CHAPTER 7
Chapter 12Audit Procedures in Response to Assessed Risks:
Substantive Tests
Learning Check
12-1.The three steps involved in assessing the risk of material
misstatement are:
1. Evaluate the type of potential misstatement(s) that may
occur, such as evaluating whether a risk is a financial statement
level risk or an assertion level risk.
2. Evaluate the magnitude of the potential misstatement(s). For
example, the auditor is attempting to determine if the magnitude
could of misstatement could aggregate to a material amount.
3. Evaluate the likelihood of potential misstatement(s). This is
a matter of determining whether the probability of misstatement is
very probable or the probability of misstatement is remote.
12-2. If there is a significant risk of material misstatement
due to financial statement level risks the auditor will increase
the level of substantive testing for many assertions. For example,
if management communicates the message that it is critical that the
company meet its financial targets, the auditor might increase the
level of substantive testing for revenue recognition, the
completeness and classification of expenditures, as well as for
many accounting estimates in the financial statements. If the risk
of material misstatement is limited to one assertion, such a poor
controls over the collection of receivables, the auditor will
increase the level of substantive testing specifically related to
the valuation and allocation assertion for receivables.
12-3.Following are examples of risks of material misstatement
that might be found while performing various risk assessment
procedures.
Risk Assessment ProcedureRisk of Material Misstatement
a. Understanding the entity and its environmenta. A companys
most significant product is at a mature stage and sales are
beginning to decline. This may affect the net realizable value of
inventory.
b. Performing analytical proceduresb. A company may report flat
sales, increasing levels of inventory, and increasing gross profit
margins. This may indicate a problem with the existence and
occurrence of inventory.
c. Understanding the risk of fraudc. A company may be very close
to not meeting its debt covenants. This might increase the risk
that company might engage in fraudulent financial reporting to
report that it in fact met debt covenants.
d. Understanding inherent risksd. The calculations associated
with the valuation of a large retail inventory using the retail
method represents a significant inherent risk that is focused on
the valuation assertion for inventory.
e. Understanding the entitys system of internal controle. A
owner-managed company might allow the bookkeeper to write and sign
check with little supervision or review by the owner. This would
increase the risk for the existence and occurrence assertion for
expenditures.
12-4. The following bullets summarize each preliminary audit
strategy, the appropriate level of planned detection risk, the
planned audit procedures that provide significant assurance, and
whether a higher or a lower level of assurance is needed from
substantive tests.
A Primarily Substantive Approach requires a low planned level of
detection risk for tests of details, audit assurance is needed
primarily from tests of details of transaction or tests of details
of balances, and the level of assurance needed from substantive
tests is high.
A Lower Assessed Level of Control Risk Approach usually results
in a high planned level of tests of details risk due to the fact
that significant assurance is obtained from tests of controls. As a
result, the level of assurance that is needed from substantive
tests is low.
Emphasis on Inherent Risk and Analytical Procedures represents
an audit strategy associated with assertions where inherent risk is
assessed below the maximum and the planned tests of details risk is
moderate or high. Evidence is needed from risk assessment
procedures to support an inherent risk assessment below the maximum
and substantive tests are performed using analytical procedures.
The planned level of assurance from substantive test of details is
often moderate, as the auditor obtains assurance from analytical
procedures and the auditors knowledge of the business and
industry.
12-5.A revised or final acceptable level of detection risk is
determined for each assertion after (1) assessing inherent risk,
(2) performing analytical procedures in audit planning, (3)
assessing the risk of fraud for an assertion, and (4) making a
final assessment of control risk for relevant controls. A risk
matrix or the audit risk model can be used to solve for the revised
acceptable level of detection risk associated with analytical
procedures and tests of details based on the actual assessed levels
of inherent and control risk and the auditor's specification of
audit risk.
12-6.The following table compares and contrasts tests of
controls and substantive tests.
Tests of ControlsSubstantive Tests
a. TypesTests of the control environment
Tests of the clients risk assessment system
Tests of the information and communication system
Tests of control activities
Tests of the monitoring system
Tests of antifraud programs and controls
Initial procedures
Analytical procedures
Tests of details of transactions
Tests of details of balances
Tests of details of accounting estimates
Substantive tests required by GAAS
Tests of details of disclosures
b. PurposeDetermine effectiveness of design and operation of
internal controlsDetermine fairness of significant financial
statement assertions.
c. Nature of test measurementFrequency of deviations from
designed controlsMonetary errors in transactions and balances.
d. Applicable audit proceduresInquiring, observing, inspecting,
reperforming, and computer assisted audit techniques. Same as tests
of controls, plus analytical procedures, counting, confirming,
tracing, and vouching.
e. Timing Primarily interim work1At balance sheet date or one or
two months prior to year-end.2
f. Audit risk componentControl RiskDetection Risk
g. Primary fieldwork standardSecond.Third
h. Required by GAAS
When audit risk cannot be reduced to a sufficiently low level by
substantive tests alone.Yes
Concurrent tests of controls are performed in audit planning
with procedures to obtain an understanding of the system of
internal control. Additional tests of controls are performed during
interim fieldwork.
2 Tests of details of transactions may also be performed with
test of controls as dual-purpose tests during fieldwork.
12-7. a.The purpose of substantive tests is to provide evidence
about the fairness of each significant financial statement
assertion, or conversely, to reveal monetary errors or
misstatements in the recording or reporting of transactions and
balances.
b.As detection risk increases substantive tests should be more
effective and auditors should seek more reliable evidence related
to the assertion. 12-8.There are several types of initial
procedures that are performed before proceeding to other
substantive tests. First, it is important for the auditor to have
an understanding of the economic substance of the transactions that
are subject to audit. Second, it is important to trace beginning
balances in the general ledger to the audited balances in the prior
years financial statements.
Two initial procedures that require special consideration in a
first time audit are (1) determining the propriety of the account
balances at the beginning of the period being audited, and (2)
ascertaining whether the accounting principles used in the
preceding period are the same as those used in the current period
as a basis for determining the consistency of application of
principles. This is normally accomplished by reference to the
working papers of a predecessor auditor. In a continuing engagement
this can be accomplished by reference to the prior years working
papers.
