Boynton SM Ch.12

CHAPTER 7

Chapter 12Audit Procedures in Response to Assessed Risks: Substantive Tests

Learning Check

12-1.The three steps involved in assessing the risk of material misstatement are:

1. Evaluate the type of potential misstatement(s) that may occur, such as evaluating whether a risk is a financial statement level risk or an assertion level risk.

2. Evaluate the magnitude of the potential misstatement(s). For example, the auditor is attempting to determine if the magnitude could of misstatement could aggregate to a material amount.

3. Evaluate the likelihood of potential misstatement(s). This is a matter of determining whether the probability of misstatement is very probable or the probability of misstatement is remote.

12-2. If there is a significant risk of material misstatement due to financial statement level risks the auditor will increase the level of substantive testing for many assertions. For example, if management communicates the message that it is critical that the company meet its financial targets, the auditor might increase the level of substantive testing for revenue recognition, the completeness and classification of expenditures, as well as for many accounting estimates in the financial statements. If the risk of material misstatement is limited to one assertion, such a poor controls over the collection of receivables, the auditor will increase the level of substantive testing specifically related to the valuation and allocation assertion for receivables.

12-3.Following are examples of risks of material misstatement that might be found while performing various risk assessment procedures.

Risk Assessment ProcedureRisk of Material Misstatement

a. Understanding the entity and its environmenta. A companys most significant product is at a mature stage and sales are beginning to decline. This may affect the net realizable value of inventory.

b. Performing analytical proceduresb. A company may report flat sales, increasing levels of inventory, and increasing gross profit margins. This may indicate a problem with the existence and occurrence of inventory.

c. Understanding the risk of fraudc. A company may be very close to not meeting its debt covenants. This might increase the risk that company might engage in fraudulent financial reporting to report that it in fact met debt covenants.

d. Understanding inherent risksd. The calculations associated with the valuation of a large retail inventory using the retail method represents a significant inherent risk that is focused on the valuation assertion for inventory.

e. Understanding the entitys system of internal controle. A owner-managed company might allow the bookkeeper to write and sign check with little supervision or review by the owner. This would increase the risk for the existence and occurrence assertion for expenditures.

12-4. The following bullets summarize each preliminary audit strategy, the appropriate level of planned detection risk, the planned audit procedures that provide significant assurance, and whether a higher or a lower level of assurance is needed from substantive tests.

A Primarily Substantive Approach requires a low planned level of detection risk for tests of details, audit assurance is needed primarily from tests of details of transaction or tests of details of balances, and the level of assurance needed from substantive tests is high.

A Lower Assessed Level of Control Risk Approach usually results in a high planned level of tests of details risk due to the fact that significant assurance is obtained from tests of controls. As a result, the level of assurance that is needed from substantive tests is low.

Emphasis on Inherent Risk and Analytical Procedures represents an audit strategy associated with assertions where inherent risk is assessed below the maximum and the planned tests of details risk is moderate or high. Evidence is needed from risk assessment procedures to support an inherent risk assessment below the maximum and substantive tests are performed using analytical procedures. The planned level of assurance from substantive test of details is often moderate, as the auditor obtains assurance from analytical procedures and the auditors knowledge of the business and industry.

12-5.A revised or final acceptable level of detection risk is determined for each assertion after (1) assessing inherent risk, (2) performing analytical procedures in audit planning, (3) assessing the risk of fraud for an assertion, and (4) making a final assessment of control risk for relevant controls. A risk matrix or the audit risk model can be used to solve for the revised acceptable level of detection risk associated with analytical procedures and tests of details based on the actual assessed levels of inherent and control risk and the auditor's specification of audit risk.

12-6.The following table compares and contrasts tests of controls and substantive tests.

Tests of ControlsSubstantive Tests

a. TypesTests of the control environment

Tests of the clients risk assessment system

Tests of the information and communication system

Tests of control activities

Tests of the monitoring system

Tests of antifraud programs and controls

Initial procedures

Analytical procedures

Tests of details of transactions

Tests of details of balances

Tests of details of accounting estimates

Substantive tests required by GAAS

Tests of details of disclosures

b. PurposeDetermine effectiveness of design and operation of internal controlsDetermine fairness of significant financial statement assertions.

c. Nature of test measurementFrequency of deviations from designed controlsMonetary errors in transactions and balances.

d. Applicable audit proceduresInquiring, observing, inspecting, reperforming, and computer assisted audit techniques. Same as tests of controls, plus analytical procedures, counting, confirming, tracing, and vouching.

e. Timing Primarily interim work1At balance sheet date or one or two months prior to year-end.2

f. Audit risk componentControl RiskDetection Risk

g. Primary fieldwork standardSecond.Third

h. Required by GAAS

When audit risk cannot be reduced to a sufficiently low level by substantive tests alone.Yes

Concurrent tests of controls are performed in audit planning with procedures to obtain an understanding of the system of internal control. Additional tests of controls are performed during interim fieldwork.

2 Tests of details of transactions may also be performed with test of controls as dual-purpose tests during fieldwork.

12-7. a.The purpose of substantive tests is to provide evidence about the fairness of each significant financial statement assertion, or conversely, to reveal monetary errors or misstatements in the recording or reporting of transactions and balances.

b.As detection risk increases substantive tests should be more effective and auditors should seek more reliable evidence related to the assertion. 12-8.There are several types of initial procedures that are performed before proceeding to other substantive tests. First, it is important for the auditor to have an understanding of the economic substance of the transactions that are subject to audit. Second, it is important to trace beginning balances in the general ledger to the audited balances in the prior years financial statements.

Two initial procedures that require special consideration in a first time audit are (1) determining the propriety of the account balances at the beginning of the period being audited, and (2) ascertaining whether the accounting principles used in the preceding period are the same as those used in the current period as a basis for determining the consistency of application of principles. This is normally accomplished by reference to the working papers of a predecessor auditor. In a continuing engagement this can be accomplished by reference to the prior years working papers.

