CHAPTER 10: SUBSTANTIVE TESTS AND DOCUMENTATIONEvidence, Procedures, Substantive tests, Working Papers

AUDIT EVIDENCEAudit RiskAttributes of Audit Evidence

Audit Risk

• The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated• This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.

• Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.

Audit Risk Risk of Material Risk That the Audit Risk = Misstatement * Auditors Fail

to Detect Misstatement

= Inherent Control Detection Risk * Risk * Risk

• Inherent Risk--Risk of a material misstatement occurring in an assertion assuming no related internal controls.

• Control Risk--Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.

• Detection Risk--Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

Audit Risk

Audit Evidence Concept

PSA 500 (Redrafted), par. 6 “Audit Evidence”

The auditor shall design and perform audit procedures that are appropriate in the circumstances for the purpose of obtaining sufficient appropriate audit evidence.

What Constitutes the Evidence

•Accounting records•Corroborating Information

Entity’s accounting records alone cannot be considered sufficient evidence to support an opinion on the financial statements. When auditing financial statements, the auditor should go beyond the accounting records. Auditor should obtain other corroborative information to support his opinion.

Attributes of Audit Evidence

Reasonable assurance is attained when the auditor has obtained sufficient appropriate evidence to reduce audit risk to an acceptable level. Audit evidence is typically obtained by performing risk assessment procedures, tests of control and substantive test.

Audit Risk Model

Set Desired Level of Audit Risk

Assess the Level of Inherent Risk

Assess the Level of Control Risk

Determine the Acceptable Level of Detection Risk

Design the Substantive Test

3rd Standard of Fieldwork

•“Sufficient competent evidential matter”

•Competence stems from nature of evidence

•Sufficiency stems from extent of testing

The Third Field Work Standard

• Third standard of field work:• The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to perform a reasonable basis for an opinion regarding the financial statements under audit

• Sufficient audit evidence• The quantity of audit evidence that must be obtained

Evaluation of Sufficiency

Factors to be considered: The competence of evidence The materiality of the item being

examined The risk involved in a particular

account Experience gained during previous

audits

Appropriateness of Audit Evidence

To be appropriate audit evidence must be:•Relevant•Reliable

Appropriateness of Audit Evidence• Principles: Audit evidence is ordinarily more reliable when it is:

• Obtained from knowledgeable independent sources outside the company rather than dependent sources

• Generated internally through a system of effective controls rather than ineffective controls.

• Obtained directly by the auditor rather than indirectly or by inference

• Documentary in form rather than oral• Provided by original documents rather than copies

Reliability of Certain Types of Audit Evidence

RELIABILITY TYPE EXAMPLE High Physical Inventory Observation

DocumentaryExternal Cutoff Bank StatementExternal/Internal Purchase InvoiceInternal Sales Invoice

Low Client Representations Management Representation Letter

Cost Benefit Consideration

•As a guiding rule, there should be a rational relationship between the cost of obtaining evidence and the usefulness of the evidence obtained. The auditor uses his professional judgment in determining the appropriate type of evidence that should be obtained.

Cost / Benefit of Evidence• Expensive Tests

• Physical examination• Confirmation

• Inexpensive tests• Observation• Inquiry• Reperformance

Evaluation of Audit Evidence• The auditor ordinarily obtains more assurance from consistent audit evidence obtained from different sources or of different nature than from items of audit evidence considered individually.

• In addition, obtaining audit evidence from different sources or of a different nature may indicate that an individual item of audit evidence is not reliable.

Overall Types of Audit Procedures

• Risk assessment procedures• To obtain an understanding of the client and its

environment, including its internal control, to assess the risks of material misstatement

• Further Audit Procedures• Tests of controls

• When appropriate, to test the operating effectiveness of controls in preventing material misstatements

• Substantive procedures• To detect material misstatements at relevant

assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

AUDIT PROCEDURESAnalytical ProceduresEnquiry/ConfirmationInquiryObservationRecalcUlation/Reperformance

Relationship Among Assertions, Objectives and Procedures

•Financial Statements Assertions-Are representations made by the management explicit or otherwise embodied in the financial statement components

Assertions used by the auditor fall into the following categories:

• a. Assertions about classes of transactions and events for the period under audit:

• b. Assertions about account balances at the period end:

• c. Assertions about presentation and disclosure:

Relationship Among Assertions, Objectives and Procedures

• Objectives• Identify the standards for good evidence, the methods for obtaining and presenting the audit evidence.

