KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY

SCHOOL OF BUSINESS

PRINCIPLES OF AUDITING (ACF 453)

Bsc. BUSINESS ADMIN (ACCOUNTING) - (FULL & PART-TIME) FOURTH YEAR – 1ST SEMESTER 2010

LECTURE 8 –SUBSTANTIVE TESTING FOR KEY AUDIT AREAS

8.1 Key Audit Areas Appropriate Working Paper Control Sheets should be used to record in detail the audit work to be carried out and to record the overall conclusion relating to that audit section drawn from the evidence obtained.

For convenience the auditor plans, carries out and records his work in sections each related to one aspect of the business or financial statements. However it is important to remember that the objective of an audit is to enable the auditor to express an opinion on the financial statements as a whole and not just a series of opinions on individual items.

The Key Audit Areas that may relevant in an audit includes:a) Revenueb) Purchases and Operating Expensesc) Pay Rolld) Corporate Taxatione) Value Added Taxf) Cash and Bank Balancesg) Trade and Other Receivablesh) Trade and Other Payablesi) Inventoriesj) Property, Plant and Equipmentk) Intangible Assets

- Goodwill- Research and Development Expenses- Preliminary Expenses- Others

l) Commitments and Contingenciesm) Provisionsn) Equity and Reserveso) Investment Propertyp) Contract Balancesq) Finance Lease and Hire Purchaser) Investmentss) Opening Balances and Comparativest) Cash Flow Statement

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8.2 Audit Programmes and risk

8.2.1 Audit Programme

An audit programme is a list of the work an auditor does on the occasion of his audit including reports to be made and procedures to be followed on important phases of examination, including tests of transactions and special procedures.

8.2.2 Purpose – The purpose of an audit programme is therefore to act as a guide covering the major areas of work to be carried out and a means of control by which the progress of the audit may be guided and responsibilities allocated for different sections of the work.

Audit programmes should be constructed to respond to assessed risks. These risks may have been specifically identified as part of the risk assessment or they may be more general risks associated with the preparation of any financial statements. It should be clear from the working paper control sheet what procedures have been designed in order to address risks identified in the risk assessment. The auditor’s aim is to carry out appropriate procedures in order to reduce the risk of material misstatement to an acceptable level.

8.2.3 Using audit programmes to respond to assessed risks, the nature, timing and extent of further audit procedures should:

• Respond to the assessed risks (identified during the risk assessment process);• Reduce audit risk to an acceptable level; and• Respond to assessed risks of material misstatements for each material class of

transactions, account balance, and disclosure.

The second phase of the audit is thus to design and perform further audit procedures that respond to the assessed risks of material misstatement and will provide the evidence necessary to support the audit opinion.

Some of the matters the auditor should consider when planning the audit procedures include:

- Assertions that cannot be addressed by substantive procedures alone. This can occur where there is highly automated processing of transactions with little or no manual intervention.

- Existence of internal control that, if tested, could reduce the need/scope for other substantive procedures.

- The potential for substantive analytical procedures that would reduce the need/scope for other types of procedures.

- The need to incorporate an element of unpredictability in procedures performed.

- The need to perform further audit procedures to address the potential for management override of controls or other fraud scenarios.

- The need to perform specific procedures to address “significant risks” that have been identified.

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Audit procedures designed to address the assessed risks could include a mixture of:- Tests of the operational effectiveness of internal control; and- Substantive procedures such as tests of details and analytical

procedures.

In other words, in designing further audit procedures the auditor should consider the following factors:

The significance of the risk (generally the higher the assessment of risk the more reliable and relevant his audit evidence must be) (Nature of assessed risks)

The likelihood of material misstatement (Nature of assessed risks) The characteristics of the item involved (Need for Unpredictability and

Other Basic or Required Audit Procedures) The nature of specific controls used by the entity and in particular whether

they are automated or manual (Use of tests of controls) Whether he expects to obtain audit evidence by testing controls to determine

whether the controls are effective in preventing or detecting and correcting material misstatements. (Use of tests of controls)

Substantive procedures should be performed for each significant risk and each material class of transactions, account balance and disclosure, regardless of whether any risk factors have been identified. This may be necessary to comply with ISAs and local requirements. Examples might include attending the inventory count, external confirmations, and subsequent events. Substantive procedures include tests of detail and substantive analytical procedures. (Other Basic or Required Audit Procedures)

8.2.4 Using Assertions in Auditing

Designing Audit Procedures

In designing audit procedures to be responsive to assessed risks, the auditor should place emphasis on addressing the relevant assertions where misstatements could occur. For example, if the risk is high that receivables are being overstated, the audit procedures should be designed to specifically address the valuation assertion. Similarly, when the auditor designs tests of controls, emphasis should be placed on testing controls over the relevant assertions rather than just significant controls.