12-9. a.The primary advantage of analytical procedures is that they are very cost effective and they are also reasonably effective at identifying accounts that may contain unintentional misstatements. The primary disadvantage is that analytical procedures are usually considered less effective than tests of details. They are also less effective at identifying accounts that are intentionally misstated as the balances have usually been misstated to appear reasonable.b.The auditor should consider the following matters when designing substantive analytical procedures:

The suitability of the substantive analytical procedure given the assertion.

The reliability of the data, whether internal or external, from which the expectation of recorded amounts or ratios is developed.

Whether the expectation is sufficiently precise to identify a material misstatement at the desired level of assurance.

The amount of any difference of recorded amounts from expected values that is acceptable.In some cases where substantive analytical procedures are effective, they may also add to the efficiency of the audit. For example, for public utilities and cable companies, relatively small amounts of revenue are billed to and collected from many thousands of customers each month. Tests of details of these high-volume, low-value revenue transactions would be very tedious and costly. On the other hand, revenues in such cases can often be estimated with a fair degree of precision using independent variables such as number of subscribers, billing rates for various types of services, temperature data (for electric and gas utilities), and so on. Alternatively, total sales commissions expense could normally be estimated from total sales revenues rather than examining the details of entries to sales commissions.

c. In some cases the auditor can obtain good nonfinancial information about the underlying drivers of revenues and expenses and use that information to estimate revenues or expenses. The following table provides several examples.

AccountAnalytical Procedure

Hotel room revenue

Tuition revenue

Wages expense

Gasoline expense

Commission ExpenseNumber of rooms x Occupancy rate x Average room rate.

Number of equivalent fulltime students x Tuition rate for a fulltime student

Average number of employees per pay period x Average pay per period x Number of pay periods.

Number of miles driven Average miles per gallon x Average per gallon cost.

Sales x Commission Rate

Income statement accounts may be tied directly to an underlying economic driver (cost driver). Balance sheet accounts are subject to transactions that cause both increases and decreases and may be less predictable. Hence, analytical procedures may provide more assurance about the fair presentation of income statement accounts.

12-10. a.Tests of details of transactions primarily involve tracing and vouching to test for understatements and overstatements, respectively. Other procedures may also be used such as inquiring and reperforming calculations.

b.Tests of details of transactions are typically more time consuming and thus more costly to perform than analytical procedures, but less costly than tests of details of balances. Their cost-efficiency is enhanced when performed concurrent with tests of controls as dual-purpose tests.

c.Tests of details may be applied directly to income statement accounts when evidence obtained from tests of related balance sheet accounts does not reduce detection risk to an acceptably low level. This may include situations in which:

Inherent risk is high, such as when (1) nonroutine transactions or (2) managements judgments and estimates affect assertions.

Control risk is high either because (1) related internal controls for nonroutine and routine transactions are ineffective, or (2) the auditor elects not to test the internal controls.

Analytical procedures reveal unusual relationships and unexpected fluctuations.

An account requires analysis because it (1) requires special disclosures in the income statement, (2) contains information needed in preparing tax returns or reports for regulatory agencies such as the SEC, or (3) has a general account title that suggests the likelihood of misclassifications and errors.

12-11. a.Tests of details of balances focus on obtaining evidence directly about an account balance (e.g., accounts receivable) rather than the individual debits and credits comprising the balance. Testing the individual debits and credits is a test of transactions. b.Tests of details of balances often involve the use of external documentation and/or the direct personal knowledge of the auditor. Therefore, they can be very effective. They also tend to be the most costly to perform.

12-12. a.Tests of accounting estimates involve understanding the entitys process of estimating future outcomes (e.g., the receivables that will not be collected in the future or the costs of providing warranty coverage in the future) of past transactions. This requires significant knowledge of the business, industry, and economy.

b.When evaluating the reasonableness of an accounting estimate the auditor should determine that

All accounting estimates that could be material to the financial statements have been developed.

The accounting estimates are reasonable in the circumstances.

The accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed.

12-13. a.As detection risk for test of details decreases, the auditor should perform substantive tests of balances closer to, or at, year-end.

b.The decision whether to perform substantive tests prior to the balance sheet date should be based on whether the auditor can:

Control the added audit risk that material misstatements existing in the account at the balance sheet date will not be detected by the auditor. This risk becomes greater as the time period remaining between the date of the interim tests and the balance sheet date is lengthened.

Reduce the cost of substantive tests necessary at the balance sheet date to meet planned audit objectives so that testing prior to the balance sheet date will be cost effective.

c.The potential added audit risk can be controlled if substantive tests for the remaining period can provide a reasonable basis for extending the audit conclusions from the tests performed at the interim date to the balance sheet date. Conditions contributing to the control of this risk are:

The internal controls during the remaining period are effective.

There are no conditions or circumstances that might predispose management to misstate the financial statements in the remaining period.

The year-end balances of the accounts examined at the interim date are reasonably predictable as to amount, relative significance, and composition.

The client's accounting system will provide information concerning significant unusual transactions and significant fluctuations that may occur in the remaining period.

12-14.As a general rule, detection risk and the extent of substantive test are inversely related; i.e., the lower the acceptable level of detection risk, the more extensive the substantive tests should be. Note however, that the auditor has choices between substantive tests involving analytical procedures and substantive tests involving tests of details.

12-15. Traditionally, account balance assertions focus on the balance sheet and transaction assertions focus on the income statement and statement of cash flows. However, when performing tests of account balance assertions the auditor often learns about the fair presentation of transactions. For example, if the auditor learns that inventory is overstated, it usually implies that cost of sales is understated. If accounts receivable is overstated, sales might also be overstated.