12-9. a.The primary advantage of analytical procedures is that
they are very cost effective and they are also reasonably effective
at identifying accounts that may contain unintentional
misstatements. The primary disadvantage is that analytical
procedures are usually considered less effective than tests of
details. They are also less effective at identifying accounts that
are intentionally misstated as the balances have usually been
misstated to appear reasonable.b.The auditor should consider the
following matters when designing substantive analytical
procedures:
The suitability of the substantive analytical procedure given
the assertion.
The reliability of the data, whether internal or external, from
which the expectation of recorded amounts or ratios is
developed.
Whether the expectation is sufficiently precise to identify a
material misstatement at the desired level of assurance.
The amount of any difference of recorded amounts from expected
values that is acceptable.In some cases where substantive
analytical procedures are effective, they may also add to the
efficiency of the audit. For example, for public utilities and
cable companies, relatively small amounts of revenue are billed to
and collected from many thousands of customers each month. Tests of
details of these high-volume, low-value revenue transactions would
be very tedious and costly. On the other hand, revenues in such
cases can often be estimated with a fair degree of precision using
independent variables such as number of subscribers, billing rates
for various types of services, temperature data (for electric and
gas utilities), and so on. Alternatively, total sales commissions
expense could normally be estimated from total sales revenues
rather than examining the details of entries to sales
commissions.
c. In some cases the auditor can obtain good nonfinancial
information about the underlying drivers of revenues and expenses
and use that information to estimate revenues or expenses. The
following table provides several examples.
AccountAnalytical Procedure
Hotel room revenue
Tuition revenue
Wages expense
Gasoline expense
Commission ExpenseNumber of rooms x Occupancy rate x Average
room rate.
Number of equivalent fulltime students x Tuition rate for a
fulltime student
Average number of employees per pay period x Average pay per
period x Number of pay periods.
Number of miles driven Average miles per gallon x Average per
gallon cost.
Sales x Commission Rate
Income statement accounts may be tied directly to an underlying
economic driver (cost driver). Balance sheet accounts are subject
to transactions that cause both increases and decreases and may be
less predictable. Hence, analytical procedures may provide more
assurance about the fair presentation of income statement
accounts.
12-10. a.Tests of details of transactions primarily involve
tracing and vouching to test for understatements and
overstatements, respectively. Other procedures may also be used
such as inquiring and reperforming calculations.
b.Tests of details of transactions are typically more time
consuming and thus more costly to perform than analytical
procedures, but less costly than tests of details of balances.
Their cost-efficiency is enhanced when performed concurrent with
tests of controls as dual-purpose tests.
c.Tests of details may be applied directly to income statement
accounts when evidence obtained from tests of related balance sheet
accounts does not reduce detection risk to an acceptably low level.
This may include situations in which:
Inherent risk is high, such as when (1) nonroutine transactions
or (2) managements judgments and estimates affect assertions.
Control risk is high either because (1) related internal
controls for nonroutine and routine transactions are ineffective,
or (2) the auditor elects not to test the internal controls.
Analytical procedures reveal unusual relationships and
unexpected fluctuations.
An account requires analysis because it (1) requires special
disclosures in the income statement, (2) contains information
needed in preparing tax returns or reports for regulatory agencies
such as the SEC, or (3) has a general account title that suggests
the likelihood of misclassifications and errors.
12-11. a.Tests of details of balances focus on obtaining
evidence directly about an account balance (e.g., accounts
receivable) rather than the individual debits and credits
comprising the balance. Testing the individual debits and credits
is a test of transactions. b.Tests of details of balances often
involve the use of external documentation and/or the direct
personal knowledge of the auditor. Therefore, they can be very
effective. They also tend to be the most costly to perform.
12-12. a.Tests of accounting estimates involve understanding the
entitys process of estimating future outcomes (e.g., the
receivables that will not be collected in the future or the costs
of providing warranty coverage in the future) of past transactions.
This requires significant knowledge of the business, industry, and
economy.
b.When evaluating the reasonableness of an accounting estimate
the auditor should determine that
All accounting estimates that could be material to the financial
statements have been developed.
The accounting estimates are reasonable in the
circumstances.
The accounting estimates are presented in conformity with
applicable accounting principles and are properly disclosed.
12-13. a.As detection risk for test of details decreases, the
auditor should perform substantive tests of balances closer to, or
at, year-end.
b.The decision whether to perform substantive tests prior to the
balance sheet date should be based on whether the auditor can:
Control the added audit risk that material misstatements
existing in the account at the balance sheet date will not be
detected by the auditor. This risk becomes greater as the time
period remaining between the date of the interim tests and the
balance sheet date is lengthened.
Reduce the cost of substantive tests necessary at the balance
sheet date to meet planned audit objectives so that testing prior
to the balance sheet date will be cost effective.
c.The potential added audit risk can be controlled if
substantive tests for the remaining period can provide a reasonable
basis for extending the audit conclusions from the tests performed
at the interim date to the balance sheet date. Conditions
contributing to the control of this risk are:
The internal controls during the remaining period are
effective.
There are no conditions or circumstances that might predispose
management to misstate the financial statements in the remaining
period.
The year-end balances of the accounts examined at the interim
date are reasonably predictable as to amount, relative
significance, and composition.
The client's accounting system will provide information
concerning significant unusual transactions and significant
fluctuations that may occur in the remaining period.
12-14.As a general rule, detection risk and the extent of
substantive test are inversely related; i.e., the lower the
acceptable level of detection risk, the more extensive the
substantive tests should be. Note however, that the auditor has
choices between substantive tests involving analytical procedures
and substantive tests involving tests of details.
12-15. Traditionally, account balance assertions focus on the
balance sheet and transaction assertions focus on the income
statement and statement of cash flows. However, when performing
tests of account balance assertions the auditor often learns about
the fair presentation of transactions. For example, if the auditor
learns that inventory is overstated, it usually implies that cost
of sales is understated. If accounts receivable is overstated,
sales might also be overstated.
12-16. a.The auditor's objectives in auditing related party
transactions are to obtain evidential matter as to (1) the purpose,
nature, and extent of these transactions and (2) their effect on
the financial statements.
b.Substantive tests that may be used in auditing related party
transactions include the following:
Obtain an understanding of the business purpose of the
transaction.