• Audit Procedure• are acts or methods used to gather the validity of the assertions.

Using Assertion to Determine the Audit Procedure to be performed

• The auditor should:• should use assertions for classes of transactions, account balances and presentation and disclosures in sufficient detail to form a basis for the assessment of risks of material statement

• identify first their audit objectives or goals for each financial statement assertions; and

• then identify the audit procedures to fulfill that objective

Example of assertion and audit objectives

Table 1. Audit objectives for debtors and related transaction classes

Assertion category

Transaction class audit objectives

Account balance audit objectives

Existenceor occurrence

Recorded sales transactions represent goods shipped during the period. Recorded cash receipts transactions represent cash received during the period.

Debtors represent amounts owed by customers at the balance sheet date.

Completeness All sales and cash receipts transactions that occurred during the period have been recorded.

Debtors include all claims on customers at the balance sheet date.

Nature, Timing and Extent of Procedures

Timing• Refers to when audit procedures are performed or the period or date to which the audit evidence appliesExtent

• Includes the quantity of a specific audit procedure to be performedEffect of E-commerce

• Audit evidence is increasingly in electronic form.• Auditors must evaluate how electronic information affects their ability to gather evidence.

• Auditors use computers to read and examine evidence.

Audit Procedures for Obtaining Audit Evidence 

Audit Procedure According to Purposea. Obtain an understanding of the entity and its environment, including its internal control, to assess the risks of material misstatement at the financial statement and relevant assertion levels ( risk assessment procedures);

b. When necessary, or when the auditor has determined to do so, test the operating effectiveness of controls in preventing or detecting material misstatements at the relevant assertion level (tests of controls)

c. Detect material misstatements at the relevant assertion level ( substantive procedures).

Audit Procedure According to Nature 

•Inspection of Records or Documents• Inspection involves examining records or documents, whether internal or external, in paper form, electronic form, or other media, or physically examining an asset.

Types of Documents

Internal Documents• Prepared and used within client company. • Does not go outside the client.

External Documents• Document has been in hands of an outside party to the transaction.

• More reliable than internal documents.

Inspection of Tangible Assets• Inspection of tangible assets consists of physical examination of the assets.

• Inspection of tangible assets may provide appropriate audit evidence with respect to their existence, but not necessarily about the entity's rights and obligations or the valuation of the assets.

• Different from examining documentation is that the asset has inherent value. 

•Direction of the Test• is important in establishing the assertion being tested by a certain procedure.

VOUCHING TRACING

-Examination of documents that support a recorded transaction or amount.-The direction of testing must be from the recorded item to the supporting document.-Tests existence or occurrence

Recorded Item to Supporting Document

-The primary test for unrecorded items and therefore tests the completeness assertion.-The direction of testing must be from the supporting document to the recorded item.

Supporting Document to Recorded Item

• Observation consists of looking at a process or procedure being performed by others.

• Auditor witnesses the physical activities of the client.

• Differs from physical examination because physical examination counts assets, while observation focuses on client activities.

• Useful in obtaining evidence that controls which leave no documentary evidence of application or existence are in operation.

Observation

Inquiry

• Inquiry consists of seeking information from knowledgeable persons in financial or nonfinancial roles within the company or outside the company.

•Auditor obtains information from the client in response to questions.

Recalculation

•Recalculation consists of checking the mathematical accuracy of documents or records.

Reperformance

•Reperformance is the auditor's independent execution of procedures or controls that were originally performed as part of the entity's internal control, either manually or through the use of Computer Assisted Audit Technique

Analytical Procedures• Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data.

• Auditors study relationships among data.• Unusual fluctuations occur when significant difference are not expected but do exist or when significant differences are expected but do not exist.

• Required during the planning stage.

Confirmation

•a specific type of inquiry, is the process of obtaining a representation of information or of an existing condition directly from a third party.

Information & its SourceInformation SourceAssetsCash in bank (example) BankAccounts receivableCustomer

Notes receivable MakerOwned inventory out on consignmentConsignee

Inventory held in public warehouses WarehouseCash surrender value of life insurance Insurance co. 

Liabilities Accounts payable CreditorNotes payable LenderAdvances from customers CustomerMortgages payable MortgagorBonds payable Bondholder

Owners’ Equity Shares outstanding Registrar and transfer agent

Other InformationInsurance coverage Insurance co.Contingent liabilities Bank, lender, and clients

legal counsel

External Confirmation

External Confirmation is the process of obtaining and evaluating audit evidence through a representation of information or an existing condition directly from a third party in response to a request for information about a particular item affecting assertions in the financial statements.