12-16. a.The auditor's objectives in auditing related party transactions are to obtain evidential matter as to (1) the purpose, nature, and extent of these transactions and (2) their effect on the financial statements.

b.Substantive tests that may be used in auditing related party transactions include the following:

Obtain an understanding of the business purpose of the transaction.

Examine invoices, executed copies of agreements, contracts, and other pertinent documents, such as receiving reports and shipping documents.

Determine whether the transaction has been approved by the board of directors or other appropriate officials.

Test for reasonableness the compilation of amounts to be disclosed, or considered for disclosure, in the financial statements.

Arrange for the audits of inter-company account balances to be performed as of concurrent dates, even if the fiscal years differ, and for the examination of specified, important, and representative related party transactions by the auditors for each of the parties, with appropriate exchange of relevant information.

Inspect or confirm, and obtain satisfaction concerning, the transferability and value of collateral.12-17.a.An audit program is a list of audit procedures to be performed.

b. The general framework for developing an audit program must accomplish two tasks.

1) It should describe the nature of procedures to be performed.

2) It should ensure that audit evidence is obtained for all financial statement assertions (audit objectives).

c.Audit programs should be sufficiently detailed to provide:

An outline of the work to be done.

A basis for coordinating, supervising, and controlling the audit.

A record of the work performed.

In addition to listing audit procedures, each audit program should have columns for (1) cross-references to other working papers containing the evidence obtained from each procedure (when applicable), (2) the initials of the auditor(s) who performed each procedure, and (3) the date performance of the procedure was completed.

12-18. a.Six types of substantive audit procedures that are normally included in an audit program are:

1) Initial procedures.

2) Substantive analytical procedures.

3) Tests of details of transactions.

4) Tests of details of balances.

5) Tests of detail of accounting estimates.

6) Tests of details of disclosures.

b.Audit programs describe the nature of audit procedures to be performed. A well designed audit program should include audit procedures to obtain sufficient, competent evidence about each relevant financial statement assertion (or audit objective).

Comprehensive Questions

12-19.(Estimated time - 15 minutes)

Example Risk FactorAudit Strategy

1. The company is in an industry that is experiencing economic difficulty and intense price competition.

2. The company has recently changed the nature of its product and is bundling software with other services to customize and implement software and related controls.

3. Analytical procedures for a manufacturer show a significant increase in both profit margins and inventory turn days.

4. Analytical procedures for a retailer show significant decreases in both profit margins and inventory turn days.

5. Senior management has sent a very strong message, and offered increased incentives, to middle managers to meet financial targets.

6. An employee in a small to medium sized business responsible for cash disbursements did not receive an expected promotion and pay increase.

7. A construction industry client uses the percentage of completion method to recognize revenue and expense on current projects.

8. A company is experiencing working capital and going-concern problems.

9. The client has a strong control environment and good controls over the existence of inventory.

10. The client has weak computer general controls including poor controls over the approval of system changes.1. Primarily Substantive Approach

2. Primarily Substantive Approach







9. A Lower Assessed Level of Control Risk Approach


12-20. (Estimated Time 30 minutes)

Example Risk FactorType of Potential MisstatementAudit Strategy

1. The client has a strong control environment and good controls over the existence of inventory.Controls are relevant to the existence of inventory

A lower assessed level of control risk approach

2. The client is in an industry that has both significant regulatory oversight and complex regulations.Misstatements may occur in many assertions or accountsA primarily substantive approach.

3. The client has recently experienced turnover in its information technology group resulting in decreased segregation of duties and a deterioration of computer general controls.Misstatements may occur in many assertions or accountsA primarily substantive approach.

4. The client is a private university with primarily full time students, a small amount of receivables at year-end, and good internal controls over revenues.Issues relate primarily to the occurrence of revenues and the existence of receivables.Predictability of transactions may allow for a response to lower inherent risk and analytical procedures.

5. A companys business plans are dependent on the success of entering new foreign markets with existing products.Issues relate primarily to the occurrence of revenues and the existence of receivables.A primarily substantive approach.

6. The client has used significant borrowing to fund expansion in a competitive industry and has a narrow tolerance range regarding debt covenants.Issues relate both to the disclosure assertion for long-term debt and to other assertions affected by debt covenants.A primarily substantive approach.

7. Analytical procedures for a manufacturer show significant increases in both profit margins and inventory turn days.The existence of inventory.A primarily substantive approach.

8. Inventory items are small in size and high in value.The existence of inventory.A primarily substantive approach.

9. The telecommunications client is in a capital intensive industry and fixed assets additions involve complex accounting issues.Valuation and allocation for fixed assets.A primarily substantive approach.

10. The audit team has experience several attempts by management to justify marginal or inappropriate accounting on the basis of immateriality.Issues may have a pervasive impact on multiple assertionsA primarily substantive approach.

11. Analytical procedures for a manufacturer show significant increases in both revenue growth and accounts receivable turn days.Revenue recognition or the net realizable value of receivables.A primarily substantive approach.

12-21 (Estimated Time: 15 minutes)

a.If the final assessed levels of control risk for the specified assertions are the same as the planned assessed levels, the auditor may proceed to design specific substantive tests based on the planned level of substantive tests of details specified as the fourth component of the audit risk model for each of the specified assertions. Otherwise, the level of substantive tests must be revised before designing specific substantive tests for each assertion in order to accommodate a revised acceptable level of detection risk that correlates with the final assessed level of control risk.

b.Determining a revised acceptable level of detection risk for an assertion can be accomplished by using the final assessed level of control risk in either a risk matrix or the audit risk model and re-solving for detection risk. Usually this is done by considering both analytical procedures risk and test of details risk.

c.No. When evidence obtained from one substantive test or group of tests reduces the risk of a material misstatement remaining undetected in an assertion, it may be appropriate to use a higher acceptable level of detection risk for any additional substantive tests performed to gather evidence for that assertion.


a.Substantive tests provide evidence about the fairness of each significant financial statement assertion. They are the primary means of obtaining sufficient competent evidential matter to establish a reasonable basis for the auditor's opinion on the client's financial statements.

b. The factors pertaining to substantive tests that can be varied to accommodate different acceptable levels of detection risk are (1) nature, (2) timing, (3) extent and (4) staffing. When a low versus a high acceptable level of detection risk must be achieved:

The nature of the tests selected should be more effective rather than less effective.