An individual procedure will often provide evidence only in respect of one assertion. When designing procedures the auditor needs to ensure that he has an appropriate focus covering the various assertions in respect of a particular item that reflects the risk he has identified. For example, where he has identified that there is a risk of omitted items (completeness) he would not want to construct a programme where the majority of procedures provide evidence in respect of existence/ occurrence.

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All assertions should be considered for each category of assets, liabilities or equity, class of transactions or other disclosure in the financial statements. Risks will not affect all assertions equally- for example the auditor may conclude that a particular set of circumstances indicates a risk that certain assets may have been omitted from a particular balance sheet heading (completeness) whilst at the same time he is satisfied that there is little risk of misstatement in the valuation of those assets that have been recorded.

All procedures on the audit programme should be related to one or more assertions. In this way the auditor can ensure that his approach is properly focused, addresses all assertions in respect of a particular category of assets or liabilities or class of transactions or disclosures, and does not result in over auditing of one or more assertions.

8.2.5 Impact of controls

Where risk exists and the client has implemented control procedures in order to eliminate or mitigate the risk the auditor may wish/ be required to place reliance on the satisfactory operation of these controls in order to eliminate or reduce the procedure he would otherwise need to carry out. If he intends to adopt this approach he must first carry out an evaluation of the control to ensure that (a) it is actually operating as intended and (b) it will in fact mitigate or eliminate the risk. If his evaluation is satisfactory then he can go on to test controls and then he will be concerned only with the residual (or uncontrolled) risk and will design additional procedures only in respect of this risk.

The auditor must test controls if the risk assessment includes an expectation that controls are operating or if the risk is one where substantive procedures alone are deemed insufficient. He may choose to test controls in relation to significant risk but it is not compulsory. However if he takes a wholly substantive approach his tests must be directly responsive to the risks identified and must consist of more than analytical procedures alone.

8.2.6 Work relating to more than one audit area

The auditor may be able to conclude that certain risks of misstatement in relation to particular account balances, classes or transactions or disclosures have been partially or completely addressed by procedures carried out in other audit areas. In this case he should record those procedures on the Section Control Sheets and cross reference those procedures to the section where the audit work is recorded.

8.2.7 Matters arising during the audit workThe results or the auditor’s procedures may indicate ‘matters arising” which need to be followed up later or dealt with by other members of the team. These should be duly recorded and may be:

Significant issues: Issues which need to be brought to the attention of the manager or partner and which need to be cleared prior to signing the audit opinion.

Client Reporting Points: Matters which need to be reported to the client management or those charged with governance such as inadequacies in internal control.

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Unadjusted misstatements: All actual and suspected non trivial errors and misstatements should be recorded for the necessary journals to be passed accordingly. These errors may be recorded in the ‘Notes and Queries Sheets” of each control section and summarized on the form “Summary of Unadjusted Errors”. This form should include extrapolated errors from procedures involving samples and variances outside tolerances in analytical procedures duly cross-referenced to supporting evidence.

Revise approach: Changes in conditions, or unexpected results of the auditor’s work, may require changes to his planned procedures. Changes to the work programmed must be documented on the Section Control Sheet so that he has an accurate record of what was actually done (rather than what was originally intended to be done).

8.2.9 Advantages of Audit Programme It facilitates the resumption of work by those taking up the audit after its

commencement, in order words; absence doesn’t disrupt the carrying out of the work

It gives the opportunity of employing clerks on various sections of the work having regard to their individual capacity.

There is less danger of any aspect of the work being overlooked since the programme offers a written and predetermined plan.

