12: AUDIT PROCEDURES IN RESPONSE TO ASSESSED RISKS: SUBSTANTIVE TESTS

Gloria Ivana - 211526334

1. ASSESSING THE RISK OF MATERIAL MISSTATEMENT

1.A. Steps for assessing the risk of material misstatement

Type of Potential Misstatement

Risk factors can affect the potential for misstatements in the financial statements in two
ways. Some risks have a pervasive effect on the financial statements and influence
multiple account balances and assertions (e.g., financial statement level risks). Other
risks factors are assertion specific (e.g., assertion level risks).
The Magnitude of Potential Misstatements
- The existence of inventory is more significant for a manufacturer than for a hotel
or many other service companies.
- Inventory is more susceptible to theft for a jeweler than for a lumber company.
- The depreciation of fixed assets is more significant for a paper manufacturer than
for an advertising agency.
- The completeness of unearned revenues is more significant for a software
company than for a point of sale retailer.
Audit time and resources are limited. Auditors need to allocate more audit attention to
the assertions that can have a potential material effect, individually or in aggregate, on
the financial statements.

Likelihood of Material Misstatement

Once the auditor has identified various business risks, inherent risks, and fraud risks that
might affect the financial statements, he or she should consider the adequacy of the
system of internal controls. The greater the effectiveness of controls that a company puts
in place, the less the likelihood of material misstatement.
As a general rule, the higher the likelihood of material misstatement (after considering
inherent risk and control risk), the more the auditor should respond with substantive tests
to obtain reasonable assurance that the auditor is able to detect and correct any material
misstatements.

1.B. Determining detection risk

Detection risk can be broken down into analytical procedures risk and tests of detailed
risk. Before making decisions about substantive tests, the auditor must determine
whether the planned level of substantive tests and associated planned detection risk
needs to be revised.
The auditor should compare the actual or final level of assurance obtained from risk
assessment procedures with the planned assessed levels of inherent risk and control
risk. If the final assessed level of risk is the same as the planned assessed level of risk,
the auditor may proceed to design specific substantive tests based on the preliminary
audit strategy. Otherwise, the level of substantive tests must be revised before designing
specific substantive tests to accommodate a revised acceptable level of detection risk.

2. DESIGNING SUBSTANTIVE TESTS

2.A. Performing further audit procedures
The auditor is likely to perform further risk assessment procedures when evidence
obtained during the audit does not confirm earlier risk assessments. he following
sections discuss:
1. The difference between tests of controls and substantive tests.
2. How information technology and generalized audit software might be used to support
substantive tests.
3. Audit choices in the design of substantive tests.
4. Special considerations in the design of substantive tests.
2.B. Comparison of test of controls and substantive test
 a. Concurrent tests of controls are performed in audit planning with risk assessment
procedures to understand the system of internal control. Additional tests of
controls are performed during interim fieldwork.
b. Tests of details of transactions may also be performed with tests of controls as
dual-purpose tests during fieldwork.
2.C. Using information technology to support substantive tests
When the client uses information technology for significant accounting applications, the
auditor has an opportunity to use audit software packages to make the audit more
effective and more efficient.
Generalized audit software : the auditor’s software that can be used for analyzing
and testing clients’ computer files. Generalized audit software enables the auditor to
deal effectively with large quantities of data. It also permits the auditor to place less
reliance on the client’s IT personnel. The auditor may be able to sort large files such
as a purchases file and select transactions of interest for further examination. Only
the availability of client data files and the auditor’s ingenuity limit the use of
generalized audit software in auditing. The software may be designed to perform
nearly all of the auditing procedures that an auditor might perform manually.

Reconcile Detail Audit Data with the General Ledger

The first step that should be performed is to ensure that the underlying detail matches
the accounting records. Auditors often obtain accounts receivable subsidiary files from a
client to prepare confirmations. If the file has a date other than month-end, which does
not match the client’s month end general ledger, it is likely that the auditor will send
confirmations in erroneous amounts. Hence, an important first step involves using
generalized audit software to total the detailed information and to compare control totals
to the general ledger (at an interim date) or to financial statement amounts (at year-end).