The timing of the tests will more often be at year-end rather than at an interim date.

The extent of the tests (e.g., sample size) will be greater.

Staffing selected will be more experienced rather than less experienced.

c.The four types of substantive tests and brief explanations of each are:

Analytical procedures which consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. Such procedures range from simple comparisons to the use of complex mathematical and statistical models involving many relationships and data elements.

Tests of details of transactions which primarily involve tracing and vouching using documents available in the client's files. In these tests, the auditor uses evidence obtained about the individual debits and credits in an account to reach a conclusion about the account balance.

Tests of details of balances which often involve the use of external documentation and/or the direct personal knowledge of the auditor. These procedures focus on obtaining evidence directly about an account balance rather than the individual debits and credits comprising the balance.

Tests of accounting estimates designed to obtain sufficient competent evidential matter to provide reasonable assurance that:




The effectiveness of analytical procedures depends on (1) the nature of the assertion, (2) the plausibility and predictability of the relationship, (3) the availability and reliability of the data used to develop the expectation, and (4) the precision of the expectation. The effectiveness of tests of details of transactions depends on the particular procedure and documents used. When these tests involve the use of internally generated documents that have not been circulated externally, they may be less effective than tests involving the use of externally generated documents or internally generated documents that have been circulated externally. The effectiveness of tests of details of balances is usually high because they typically involve (1) the use of external documentation received directly by the auditor or (2) the direct personal knowledge of the auditor. The effectiveness of tests of accounting estimates depend on the auditors knowledge of (1) the underlying drivers that influence the accounting estimate and (2) the business, industry and economy.

Analytical procedures are generally the least costly tests to perform. Tests of details of transactions are typically more time consuming and thus more costly than analytical procedures. The cost-efficiency of tests of details of transactions is enhanced when performed concurrent with tests of controls as dual-purpose tests. Tests of details of balances tend to be the most costly to perform because of their focus on external documentation or the auditor's direct personal knowledge. Tests of accounting estimates requires significant professional judgment and may be more costly due to the need for more experience staff to perform audit procedures.

12-23.(Estimated Time 20 minutes)

a.An audit program is a list of auditing procedures to be performed. Each program should have columns for the initials of the individuals who performed each procedure, the dates the procedures were completed, and cross-references to other working papers containing evidence obtained from the procedures. Audit programs should be sufficiently detailed to provide:

An outline of the work to be done.

A basis for coordinating, supervising, and controlling the audit.

A record of the work performed.

b.Eight steps in the general framework for specifying substantive tests to be included in an audit program include:

1. Obtain an understanding of the business and industry and determine:

The significance of the transaction class and account balance to the entity.

The key economic drivers that influence the transaction class and account balance.

2. Specify initial procedures to:

Trace beginning balance to prior years working papers (if applicable).

Review activity in applicable general ledger accounts and investigate unusual items.

Verify totals of supporting records or schedules to be used in subsequent tests and determine their agreement with general ledger balances, when applicable, to establish tie-in of detail with control accounts.

3. Specify analytical procedures to be performed.

4. Specify tests of details of transactions to be performed.

5. Specify tests of details of balances to be performed.

6. Specify tests of details of balances involving accounting estimates to be performed.

7. Consider whether there are any special requirements or procedures applicable to assertions being tested in the circumstances such as procedures required by SAS (for example, observation of inventories) or by regulatory agencies that have not been included in (3) and (4) above.

8. Specify procedures to determine conformity of presentation and disclosure with GAAP.

c.In initial engagements, the detailed specification of substantive tests in audit programs is generally not completed until after the study and evaluation of internal controls has been completed and the auditor has a significant understanding of the business and industry. Until then the auditor may not have a reasonable basis for specifying appropriate detection risk levels which affect the design of substantive tests for significant financial statement assertions. In contrast, in recurring engagements the auditor has access to audit programs used in the preceding period(s) and the working papers pertaining to those programs. In such cases, needs to understand major changes in the business, but the auditor's preliminary audit strategies are often based on a presumption that the risk levels and audit programs for substantive tests used in the previous period may be appropriate for the current period. Thus, the audit programs for the current engagement are often prepared before the auditor completes the evaluation of the internal controls with the understanding they may subsequently require modification.


ObjectiveAssertionObjectiveAssertion

1.C 8.C

2.EO 9.EO

3.PD 10.PD

4.VA 11.VA

5.VA 12.PD

6.RO 13.PD

7.RO 14.PD


Note: The student is required to list only one type of test, type of evidence, and assertion for each auditing procedure. In some cases, alternative answers are indicated in the tabulation below.

Audit ProcedureType of TestAudit Objective

1.Count cash on handT of D of balancesExistence, Completeness, Valuation and allocation

2.Confirm accounts receivable.