•Positive•Negative

Two Kinds of Confirmation

Positive Confirmations

- asks for response even if balance is correct.- request asks the respondent to reply to the auditor in all cases either by indicating the respondent's agreement with the given information- or by asking the respondent to fill in information- ordinarily expected to provide reliable audit evidence however there is a risk may reply to the request without verifying the information- may result to lower response rates 

Negative Confirmations

• asks for a response only if balance is incorrect.

• uncertainty associated with no response.

• respondents reply only in the event of disagreement with the information provided in the request

• ordinarily provides less reliable audit evidence

Management Request Not to Confirm Information

The auditor should•consider whether there are valid grounds for such request: and

•obtain audit evidence to support the validity of management requests

Auditor’s Decision on the Management’s Request not to seek External Confirmations

The auditor Accepts the Request

the auditor should - Apply alternative audit procedures to obtain sufficient appropriate audit evidence

The auditor does not accept -There is a limitation of scope- The auditor should consider the possible effect on the auditor’s report.

Auditor ControlThe auditor should maintain control:• on the process of selecting people to whom request will be sent

• preparation and sending information requests

• responses to those requests

SUBSTANTIVE TESTINGAnalytical Procedures, Test of Details

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Performing Substantive Tests

Chapter 10

Set desired level of

Audit Risk

Assess Inherent

Risk

Assess Control

Risk

Determine Acceptable

Level of Detection Risk

Audit PlanningInternal Control

Consideration

Performing Substantive

Test

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URBN LOFTSChapter 10

DR =

ARIR x CR

Audit Risk Model

Audit Risk = Inherent Risk x Control Risk x Detection Risk

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URBN LOFTSChapter 10Audit Risk Model

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Audit Risk - risk that auditor expresses an inappropriate audit

opinion when the financial statements are materially

misstated

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URBN LOFTSChapter 10Audit Risk Model

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Risk of material misstatement is a risk that financial statements

might be misstated and this risk can further be divided into two

components:Inherent Risk x Control Risk

Risk of Material Misstatements

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URBN LOFTSChapter 10Audit Risk Model

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Inherent Risk - errors (or misstatements or deviations) will

occur before internal controls

CLIENT‑CONTROLLED/INDEPENDENT

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Audit Risk = Inherent Risk x Control Risk x Detection Risk

Control Risk (CR) -risk that client's internal control system will fail to

prevent/ detect/correct error

CLIENT‑CONTROLLED/INDEPENDENT

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URBN LOFTSChapter 10Audit Risk Model

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Detection risk -auditor’s procedures will not be able to

detect material misstatements in the financial statements

AUDITOR‑CONTROLLED/DEPENDENT

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URBN LOFTSChapter 10Audit Risk Model

Audit Risk = Inherent Risk x Control Risk x Detection Risk

SETAudit

Planning

AssessedAudit

Planning

Pre-Assessment

Audit Planning

Final-AssessmentInternal Control

Tests

SOLVE! Substantive

Testing

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URBN LOFTSChapter 10Audit Risk ModelCompany A

High IR and CRRisk of Material Misstatements

Company B

Low IR and CRRisk of Material Misstatements

Which Company will require more effort?

More Audit EffortLow Detection Risk

Less Audit EffortHigh Detection Risk

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DR =

ARIR x CR

Detection Risk is INVERSELY related to:

1. Risk of Material Misstatements

- Inherent Risk- Control Risk

3. Substantive Procedures

Relationships

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Recap: Audit ProceduresChapter 10

Analytical Procedure Enquiry/Confirmation Inspection Observation

RecalcUlation/Reperformance

Mnemonic

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Procedures as to Type and Nature

Chapter 10

Procedure RAP TOC ST

Analytical Procedure Enquiry Confirmation Inspection Observation RecalcUlation Reperformance

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Types of Test According to Cost

Chapter 10

Analytical Procedures

Risk Assessment Procedures

Test of Controls

Test of Details of Transactions

Test of Details of Balances

Cheapest to Most Expensive

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Types of Test (Further Audit Procedures)

Chapter 10

    Relation to Risk Model

Test Name Control Risk

Detection Risk

TOCTODT

APTODB

Tests of ControlsTest of Details of TransactionsAnalytical ProceduresTests of Details of Balances

X  X

XX

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Substantive Tests VSTest of Controls

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Tests of ControlsChapter 10

• Reliance of Clients Internal Control• Purpose: Reduce Substantiate Work• Low Control Risk

Test of Control are audit procedures used to test the operating effectiveness of control policies and procedures in

support of a reduced assessed control risk.

