Professional Documents
Culture Documents
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 Controls
Tests 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
a.
Types
b.
Purpose
c.
Nature of test
measurement
Applicable audit
procedures
d.
e.
Timing
f.
g.
Control Risk
Second.
h.
Substantive Tests
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
Determine fairness of significant
financial statement assertions.
Monetary errors in transactions and
balances.
Same as tests of controls, plus
analytical procedures, counting,
confirming, tracing, and vouching.
At balance sheet date or one or two
months prior to year-end.2
Detection Risk
Third
12-7. a.
b.
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.
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.
1
2
12-9. a.
b.
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.
The auditor should consider the following matters when designing substantive
analytical procedures:
The reliability of the data, whether internal or external, from which the
expectation of recorded amounts or ratios is developed.
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.
Account
Hotel room revenue
Tuition revenue
Wages expense
Gasoline expense
Commission Expense
Analytical Procedure
Number 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
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.
12-11. a.
b.
12-12. a.
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.
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.
12-13. a.
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.
b.
12-17. a.
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.
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.
Comprehensive Questions
12-19. (Estimated time - 15 minutes)
Example Risk Factor
1.
Audit Strategy
1. Primarily Substantive Approach
2. Primarily Substantive Approach
4.
5.
6.
7.
Type of Potential
Misstatement
Controls are relevant to the
existence of inventory
A primarily substantive
approach.
A primarily substantive
approach.
Predictability of
transactions may allow for a
response to lower inherent
risk and analytical
procedures.
A primarily substantive
approach.
Audit Strategy
A primarily substantive
approach.
A primarily substantive
approach.
A primarily substantive
approach.
A primarily substantive
approach.
A primarily substantive
approach.
A primarily substantive
approach.
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
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.
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.
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
b.
c.
Assertion
C
EO
PD
VA
VA
RO
RO
Objective
8.
9.
10.
11.
12.
13.
14.
Assertion
C
EO
PD
VA
PD
PD
PD
Audit Procedure
Count cash on hand
Type of Test
T of D of balances
2.
T of D of balances
Audit Objective
Existence, Completeness,
Valuation and allocation
Existence
3.
T of D of transactions
Occurrence, Accuracy
T of D of balances
Existence, Completeness,
Valuation and allocation
Completeness of disclosures
Initial procedures
Tests of accounting
estimates
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
T of D of disclosures
Analytical procedure
T of D of balances
T of D of balances
Existence, completeness,
valuation and allocation
Valuation and allocation
Existence, Completeness,
Rights and obligations,
Valuation and allocation
Accuracy, Valuation and
allocation
Initial procedures
T of D of disclosures
Completeness of presentation
and disclosure, Occurrence
and rights and obligations of
disclosures
Valuation and allocation
T of D of
Balances
Analytical procedure
15.
16.
17.
18.
Audit Procedure
Trace bad-debt write-off
authorizations to accounts
receivable.
Observe clients inventory
taking.
Trace unpaid vendors invoices
to accounts payable at year-end.
Compare pension disclosures to
a disclosure check list.
Type of Test
T of D of transactions
Audit Objective
Occurrence, Accuracy
T of D of balances
Existence, Completeness,
Valuation and allocation
Completeness
Test of details of
transactions
T of D of disclosures
Completeness of presentation
and disclosure, Occurrence
and rights and obligations of
disclosures
Assertion
Valuation or allocation
Completeness
Existence or occurrence
Valuation or allocation
Presentation and disclosure
Existence or occurrence
Rights and obligations
Presentation and disclosure
Completeness
Rights and obligations
Completeness
Presentation and disclosure
Completeness
Presentation and disclosure
Valuation or allocation
Substantive Test
C, J
A, B, E, F
C, D
I, K
L
A, B
A, B, E, H, I
M
B, E, H
E, H
F
L
E
L
I, K
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.
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.
d.
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.
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.
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.
f.
a. Substantive Test
1)
2)
Analytical
Procedures
3)
b. Audit
Objectives
EO, C, RO,
VA,PD
VA1
EO, C, VA, PD
Category
Tests of
Details of
Transactions
Tests of
Details of
Balances
a. Substantive Test
4)
5)
6)
7)
8)
Tests of
Details of
Balances:
Accounting
Estimates
Presentation
and
Disclosure
b. Audit
Objectives
EO1, EO2,
C2RO1, VA1,
PD1
EO1, EO2, C2,
RO1, VA1, PD1
EO1, VA1, PD1
EO3,RO1, VA2,
PD4
EO3, RO1
VA2, PD5
PD2, PD3,
PD4, PD5
9)
VA2
Related
Party
Transactions
Situation
Accounting
Estimates
Audit
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
The 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. fn 5
e.
Review the extent and nature of business transacted with major customers,
suppliers, borrowers, and lenders for indications of previously undisclosed
relationships.
f.
g.
h.
i.
j.
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.
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.
Review confirmations of compensating balance arrangements for indications that
balances are or were maintained for or by related parties.
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.
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
Situation
Related
Party
Transactions
Audit
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.
.09
.10
.11
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.
.12
Develop 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.
.13
.14
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
Situation
Category
Initial
Procedures
Analytical
Procedures
Related
Party
Transactions
Accounting
Estimates
Substantive Test
1) 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.
3) 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.
Category
Tests of
Details of
Transactions
Tests of
Details of
Balances
Tests of
Details of
Balances:
Accounting
Estimates
Required
Procedures
Substantive Test
4) 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 writeoffs.
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.
8) 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.
10) 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.
11) Confirmation of receivable included in step 7 above.
Category
Tests of
Details of
Presentation
and
Disclosure
Substantive Test
12) 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.