Common audit adjustments: what Hong Kong companies should expect during the audit

Common Audit Adjustments Found in Hong Kong Company Audits

Every Hong Kong incorporated company must have its financial statements audited annually by a practising certified public accountant registered with the Hong Kong Institute of Certified Public Accountants (HKICPA). During the statutory audit, the auditor examines the company’s accounting records and proposes adjustments where the financial statements do not present a true and fair view. Understanding the common audit adjustments Hong Kong auditors identify helps directors and accountants prepare more accurate accounts and reduce the risk of a modified audit opinion.

Accrual and Prepayment Corrections

The most frequent audit adjustments relate to accruals and prepayments. Hong Kong companies must prepare financial statements on an accrual basis under HKFRS or the applicable framework (HKFRS for Private Entities or SME-FRF and SME-FRS). An accrual records income earned or expenses incurred before cash changes hands. A prepayment records cash paid for expenses that relate to a future period.

Auditors commonly find that companies have omitted accruals for utilities and telephone charges consumed but not yet billed at the year end, professional fees for services rendered before the balance sheet date, and interest on loans that has accrued but not been paid. Prepayments for insurance premiums, rental deposits, or annual subscriptions are often left in the profit and loss account rather than being recognised as assets on the balance sheet.

Example: A company pays HK$120,000 for an annual insurance policy on 1 October. The financial year ends on 31 December. Only three months of cover (HK$30,000) should be expensed. The remaining HK$90,000 is a prepayment. If the company has expensed the full amount, the auditor proposes a journal entry to debit prepayments and credit the insurance expense.

Cut-Off Errors

Cut-off errors arise when transactions are recorded in the wrong accounting period. The auditor tests whether sales, purchases, receipts and payments are recorded in the correct financial year. Common cut-off adjustments include sales invoices dated after the year end but recorded before the year end, purchase invoices received after the year end for goods delivered before the year end, and cash receipts or payments recorded in the wrong period due to bank clearing delays.

Example: Goods are delivered to a customer on 28 December, but the sales invoice is raised on 3 January. If the company records the sale in January, revenue is understated in the current year and overstated in the next. The auditor proposes an adjustment to recognise the sale in the correct period.

Depreciation Miscalculations

Depreciation adjustments arise when the useful life, residual value, or depreciation method applied to a fixed asset does not comply with the accounting framework. Auditors also find errors where assets have been fully depreciated but remain in use and no further depreciation has been charged. Depreciation calculated on the wrong cost base, using the tax written-down value instead of the cost, is another common finding. Additions or disposals during the year may not have been depreciated on a pro-rata basis.

Example: A company purchases machinery for HK$500,000 in July and depreciates it over five years using the straight-line method. The company charges a full year’s depreciation of HK$100,000 in the year of purchase. The auditor adjusts to reflect only six months of depreciation (HK$50,000) because the asset was not in use for the full year.

Director’s Loan Misclassification

Director’s loan accounts are a frequent source of audit adjustments. The Companies Ordinance (Cap. 622) requires that loans to directors be disclosed separately in the financial statements. Auditors commonly find that director’s drawings are recorded as expenses rather than as loans, repayments are not properly allocated between salary, dividends and loan repayments, and interest on director’s loans is not calculated or recorded.

Example: A director withdraws HK$200,000 from the company bank account during the year. The company records the withdrawal as “director’s remuneration” but no employment contract or board resolution supports the payment. The auditor reclassifies the amount as a director’s loan and requires disclosure in the notes to the financial statements.

Inventory Write-Downs

Inventory must be stated at the lower of cost and net realisable value under HKFRS. Auditors frequently adjust inventory where obsolete or slow-moving stock has not been written down, inventory quantities in the accounting records do not match the physical count, or cost allocations are incorrect, for example where overheads have been excluded from the cost of finished goods.

Example: A trading company holds 1,000 units of a product purchased at HK$50 each. The market price has fallen to HK$35 per unit, and the company expects to sell the stock at HK$30 after selling costs. The net realisable value is HK$30 per unit, requiring a write-down of HK$20 per unit (HK$20,000 in total). If the company has not recorded this write-down, the auditor proposes an adjustment.

Recurring Adjustments and Audit Implications

When an auditor identifies the same type of adjustment year after year, it may indicate weak internal controls over financial reporting. The auditor will assess whether the misstatements are material, individually or in aggregate. If uncorrected misstatements exceed the materiality threshold, the auditor may issue a modified opinion in the auditor’s report.

A modified opinion can affect the company’s ability to obtain bank financing, secure trade credit, or comply with regulatory requirements. Directors should review the audit adjustment schedule each year and implement controls to prevent recurring errors. Common controls include a monthly review of accruals and prepayments, cut-off procedures at each month end, fixed asset register maintenance with depreciation calculations, clear policies for director’s loan transactions, and regular inventory counts and valuation reviews.

Hong Kong Audit Journal Entries

The auditor proposes adjustments through hong kong audit journal entries that are posted to the company’s accounting records before the final financial statements are prepared. These journal entries include a debit to the appropriate balance sheet or profit and loss account, a credit to the corresponding account, and a narrative explaining the reason for the adjustment.

Management must decide whether to accept or reject each proposed adjustment. If management rejects a material adjustment and the auditor considers the financial statements to be misstated, the auditor will qualify the audit opinion.

Audit Adjustments Accruals Hong Kong

For audit adjustments accruals hong kong, the auditor focuses on whether the company has recorded all liabilities that existed at the balance sheet date. The auditor tests accruals by reviewing payments made after the year end for expenses that relate to the prior period, comparing accrual balances to prior year amounts and investigating significant variances, and confirming accruals with third parties where possible.

Hong Kong Audit Misstatements

Hong Kong audit misstatements are classified as factual misstatements (where the auditor has evidence of the correct amount), judgmental misstatements (where the auditor disagrees with management’s estimate), or projected misstatements (where the auditor extrapolates errors found in a sample). The auditor communicates all identified misstatements to management and those charged with governance, regardless of whether they are corrected.

Practical Steps for Directors

Reduce the number of audit adjustments by ensuring the company’s accounting records are complete and accurate before the audit begins. Prepare a detailed year-end closing schedule that includes accruals, prepayments and cut-off procedures. Reconcile all balance sheet accounts, including director’s loans and intercompany balances. Review the fixed asset register and calculate depreciation in accordance with the chosen accounting policy. Conduct a physical inventory count and compare the results to the accounting records.

The Companies Registry and HKICPA provide guidance on the preparation of financial statements and the conduct of statutory audits. Directors who understand the common adjustments their auditor is likely to propose can prepare more accurate accounts and avoid the consequences of a modified audit opinion.