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Substantive TestChapter 10

Purpose• To substantiate account balances• To detect material misstatements that

have passed through the accounting/internal control system filter.

Substantive tests are audit procedures designed to test for errors or irregularities

directly affecting the Monetary correctness of financial statement assertions.

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URBN LOFTSTOC vs ST Chapter 10

Completeness of Payables

Test of Controls

Substantive Tests

Inspect a sample of supplier statement reconciliations for

evidence that they have been reviewed by an appropriate level of

management.

Inspect the cash book payments in the past year

for any significant payments to suppliers to

ensure the year end liability is accurately

recorded.

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Procedures to Reduce RiskControl Risk

• Procedures to gain an understanding of

internal control• Tests of controls

Detection Risk• Substantive tests of

transactions• Analytical procedures

• Tests of details of balances

TAKE NOTE: • Stronger controls will allow the auditor to

assess control risk below the maximum.• The more evidence an auditor collects from

the Substantive Tests, the lower the detection risk. Detection risk must be lower when control risk is higher. (Inverse Relationship)

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URBN LOFTSAudit Assurance at Different Levels of Internal Control Effectiveness

Acceptableassurance

Noassurance

INTERNAL CONTROL EFFECTIVENESSWeak control Strong control

Reliance on controls: C3 – None, C2 – Some, C1 – Maximum

Audit assurancefrom control riskassessment andtests of control

Audit assurancefrom substantivetests

A C B

C3

C2

C1

AU

DIT

AS

SU

RA

NC

E

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Basic Understanding of Internal Control

LOW CONTROL RISK HIGH

Test of Controls

Substantive Tests

HIGH DETECTION RISK LOW

Test of Controls vs. Substantive Tests

Why is there a GAP here?

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The Auditor will Always DO SUBSTANTIVE TESTING

regardless of the assessed level of Control Risk.

THERE IS NO PURE CONTROL BASED APPROACH.

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URBN LOFTSAudit ApproachTwo kinds of Approach

1. Combined Approach2. Substantive Approach

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URBN LOFTSAudit ApproachApproach Source of

Audit Assurance

Control Risk

Detection Risk

Combined Approach/Reliance

Internal Controls and Substantive Test

Less than Maximum

Increase

Substantive Approach/No Reliance

Substantive Test only

At Maximum

Decrease

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Relationship between Test of Controls, Detection Risk and

Substantive Procedures

Chapter 10

Approach Result of Test of Controls

Final Assessment of Control Risk

Assessed Level of Detection Risk

Substantive Test

Combined Approach

Internal Control is Reliable

Decrease Increase Less Extensive

Substantive Approach

Internal Control is Not Reliable

Increase Decrease More Extensive

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Types of Substantive Tests

Chapter 10

1. Substantive Analytical Procedures

2. Test of Details of Classes of:• Transactions• Account Balances• Disclosures

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Substantive Analytical Procedures

Chapter 10

• Required for Planning and Overall review

• Not Required for Substantive Testing

TAKE NOTE

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Substantive Analytical Procedures

Chapter 10

• Evaluation of Financial Information

• Identify/Study Plausible Relationships

• Uses Financial & Non-Financial DataExpect

How much

to accept?

CompareExpectation to Reality

Investigate

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Generalizations On Plausible Relationships

Chapter 10

Plausible – appearance of truth/persuasive

Relationships DIFFER in their Predictability.

Therefore, with regards to Predictability

Dynamic/Unstable < Stable Environment

Balance Sheet < Income Statement

Management Discretion < Other actions in entity

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Types of Analytical Procedures

Chapter 10

• Direct Test - Test reasonableness of accrued commissions/expense by multiplying sales x rate

• Indirect test - Compute gross margin(provides evidence as to likelihood of errors in inventory and accounts receivable).