Since the audit programme offers a clear perspective of the work to be done, it saves the audit clerks from repeating unnecessarily, much of the enquiries made at previous audit much to the advantage of both client and staff.

It acts as a checklist to ensure that no important tests are omitted. As definite instructions are laid down junior clerks may need less supervision. The clerks initialling for the work done by them accept responsibility for them

and in the event of any subsequent enquiry the actual staff engaged on the work may need less supervision.

Should the auditor at anytime be charged with negligence in the performance of his duties, a detailed audit programme duly completed may be of a considerable value in establishing that he has brought to bear on his work that reasonable skill and care to be expected of a professional auditor.

8.2.9 Disadvantages of Audit Programme Work may tend to be mechanical, following the same pattern from year to year.

The working system of the business may change but the same programme may still be used.

Work may be hurried in order to complete that required schedule. The programme may tend to become rigid and inflexible following the set pattern

with no room for one to use his discretion. The fixed audit programme may restrict or prevent the efficient clerk with

initiative who should be able to decide on his own. If work is performed to a predetermined plan, client staff may become aware of

that fact and fraud may be facilitated

8.2.10 Suggestions to minimize the perceived disadvantages of Audit Programme A conscious effort should be made to encourage initiative among all level of staff. There should be a constant and periodic review in the Audit programme.

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Discussions with the client staff of the audit programme and the extent with its application be vigorously discouraged.

There should be surprise check outside the audit programme and additional recommendation scheme should be done.

There should be surprise investigations and enquiries to reveal serious discrepancies in the accounts.

Audit staff flexibility in risk assessment and appropriate responses would negate the rigidity of the programme

8.2.12 Format of audit sections

Each of the sections which follow will take the following format

* Main risks associated with the areaIn all cases risks other than those outlined below may exist- depending on the client and its particular circumstances.

* Typical procedures in response to those risksIn all cases audit procedures other than those outlined below may be appropriate- depending on our assessment of risk.

* Typical purpose of controls that may be present where relevant.It is the responsibility of each auditor to satisfy himself / herself regarding the completeness of identified risks and the appropriateness and adequacy of audit testing of each assertion.

8.3 REVENUE

8.3.1 Main risks usually associated with revenueCompleteness – the client has failed to record all transactions giving rise to revenue. This may be due to weaknesses in systems or deliberate omission.

Occurrence – the client has incorrectly recorded transactions as giving rise to revenue when no transaction has occurred or no revenue should be recognized.

Accuracy and classification – errors may arise through application of an inappropriate accounting policy (see note below).

Accuracy and classification – errors may also arise through incorrect application of an appropriate accounting policy (see note below).

Occurrence – revenue is recognized in the wrong period. Occurrence errors may be accidental or deliberate. Occurrence errors assume a greater significance when the result is a mismatch between recognition of revenue and the related cost of sales – for example where a sale is recorded but the related inventory has not been recorded as dispatched/shipped, or advance billing in respect of services yet to be performed is recorded as a sale.

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Note: fraud riskRevenue recognition is one area where there is often considerable scope for deliberate misstatement (fraud) in order to give a misleading impression about the level of business carried out by the client, profit generated or growth trends. For this reason there is a general presumption that there are risks of fraud in this area. Such risks are considered “significant risks”.

8.3.2 Procedures in response to risksSome or all of the following procedures may be appropriate where they relate to risk of material misstatement in the financial statements. Consider the appropriateness of accounting policies for revenue recognition – bearing

in mind incentives/pressures on management for fraudulent reporting/aggressive earnings management

Make enquiries and examine board minutes for indication of changes in levels of activity

Analytical procedures including examination of margins, review of seasonal/cyclical performance, comparison of reported amounts for revenue in relation to known levels of activity, knowledge of client and sector performance

Trace recorded revenue to source documentation to support recorded revenue Examine documentation relation to dispatch/shipping of goods/performance of

services to ensure they give rise to revenue billed Examine contracts with major customers to identify completeness/accuracy/existence

of special terms for example volume discounts; early settlement discounts etc. Examine recorded transactions around the period end – to check that revenue relating

to the period is recorded and revenue relating to the subsequent period are not recorded

The auditor may obtain evidence relating to the completeness of revenue and occurrence from his work on trade receivables and inventory.