Selecting and Printing Audit Samples

Auditors can program the computer to choose audit samples. These samples are
adaptable. The auditor may confirm individual client accounts receivable or all items over
a specified dollar amount. Computers can produce confirmation letters and envelopes.
The auditor might also use generalized audit software to sample items that are likely to
contain errors. For ex : The auditor may sample manufactured inventory costs that have
changed by more than 10% from the previous audit. Stable prices may be less
error-prone than fluctuating ones.

Testing Calculations and Making Computations

Inventory quantities may be extended by a unit cost and the amount of the inventory
recalculated. An auditor might be able to use the client’s data to recalculate the accounts
receivable aging.

Testing the Entire Population

Generalized audit software lets auditors screen a complete population instead of
sampling. Generalized audit software can create a payment history for each client to
 assess the allowance for dubious accounts. Generalized audit software lets auditors
swiftly track sales transaction time from shipment to payment. An auditor can analyze a
perpetual inventory file for slow-moving items.

Summarizing Data and Performing Analyses

The auditor frequently desires to have the client data reorganized in a manner that will
suit a special purpose. For instance, the auditor may want to determine slow-moving
inventory items, debit balances in accounts payable, or past due accounts receivable.
Similarly, in performing analytical procedures, the auditor may utilize the computer to
compute desired ratios, extract nonfinancial data from the client’s database for
comparison with financial data, or perform statistical regression analysis and an
analytical procedure.

2.D. Audit Choices in the design of substantive tests

Substantive tests provide evidence about the fairness of each significant financial
statement assertion, or they may reveal monetary errors or misstatements in the
recording or reporting of transactions and balances. The auditor must make decisions
about the nature, timing, extent, and staffing of substantive tests in order to have a
reasonable basis for an opinion on the client’s financial statements.

Nature of Substantive Tests

The nature of substantive tests refers to the type and effectiveness of the auditing
procedures to be performed. When the acceptable level of detection risk is low, the
auditor must use more effective procedures. When the acceptable level of detection risk
is high, less effective and less costly procedures can be used.
1. Initial Procedures
First, the auditor has to understand the transactions' economic nature. The
auditor must also watch for consignment sales. In software companies, the sale
may include a license agreement and consulting services to customize the
product. In this instance, revenue may not be recognized immediately. The client
may issue redeemable preferred stock, which is legally equity but economic debt
and should be represented as debt on the balance sheet.
Tracing general ledger beginning balances to audited prior-year financial records
is another crucial initial step. auditors frequently receive precise, electronic
information regarding account balances such accounts receivable, perpetual
inventory, and accounts payable subsidiary ledgers. Before continuing audit
work, these detail balances must be added to the general ledger. The auditor
may audit incorrect data.
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
(2) ascertaining the accounting principles used in the preceding period as a basis
for determining the consistency of application of such principles in the current
period.

2. Substantive Analytical Procedures

Analytical procedures may be used as the primary substantive test when inherent
risk is moderate or low. However, substantive analytical procedures should not be
used as the primary test for assertions with significant inherent risks.
For many assertions, substantive analytical procedures that compare plausible
relationships among both financial and nonfinancial data may be effective
substantive tests. Generally accepted auditing standards state that 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.
An increased level of understanding of the entity and its environment usually will
help the auditor design analytical procedures with more predictable relationships
that, in turn, provide more effective evidence.

For high inherent risk assertions, substantive analytical procedures are

considered less effective than tests of details.
In some cases where substantive analytical procedures are effective, they may
also add to the efficiency of the audit.
 The auditor’s estimated balance for revenues can then be compared with the
reported balance as part of the evidence used in determining whether revenues
are fairly stated. In other cases, the expected relationship of one account balance
to another might be used.

When the results of the substantive analytical procedures conform to

expectations, and the acceptable level of detection risk for the assertion is high, it
may not be necessary to perform tests of details. Thus, consideration should be
given to the extent to which these procedures can contribute to achieving the
acceptable level of detection risk before selecting tests of details. When
evaluating overall detection risk, it is often cost efficient to obtain a final
assessment for analytical procedures risk before performing tests of details.