T of D of balancesExistence

3.Vouch plant asset additions to purchase documents.T of D of transactionsOccurrence, Accuracy

4.Recalculate accrued interest on notes payable.T of D of balancesExistence, Completeness, Valuation and allocation

5.Inquire of management about pledging of plant assets as security for long-term debt.T of D of disclosuresCompleteness of disclosures

6.Compute inventory turnover ratio.Analytical procedureExistence, completeness, valuation and allocation

7.Vouch ending inventory pricing to purchase invoices.T of D of balancesValuation and allocation

8.Review client-prepared bank reconciliation.T of D of balancesExistence, Completeness, Rights and obligations, Valuation and allocation

9.Verify accuracy of accounts receivable balance and agreement with subsidiary ledger.Initial proceduresAccuracy, Valuation and allocation

10.Obtain details of accounts receivable subsidiary ledger and reconcile to the general ledger.Initial proceduresAccuracy, Valuation and allocation

11.Compare statement disclosures for leases with GAAP.T of D of disclosuresCompleteness of presentation and disclosure, Occurrence and rights and obligations of disclosures

12.Review adequacy of clients provision for uncollectible accounts.Tests of accounting estimatesValuation and allocation

13.Examine certificates of title for delivery equipment.T of D of BalancesRights and obligations

14.Confirm receivables.Analytical procedureExistence, Completeness, Valuation and allocation

15.Trace bad-debt write-off authorizations to accounts receivable.T of D of transactionsOccurrence, Accuracy

16.Observe clients inventory taking.T of D of balancesExistence, Completeness, Valuation and allocation

17.Trace unpaid vendors invoices to accounts payable at year-end.Test of details of transactionsCompleteness

18.Compare pension disclosures to a disclosure check list.T of D of disclosuresCompleteness of presentation and disclosure, Occurrence and rights and obligations of disclosures


AssertionSubstantive Test

1.Valuation or allocationC, J

2.CompletenessA, B, E, F

3.Existence or occurrenceC, D

4.Valuation or allocationI, K

5.Presentation and disclosureL

6.Existence or occurrenceA, B

7.Rights and obligationsA, B, E, H, I

8.Presentation and disclosureM

9.CompletenessB, E, H

10.Rights and obligationsE, H

11.CompletenessF


13.CompletenessE


15.Valuation or allocationI, K

12-27. (Estimated Time 20 Minutes)

a. Before applying principal substantive tests to General's balance sheet accounts at April 30, 20X6, Cook should consider whether it is possible to control the added audit risk that material misstatements existing in the accounts at the balance sheet date will not be detected. Conditions that contribute controlling this risk are:

Internal controls during the remaining period are effective. There are no conditions or circumstances that might predispose management to misstate the financial statements in the remaining period. The year-end balances of the accounts examined at the interim date are reasonably predictable as to amount, relative significance, and composition. The client's accounting system will provide information concerning significant unusual transactions and significant fluctuations that may occur in the remaining period.b.Substantive tests for the remaining period ordinarily should include (1) comparison of the account balances at June 30 and April 30 to identify amounts that appear to be unusual and investigation of any such amounts, and (2) such other analytical procedures or other substantive tests of details as the auditor considers necessary to provide a reasonable basis for extending the interim audit conclusions to the balance sheet date.

12-28. (Estimated Time 30 minutes)

a.The auditor may perform substantive tests prior to the balance sheet date when he or she can:

Control the added audit risk that material misstatements existing in the account at the balance sheet date will not be detected by the auditor.

Reduce the cost of substantive tests necessary at the balance sheet date to meet planned audit objectives so that testing prior to the balance sheet date will be cost effective.

In practice, early substantive testing of account balances is not done unless tests of controls have provided convincing evidence that internal controls are operating effectively. Moreover, it is unlikely that the auditor will perform substantive tests prior to the balance sheet date on all assertions pertaining to an account.

b.The potential added audit risk can be controlled if substantive tests for the remaining period can provide a reasonable basis for extending the audit conclusions from the tests performed at the interim date to the balance sheet date. Conditions contributing to the control of this risk are:

Internal controls during the remaining period are effective.

There are no conditions or circumstances that might predispose management to misstate the financial statements in the remaining period.

The year-end balances of the accounts examined at the interim date are reasonably predictable as to amount, relative significance, and composition.

The client's accounting system will provide information concerning significant unusual transactions and significant fluctuations that may occur in the remaining period.

c.Substantive tests for the remaining period ordinarily should include:

Comparison of the account balances at the two dates to identify amounts that appear to be unusual and investigation of such amounts.

Other analytical procedures or other substantive tests of details to provide a reasonable basis for extending the interim audit conclusions to the balance sheet date.

d.As compared with substantive tests of balance sheet accounts, tests of income statement accounts rely more heavily on analytical procedures and less on tests of details of transactions and balances. Each income statement account is inextricably linked to one or more balance sheet accounts (e.g., sales and accounts receivable, and cost of goods sold and inventories). Thus evidence obtained from tests of details performed on balance sheet accounts also pertains to the related income statement accounts, reducing the need for additional tests of details.

e.Analytical procedures arc used both directly and indirectly in obtaining evidence about income statement accounts. Direct tests occur when a revenue or an expense account is compared with other relevant data to determine the reasonableness of its balance (e.g., the ratio of sales commissions to sales can be compared with the results of prior years and budget data for the current year). Indirect tests occur when evidence concerning income statement balances can be derived from analytical procedures applied to related balance sheet accounts (e.g., the accounts receivable turnover ratio used in verifying accounts receivable may also be used in determining whether bad debts expense is fairly stated). In addition, in applying analytical procedures to income statement accounts, there are many opportunities for comparing financial information with nonfinancial information such as using number of employees and number of miles driven to estimate wages expense and gasoline expense, respectively.

f.The circumstances that may necessitate performing tests of details of income statement accounts are as follows:

Inherent risk is high. This may occur in the case of nonroutine transactions and management's judgments and estimates.

Control risk is high. This situation may occur when (1) internal controls for nonroutine and routine transactions are ineffective or (2) the auditor elects not to test the internal controls.