Examine invoices, executed copies of agreements, contracts, and
other pertinent documents, such as receiving reports and shipping
documents.
Determine whether the transaction has been approved by the board
of directors or other appropriate officials.
Test for reasonableness the compilation of amounts to be
disclosed, or considered for disclosure, in the financial
statements.
Arrange for the audits of inter-company account balances to be
performed as of concurrent dates, even if the fiscal years differ,
and for the examination of specified, important, and representative
related party transactions by the auditors for each of the parties,
with appropriate exchange of relevant information.
Inspect or confirm, and obtain satisfaction concerning, the
transferability and value of collateral.12-17.a.An audit program is
a list of audit procedures to be performed.
b. The general framework for developing an audit program must
accomplish two tasks.
1) It should describe the nature of procedures to be
performed.
2) It should ensure that audit evidence is obtained for all
financial statement assertions (audit objectives).
c.Audit programs should be sufficiently detailed to provide:
An outline of the work to be done.
A basis for coordinating, supervising, and controlling the
audit.
A record of the work performed.
In addition to listing audit procedures, each audit program
should have columns for (1) cross-references to other working
papers containing the evidence obtained from each procedure (when
applicable), (2) the initials of the auditor(s) who performed each
procedure, and (3) the date performance of the procedure was
completed.
12-18. a.Six types of substantive audit procedures that are
normally included in an audit program are:
1) Initial procedures.
2) Substantive analytical procedures.
3) Tests of details of transactions.
4) Tests of details of balances.
5) Tests of detail of accounting estimates.
6) Tests of details of disclosures.
b.Audit programs describe the nature of audit procedures to be
performed. A well designed audit program should include audit
procedures to obtain sufficient, competent evidence about each
relevant financial statement assertion (or audit objective).
Comprehensive Questions
12-19.(Estimated time - 15 minutes)
Example Risk FactorAudit Strategy
1. The company is in an industry that is experiencing economic
difficulty and intense price competition.
2. The company has recently changed the nature of its product
and is bundling software with other services to customize and
implement software and related controls.
3. Analytical procedures for a manufacturer show a significant
increase in both profit margins and inventory turn days.
4. Analytical procedures for a retailer show significant
decreases in both profit margins and inventory turn days.
5. Senior management has sent a very strong message, and offered
increased incentives, to middle managers to meet financial
targets.
6. An employee in a small to medium sized business responsible
for cash disbursements did not receive an expected promotion and
pay increase.
7. A construction industry client uses the percentage of
completion method to recognize revenue and expense on current
projects.
8. A company is experiencing working capital and going-concern
problems.
9. The client has a strong control environment and good controls
over the existence of inventory.
10. The client has weak computer general controls including poor
controls over the approval of system changes.1. Primarily
Substantive Approach
2. Primarily Substantive Approach
3. Primarily Substantive Approach
4. Primarily Substantive Approach
5. Primarily Substantive Approach
6. Primarily Substantive Approach
7. Primarily Substantive Approach
8. Primarily Substantive Approach
9. A Lower Assessed Level of Control Risk Approach
10. Primarily Substantive Approach
12-20. (Estimated Time 30 minutes)
Example Risk FactorType of Potential MisstatementAudit
Strategy
1. The client has a strong control environment and good controls
over the existence of inventory.Controls are relevant to the
existence of inventory
A lower assessed level of control risk approach
2. The client is in an industry that has both significant
regulatory oversight and complex regulations.Misstatements may
occur in many assertions or accountsA primarily substantive
approach.
3. The client has recently experienced turnover in its
information technology group resulting in decreased segregation of
duties and a deterioration of computer general
controls.Misstatements may occur in many assertions or accountsA
primarily substantive approach.
4. The client is a private university with primarily full time
students, a small amount of receivables at year-end, and good
internal controls over revenues.Issues relate primarily to the
occurrence of revenues and the existence of
receivables.Predictability of transactions may allow for a response
to lower inherent risk and analytical procedures.
5. A companys business plans are dependent on the success of
entering new foreign markets with existing products.Issues relate
primarily to the occurrence of revenues and the existence of
receivables.A primarily substantive approach.
6. The client has used significant borrowing to fund expansion
in a competitive industry and has a narrow tolerance range
regarding debt covenants.Issues relate both to the disclosure
assertion for long-term debt and to other assertions affected by
debt covenants.A primarily substantive approach.
7. Analytical procedures for a manufacturer show significant
increases in both profit margins and inventory turn days.The
existence of inventory.A primarily substantive approach.
8. Inventory items are small in size and high in value.The
existence of inventory.A primarily substantive approach.
9. The telecommunications client is in a capital intensive
industry and fixed assets additions involve complex accounting
issues.Valuation and allocation for fixed assets.A primarily
substantive approach.
10. The audit team has experience several attempts by management
to justify marginal or inappropriate accounting on the basis of
immateriality.Issues may have a pervasive impact on multiple
assertionsA primarily substantive approach.
11. Analytical procedures for a manufacturer show significant
increases in both revenue growth and accounts receivable turn
days.Revenue recognition or the net realizable value of
receivables.A primarily substantive approach.
12-21 (Estimated Time: 15 minutes)
a.If the final assessed levels of control risk for the specified
assertions are the same as the planned assessed levels, the auditor
may proceed to design specific substantive tests based on the
planned level of substantive tests of details specified as the
fourth component of the audit risk model for each of the specified
assertions. Otherwise, the level of substantive tests must be
revised before designing specific substantive tests for each
assertion in order to accommodate a revised acceptable level of
detection risk that correlates with the final assessed level of
control risk.
b.Determining a revised acceptable level of detection risk for
an assertion can be accomplished by using the final assessed level
of control risk in either a risk matrix or the audit risk model and
re-solving for detection risk. Usually this is done by considering
both analytical procedures risk and test of details risk.
c.No. When evidence obtained from one substantive test or group
of tests reduces the risk of a material misstatement remaining
undetected in an assertion, it may be appropriate to use a higher
acceptable level of detection risk for any additional substantive
tests performed to gather evidence for that assertion.