3. Tests of Details of Transactions

Tracing and vouching transactions are the main tests. To assess completeness,
trace transactions from source documents such sales orders and bills of lading to
sales journal invoices. To prove existence, occurrence, and valuation, the cash
disbursements log and perpetual inventory records can be verified by canceled
checks and vendor invoices. The auditor seeks monetary faults in these
substantive tests.
The auditor utilizes evidence from some (a sample) or all account transactions to
determine the account balance in these tests. These tests employ client file
documents. Test efficacy depends on the process and papers. For instance,
vendor invoices, canceled checks, and internal records that are circulated
externally are more reliable than purchase requisitions.
Targeting potential inaccuracies in transaction information can be useful.
Computer-assisted audit strategies can help the auditor find payroll transactions
when the employee worked more hours than planned or buy transactions that
exceeded expectations. Continuous monitoring or generalized audit software can
tag such transactions. Generalized audit software helps improve detailed tests.
Dual-purpose examinations of transaction information and controls can reduce
costs. The auditor may assess the client's controls over the allowance for
doubtful accounts and independently assess its reasonableness.
Analytical processes and learning about transactions while auditing account
balances can provide a lot of evidence about transaction class statements. For
example, an overstatement of inventories understates cost of sales. Direct tests
of income statement account assertions are needed when analytical procedures
and tests of related balance sheet accounts that also provide evidence about
transaction class assertions do not reduce detection risk to an acceptable level.
This may be the case when:
a. Inherent risk is high. occur in the case of assertions affected by
nonroutine transactions and management’s judgments and estimates.
and significant inherent risk such as revenue recognition.
b. Control risk is high. occur when related internal controls for nonroutine
and routine transactions are ineffective or the auditor elects not to test the
internal controls.
c. Analytical procedures reveal unusual relationships and unexpected
fluctuations. These circumstances are explained in a preceding section.
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.
Accounts that usually require separate analysis using tests of details of
transactions generally include:
● Legal expense and professional fees
● Taxes, licenses, and fees
● Maintenance and repairs
● Rents and royalties
● Travel and entertainment
● Contributions
● Officers’ salaries and expenses
● Advertising

4. Tests of Details of Balance

Balance details tests seek evidence of an account balance rather than its debits
and credits. The auditor may ask banks and customers to verify cash and
accounts receivable balances. The auditor may also evaluate plant assets, watch
client inventory taking, and price test ending inventory.
These tests are successful depending on the process and evidence. The
following shows how balance tests might be adjusted to suit different detection
risk levels for cash in bank valuation or allocation assertions:
*when detection risk is high, the auditor may use internally prepared documentation and perform
limited auditing procedures. In contrast, when detection risk is very low, the auditor uses
documentation obtained directly from the bank and performs extensive auditing procedures.

5. Tests of Details of Accounting Estimates

Accounting estimates are approximations of financial statement elements, items, and accounts
without precise measurement. Depreciation, bad debts, and warranty expenses are accounting
estimates. Accounting estimates frequently need unique proof. Accounts receivable
confirmation may prove a customer owes the company and the amount. It does not prove the
receivable is recoverable. The auditor must gather client payment history documentation.
Accounting estimates sometimes depend on the future, such as whether receivables will be
recovered or whether warranties will be paid. Management establishes accounting estimate
processes and controls. Auditors should evaluate accounting estimates with professional
skepticism and watch out for contradictory estimates when management over-reserves in good
times (building "cookie jar" reserves) to under-reserve in bad times.

auditor’s objective in performing tests of details of accounting estimates is to obtain sufficient