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Types of Expectations

Chapter 10

Trend analysis - analyze changes in accounts of a company over timeRatio analysis – compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial data• Liquidity (e.g., current ratio)• Leverage (e.g., debt to equity)• Profitability (e.g., gross profit

percentage)• Activity (e.g., inventory turnover)

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Approaches to ratio analysis

Chapter 10

• Horizontal analysis• Review ratios over time

• Cross sectional analysis• Analyze ratios of similar firms at a

point in time• Vertical analysis

• Analyze relationships within a period

• “Common size” statements prepared

• Other methods• Regression analysis,

reasonableness test

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Test of DetailsChapter 10

Two General Types of Test of Details

1. Substantive Tests of Transactions or Test of Details of Transactions

2. Tests of details of account balances and disclosures

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URBN LOFTSTest of Details Chapter 10Test of Details of Transactions/

Substantive Tests of Transactions

Testing for monetary misstatements to determineif the following 6 transaction-

related audit objectiveshave been met:

ExistenceCompleteness

AccuracyClassification

TimingPosting and Summarization

Tests of Details of Balances

Testing for monetarymisstatements to determine if

the following 9 balance-related Audit objectives have been met:

ExistenceCompleteness

AccuracyClassification

CutoffDetail tie-in

Realizable valueRights and obligations

Presentation and disclosure

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Test of Details of Transactions

Chapter 10

• Substantive Test of Transactions• test for errors or fraud in individual

transactions.

EX: An auditor may examine a large purchase of inventory by testing that the cost of the goods included on the invoice is properly recorded in the inventory and accounts payable accounts.

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Test of Details of Balances & Disclosures

Chapter 10

• focus on the items that are contained in the financial statement account balances and disclosures.

Example: BalancesThe auditor may want to test accounts payable by examining a sample of individual invoices that make up the ending balance of accounts payable.

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Example: DisclosuresChapter 10

• For example, the auditor might read a loan contract to ascertain the maturity schedule and debt covenants for the loan

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Test of Details of Balances

Chapter 10

• If the results of tests of controls, substantive tests of transactions, and analytical procedures are inconsistent with the predictions, tests of details of balances will need to be changed as the audit progresses.

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Test of Details of Accounting Estimates

Chapter 10

• involve obtaining evidence in support of the client's estimations process

• ensures that the estimation process is applied consistently from period to period.

Take Note: Other Types

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URBN LOFTSDual Purpose TestsChapter 10

• Audit procedures are classified as substantive tests or tests of controls.

• Reperformance of client procedures

Example: re-add client invoice• TOC - was client verification

procedure effective?• STOT - was transaction accurate?

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Scope of Audit Procedures

Chapter 10

• One may change the scope of audit procedures by changing the (NTE, or re-ordered as NET): • Nature (type and form)• Timing (when performed)• Extent (quantity of evidence

obtained)

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Timing of Substantive Test

Chapter 10

• YEAR END SUBSTANTIVE PROCEDURES ARE ALWAYS MORE RELIABLE.

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Timing of TestsChapter 10

1. Test of Controls (TOC) and Test of Details of Transactions (TODT) performed simultaneously

2. When used as direct evidence, Analytical Procedures (AP) follows TODT and TOC.

3. Most TODB are performed last, and are performed after year-end.

4. Where controls are good, it is also possible to perform some TODB at an interim date.

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URBN LOFTSConsideration: Early Substantive Tests

Chapter 10

• Early Substantive Testing is applicable when the auditor has assessed low control risk for that period. • The auditor may sometimes consider

applying tests of controls while extending his substantive procedures.

• In situations of actual or expected fraud, auditor may prefer applying substantive procedures at period end.

• There should be an ALLOWANCE for SIGNIFICANT CHANGES.

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URBN LOFTSConsideration: Early Substantive Tests

Chapter 10

• Perform substantive procedures or combined approach to cover the remaining period

FACTORS to consider• The control environment and other

relevant controls• The availability of information • Objective of the substantive procedure. • The assessed risk of material

misstatement• The nature of the class of transactions • The ability of the auditor

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URBN LOFTSInterim Testing:Roll Forward Procedures

Chapter 10

• Auditor should determine what additional evidence concerning the operation of the controls for the remaining period is necessary

Accounts Receivable, Nov. 30 xxAdd: December Sales xxLess: December Collections (xx)Accounts Receivables, Dec 31 xx

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Factors to Consider in Updating Interim Tests’ Evidences to Year End

Chapter 10

• Specific control tested prior to the as-of date

• Sufficiency of the evidence of effectiveness

• The length of the remaining period• Significant Changes in Internal Control

Low Control Risk during Roll Forward Period Inquiry as a Roll Forward Procedure will SUFFICE.