12-22.(Estimated time - 15 minutes)
a.Substantive tests provide evidence about the fairness of each
significant financial statement assertion. They are the primary
means of obtaining sufficient competent evidential matter to
establish a reasonable basis for the auditor's opinion on the
client's financial statements.
b. The factors pertaining to substantive tests that can be
varied to accommodate different acceptable levels of detection risk
are (1) nature, (2) timing, (3) extent and (4) staffing. When a low
versus a high acceptable level of detection risk must be
achieved:
The nature of the tests selected should be more effective rather
than less effective.
The timing of the tests will more often be at year-end rather
than at an interim date.
The extent of the tests (e.g., sample size) will be greater.
Staffing selected will be more experienced rather than less
experienced.
c.The four types of substantive tests and brief explanations of
each are:
Analytical procedures which consist of evaluations of financial
information made by a study of plausible relationships among both
financial and nonfinancial data. Such procedures range from simple
comparisons to the use of complex mathematical and statistical
models involving many relationships and data elements.
Tests of details of transactions which primarily involve tracing
and vouching using documents available in the client's files. In
these tests, the auditor uses evidence obtained about the
individual debits and credits in an account to reach a conclusion
about the account balance.
Tests of details of balances which often involve the use of
external documentation and/or the direct personal knowledge of the
auditor. These procedures focus on obtaining evidence directly
about an account balance rather than the individual debits and
credits comprising the balance.
Tests of accounting estimates designed to obtain sufficient
competent evidential matter to provide reasonable assurance
that:
All accounting estimates that could be material to the financial
statements have been developed.
The accounting estimates are reasonable in the
circumstances.
The accounting estimates are presented in conformity with
applicable accounting principles and are properly disclosed.
The effectiveness of analytical procedures depends on (1) the
nature of the assertion, (2) the plausibility and predictability of
the relationship, (3) the availability and reliability of the data
used to develop the expectation, and (4) the precision of the
expectation. The effectiveness of tests of details of transactions
depends on the particular procedure and documents used. When these
tests involve the use of internally generated documents that have
not been circulated externally, they may be less effective than
tests involving the use of externally generated documents or
internally generated documents that have been circulated
externally. The effectiveness of tests of details of balances is
usually high because they typically involve (1) the use of external
documentation received directly by the auditor or (2) the direct
personal knowledge of the auditor. The effectiveness of tests of
accounting estimates depend on the auditors knowledge of (1) the
underlying drivers that influence the accounting estimate and (2)
the business, industry and economy.
Analytical procedures are generally the least costly tests to
perform. Tests of details of transactions are typically more time
consuming and thus more costly than analytical procedures. The
cost-efficiency of tests of details of transactions is enhanced
when performed concurrent with tests of controls as dual-purpose
tests. Tests of details of balances tend to be the most costly to
perform because of their focus on external documentation or the
auditor's direct personal knowledge. Tests of accounting estimates
requires significant professional judgment and may be more costly
due to the need for more experience staff to perform audit
procedures.
12-23.(Estimated Time 20 minutes)
a.An audit program is a list of auditing procedures to be
performed. Each program should have columns for the initials of the
individuals who performed each procedure, the dates the procedures
were completed, and cross-references to other working papers
containing evidence obtained from the procedures. Audit programs
should be sufficiently detailed to provide:
An outline of the work to be done.
A basis for coordinating, supervising, and controlling the
audit.
A record of the work performed.
b.Eight steps in the general framework for specifying
substantive tests to be included in an audit program include:
1. Obtain an understanding of the business and industry and
determine:
The significance of the transaction class and account balance to
the entity.
The key economic drivers that influence the transaction class
and account balance.
2. Specify initial procedures to:
Trace beginning balance to prior years working papers (if
applicable).
Review activity in applicable general ledger accounts and
investigate unusual items.
Verify totals of supporting records or schedules to be used in
subsequent tests and determine their agreement with general ledger
balances, when applicable, to establish tie-in of detail with
control accounts.
3. Specify analytical procedures to be performed.
4. Specify tests of details of transactions to be performed.
5. Specify tests of details of balances to be performed.
6. Specify tests of details of balances involving accounting
estimates to be performed.
7. Consider whether there are any special requirements or
procedures applicable to assertions being tested in the
circumstances such as procedures required by SAS (for example,
observation of inventories) or by regulatory agencies that have not
been included in (3) and (4) above.
8. Specify procedures to determine conformity of presentation
and disclosure with GAAP.
c.In initial engagements, the detailed specification of
substantive tests in audit programs is generally not completed
until after the study and evaluation of internal controls has been
completed and the auditor has a significant understanding of the
business and industry. Until then the auditor may not have a
reasonable basis for specifying appropriate detection risk levels
which affect the design of substantive tests for significant
financial statement assertions. In contrast, in recurring
engagements the auditor has access to audit programs used in the
preceding period(s) and the working papers pertaining to those
programs. In such cases, needs to understand major changes in the
business, but the auditor's preliminary audit strategies are often
based on a presumption that the risk levels and audit programs for
substantive tests used in the previous period may be appropriate
for the current period. Thus, the audit programs for the current
engagement are often prepared before the auditor completes the
evaluation of the internal controls with the understanding they may
subsequently require modification.
12-24.(Estimated Time 25 minutes)
ObjectiveAssertionObjectiveAssertion
1.C 8.C
2.EO 9.EO
3.PD 10.PD
4.VA 11.VA
5.VA 12.PD
6.RO 13.PD
7.RO 14.PD
12-25.(Estimated Time 20 minutes)
Note: The student is required to list only one type of test,
type of evidence, and assertion for each auditing procedure. In
some cases, alternative answers are indicated in the tabulation
below.
Audit ProcedureType of TestAudit Objective
1.Count cash on handT of D of balancesExistence, Completeness,
Valuation and allocation
2.Confirm accounts receivable.
