substantive tests of transactions and balances · chapter 10: substantive tests ... ppts t/a...

Copyright 2003 McGraw-Hill Australia Pty Ltd

PPTs t/a Auditing and Assurance Services in Australia by Gay & Simnett

Slides prepared by Roger Simnett 1

CHAPTER 10:

SUBSTANTIVE TESTS OF 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.

Source

Documents

existence (of account balance components)/

occurrence (of transactions in accounting records)

Accounting

Records

Completeness (of accounts balance components or

transactions 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 — KEY

AUDIT 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 procedures such as examining evidence of subsequent cash receipts, and examining sales and shipping documents.




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 YES

Confirmations 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 are

generally:

• Existence

• Valuation




INVENTORY — KEY

PROCEDURES

• Observation of physical inventories

• Analytical procedures

• Cut-off

• Tests of pricing and summarisation





FOR PURCHASES AND INVENTORY I





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 and recomputation. In performing these procedures 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 AND

EQUIPMENT

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





FOR PROPERTY, PLANT AND EQUIPMENT




INVESTMENTS AND

INTANGIBLE ASSETS

Assertions generally of interest are:

• Rights and obligations

• Existence

• Valuation





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





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.