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URBN LOFTSChapter 10Excerpt: Audit program – Test of BalancesInventory & Warehousing CycleScenario and Amounts are assumed.

Audit objective Audit procedure CommentsInventory as recorded on tags exists – Validity.[Purpose: to uncover the inclusion of non-existent items in inventory.]

(a) Select a random sample of tag numbers & identify the tag with that number attached to the actual inventory.

(b) Observe whether movement of inventory takes place during the count.

(a)All inventory tag numbers should tally with the number written on the inventory.

(b)No movement of inventory during the count.

Inventory is valued correctly – Valuation.

(a) Trace unit costs in the inventory listing as at 31 Dec 2006 to standard costs or supplier invoices.

(b) Perform a lower of cost & net realisable value test on inventory items.

(a)No exceptions noted.

(b)Lower of cost & NRV test valuation of finished goods is correct.

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URBN LOFTSChapter 10Excerpt: Audit program – Analytical ProceduresInventory & Warehousing CycleScenario and Amounts are assumed.

Audit procedure

Audit objectives Comments

Compare unit costs of inventory with those of previous years.

Over/understatement of unit costs, which affect inventory & cost of goods sold.

Appendix A.Unit costs have remained reasonably consistent.

Compare total inventory value with that of previous years.

Misstatements in compilation, unit costs or extensions, which affect inventory & cost of goods sold.

Appendix B.Noted an increase in pencil inventories – awaiting shipment which subsequently took place on 3.1.2007.

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URBN LOFTSChapter 10Appendix A

2006 2005 Variance 2006 2005 VarianceUnit cost 2.50 2.48 0.81% 2.45 2.43 0.82%

Pens Pencils

Pens Pencils Pens Pencils Variance

Unit cost 2.50 2.45 2.48 2.43

No. of units 37,283.26 112,869.34 35,704.73 95,590.58 Inventory value 93,208.15 276,529.88 88,547.74 232,285.10 Total inventory 369,738.03 320,832.84 48,905.19

15.24%

2006 2005

Appendix B

FRAUD AND ERROR

FRAUD AND ERRORERRORunintentional misstatement in financial statements, • Misinterpretatio

n of an accounting estimate

• Omission of amount

FRAUDintentional misstatementsresulting from:

1. Management Fraud

2. Employee Fraud

Two types of intentional misstatements

1. Management Fraud/Fraudulent Financial Reporting – fraud involving one or more members of management or those charged with governance

2. Employee Fraud - fraud involving only employees of entity“

Fraud, whether fraudulent financial reporting or misappropriation of assets, involves:• Incentive or pressure to

commit fraud• Perceived opportunity to do so• Rationalization of the act.

For example:

(a) Incentive or pressure to commit fraudulent financial reporting may exist when management is under pressure, from sources outside or inside the entity, to achieve an expected earnings target or financial outcome.

(b) A perceived opportunity to commit fraud may exist when an individual believes internal control can be overridden.

(c) Individuals may be able to rationalize committing a fraudulent act.

PrimaryRESPONSIBILITIES

Management/Governance

Auditor

prevention and detection of fraud

obtaining reasonable assurance that the

financial statements taken as a whole are

free from material misstatement,

whether caused by fraud or error.

INHERENT LIMITATIONS OF AUDIT

The risk of not detecting a material misstatement resulting from fraud is higher than the risk of not detecting one resulting from error.

The auditor’s ability to detect a fraud depends on factors such as:

1.skillfulness of the perpetrator2.the frequency and extent of manipulation3.the degree of collusion involved4.the relative size of individual amounts manipulated,5.the seniority of those individuals involved.

TAKE NOTE:The risk of the auditor not detecting a material misstatement resulting from management fraud is greater than for employee fraud.

PROFESSIONAL SKEPTICISM• Attitude of questioning mindThis enables the auditor to identify/evaluate:(1) matters that increase the risk of material

misstatement(2) circumstances that make the auditor

suspect that financial statements are materially misstated

(3) evidence obtained that brings into question the reliability of management representations.

FRAUD RISK FACTORS• events or conditions that indicate

an:• Incentive or pressure commit

fraud• Opportunity to commit fraud• Attitudes/Rationalizations

• Uses professional judgment.

Fraud risk factors

EFFECT

Inherent and

Control Risk

TAKE NOTE:The size, complexity, and ownership characteristics of the entity have a significant influence on the consideration of relevant fraud risk factors.