T of D of balancesExistence
3.Vouch plant asset additions to purchase documents.T of D of
transactionsOccurrence, Accuracy
4.Recalculate accrued interest on notes payable.T of D of
balancesExistence, Completeness, Valuation and allocation
5.Inquire of management about pledging of plant assets as
security for long-term debt.T of D of disclosuresCompleteness of
disclosures
6.Compute inventory turnover ratio.Analytical
procedureExistence, completeness, valuation and allocation
7.Vouch ending inventory pricing to purchase invoices.T of D of
balancesValuation and allocation
8.Review client-prepared bank reconciliation.T of D of
balancesExistence, Completeness, Rights and obligations, Valuation
and allocation
9.Verify accuracy of accounts receivable balance and agreement
with subsidiary ledger.Initial proceduresAccuracy, Valuation and
allocation
10.Obtain details of accounts receivable subsidiary ledger and
reconcile to the general ledger.Initial proceduresAccuracy,
Valuation and allocation
11.Compare statement disclosures for leases with GAAP.T of D of
disclosuresCompleteness of presentation and disclosure, Occurrence
and rights and obligations of disclosures
12.Review adequacy of clients provision for uncollectible
accounts.Tests of accounting estimatesValuation and allocation
13.Examine certificates of title for delivery equipment.T of D
of BalancesRights and obligations
14.Confirm receivables.Analytical procedureExistence,
Completeness, Valuation and allocation
15.Trace bad-debt write-off authorizations to accounts
receivable.T of D of transactionsOccurrence, Accuracy
16.Observe clients inventory taking.T of D of balancesExistence,
Completeness, Valuation and allocation
17.Trace unpaid vendors invoices to accounts payable at
year-end.Test of details of transactionsCompleteness
18.Compare pension disclosures to a disclosure check list.T of D
of disclosuresCompleteness of presentation and disclosure,
Occurrence and rights and obligations of disclosures
12-26.(Estimated time - 25 minutes)
AssertionSubstantive Test
1.Valuation or allocationC, J
2.CompletenessA, B, E, F
3.Existence or occurrenceC, D
4.Valuation or allocationI, K
5.Presentation and disclosureL
6.Existence or occurrenceA, B
7.Rights and obligationsA, B, E, H, I
8.Presentation and disclosureM
9.CompletenessB, E, H
10.Rights and obligationsE, H
11.CompletenessF
12.Presentation and disclosureL
13.CompletenessE
14.Presentation and disclosureL
15.Valuation or allocationI, K
12-27. (Estimated Time 20 Minutes)
a. Before applying principal substantive tests to General's
balance sheet accounts at April 30, 20X6, Cook should consider
whether it is possible to control the added audit risk that
material misstatements existing in the accounts at the balance
sheet date will not be detected. Conditions that contribute
controlling this risk are:
Internal controls during the remaining period are effective.
There are no conditions or circumstances that might predispose
management to misstate the financial statements in the remaining
period. The year-end balances of the accounts examined at the
interim date are reasonably predictable as to amount, relative
significance, and composition. The client's accounting system will
provide information concerning significant unusual transactions and
significant fluctuations that may occur in the remaining
period.b.Substantive tests for the remaining period ordinarily
should include (1) comparison of the account balances at June 30
and April 30 to identify amounts that appear to be unusual and
investigation of any such amounts, and (2) such other analytical
procedures or other substantive tests of details as the auditor
considers necessary to provide a reasonable basis for extending the
interim audit conclusions to the balance sheet date.
12-28. (Estimated Time 30 minutes)
a.The auditor may perform substantive tests prior to the balance
sheet date when he or she can:
Control the added audit risk that material misstatements
existing in the account at the balance sheet date will not be
detected by the auditor.
Reduce the cost of substantive tests necessary at the balance
sheet date to meet planned audit objectives so that testing prior
to the balance sheet date will be cost effective.
In practice, early substantive testing of account balances is
not done unless tests of controls have provided convincing evidence
that internal controls are operating effectively. Moreover, it is
unlikely that the auditor will perform substantive tests prior to
the balance sheet date on all assertions pertaining to an
account.
b.The potential added audit risk can be controlled if
substantive tests for the remaining period can provide a reasonable
basis for extending the audit conclusions from the tests performed
at the interim date to the balance sheet date. Conditions
contributing to the control of this risk are:
Internal controls during the remaining period are effective.
There are no conditions or circumstances that might predispose
management to misstate the financial statements in the remaining
period.
The year-end balances of the accounts examined at the interim
date are reasonably predictable as to amount, relative
significance, and composition.
The client's accounting system will provide information
concerning significant unusual transactions and significant
fluctuations that may occur in the remaining period.
c.Substantive tests for the remaining period ordinarily should
include:
Comparison of the account balances at the two dates to identify
amounts that appear to be unusual and investigation of such
amounts.
Other analytical procedures or other substantive tests of
details to provide a reasonable basis for extending the interim
audit conclusions to the balance sheet date.
d.As compared with substantive tests of balance sheet accounts,
tests of income statement accounts rely more heavily on analytical
procedures and less on tests of details of transactions and
balances. Each income statement account is inextricably linked to
one or more balance sheet accounts (e.g., sales and accounts
receivable, and cost of goods sold and inventories). Thus evidence
obtained from tests of details performed on balance sheet accounts
also pertains to the related income statement accounts, reducing
the need for additional tests of details.
e.Analytical procedures arc used both directly and indirectly in
obtaining evidence about income statement accounts. Direct tests
occur when a revenue or an expense account is compared with other
relevant data to determine the reasonableness of its balance (e.g.,
the ratio of sales commissions to sales can be compared with the
results of prior years and budget data for the current year).
Indirect tests occur when evidence concerning income statement
balances can be derived from analytical procedures applied to
related balance sheet accounts (e.g., the accounts receivable
turnover ratio used in verifying accounts receivable may also be
used in determining whether bad debts expense is fairly stated). In
addition, in applying analytical procedures to income statement
accounts, there are many opportunities for comparing financial
information with nonfinancial information such as using number of
employees and number of miles driven to estimate wages expense and
gasoline expense, respectively.
f.The circumstances that may necessitate performing tests of
details of income statement accounts are as follows:
Inherent risk is high. This may occur in the case of nonroutine
transactions and management's judgments and estimates.
Control risk is high. This situation may occur when (1) internal
controls for nonroutine and routine transactions are ineffective or
(2) the auditor elects not to test the internal controls.
