Auditing Loans and Advances – Risk, Assertions, And Procedures

Overview:

Loans and advances are other forms of financial liabilities with their accounting treatment scoped under IFRS 9 Financial Instruments.

Auditors are very likely to come across Loans and Advances when auditing an entity as they are some standard instruments most businesses use to finance their new ventures or working capitals.

Risks:

Before we can decide what procedures to perform, we, as an auditor, must first identify the risks associated with auditing Loans and Advances:

  • Risk of Material Misstatement: The Risk of Material Misstatement when auditing Loans and Advances is high when the entity is highly geared. The entity relies solely on debt to finance its aggressive business strategy or a history of defaulting interest payments. When such factors are present, risks such as classification error and the possibility of overstating assets or cash and understating liability or debts are highly likely to occur as the entity will try to present a better picture of its financial position to the user financial statements.
  • Control Risk: The Control Risks related to Loans and Advances are the absence of control in monitoring compliance with loan covenants, lack of appropriate procedures in approving procurement of Loans and Advances, and no appropriate procedure in place to monitor classification and measurement of Loans and Advances.
  • Detection Risk: Detection Risk arises when the auditor cannot detect the material misstatements in the reported amounts or disclosure of Loans and Advances.

The audit risk for Loans and Advances is generally low (except when the factors stated above are present) as Loans and Advances can be easily verified against legal documents, bank correspondences, and external confirmations.

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Furthermore, the accounting treatment of Loans and Advances are also clearly specified in IFRS 9.

Assertions:

For an auditor to be reasonably assured of the Loans and Advances amount in the financial statements and its relevant disclosure, tests will be performed to cover the audit assertions. The assertions applicable are:

  • Existence: The Loans and Advances recorded in the entity’s book exist.      
  • Completeness: All Loans and Advances obtained by the entity have been recorded and presented in the financial statements.
  • Rights and Obligation: The obligation to make payments on the principal and interests for the Loans and Advances belongs to the entity.
  • Valuation: The Loans and Advances are initially and subsequently measured under IFRS 9. For Loans and Advances denominated in foreign currency, they are translated using the correct foreign exchange rate at the reporting date.
  • Presentation and Disclosure: The Loans and Advances amounts in the financial statements and the relevant disclosure notes to the financial statement are complete and following the applicable accounting standards.

Procedures:

Audit Procedures for testing Loans and Advances include Tests of Controls and Substantive Tests. 

Test of Controls:

Controls relevant to Loans and Advances include approving new bank facilities, monitoring loan covenants, reviewing classification and measurement, and segregating duties.

  • Approving New Bank Facilities: This control ensures all new facilities such as overdrafts, term loans, or advances obtain from any financial institutions are approved by appropriate and authorized personnel within the entity. This can reduce the risk of “hidden” Loans and Advances which are either obtained for management’s personal reason or to finance unauthorized projects.
  • Monitoring of Loan Covenants: All Loans and Advances have covenants attached, such as compliance with a certain gearing ratio or requirement of approval from the lender before paying a dividend. This is a way for the lender to protect itself from potential defaults. Breaching the loan covenants can trigger a default clause, allowing the lender to demand full repayment immediately. This control helps the entity monitor the compliance to loan covenants and avoid a breach.
  • Review Classification and Measurement: This control ensures the entity correctly applied the guidance under IFRS 9 to classify, initially measure and subsequently remeasure its Loans and Advances.
  • Segregation of Duties: This control is essential as it helps to ensure work performed by one individual is subsequently reviewed by another individual. This will reduce the Risk of Material Misstatement arising from either fraud or error.
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Substantive Audit Procedures for Loans and Advances:

Substantive Audit Procedures for Loans and Advances consist of the following components:

1) Substantive Analytical Procedures:

Substantive Analytical Procedures are performed by looking at the changes or lack of changes in the entity’s financials’ performance.

The changes or lack of changes must be benchmarked against a set expectation such as historical performance, latest business developments, and any other information relevant to the entity. Such information will then allow the auditor to detect the potential risk of material misstatements.

For example, a substantial increase or decrease in Loans and Advances by itself may not indicate or provide any audit evidence or indication of risk.

It could mean the entity has obtained additional Loans and Advances (increase) or has repaid them (decrease).

However, if such growth is benchmarked against an increased gearing ratio or interest cover ratio, this could help identify risks such as overstatement of assets or profit.

2) Test of Details for Loans and Advances:

To test details for Loans and Advances, audit procedures are designed around assertions. Example and description of test of details are given in the table below:

Audit AssertionExample of Audit Procedure
Existence/Rights and ObligationSighting to legal documents, bank statements (cash received from Loans and Advances drawdown), and obtaining external bank confirmation.
Completeness  Obtaining external bank confirmation from all banks the entity has financial dealings with as the banks will often disclose incomplete, such financial transactions when requested by the auditor.
ValuationReviewing and recomputing the accounting treatment applied by the entity on the classification and measurement of Loans and Advances to ensure compliance with IFRS 9.   Recomputing foreign currency-denominated Loans and Advances.
Presentation and DisclosureReviewing the entity’s financial statements and identifying if the Loans and Advances amounts reported in financial notices and the relevant disclosures are correct and complete following applicable accounting standards.
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