Analytical procedures reveal unusual relationships and unexpected fluctuations. Examples of this situation include (1) a company exceeding its sales growth target in spite of an unexpected downturn in its industry and the economy as a whole and (2) an unexplained increase in the inventory turnover ratio.

The account requires analysis. Analysis is usually required for accounts that (1) require special disclosure in the income statement, (2) contain information needed in preparing tax returns and reports for regulatory agencies such as the SEC, and (3) have general account titles that suggest the likelihood of misclassifications and errors.


a.The auditor's objective in auditing accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that:




The auditor's objective in auditing related party transactions is to obtain evidential matter as to the purpose, nature, and extent of these transactions and their effect on the financial statements.

b.Auditing procedures that may be used to obtain evidence about these two types of accounts include the following:

Accounts involving accounting estimates

Review and test management's process in making the estimate.

Prepare an independent expectation of the estimate.

Review subsequent transactions and events occurring prior to completing the audit that pertain to the estimate.

Accounts involving related party transactions

Obtain an understanding of the business purpose of the transaction.

Examine invoices, executed copies of agreements, contracts, and other pertinent documents, such as receiving reports and shipping documents.

Determine whether the transaction has been approved by the board of directors or other appropriate officials.

Test for reasonableness the compilation of amounts to be disclosed, or considered for disclosure, in the financial statements.

Arrange for the audits of inter-company account balances to be performed as of concurrent dates, even if the fiscal years differ, and for the examination of specified, important, and representative related party transactions by the auditors for each of the parties, with appropriate exchange of relevant information.

Inspect or confirm and obtain satisfaction concerning the transferability and value of collateral.

c.In auditing identified related party transactions, the auditor is not expected to determine (1) whether a particular transaction would have occurred if the parties had not been related or (2) what the exchange price and terms would have been. The auditor is required, however, to determine the substance of the related party transactions and their effects on the financial statements.

d.Management is responsible for establishing the process and controls for preparing accounting estimates which it includes in the financial statements. The auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. This includes (1) considering the relevance, reliability, and sufficiency of the data and other factors used by management, (2) evaluating the reasonableness and consistency of the assumptions, and (3) reperforming the calculations made by management. In some cases, the auditor may find it useful to obtain the opinion of a specialist regarding the assumptions.

e.To evaluate the reasonableness of accounting estimates, the auditor should normally concentrate on the key factors and assumptions used by management including those that are (1) significant to the accounting estimate, (2) sensitive to variations, (3) deviations from historical patterns, and (4) subjective and susceptible to misstatement and bias.

f.Sources of evidence concerning the reasonableness of accounting estimates include the following:

Information supplied by management concerning the process used and assumptions made.

Historical data used by management in developing the estimates.

Recalculation by the auditor of management's estimates.

Independent expectations developed by the auditor for comparison with management's estimates.

Events or transactions that occur subsequent to the date of the balance sheet but prior to the completion of field work that relate to the key factors and assumptions used by management.

Opinions supplied by a specialist.12-30. (Estimated Time 60 minutes)

Categorya. Substantive Testb. Audit Objectives

Initial Procedures1) Obtain an understanding of the business and industry and determine:

a) The significance of plant assets, and changes in plant assets, to the entity.

b) Key economic drivers that influence the entitys acquisition of plant assets.

c) Industry standards for the extent to which the entity is capital intensive and the impact of plant assets on earnings.

2) Perform initial procedures on plant assets balances and records that will be subjected to further testing.

a) Trace beginning balance for plant assets and accumulated depreciation to prior years working papers.

b) Review activity in general ledger accounts plant assets and depreciation expense and investigate entries that appear unusual in amount or source.

c) Obtain client-prepared schedules of plant asset additions, retirements and depreciation expense, and determine that they accurately represent the underlying accounting records from which they were prepared by:

i) Footing and crossfooting the schedules and reconciling the totals with increases or decreases in the related general ledger balances during the period.

ii) Testing agreement of items on schedules with entries in related general ledger accounts.EO, C, RO, VA,PD

VA1

Analytical Procedures3) Perform analytical procedures:

a) Develop an expectation for plant assets using knowledge of the industry and the entitys business activity

b) Calculate ratios such as fixed asset turnover, depreciation expense as a percent of sales, repair and maintenance expense as a percent of sales and rate of return on assets

c) Analyze ratio results relative to expectations based on prior years, industry data, budgeted amounts, or other data.

EO, C, VA, PD

Tests of Details of Transactions4) Vouch plant asset additions to supporting documentation.

5) Vouch plant asset disposals to supporting documentation.

6) Review entries to repairs and maintenance expense. EO1, EO2, C2RO1, VA1, PD1EO1, EO2, C2, RO1, VA1, PD1

EO1, VA1, PD1

Tests of Details of Balances7) Inspect plant asset.

a) Inspect plant asset additions.

b) Tour other plant assets and be alert to evidence of additions and disposals not included on clients schedules and to conditions that bear on the proper valuation and classification of the plant assets.

8) Examine title documents and contracts

EO3,RO1, VA2, PD4EO3, RO1

Tests of Details of Balances: Accounting Estimates9) Evaluate the fair presentation of depreciation expense by evaluating the appropriateness of useful lives and estimated salvage values.

10) Determine if any significant events have resulted in an impairment of the value of plant assets.VA2, PD5VA2

Presentation and Disclosure11) Compare statement presentation with GAAP.

a) Determine that plant assets and related expenses, gains, and losses are properly identified and classified in the financial statements.

b) Determine the appropriateness of disclosures related to the cost, book value, depreciation methods, and useful lives of major classes of plant assets, the pledging of plant assets as collateral and the terms of lease contracts. PD2, PD3, PD4, PD5

Related Party Transactions

SituationAccounting EstimatesAudit Program

Since this is a first year audit it is clear that related party transactions will be a significant portion of this audit. The engagement partner has asked you to research the firms responsibilities with respect to related party transactions. Cut and paste the auditing standard sections that explain the general procedures that should be performed to (1) determine the existence of related parties and (2) identify transactions with related parties.

