ppt_ch10

Copyright 2003 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett

Slides prepared by Roger Simnett1

CHAPTER 10:

SUBSTANTIVE TESTSOF TRANSACTIONS

AND BALANCES



RELATIONSHIP BETWEEN TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS

• Most controls built around transaction flows.

• Tests of controls: transactions selected to test whether related controls are working.

• Substantive test of transactions: transactions selected to determine whether monetary errors have occurred.



DUAL PURPOSE TESTS• These are tests of transactions that address

both control and financial misstatement issues simultaneously.

• Very common in practice since both tests of controls and substantive tests of transactions involve inspection of documents.

• It is efficient to perform tests on transactions selected simultaneously, e.g. select document and check evidence of authorisation (test of control) and recompute amount (substantive test of transaction).



SUBSTANTIVE TESTS OF TRANSACTIONS AND BALANCES

• Objective is to provide reasonable assurance of validity and propriety of financial report or identify monetary misstatements and thus reduce detection risk of auditor.

• Substantive tests of transactions focus on the individual transactions that make up the balance.

• Substantive tests of balances substantiate the ending balance of an account.



DISTINGUISHING BETWEEN SUBSTANTIVE TESTS OF TRANSACTIONS AND SUBSTANTIVE TESTS OF BALANCES

• The $5000 balance for Able could be verified by confirming this balance with customer (test of balances) or verifying to supporting documentation the three transactions comprising this balance (tests of transactions).

Extract from Accounts Receivable Subsidiary Ledger Customer Year-end Balance Transactions for Able Able 5000 Sales 2000 Receipts (1000) Sales 4000 Baker 500 Chan 1000



FINANCIAL REPORT ASSERTIONS OF INTEREST



EXISTENCE/ OCCURRENCE AND COMPLETENESS ASSERTIONS

Note that the direction of testing determines whether existence/occurrence or completeness assertion is tested.

SourceDocuments

existence (of account balance components)/occurrence (of transactions in accounting records)

AccountingRecords

Completeness (of accounts balance components ortransactions in accounting records)



DETERMINANTS OF AUDIT PROCEDURES USED

Will be determined by:• The assertion/audit objective to be

tested• The nature of the item and available

evidence



CASH, CASH RECEIPTS AND CASH PAYMENTS — ASSERTIONS OF PRIMARY INTERESTS

Cash Cash receipts/payments

•Existence;•Completeness; and

possibly•Valuation (if foreign

currency balances).

•Occurrence•Completeness; and

possibly•Measurement (if foreign

currency transactions).

These are primarily:

- since these are areas where misstatement is most likely to occur



APPROACH IN AUDITING CASH BALANCES

• Determined by assessed level of control risk in bank and cash handling procedures.

• Much of this information will come from evaluations and tests of controls in the sales and cash receipts, purchases and cash payments systems.



ASSERTIONS, OBJECTIVES AND PROCEDURES FOR CASH BALANCES



CASH — KEY PROCEDURES

These are:• Testing of client’s bank

reconciliation

• Obtaining confirmation of bank balances from client’s bankers



SALES, CASH RECEIPTS, ACCOUNTS RECEIVABLE — ASSERTIONS OF INTEREST

Sales/cash receipts

Accounts receivable

•Occurrence•Measurement

•Existence•Valuation

- as these are areas in which misstatement is most likely to occur



ACCOUNTS RECEIVABLE — KEYAUDIT PROCEDURES

• Confirmation• Subsequent receipts review• Cut-off• Analytical procedures• Tests of sales transactions• Review of aged trial balance



ASSERTIONS, OBJECTIVES AND PROCEDURES FOR SALES AND ACCOUNTS RECEIVABLE



ACCOUNTS RECEIVABLE —CONFIRMATION AND OTHER PROCEDURES

Auditor might plan to obtain direct confirmation from debtors using:

• Positive form — asks client to respond, whether or not they agree with information as to amount owed in request

• Negative form — requests client to respond when they disagree with amount shown

Auditor should also consider other proceduressuch as examining evidence of subsequent

cashreceipts, and examining sales and shippingdocuments.



FORMAT OF POSITIVE ACCOUNTS RECEIVABLE CONFIRMATION REQUESTS



CONFIRMATION PROCEDURE VERSUS SUBSEQUENT CASH RECEIPTS TESTING

Subsequent cash receipts commonly viewed as superior form of evidence because achieves both key assertions.

Confirmations Subsequent cash receipts testing

•Existence YES

•Valuation NO

•Existence YES

•Valuation YESConfirmations still require tests of likelihood of

payment (doubtful debts provision).



PURCHASES AND INVENTORY

• Inventory consists of goods to be sold or used in the production of saleable goods.

• Transactions involving inventory: increase to inventory when goods purchased and decrease to inventory when goods sold.



RISK ASSESSMENT OF INVENTORY

Inventory generally considered high risk

because:• Significant to determination of

income• High volume of activity• Accounting complexities• Possibility of manipulation in this

area



INVENTORY — ASSERTIONS OF INTEREST

Two key assertions of inventory aregenerally:• Existence• Valuation



INVENTORY — KEY PROCEDURES

• Observation of physical inventories• Analytical procedures• Cut-off• Tests of pricing and summarisation



ASSERTIONS, OBJECTIVES AND PROCEDURES FOR PURCHASES AND INVENTORY I



ASSERTIONS, OBJECTIVES AND PROCEDURES FOR PURCHASES AND INVENTORY II



INVENTORY — OBSERVATION OF PHYSICAL INVENTORY: STOCKTAKE

• Where inventory is considered material, auditor should attend physical inventory count (stocktake), unless impractical.