8.3.3 Purposes of main controls that may be present to ensure invoices rendered for all goods dispatched/shipped to ensure all invoices rendered are accurately recorded to ensure invoices are rendered at proper amounts to ensure credit notes are properly supported to ensure transactions are recorded in the correct account and in the correct

accounting period

8.4 PURCHASES AND OPERATING EXPENSES

8.4.1 Cost of Sales

8.4.1.1 Main risks usually associated with cost of sales

Completeness – the client has failed to record all costs associated with recorded revenue. This may be due to weaknesses in systems or deliberate omission.

Occurrence – the client has incorrectly recorded costs when no transaction has occurred or no cost of sales should be recognized.

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Accuracy and classification – errors may also arise through incorrect application of an appropriate accounting policy (see note below).

Occurrence - cost of sales recognized in the wrong period. Cut off errors may be accidental or deliberate. Cut off errors assume a greater significance when they result in a mismatch between recognition of revenue and the related cost of sales – for example where a sale is recorded but the related inventory has not been recorded as dispatched/shipped, or advance billing in respect of services yet to be performed is recorded as a sale.

8.4.1.2 Procedures in response to risks

Some or all of the following procedures may be appropriate where they relate to risk of material misstatement in the financial statements. consider the appropriateness of accounting policy for recognizing revenue and related

cost of sales analytical procedures including examination of margins; review of management

accounts; comparison with prior periods and sector performance make enquiries and examine board minutes for indication of changes in levels of

activity trace recorded cost of sales to source documentation to support recorded costs Examine contracts with major suppliers to identify completeness/ accuracy / existence

of special terms, example volume discounts; early settlement discounts etc.

The auditor may obtain evidence relating to completeness and occurrence from his work on trade payables, inventory and contract balances. 8.4.2 Other expenses

8.4.2.1 Main risks usually associated with other expensesAccuracy – expenses are not computed accuratelyClassification – expenses have been inappropriately classifiedCompleteness – expenses have been omitted from the financial statementsOccurrence – expenses are recorded in the wrong accounting period

8.4.2.2 Procedures in response to risks

perform analytical procedures where items are recurring or otherwise predictable check or test calculations of expenditure agree items of expenditure to source documentation make enquiries and review board minutes – looking for: evidence to support

recorded items of expenditure; and evidence of unrecorded items or expenditure examine invoices booked after the period end to ensure they do not relate to the

period under audit

The auditor may obtain some evidence relating to the completeness and valuation of other expenses from his work on prepayments.

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8.4.2.3 Purpose of main controls that may be present

to ensure reported purchases and other expenses are properly supported and are for the client

to ensure liabilities are recorded only upon proof of receipt of good or services to ensure charges are posted to the correct accounts

8.5 RECEIVABLES

8.5.1 Main risks usually associated with trade receivables

Completeness – the system has failed to record all trade receivables i.e. goods or services have been delivered or rendered but no corresponding right to receive payment has been recorded. This may result from weaknesses in systems or fraud. Entities should have robust systems and controls to prevent such misstatements.

Occurrence – goods or services dispatched/shipped or rendered around the year end and /or the corresponding trade debtor are recorded in the wrong accounting period, or alternatively payments received from trade receivables are recorded in the wrong period.

Occurrence errors may be particularly serious when one side of the transaction is recorded but the other is not (see completeness above). For example when goods dispatched/shipped are excluded in inventory but the receivable is not included in trade receivables. These misstatements can occur at either end of the accounting period and will have a direct impact on reported profit – both in the current period and in the previous or subsequent period.

Existence/Rights – trade receivables include amounts that are not receivables of the company – this might arise for example from a breakdown in the clients’ system for recording receipts from receivable or fraud by employees or customers (or both acting in collusion) involving the creation of fictitious receivable balances

Accuracy – where sales are subject to retrospective volume discounts or other rebates or price adjustments there is a risk that these amounts may be incorrectly calculated

Valuation – insufficient allowance may have been made for amounts that may be valid receivables but may prove to be uncollectible by the client.