AU 334.07 Addresses the procedures to be performed to determine the existence of related parties.

.07 The auditor should place emphasis on testing material transactions with parties he knows are related to the reporting entity. Certain relationships, such as parent-subsidiary or investor-investee, may be clearly evident. Determining the existence of others requires the application of specific audit procedures, which may include the following:

a.Evaluate the company's procedures for identifying and properly accounting for related party transactions.

b.Request from appropriate management personnel the names of all related parties and inquire whether there were any transactions with these parties during the period.

c.Review filings by the reporting entity with the Securities and Exchange Commission and other regulatory agencies for the names of related parties and for other businesses in which officers and directors occupy directorship or management positions.

d.Determine the names of all pension and other trusts established for the benefit of employees and the names of their officers and trustees.fn4

e.Review stockholder listings of closely held companies to identify principal stockholders.

f.Review prior years' working papers for the names of known related parties.

g.Inquire of predecessor, principal, or other auditors of related entities concerning their knowledge of existing relationships and the extent of management involvement in material transactions.

h.Review material investment transactions during the period under audit to determine whether the nature and extent of investments during the period create related parties.

Au 334.08 explains the general procedures that should be performed to identify transactions with related parties.

.08The following procedures are intended to provide guidance for identifying material transactions with parties known to be related and for identifying material transactions that may be indicative of the existence of previously undetermined relationships:

a.Provide audit personnel performing segments of the audit or auditing and reporting separately on the accounts of related components of the reporting entity with the names of known related parties so that they may become aware of transactions with such parties during their audits.

b.Review the minutes of meetings of the board of directors and executive or operating committees for information about material transactions authorized or discussed at their meetings.

c.Review proxy and other material filed with the Securities and Exchange Commission and comparable data filed with other regulatory agencies for information about material transactions with related parties.

d.Review conflict-of-interests statements obtained by the company from its management.fn5

e.Review the extent and nature of business transacted with major customers, suppliers, borrowers, and lenders for indications of previously undisclosed relationships.

f.Consider whether transactions are occurring, but are not being given accounting recognition, such as receiving or providing accounting, management or other services at no charge or a major stockholder absorbing corporate expenses.

g.Review accounting records for large, unusual, or nonrecurring transactions or balances, paying particular attention to transactions recognized at or near the end of the reporting period.

h.Review confirmations of compensating balance arrangements for indications that balances are or were maintained for or by related parties.

i.Review invoices from law firms that have performed regular or special services for the company for indications of the existence of related parties or related party transactions.

j.Review confirmations of loans receivable and payable for indications of guarantees. When guarantees are indicated, determine their nature and the relationships, if any, of the guarantors to the reporting entity.

Accounting Estimates

SituationRelated Party TransactionsAudit Program

AU 342.09 -.14 explain the general procedures that should be performed in evaluating the reasonableness of an accounting estimate such as the provision for warranties.

.09In evaluating the reasonableness of an estimate, the auditor normally concentrates on key factors and assumptions that are

a.Significant to the accounting estimate.

b.Sensitive to variations.

c.Deviations from historical patterns.

d.Subjective and susceptible to misstatement and bias.

The auditor normally should consider the historical experience of the entity in making past estimates as well as the auditor's experience in the industry. However, changes in facts, circumstances, or entity's procedures may cause factors different from those considered in the past to become significant to the accounting estimate.fn4

.10In evaluating reasonableness, the auditor should obtain an understanding of how management developed the estimate. Based on that understanding, the auditor should use one or a combination of the following approaches:

a.Review and test the process used by management to develop the estimate.

b.Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate.

c.Review subsequent events or transactions occurring prior to completion of fieldwork.

.11Review and test management's process. In many situations, the auditor assesses the reasonableness of an accounting estimate by performing procedures to test the process used by management to make the estimate. The following are procedures the auditor may consider performing when using this approach:

a.Identify whether there are controls over the preparation of accounting estimates and supporting data that may be useful in the evaluation.

b.Identify the sources of data and factors that management used in forming the assumptions, and consider whether such data and factors are relevant, reliable, and sufficient for the purpose based on information gathered in other audit tests.

c.Consider whether there are additional key factors or alternative assumptions about the factors.

d.Evaluate whether the assumptions are consistent with each other, the supporting data, relevant historical data, and industry data.

e.Analyze historical data used in developing the assumptions to assess whether the data is comparable and consistent with data of the period under audit, and consider whether such data is sufficiently reliable for the purpose.

f.Consider whether changes in the business or industry may cause other factors to become significant to the assumptions.

g.Review available documentation of the assumptions used in developing the accounting estimates and inquire about any other plans, goals, and objectives of the entity, as well as consider their relationship to the assumptions.

h.Consider using the work of a specialist regarding certain assumptions (section 336, Using the Work of a Specialist).

i.Test the calculations used by management to translate the assumptions and key factors into the accounting estimate.

.12Develop an expectation. Based on the auditor's understanding of the facts and circumstances, he may independently develop an expectation as to the estimate by using other key factors or alternative assumptions about those factors.

.13Review subsequent events or transactions. Events or transactions sometimes occur subsequent to the date of the balance sheet, but prior to the completion of fieldwork, that are important in identifying and evaluating the reasonableness of accounting estimates or key factors or assumptions used in the preparation of the estimate. In such circumstances, an evaluation of the estimate or of a key factor or assumption may be minimized or unnecessary as the event or transaction can be used by the auditor in evaluating their reasonableness.