• When attending stocktake, auditor uses a combination of observation and inquiry and making test counts.

• If inventory outside auditor’s area of expertise, should consider utilising services of expert.



INVENTORY — TESTS OF PRICING AND SUMMARISATION OF COUNT PROCEDURES

A combination of vouching, tracing andrecomputation. In performing theseprocedures auditor’s main concerns are:• Identifying obsolete, excess and slow-moving

items• That inventory is counted correctly and results

of inventory count are updated correctly• That prices for goods are applied appropriately• That inventory is valued at the lower of cost

and net realisable value



ACCOUNTS PAYABLE AND PAYMENTS• Primary assertion of concern is

completeness, as most likely form of misstatement is understatement.

• Common audit procedures to address this assertion are confirmation, a search for unrecorded liabilities and analytical procedures performed on related expense account balances.



ASSERTIONS, OBJECTIVES AND PROCEDURES OF ACCOUNTS PAYABLE



NON-CURRENT ASSETS• The balances of non-current asset

accounts are usually affected by a few relatively large transactions each year.

• For this reason, it is usually efficient for auditor to verify account balances by performing tests on individual transactions.



PROPERTY, PLANT ANDEQUIPMENT

Assertions of interest are generally:

• Existence• Rights and obligations• Valuation



PROPERTY, PLANT AND EQUIPMENT — KEY PROCEDURES

• Substantiating additions and identifying retirements

• Considering any revaluations

• Analytically testing or recomputing related expense accounts such as depreciation



ASSERTIONS, OBJECTIVES AND PROCEDURES FOR PROPERTY, PLANT AND EQUIPMENT



INVESTMENTS AND INTANGIBLE ASSETS

Assertions generally of interest are:• Rights and obligations• Existence• Valuation



ASSERTIONS, OBJECTIVES AND PROCEDURES FOR INVESTMENTS



INTANGIBLES — USE OF EXPERT

• Assertions in relation to valuation and existence for intangible assets are particularly subjective given nature of intangible assets.

• Auditor may consider use of experts where issues are outside auditor’s own expertise.



INVESTMENTS AND INTANGIBLES — KEY PROCEDURES

• Physical examination• Confirmation• Inspection of legal documents • Recomputation, vouching, tracing• Specialised valuation procedures



NON-CURRENT LIABILITIES AND OWNERS’ EQUITY

Key assertions completeness:

Key procedures:• Confirmations• Reading minutes of meetings• Examination of contracts and

agreements• Inspection of share registers



ASSERTIONS, OBJECTIVES AND PROCEDURES FOR NON-CURRENT LIABILITIES



STATEMENT OF FINANCIAL PERFORMANCE ACCOUNTS: ASSERTIONS OF INTEREST

• Occurrence• Completeness• Rights and obligations• Measurement• Disclosure



AUDIT PROCEDURES FOR STATEMENT OF FINANCIAL PERFORMANCE ACCOUNTS I

• Substantiation indirectly by simultaneous tests of statement of financial performance accounts, e.g. sales accounts receivable; cost of goods sold inventory

• Substantiation directly in conjunction with statement of financial position accounts, e.g. property, plant & equipment depreciation



AUDIT PROCEDURES FOR STATEMENT OF FINANCIAL PERFORMANCE ACCOUNTS II

• Substantiation directly by analytical procedures, e.g. relationships between amounts that are expected to follow a predictable pattern such as sales sales commission

• Substantiation directly by separate direct tests of individually significant transactions or events or account balances of intrusive interest, e.g. discontinued operations



AUDITING BY COMPUTER: TESTING CLIENTS’ FILES

The major way the auditor uses the computer for substantive tests involves using audit software to read clients’ master files and/or transactions files.

Major advantages:• Directs auditor’s attention to items of risk

and/or materiality• Undertakes routine audit tasks efficiently



AUDITING BY COMPUTER: FOUR MAJOR TECHNIQUES

• Generalised audit software — audit interrogation software used with many clients

• Specialised audit software — audit interrogation software especially written for client, task or industry

• Utility programs — routines written by manufacturer for hardware, e.g. sort, merge

• Systems management programs — enhanced productivity tools (e.g. data retrieval software) typically part of sophisticated operating systems environments



FUNCTIONS OF AUDIT SOFTWARE

This software can interrogate clients’ files in order to:

• Select sample items• Identify records meeting specified criteria

(exception reporting)• Test and make calculations• Compare data in separate fields or on

separate files• Summarise data• Write reports



EFFECT OF STRATEGIC BUSINESS RISK ON SUBSTANTIVE TESTS

• Increased emphasis on tests of controls for routine transactions implies decreased emphasis for substantive tests for such transactions.

• Increased emphasis on non-routine transactions implies increased emphasis on substantive tests, as would not expect sophisticated control systems around non-routine transactions.

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