Analytical procedures reveal unusual relationships and
unexpected fluctuations. Examples of this situation include (1) a
company exceeding its sales growth target in spite of an unexpected
downturn in its industry and the economy as a whole and (2) an
unexplained increase in the inventory turnover ratio.
The account requires analysis. Analysis is usually required for
accounts that (1) require special disclosure in the income
statement, (2) contain information needed in preparing tax returns
and reports for regulatory agencies such as the SEC, and (3) have
general account titles that suggest the likelihood of
misclassifications and errors.
12-29.(Estimated Time 25 minutes)
a.The auditor's objective in auditing accounting estimates is to
obtain sufficient competent evidential matter to provide reasonable
assurance that:
All accounting estimates that could be material to the financial
statements have been developed.
The accounting estimates are reasonable in the
circumstances.
The accounting estimates are presented in conformity with
applicable accounting principles and are properly disclosed.
The auditor's objective in auditing related party transactions
is to obtain evidential matter as to the purpose, nature, and
extent of these transactions and their effect on the financial
statements.
b.Auditing procedures that may be used to obtain evidence about
these two types of accounts include the following:
Accounts involving accounting estimates
Review and test management's process in making the estimate.
Prepare an independent expectation of the estimate.
Review subsequent transactions and events occurring prior to
completing the audit that pertain to the estimate.
Accounts involving related party transactions
Obtain an understanding of the business purpose of the
transaction.
Examine invoices, executed copies of agreements, contracts, and
other pertinent documents, such as receiving reports and shipping
documents.
Determine whether the transaction has been approved by the board
of directors or other appropriate officials.
Test for reasonableness the compilation of amounts to be
disclosed, or considered for disclosure, in the financial
statements.
Arrange for the audits of inter-company account balances to be
performed as of concurrent dates, even if the fiscal years differ,
and for the examination of specified, important, and representative
related party transactions by the auditors for each of the parties,
with appropriate exchange of relevant information.
Inspect or confirm and obtain satisfaction concerning the
transferability and value of collateral.
c.In auditing identified related party transactions, the auditor
is not expected to determine (1) whether a particular transaction
would have occurred if the parties had not been related or (2) what
the exchange price and terms would have been. The auditor is
required, however, to determine the substance of the related party
transactions and their effects on the financial statements.
d.Management is responsible for establishing the process and
controls for preparing accounting estimates which it includes in
the financial statements. The auditor is responsible for evaluating
the reasonableness of accounting estimates made by management in
the context of the financial statements taken as a whole. This
includes (1) considering the relevance, reliability, and
sufficiency of the data and other factors used by management, (2)
evaluating the reasonableness and consistency of the assumptions,
and (3) reperforming the calculations made by management. In some
cases, the auditor may find it useful to obtain the opinion of a
specialist regarding the assumptions.
e.To evaluate the reasonableness of accounting estimates, the
auditor should normally concentrate on the key factors and
assumptions used by management including those that are (1)
significant to the accounting estimate, (2) sensitive to
variations, (3) deviations from historical patterns, and (4)
subjective and susceptible to misstatement and bias.
f.Sources of evidence concerning the reasonableness of
accounting estimates include the following:
Information supplied by management concerning the process used
and assumptions made.
Historical data used by management in developing the
estimates.
Recalculation by the auditor of management's estimates.
Independent expectations developed by the auditor for comparison
with management's estimates.
Events or transactions that occur subsequent to the date of the
balance sheet but prior to the completion of field work that relate
to the key factors and assumptions used by management.
Opinions supplied by a specialist.12-30. (Estimated Time 60
minutes)
Categorya. Substantive Testb. Audit Objectives
Initial Procedures1) Obtain an understanding of the business and
industry and determine:
a) The significance of plant assets, and changes in plant
assets, to the entity.
b) Key economic drivers that influence the entitys acquisition
of plant assets.
c) Industry standards for the extent to which the entity is
capital intensive and the impact of plant assets on earnings.
2) Perform initial procedures on plant assets balances and
records that will be subjected to further testing.
a) Trace beginning balance for plant assets and accumulated
depreciation to prior years working papers.
b) Review activity in general ledger accounts plant assets and
depreciation expense and investigate entries that appear unusual in
amount or source.
c) Obtain client-prepared schedules of plant asset additions,
retirements and depreciation expense, and determine that they
accurately represent the underlying accounting records from which
they were prepared by:
i) Footing and crossfooting the schedules and reconciling the
totals with increases or decreases in the related general ledger
balances during the period.
ii) Testing agreement of items on schedules with entries in
related general ledger accounts.EO, C, RO, VA,PD
VA1
Analytical Procedures3) Perform analytical procedures:
a) Develop an expectation for plant assets using knowledge of
the industry and the entitys business activity
b) Calculate ratios such as fixed asset turnover, depreciation
expense as a percent of sales, repair and maintenance expense as a
percent of sales and rate of return on assets
c) Analyze ratio results relative to expectations based on prior
years, industry data, budgeted amounts, or other data.
EO, C, VA, PD
Tests of Details of Transactions4) Vouch plant asset additions
to supporting documentation.
5) Vouch plant asset disposals to supporting documentation.
6) Review entries to repairs and maintenance expense. EO1, EO2,
C2RO1, VA1, PD1EO1, EO2, C2, RO1, VA1, PD1
EO1, VA1, PD1
Tests of Details of Balances7) Inspect plant asset.
a) Inspect plant asset additions.
b) Tour other plant assets and be alert to evidence of additions
and disposals not included on clients schedules and to conditions
that bear on the proper valuation and classification of the plant
assets.
8) Examine title documents and contracts
EO3,RO1, VA2, PD4EO3, RO1
Tests of Details of Balances: Accounting Estimates9) Evaluate
the fair presentation of depreciation expense by evaluating the
appropriateness of useful lives and estimated salvage values.