8.5.2 Procedures in response to risks

Some or all of the following procedures may be appropriate where they relate to risk of material misstatement in the financial statements.

examination, testing or re-performance of period end reconciliation of sales ledger balances to control

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consideration of the value of receivables in relation to known levels of activity and previous periods

examination of movements in the control account around the period end, obtaining explanations for unusual items

examination of the make-up of individual sales ledger balances, test checking to original documentation –generally schedule balances should be made up of identifiable individual amounts relation to specific invoices or other transactions

examination of receivables listing to identify items (such as significant credit balances) that should not be classified as receivables

examination of post year-end cash receipts – as evidence of recoverability of recorded receivables and as an indication of potential bad debts

direct confirmation of debt balances with third parties – confirmations often provide evidence of existence but not of recoverability

examination of credit notes issued post year end – to identify sales recorded pre year end that should not have been recorded as such

follow up tests on inventory movements around year end ensuring that inventory movements, revenue and receivables are all recorded in the same period

examination of contracts with significant customers – looking for evidence of volume discount/rebate arrangements

examination of aged receivable listing to identify potential irrecoverable balances supplemented by enquiry into reasons for provision/non-provision

examination of board minutes, correspondence and legal correspondence relating to disputed or defaulted debts

where there are significant amounts recoverable in more than one year: consider the appropriateness of accounting policy in respect of discounts obtained as evidence to support use of an appropriate discount rate (where applicable)

The auditor may obtain some evidence relating to the completeness and valuation of receivables from our work on revenue.

Other receivables and other current assets

8.5.3 Main risks usually associated with other receivables

Other receivables and other current assets will typically include prepayments, accrued income, miscellaneous (non-trade) receivables, loans receivable, amounts due from directors and other related parties, non-trading balances with group companies. The risks associated with each type of other current receivable/asset will differ. Items under this heading could arise from a large variety of different transactions or events and will not necessarily be expected to be consistent from one period to the next. Often the transactions or events giving rise to the liabilities will fall outside the client’s normal operating cycles and may not be subject to the same systems and controls as are applied to other transactions. In particular these transactions may be more susceptible than others to management override of controls

Completeness – the system has failed to record all other receivables/assets, recoverables or payments in advance. This may result from weaknesses in systems or fraud. Entities should have robust systems and controls to prevent such misstatements.

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Occurrence – Expenditure and /or income recorded in the wrong accounting period as prepayments or expenses or accrued income are not correctly identified. These misstatements will have a direct impact on reported profit – both in the current period and in the previous or subsequent period.

Existence/ Rights – current assets include amounts that are not recoverable by the company - this might arise for example from a breakdown in the client’s system for recording receipts from investments or fraud by employees or suppliers (or both acting in collusion) involving the creation of fictitious balances

Accuracy – there is a risk that prepayments/accrued income may be incorrectly calculated

Valuation – insufficient allowance may have been made for amounts that may be valid receivables but may prove to be uncollectible by the client.

8.5.4 Procedures in response to risks

Some or all of the following procedures may be appropriate where they relate to risk of material misstatement in the financial statements. Analytical procedures applied to items of income and expenditure to identify

errors in calculation or omission in identifying prepayments/accrued income Comparisons with prior years Where accrued income or deferred (prepaid) expenditure arises from the

application of a revenue recognition accounting policy consider the appropriateness of the policy and perform procedures to check its consistent application

Perform checks on calculations of individual items Obtain direct confirmation of balances due from third parties and group

companies - confirmations often provide evidence of existence but not of recoverability (Note confirmations obtained from group companies and other related parties are likely to provide less satisfactory evidence that would be the case with confirmations obtained from independent unrelated parties)

Obtain evidence of recoverability of balances – e.g. cash after balance sheet date Consider recoverability of unsettled balances e.g. balances from group companies,

related parties and others – obtain evidence that such parties have the financial ability to settle the debt in due course

Review of post year-end cash receipts to identify any omissions/overstatements in current assets

Review of post year end management accounts to identify any omissions/overstatements in current assets

8.5.5 Purpose of main controls that may be present

to ensure sales are not recorded until goods are dispatched or shipped or services rendered

to ensure collections made are deposited intact and properly credited to ensure accounts receivable are reconciled to control accounts on a regular basis to ensure sales are only made to authorized (credit worthy) customers to ensure write offs of accounts receivables are properly authorized

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to ensure management review and follow up of accounts receivable on a regular basis

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