EX: Circumstances indicative of fraud 1. Discrepancies in the accounting records • Unauthorized balances/transactions

• Last-minute significant adjustments

2. Conflicting or missing evidence, • Missing documents. • Likely altered documents

3. Unusual relationships between the auditor and management

• Denial of access to records• Undue time pressures

Actions to be taken related to Fraud and Error:1. Identify if there are circumstances that indicate a possible misstatement in the financial statements.2. Determine whether statements are materially misstated.

3. If misstatements are identified, the auditor should consider whether such misstatement may be indicative of fraud.4. In evaluating and disposing of misstatements, consider materiality.

5. The auditor should document: (1) Fraud risk factors identified as being present during the risk assessment process and during the performance of audit; (2) the auditor’s responses to the fraud risk factors.

COMMUNICATIONMatters to communicate:1. Management competence and

integrity.2. Management Fraud3. Material Misstatements from:

• Error• Material weakness in internal

control• Future effect on Financial

Statements

To WHOM to REPORT:

•To Management•To Those Charged With Governance •To Regulatory and Enforcement Authorities

Auditor Unable to Continue the Engagement(a)Determine the professional and legal

responsibilities(b)Consider whether it is appropriate to

withdraw from the engagement(c) If the auditor withdraws:• Discuss with the appropriate level of

management/governance the auditor’s withdrawal

• Determine whether there is a professional or legal requirement to report

AUDITING ACCOUNTING ESTIMATES

Accounting Estimates • an approximation of the

monetary amount in the absence of a precise means of measurement.

Example:

•Allowance for doubtful accounts•Inventory obsolescence•Warranty obligations•Depreciation•Impairment loss•Fair value determination

Responsibility

Management Auditor

making accounting estimates

obtain sufficient appropriate evidence as to whether accounting

estimate is properly accounted for and

disclosed and accounting estimate is reasonable in

the circumstances

Risk or material misstatement is greater when estimation of uncertainty is based on assumptions 1. accounting estimates

relating to the outcome of litigation

2. fair value estimates of financial instruments that are not publicly traded

When assessing the risk of material misstatement relating to accounting estimates, the auditor should:1. understand the degree of

uncertainty involved the requirement of the standards

2. the procedures used by the client in making these estimates

When evaluating the reasonableness of accounting estimates, the auditor should :1.obtain an understanding of the procedures and methods including the accounting 2.internal control system used by management in making accounting estimates

In evaluating estimates, the auditor may use these approaches:1. Review and test the process

used by management to develop the estimate

2. Making independent estimate

3. Reviewing subsequent events which confirm estimate made.

Case where only disclosure required by generally accepted accounting principle is necessary:

•Some estimates, such as a potential loss from litigation, (because there are no relevant historical data or transaction in subsequent period).

AUDIT DOCUMENTATIONAudit Working Papers

Audit Documentation &Working PapersAudit documentation

• the principal record of the basis for the auditor’s conclusions

• principal support for the representations in the auditor’s report.

• includes records on the planning and performance of the work, the procedures performed, evidence obtained, and conclusions reached by the auditor.

“Documentation means the material (working papers) prepared by and for, or obtained and retained by the auditor in connection with the performance of the audit. Working papers may be in the form of data stored on paper, film, electronic media or other media.” PSA 230

Working Papers• A direct aid in the planning,

performance, and supervision of the audit;

• Record the audit evidence• Assist in review of the audit work.• Provide proof of the adequacy of the

audit

Significant Matters

• PSA 230 states: “The auditor should record in the working papers information on planning the audit, the nature, timing and extent of the audit procedures performed and the results thereof, and the conclusions drawn from the audit evidence obtained.”

• The auditor must document significant findings or issues, actions taken to address them (including additional evidence obtained), and the basis for the conclusions reached.

Form and Content of the Working Papers

• Audit documentation must contain sufficient information to enable an experienced auditor, having no previous connection with the engagement

• Convey the auditor’s reasoning on all matters which require the exercise of judgment and the auditor’s conclusions. (Professional Judgment)

• Designed and organized to meet the circumstances and the auditor’s needs

The working papers should contain at a minimum:

• information on planning the audit work;

• the nature, timing, and content of the audit procedures performed;

• the results of the audit procedures; and

• the conclusions drawn leading to an opinion.

Document Retention (PSA 230)• The auditor should adopt appropriate

procedures for maintaining the confidentiality and safe custody of the working papers and for retaining them for a period sufficient to meet the needs of the practice and in accordance with legal and professional requirements of record retention.

• When additions are made, the documentation added must indicate the date the information was added, by whom it was added, and the reason for adding it.

• Working papers are the property of the auditor.

Types of Working Files

Current files Current year working papers Index and cross-referencing

Permanent files Items of continuing audit interest

ExamplesPermanent File Current File• Copies or

excerpts of company documents

• Prior year analysis

• Internal control information

• accounting-related information such as trial balances

• lead schedules• analyses of

transactions and balances

• recommended journal entries

The permanent file usually includes the following:

The current file work papers will usually contain accounting-related information such as trial balances, lead schedules, analyses of transactions and balances and, if necessary, recommended journal entries to correct the accounts records.

The largest portion of working papers includes the detailed schedules prepared by the client or the auditors in support of specific amounts on the financial statements.

Lead Schedules• Supports Trial Balance• Each detailed account on the lead

schedule is supported by audit work performed and the conclusions drawn.

The major types of supporting schedules • Account analysis• List schedules• Reconciliation of amounts• Tests of reasonableness

Preparation of working papersRequires structuring the informationWorking Paper Elements1. Heading (client’s name, period covered,

a description of contents of the work paper, the date of preparation,

2. Index code3. Initials/Dates of the staff/reviewer4. Tick Marks

Tick Marks and Indexing

• Tick marks - the nature and extent of procedures

• Indexing - cross referenced to aid in the organizing and filing.

APPLICATIONKnowledge becomes Wisdom when shared.

Tinkerbell Toys Co.Tinkerbell Toys Co (Tinkerbell) is a manufacturer of children’s building block toys; they have been trading for over 35 years and they sell to a wide variety of customers including large and small toy retailers across the country. The company’s year end is 31 May 2011.

Sales ordering and Invoicing

Each customer has a unique customer account number and this is used to enter sales orders when they are received in writing from customers. The orders are entered by an order clerk and the system automatically checks that the goods are available and that the order will not take the customer over their credit limit. For new customers, a sales manager completes a credit application; this is checked through a credit agency and a credit limit entered into the system by the credit controller. The company has a price list, which is updated twice a year. Larger customers are entitled to a discount; this is agreed by the sales director and set up within the customer master file.

Test of control Objective of test

The auditor should attempt to enter an order for a fictitious customer account number. The system should not accept this order

To ensure that orders are only accepted and processed forvalid customers.

Confirm discounts applied to invoices agree to the customer master file.

To ensure that sales discounts are only provided to validcustomers.

Substantive Procedure• Select a sample of sales invoices for larger

customers and recalculate the discounts allowed to ensure that these are accurate. (Vouching - Existence)

• Select a sample of credit notes issued after the year end and follow through to sales invoice to ensure the returns were recorded in the proper period. (Tracing - Completeness)

Test of Control

Tinkerbell Toys Co.

FRAUDDuring the year a material fraud was uncovered. It involved cash/cheque receipts from customers being diverted into employees’ personal accounts. In order to cover up the fraud, receipts from subsequent unrelated customers would then be recorded against the earlier outstanding receivable balances and this cycle of fraud would continue.

The fraud occurred because two members of staff ‘who were related’ colluded. One processed cash receipts and prepared the weekly bank reconciliation; the other employee recorded customer receipts in the sales ledger. An unrelated sales ledger clerk was supposed to send out monthly customer statements but this was not performed. The bank reconciliations each had a small unreconciled amount but no-one reviewed the reconciliations after they were prepared. The fraud was only uncovered when the two employees went on holiday.

Control Mitigate Risk

Members of staff who are related should not be permitted towork in the same department whereby they can breachSegregation of duty controls.

This should reduce the risk of staff collusion and being ableto commit a fraud without easily being discovered.

Bank reconciliations should be reviewed by a responsibleofficial (different to the preparer of the reconciliation) on aregular basis. Any unreconciled amounts should be promptlyinvestigated and resolved.

A small unreconciled amount can actually represent twolarge balances which almost cancel each other out andhence could indicate significant problems with cash andbank.

Where fraud arises it can often be quickly spotted byperforming and reviewing a bank reconciliation.

Test of Control

Keep your eyes on the stars, and your feet on

the ground.

Thank You!God Bless us.

Falculan, Plata, Pumida, Mendoza