Journal Entry Testing: Definition, Process, and Importance

What is Journal Entry Testing?

The underlying need for journal entry testing arises when the auditor needs to test the nature, timing, as well as extent of the underlying journal entries.

It is mostly undertaken in order to recognize the material misstatement that occurs as a result of fraud when organizations are recording financial transactions, as per ISA 240.

The auditor is supposed to be increasingly vigilant when it comes to auditing transactions in the financial statements.

This requires the auditor to maintain a certain degree of professional skepticism so that they are able to find out any inconsistencies in the financial statement reporting.

In order to do this, the auditor is supposed to verify all transactions with the required supporting documents.

Furthermore, a higher authority should also duly amortize the given entries once the accountant records the transactions.

Therefore, journal entry testing can be defined as a process that is undertaken by auditors in order to ensure that all the transactions (i.e. journal entries) have been posted correctly in the financial statements.

In order to do this, the auditor mostly tests the sample transactions that are followed by substantive procedures.

The auditor is required to test the sample transactions in order to check for authenticity, validity as well as the accuracy of the transactions.

It must also be noted that journal entry testing is also carried out for external requirements that are undertaken when there are suspicions of fraud and accounting malpractice by the company.

 Process of Journal Entry Testing

Journal Entry Testing can be defined as one of the most significant audit tests during the course of the audit, primarily because of the reason that it impacts line items in both, the income statement, as well the balance sheet.

Journal entries are referred to as adjusting transactions that occur outside the normal recording process.

Financial Statements that are prepared at respective year-ends for companies include an amalgamation of all the entries that took place over the past few years.

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This includes journal entries pertaining to sales, purchases, returns, expenses, accruals, prepaid expenses, so on and so forth.

Additionally, it also includes journal entries or journal vouchers that are presented in different accounting formats across the company.

When several different entries, both adjusting, and non-adjusting ones are posted in the financial statement, the risk exposure towards error occurring in the financial statements increases substantially.

Therefore, in order to mitigate the risk of material misstatement in the financial statements, journal entry testing is carried out so that the extent of misstatements in the financial statements can be properly ascertained.

In order to properly execute journal testing, and ensure that companies execute these features in a proper manner, auditors go through the following steps:

  • Understanding the nature of journal entries:  There is a need to understand the nature of transactions that are posted in the form of journal entries. Some transactions are normal for the company and are considered low-risk, including depreciation, interest expense, as well as income. These transactions take place on a recurring basis, probably on a month-to-month basis. There is a need for the auditors to understand how journal entries are recorded, and subsequently posted in the financial statements. It also covers aspects like internal control within the organization.
  • Extracting all the journal entries: Since there are a plethora of transactions surrounding journal entries, there is a need to properly sort and analyze all the respective transactions. For example, transactions pertaining to a certain month should be extracted and then sorted one by one in order to properly analyze the existing problem at hand.
  • Ensuring completeness in the journal entries: Once the relevant journal entries have been extracted, auditors need to undertake completeness testing. This is mainly to ensure that transactions are not excluded for any reason from the financial statements. All journal entries should be completely posted so that the ending balances on accounts are properly maintained.
  • Separating recurring, and non-recurring transactions: There is a need to segregate recurring from non-recurring transactions because of the inherent risk involved. Recurring adjustments are low-risk adjustments, which can be analyzed and audited in a quicker time frame. On the other hand, non-recurring adjustments are high risk, since they are one-off, and are more prone to error. Therefore, it is important for auditors to separate the two so that they can carry out inspection procedures accordingly.
  • Testing of recurring adjustments: In order to test for recurring adjustments, there is a need to group all the transactions, so that the auditors can go through the accounting treatment of each transaction. In the case where these adjustments are correct, the auditors can go through the unusual transaction amount for the required services.  
  • Testing of non-recurring adjustments: Since non-recurring adjustments are high risk, they cannot be categorized into any group as such. However, within the umbrella of non-recurring adjustments, there is a need to segregate high-risk accounts from low-risk accounts. The auditors already have an idea of all the high-risk accounts, and depending on the risk involved, they can choose to proceed with the transactions. Since going through all these transactions individually might be an increasing challenge for the company, auditors often extrapolate the accuracy of non-recurring adjustment postings using sampling techniques.
  • Test unusual items: The unusual items include large amount transactions, negative transactions of assets, and revenues accounts. The auditor should also review the transactions that are posted or recorded during the weekend and holidays while accountants who performed the posting are supposed to be on the holidays. Auditors should consider scanning through the transactions that are posted by the users that might not be in the accounting. To do this, the list of team members in the accounting and finance team that is responsible to records all of the transactions during the period of posting should be obtained and verified again by the users that record those transactions.

Importance of Journal Entry Testing

Journal Entry Testing holds tantamount importance because of several different reasons. The importance of journal entry testing from the perspective of the auditors is as follows:

  • Risk Mitigation during the audit process: By default, journal entries are risky, since the sheer volume of transactions makes the risk exposure quite high. Therefore, journal entry testing tends to reduce this risk, by going through all the transactions to make sure all entries are properly posted in the financial systems.
  • Detection of error and fraud: Given the fact that journal entries cannot always be subject to internal controls, the chances of error and fraud are higher than other line items. Hence, journal entry testing tends to override this issue, since it covers ground pertaining to journal entries, as well as other testing areas.
  • Testing internal controls: Internal Controls help to prevent fraud within the company. Journal Entry testing helps to gauge the level of internal controls present, based on which auditors can make judgments about the accuracy of the financial statements.
  • Data Analysis in the auditing process: Journal entry testing is a part of the auditors’ role in gathering sufficient and appropriate audit evidence. Hence, journal entry testing helps auditors effectively carry out the authenticity, validity, as well as accuracy of the business transactions.
  • Quality and Efficiency in the auditing process: Testing for accuracies in the journal entry systems help companies maintain a reasonable standard of quality and efficiency in the auditing process. This is because journal entries eventually lead to the creation and subsequent maintenance of the financial statements. Hence, testing these journal entries makes sure that their foundations and the fundamentals of business processes are properly carried out, i.e. quality and efficiency are maintained within the company.