & Robins case of U.S.A. an auditor is expected to be present at and see for himself the actual physical stock­taking.

In actual practice an auditor should apply reasonable care and skill and nor­mally take the following steps in respect of stock-in-trade in order to be able to prove, if necessary, that he exercised reasonable care and skill:

(a) Carefully examine the system of internal control in force and note any possible loopholes therein. Go through pro­gramme of stock-taking adopted by management and instructions issued to staff for this purpose.

(b) Obtain stock-sheets containing descrip­tion, quantity, rate and value of stock including special types of stock, if any, duly initialled by all persons connected with stock-taking and certified by prop­erly authorised person.

(c) Carefully check goods inward and out­ward books and also purchase and sales records for the last week or so of the accounting year under audit with a view to finding out any purchase and receipt of material that may not have been included in the stock list, or any sale that may have been included although cor­responding goods have not been actu­ally delivered to the consumer.

(d) See by means of test checks that a proper basis of valuation is adopted and that the same principle is consistently followed from year to year unless there are valid grounds for changing the basis.

(e) See that non-moving, slow-moving or obsolete stocks, if any, are duly written- off or adjusted and that other assets like loose tools not meant for trading purposes are excluded from the stock- sheets.

(f) Compare percentage of gross profit on turnover with previous year’s figure and enquire about any abnormal fluc­tuation.

(g) Compare some of the items of the stock- sheets, particularly the bigger or mate­rial ones, with previous year’s list and also with balances indicated by bin cards or stock ledger accounts and ascertain the reasons for discrepancies, if any.

(h) Check casting of stock-sheets and a portion of the calculations.

(i) Verify some selected stock-items physi­cally, if possible, or be present at least for some time during stock-taking. Com­pare inventories with stock records.

(j) Refer to the year-ending stock statement submitted to bankers under overdraft/ cash credit arrangement, if any.

(iv) Loans and Advances:

(v) Security and Other Deposits:

 

(vi) Bills Receivable:

 (vii) Unexpired Expenses and Accrued Incomes:

(viii) Fixed Assets:

The criteria and methods of valuation and verification in respect of important fixed assets are tabulated hereunder: