Observation Test: Physical and Visual Verification by Inspection of Financial Statement Items or Activities

An Observation Test involves external auditors evaluating how company employees conduct accounting tasks through visual and physical verification to ensure the accuracy, existence, and proper valuation of financial statement items.

An Observation Test is a key auditing technique used by external auditors to physically and visually verify various items and activities within a company’s financial statements. This process involves closely monitoring and assessing how company employees perform different accounting-related tasks to ensure compliance with established procedures and the accuracy of reported figures.

Purpose and Scope

Ensuring Accurate Documentation

The primary goal of an observation test is to verify that financial transactions and activities are accurately documented. This involves:

• Existence and Valuation of Assets: Confirming that reported assets exist and are recorded at their proper values.
• Safeguarding Assets: Ensuring that the listed assets are properly safeguarded against theft or mismanagement.
• Approval of Expense Accounts: Checking that expenses are approved according to company policies.
• Inventory Counting: Verifying the physical count of inventory against recorded quantities.

Process of Observation Test

Planning Phase

During the planning phase, auditors determine which specific areas and activities require observation. Key activities often include:

• Physical Inspection of Assets: Visually and physically verifying assets listed on the balance sheet.
• Employee Observation: Watching employees perform tasks such as counting inventory or processing transactions.
• Compliance Checking: Observing procedures to ensure compliance with internal controls and company policies.

Execution Phase

In this phase, the observation is carried out based on the planned areas. Auditors:

• Note Deviations: Identify any discrepancies or deviations from established procedures.
• Document Findings: Record observations and evidence collected during the examination.
• Assess Controls: Evaluate the effectiveness of internal controls observed.

Reporting Phase

After the observation, auditors compile a report detailing their findings, discrepancies noted, and any recommendations for improvements.

Special Considerations

Bias and Observer Effects

• Hawthorne Effect: Employees may alter their behavior when they know they are being observed, potentially affecting the accuracy of the observation.
• Bias Mitigation: Auditors must strive to remain as unobtrusive as possible and use additional evidence to corroborate their observations.

Examples

• Inventory Check: An auditor observes the inventory counting process in a warehouse to ensure all items are accounted for and correctly documented.
• Expense Approval: An auditor watches the approval process for large expenses to ensure compliance with company policies.

Historical Context

The concept of auditing through physical and visual verification dates back to early accounting practices where visual evidence was a primary means of verifying the accuracy of records. As financial reporting and internal control systems have evolved, observation tests remain a fundamental aspect of the audit process.

Applicability

Observation tests are particularly useful in industries and scenarios where:

• High Inventory Levels: Retail and manufacturing industries with significant inventories.
• Asset Intensive Operations: Companies with valuable physical assets like machinery or real estate.

Comparisons

• Observation Test vs. Substantive Test: While observation tests focus on visual and physical verification, substantive tests involve detailed transaction testing and data analysis.
• Observation Test vs. Inquiry: Inquiry involves asking questions and obtaining verbal or written responses, whereas observation is about directly witnessing activities and procedures.

Related Terms

• Internal Controls: Mechanisms designed to ensure the integrity of financial and accounting information.
• Compliance Audit: An audit that focuses on adherence to laws, regulations, and internal policies.
• Substantive Testing: Detailed accounting testing to directly verify the accuracy of transactions and balances.

FAQs

What is the primary benefit of an observation test?

The primary benefit is ensuring the accuracy and integrity of financial statements by directly observing and verifying accounting processes and controls.

How does an auditor mitigate the Hawthorne effect?

Auditors can mitigate the Hawthorne effect by using additional evidence to corroborate their observations and by being as discreet as possible during the observation process.

Can observation tests be applied to all types of companies?

While observation tests can be useful for any company, they are particularly beneficial for businesses with significant physical assets or inventory.

References

1. Arens, A. A., Elder, R. J., & Beasley, M. S. (2017). Auditing and Assurance Services: An Integrated Approach. Pearson.
2. Messier, W. F., Glover, S. M., & Prawitt, D. F. (2018). Auditing & Assurance Services: A Systematic Approach. McGraw-Hill Education.
3. PCAOB Auditing Standards. Public Company Accounting Oversight Board (PCAOB).

Summary

An observation test is an essential auditing technique that involves the physical and visual verification of financial statement items and activities. By closely monitoring accounting tasks such as asset valuation and inventory counting, auditors can ensure the accuracy, validity, and transparency of the processes being audited. Despite potential challenges like observer bias, observation tests provide valuable insights that help maintain the integrity of financial reporting.