10) Determine if any significant events have resulted in an
impairment of the value of plant assets.VA2, PD5VA2
Presentation and Disclosure11) Compare statement presentation
with GAAP.
a) Determine that plant assets and related expenses, gains, and
losses are properly identified and classified in the financial
statements.
b) Determine the appropriateness of disclosures related to the
cost, book value, depreciation methods, and useful lives of major
classes of plant assets, the pledging of plant assets as collateral
and the terms of lease contracts. PD2, PD3, PD4, PD5
Related Party Transactions
SituationAccounting EstimatesAudit Program
Since this is a first year audit it is clear that related party
transactions will be a significant portion of this audit. The
engagement partner has asked you to research the firms
responsibilities with respect to related party transactions. Cut
and paste the auditing standard sections that explain the general
procedures that should be performed to (1) determine the existence
of related parties and (2) identify transactions with related
parties.
AU 334.07 Addresses the procedures to be performed to determine
the existence of related parties.
.07 The auditor should place emphasis on testing material
transactions with parties he knows are related to the reporting
entity. Certain relationships, such as parent-subsidiary or
investor-investee, may be clearly evident. Determining the
existence of others requires the application of specific audit
procedures, which may include the following:
a.Evaluate the company's procedures for identifying and properly
accounting for related party transactions.
b.Request from appropriate management personnel the names of all
related parties and inquire whether there were any transactions
with these parties during the period.
c.Review filings by the reporting entity with the Securities and
Exchange Commission and other regulatory agencies for the names of
related parties and for other businesses in which officers and
directors occupy directorship or management positions.
d.Determine the names of all pension and other trusts
established for the benefit of employees and the names of their
officers and trustees.fn4
e.Review stockholder listings of closely held companies to
identify principal stockholders.
f.Review prior years' working papers for the names of known
related parties.
g.Inquire of predecessor, principal, or other auditors of
related entities concerning their knowledge of existing
relationships and the extent of management involvement in material
transactions.
h.Review material investment transactions during the period
under audit to determine whether the nature and extent of
investments during the period create related parties.
Au 334.08 explains the general procedures that should be
performed to identify transactions with related parties.
.08The following procedures are intended to provide guidance for
identifying material transactions with parties known to be related
and for identifying material transactions that may be indicative of
the existence of previously undetermined relationships:
a.Provide audit personnel performing segments of the audit or
auditing and reporting separately on the accounts of related
components of the reporting entity with the names of known related
parties so that they may become aware of transactions with such
parties during their audits.
b.Review the minutes of meetings of the board of directors and
executive or operating committees for information about material
transactions authorized or discussed at their meetings.
c.Review proxy and other material filed with the Securities and
Exchange Commission and comparable data filed with other regulatory
agencies for information about material transactions with related
parties.
d.Review conflict-of-interests statements obtained by the
company from its management.fn5
e.Review the extent and nature of business transacted with major
customers, suppliers, borrowers, and lenders for indications of
previously undisclosed relationships.
f.Consider whether transactions are occurring, but are not being
given accounting recognition, such as receiving or providing
accounting, management or other services at no charge or a major
stockholder absorbing corporate expenses.
g.Review accounting records for large, unusual, or nonrecurring
transactions or balances, paying particular attention to
transactions recognized at or near the end of the reporting
period.
h.Review confirmations of compensating balance arrangements for
indications that balances are or were maintained for or by related
parties.
i.Review invoices from law firms that have performed regular or
special services for the company for indications of the existence
of related parties or related party transactions.
j.Review confirmations of loans receivable and payable for
indications of guarantees. When guarantees are indicated, determine
their nature and the relationships, if any, of the guarantors to
the reporting entity.
Accounting Estimates
SituationRelated Party TransactionsAudit Program
AU 342.09 -.14 explain the general procedures that should be
performed in evaluating the reasonableness of an accounting
estimate such as the provision for warranties.
.09In evaluating the reasonableness of an estimate, the auditor
normally concentrates on key factors and assumptions that are
a.Significant to the accounting estimate.
b.Sensitive to variations.
c.Deviations from historical patterns.
d.Subjective and susceptible to misstatement and bias.
The auditor normally should consider the historical experience
of the entity in making past estimates as well as the auditor's
experience in the industry. However, changes in facts,
circumstances, or entity's procedures may cause factors different
from those considered in the past to become significant to the
accounting estimate.fn4
.10In evaluating reasonableness, the auditor should obtain an
understanding of how management developed the estimate. Based on
that understanding, the auditor should use one or a combination of
the following approaches:
a.Review and test the process used by management to develop the
estimate.
b.Develop an independent expectation of the estimate to
corroborate the reasonableness of management's estimate.
c.Review subsequent events or transactions occurring prior to
completion of fieldwork.
.11Review and test management's process. In many situations, the
auditor assesses the reasonableness of an accounting estimate by
performing procedures to test the process used by management to
make the estimate. The following are procedures the auditor may
consider performing when using this approach:
a.Identify whether there are controls over the preparation of
accounting estimates and supporting data that may be useful in the
evaluation.
b.Identify the sources of data and factors that management used
in forming the assumptions, and consider whether such data and
factors are relevant, reliable, and sufficient for the purpose
based on information gathered in other audit tests.
c.Consider whether there are additional key factors or
alternative assumptions about the factors.
d.Evaluate whether the assumptions are consistent with each
other, the supporting data, relevant historical data, and industry
data.
e.Analyze historical data used in developing the assumptions to
assess whether the data is comparable and consistent with data of
the period under audit, and consider whether such data is
sufficiently reliable for the purpose.
f.Consider whether changes in the business or industry may cause
other factors to become significant to the assumptions.
g.Review available documentation of the assumptions used in
developing the accounting estimates and inquire about any other
plans, goals, and objectives of the entity, as well as consider
their relationship to the assumptions.
h.Consider using the work of a specialist regarding certain
assumptions (section 336, Using the Work of a Specialist).
i.Test the calculations used by management to translate the
assumptions and key factors into the accounting estimate.
.12Develop an expectation. Based on the auditor's understanding
of the facts and circumstances, he may independently develop an
expectation as to the estimate by using other key factors or
alternative assumptions about those factors.
.13Review subsequent events or transactions. Events or
transactions sometimes occur subsequent to the date of the balance
sheet, but prior to the completion of fieldwork, that are important
in identifying and evaluating the reasonableness of accounting
estimates or key factors or assumptions used in the preparation of
the estimate. In such circumstances, an evaluation of the estimate
or of a key factor or assumption may be minimized or unnecessary as
the event or transaction can be used by the auditor in evaluating
their reasonableness.