.14As discussed in section 312, Audit Risk and Materiality in Conducting an Audit, paragraph .36, the auditor evaluates the reasonableness of accounting estimates in relationship to the financial statements taken as a whole:

Since no one accounting estimate can be considered accurate with certainty, the auditor recognizes that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements may be reasonable, and such difference would not be considered to be a likely misstatement. However, if the auditor believes the estimated amount included in the financial statements is unreasonable, he should treat the difference between that estimate and the closest reasonable estimate as a likely misstatement and aggregate it with other likely misstatements. The auditor should also consider whether the difference between estimates best supported by the audit evidence and the estimates included in the financial statements, which are individually reasonable, indicate a possible bias on the part of the entity's management. For example, if each accounting estimate included in the financial statements was individually reasonable, but the effect of the difference between each estimate and the estimate best supported by the audit evidence was to increase income, the auditor should reconsider the estimates taken as a whole.

Audit Program

SituationRelated Party TransactionsAccounting Estimates

CategorySubstantive Test

Initial Procedures1) Obtain an understanding of the business and industry and determine:

a) The significance of revenues and accounts receivable to the entity.

b) Key economic drivers that influence the entitys sales, margins, and collections.

c) Standard trade terms in the industry, including seasonal dating, collections period, etc.

d) The extent of concentration of activity with customers.

2) Perform initial procedures accounts payable balance and records that will be subjected to further testing.

a) Trace beginning balance for accounts receivable to prior years working papers.

b) Review activity in general ledger account for accounts receivable and investigate entries that appear unusual in amount or source.

c) Obtain accounts receivable trial balance and determine that it accurately represents the underlying accounting records by:

i) Footing the trail balance and determining agreement with (1) the total of the subsidiary ledger or accounts receivable master file, and (2) the general ledger balance.

ii) Testing agreement of customer and balances listed on the trial balance with those included in the subsidiary ledger or master file.

Analytical Procedures3) Perform analytical procedures:

a) Develop an expectation for accounts receivable using knowledge of the entitys business activity, market share, normal trade terms, and its history of accounts receivable turn days.

b) Calculate ratios:

i) Compare sales to the entitys capacity.

ii) Compare sales growth and receivable growth.

iii) Accounts receivable turn days.

iv) Uncollectible accounts expense to net credit sales

v) Uncollectible accounts expense to accounts receivable write-offs

c) Analyze ratio results relative to expectations based on prior years, industry data, budgeted amounts, or other data.

Tests of Details of Transactions4) Vouch a sample of recorded revenue cycle transactions to supporting documentation.

a) Vouch receivable debits to supporting sales invoices, shipping documents, and sales orders.

b) Vouch receivable credits to supporting cash receipts and cash prelists.

c) Vouch receivable credits to remittance advices or sales adjustment authorizations for sales returns and allowance or uncollectible account write-offs.

5) Trace a sample of revenue transactions from shipments to recording in the sales journal. Also trace a sample of cash receipts and sales returns to their recording in the accounting records.

6) Perform cutoff test for sales and sales returns.

a) Select a sample of recorded sales transactions from several days before and after year-end and examine supporting sales invoices and shipping documents to determine sales were recorded in the proper period.

b) Select sample of credit memos issued after year-end, examine supporting documentation such as dated receiving reports and determine that returns were recorded in the proper period. Also consider whether volume of sales returns after year-end suggest possibility of unauthorized shipments before year-end.

7) Perform cash receipts cutoff test.

a) Observe that all cash received through the close of business on the last day of the fiscal year is included in cash on hand or deposits in transit and that no receipts of the subsequent period are included, or

b) Review documentation such as daily cash summaries, duplicate deposit slips, and bank statements covering several days before and after year-end for proper cutoff.

Tests of Details of Balances8) Confirm accounts receivable

a) Determine the form, timing, and extent of confirmation requests.

b) Select and execute sample and investigate exceptions.

c) For positive confirmation requests for which no reply was received, perform alternative follow-up procedures:

Vouch subsequent cash receipts identifiable with items comprising account balance at confirmation date to supporting documentation.

Vouch items comprising balance at confirmation date to documentary support such as sale orders and shipping documents.

9) a) Make Inquiries about the sale, factoring, or pledging of accounts receivable.

b) Send confirmations to entities who have purchased accounts receivable or hold accounts receivable as collateral.

Tests of Details of Balances: Accounting Estimates10) Evaluate adequacy of allowance component for each aging category and in the aggregate.

a) Foot and crossfoot the aged trail balance of receivables and agree total to the general ledger.

b) Test aging by vouching amounts in aging categories for sample of accounts to supporting documents.

d) For pastdue accounts:

Examining evidence of collectibility such as correspondence with customers and outside collection agencies, credit reports, and customers financial statements.

Discuss collectibility of accounts with appropriate management personnel.

e) Evaluate managements process for estimating the allowance for doubtful accounts using hindsight.

f) Evaluate the adequacy of the allowance given information about

Industry trends.

Aging trends.

Collection history for specific customers.

Required Procedures

11) Confirmation of receivable included in step 7 above.

Tests of Details of Presentation and Disclosure12) Compare statement presentation with GAAP.

a) Compare disclosures related to existence and rights and obligations of receivables to the results of tests performed above.

b) Determine that receivables are properly identified and classified as to type and expected period of realization

c) Determine whether there are credit balances that are significant in the aggregate and that should be reclassified as liabilities.

d) Determine the appropriateness of disclosures and accounting for related party, pledged, assigned or factored receivables.

e) Determine the need for disclosures regarding significant customers or sales by line of business.

f) Evaluate the completeness of presentation and disclosures for receivables in drafts of financial statements to determine conformity to GAAP by reference to disclosure checklist.

g) Read disclosures and independently evaluate their understandability.

h) Vouch the accuracy of receivable disclosures to tests performed above.

Documents

Boynton SM Ch.12