.14As discussed in section 312, Audit Risk and Materiality in
Conducting an Audit, paragraph .36, the auditor evaluates the
reasonableness of accounting estimates in relationship to the
financial statements taken as a whole:
Since no one accounting estimate can be considered accurate with
certainty, the auditor recognizes that a difference between an
estimated amount best supported by the audit evidence and the
estimated amount included in the financial statements may be
reasonable, and such difference would not be considered to be a
likely misstatement. However, if the auditor believes the estimated
amount included in the financial statements is unreasonable, he
should treat the difference between that estimate and the closest
reasonable estimate as a likely misstatement and aggregate it with
other likely misstatements. The auditor should also consider
whether the difference between estimates best supported by the
audit evidence and the estimates included in the financial
statements, which are individually reasonable, indicate a possible
bias on the part of the entity's management. For example, if each
accounting estimate included in the financial statements was
individually reasonable, but the effect of the difference between
each estimate and the estimate best supported by the audit evidence
was to increase income, the auditor should reconsider the estimates
taken as a whole.
Audit Program
SituationRelated Party TransactionsAccounting Estimates
CategorySubstantive Test
Initial Procedures1) Obtain an understanding of the business and
industry and determine:
a) The significance of revenues and accounts receivable to the
entity.
b) Key economic drivers that influence the entitys sales,
margins, and collections.
c) Standard trade terms in the industry, including seasonal
dating, collections period, etc.
d) The extent of concentration of activity with customers.
2) Perform initial procedures accounts payable balance and
records that will be subjected to further testing.
a) Trace beginning balance for accounts receivable to prior
years working papers.
b) Review activity in general ledger account for accounts
receivable and investigate entries that appear unusual in amount or
source.
c) Obtain accounts receivable trial balance and determine that
it accurately represents the underlying accounting records by:
i) Footing the trail balance and determining agreement with (1)
the total of the subsidiary ledger or accounts receivable master
file, and (2) the general ledger balance.
ii) Testing agreement of customer and balances listed on the
trial balance with those included in the subsidiary ledger or
master file.
Analytical Procedures3) Perform analytical procedures:
a) Develop an expectation for accounts receivable using
knowledge of the entitys business activity, market share, normal
trade terms, and its history of accounts receivable turn days.
b) Calculate ratios:
i) Compare sales to the entitys capacity.
ii) Compare sales growth and receivable growth.
iii) Accounts receivable turn days.
iv) Uncollectible accounts expense to net credit sales
v) Uncollectible accounts expense to accounts receivable
write-offs
c) Analyze ratio results relative to expectations based on prior
years, industry data, budgeted amounts, or other data.
Tests of Details of Transactions4) Vouch a sample of recorded
revenue cycle transactions to supporting documentation.
a) Vouch receivable debits to supporting sales invoices,
shipping documents, and sales orders.
b) Vouch receivable credits to supporting cash receipts and cash
prelists.
c) Vouch receivable credits to remittance advices or sales
adjustment authorizations for sales returns and allowance or
uncollectible account write-offs.
5) Trace a sample of revenue transactions from shipments to
recording in the sales journal. Also trace a sample of cash
receipts and sales returns to their recording in the accounting
records.
6) Perform cutoff test for sales and sales returns.
a) Select a sample of recorded sales transactions from several
days before and after year-end and examine supporting sales
invoices and shipping documents to determine sales were recorded in
the proper period.
b) Select sample of credit memos issued after year-end, examine
supporting documentation such as dated receiving reports and
determine that returns were recorded in the proper period. Also
consider whether volume of sales returns after year-end suggest
possibility of unauthorized shipments before year-end.
7) Perform cash receipts cutoff test.
a) Observe that all cash received through the close of business
on the last day of the fiscal year is included in cash on hand or
deposits in transit and that no receipts of the subsequent period
are included, or
b) Review documentation such as daily cash summaries, duplicate
deposit slips, and bank statements covering several days before and
after year-end for proper cutoff.
Tests of Details of Balances8) Confirm accounts receivable
a) Determine the form, timing, and extent of confirmation
requests.
b) Select and execute sample and investigate exceptions.
c) For positive confirmation requests for which no reply was
received, perform alternative follow-up procedures:
Vouch subsequent cash receipts identifiable with items
comprising account balance at confirmation date to supporting
documentation.
Vouch items comprising balance at confirmation date to
documentary support such as sale orders and shipping documents.
9) a) Make Inquiries about the sale, factoring, or pledging of
accounts receivable.
b) Send confirmations to entities who have purchased accounts
receivable or hold accounts receivable as collateral.
Tests of Details of Balances: Accounting Estimates10) Evaluate
adequacy of allowance component for each aging category and in the
aggregate.
a) Foot and crossfoot the aged trail balance of receivables and
agree total to the general ledger.
b) Test aging by vouching amounts in aging categories for sample
of accounts to supporting documents.
d) For pastdue accounts:
Examining evidence of collectibility such as correspondence with
customers and outside collection agencies, credit reports, and
customers financial statements.
Discuss collectibility of accounts with appropriate management
personnel.
e) Evaluate managements process for estimating the allowance for
doubtful accounts using hindsight.
f) Evaluate the adequacy of the allowance given information
about
Industry trends.
Aging trends.
Collection history for specific customers.
Required Procedures
11) Confirmation of receivable included in step 7 above.
Tests of Details of Presentation and Disclosure12) Compare
statement presentation with GAAP.
a) Compare disclosures related to existence and rights and
obligations of receivables to the results of tests performed
above.
b) Determine that receivables are properly identified and
classified as to type and expected period of realization
c) Determine whether there are credit balances that are
significant in the aggregate and that should be reclassified as
liabilities.
d) Determine the appropriateness of disclosures and accounting
for related party, pledged, assigned or factored receivables.
e) Determine the need for disclosures regarding significant
customers or sales by line of business.
f) Evaluate the completeness of presentation and disclosures for
receivables in drafts of financial statements to determine
conformity to GAAP by reference to disclosure checklist.
g) Read disclosures and independently evaluate their
understandability.
h) Vouch the accuracy of receivable disclosures to tests
performed above.