competent evidential matter to provide reasonable assurance that
a. All accounting estimates that could be material to the financial statements have been
developed.
b. The accounting estimates are reasonable in the circumstances
c. The accounting estimates are presented in conformity with applicable accounting
principles and are properly disclosed.
Evidence of the reasonableness of an estimate may be obtained by the auditor from one or a
combination of the following approaches:
a. Perform procedures to review and test management’s process in making the estimate.
For example, the auditor might review the data used by management in developing an
 allowance for doubtful accounts. The auditor might review the client’s evaluations of
customer credit and a disclosure committee’s review of customers with past due
receivables.
b. Prepare an independent expectation of the estimate. Many private companies do not
have adequate controls over accounting estimates. A controller might estimate the
allowance for doubtful accounts, and the only review is the auditor’s tests. In this case
the auditor might use generalized audit software to test the client’s aging of receivables
and to calculate payments histories for clients with past due receivables.
c. Review subsequent transactions and events occurring prior to completing the audit that
pertain to the estimate. An effective means of evaluating an accounting estimate
involves the use of hindsight. The auditor might review the client’s collection history
during the first 45 days of the year before drawing a final conclusion about the allowance
for doubtful accounts.
6. Disclosure Detail Tests
Disclosure details are tested for completeness, existence, rights and obligations, valuation and
allocation, and categorization understandability. Most auditors use disclosure checklists to verify
disclosures. These disclosure checklists list GAAP-required disclosures by account balance or
financial reporting issue and provide a thorough summary. The audit team must complete the
disclosure checklist and compare existing disclosures to anticipated financial statement
disclosures.
Financial statement disclosures are tested directly by reading contracts, vouching information to
underlying transaction information, confirming information with outside third parties, and
recalculating. The auditor may use an actuary's report to obtain appropriate, competent
evidence for defined benefit pension plan disclosures. Auditors use professional judgment to
assess disclosure clarity and compare them to similar disclosures in other financial statements.
Responding to Significant Inherent risks
The auditor must test transactions and balances if a risk is considerable. Auditors can also
combine transaction or balance checks with risk-specific analytical processes. The auditor must
collect proof of effective internal controls during the current audit period if internal controls are
used to modify audit tests. Thus, the auditor usually examines transactions to determine
whether revenue recognition is appropriate given the transaction circumstances. Revenue
recognition for complex transactions with many deliveries may receive more attention from the
auditor than a simple shipment transaction.

Timing of Substantive tests

Substantial tests may be delayed depending on detection risk. Tests can be done months before
the end of the year if control risk is low and detection risk is high. Substantial tests are usually
done near the balance sheet date when detection risk is low.

Substantive Tests Prior to Balance Sheet date

An auditor may perform interim substantive tests on an account. If the auditor can control the
extra audit risk of missing material misstatements in the account at the balance sheet date, the
tests should be done before the balance sheet date. As time passes between interim testing
and balance sheet date, this risk increases.
Substantial testing for the remaining period can offer a reasonable foundation for extending
audit conclusions from the interim date to the balance sheet date, reducing audit risk. AU 313,
Substantive Tests Prior to Balance Sheet Date (SAS No. 45), lists the conditions that mitigate
this risk:
(1) internal control during the remaining period is effective
(2) there are no conditions or circumstances that might predispose management to misstate the
financial statements in the remaining period
(3) the year-end balances of the accounts examined at the interim date are reasonably
predictable as to amount, relative significance. If these prerequisites are not met, evaluate the
account at balance sheet date.
Early substantive testing of account balances is not done until controls have shown effective
internal control. The auditor may not substantively test all account assertions before the balance
sheet date. The auditor may see the client's inventory meeting existence, occurrence, and
completeness assertions early. The auditor would get market value quotes after the balance
sheet date to prove valuation or allocation.
Substantive tests prior to the balance sheet date do not eliminate the need for substantive tests
at the balance sheet date. 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.

Extent of Substantive Test

The acceptable level of detection risk will also affect the extent of substantive tests. If detection
risk is high, less extensive tests may be performed. In contrast, when detection risk for an
assertion is low, the substantive tests will ordinarily be more extensive. Extent is used in practice
to mean the number of items or sample size to which a particular test or procedure is applied.
However, the auditor should take note that increasing the extent of tests is only helpful when the
test is relevant to the assertion being tested. In addition, the auditor can increase the
extensiveness of tests by using generalized audit software. This tool can allow the auditor to
scan 100 percent of a population of transactions or balances with particular characteristics.

Staffing Substantive Tests

auditors should be assigned to tasks and supervised commensurate with their level of
knowledge, skill, and ability so that they can evaluate the audit evidence they are examining.
auditor may respond to the risk of material misstatement due to fraud by the assignment of
personnel. A task such as evaluating the obsolescence of inventory may require a greater level
of industry expertise and experience than observing the existence of inventory. Substantive
tests should be assigned to personnel with the requisite skill, ability, and experience.

Summary of Relationships among Audit Risk Components and the Nature, Timing, and Extent
of Substantive Tests
Designing substantive tests involves determining the nature, timing, and extent of substantive
tests for each significant financial statement assertion. In the next section, we consider how the
auditor relates assertions and substantive tests in developing written audit programs for
substantive tests.

2.E. Special Considerations in designing substantive tests

auditors must determine whether some special considerations are relevant to designing
substantive tests for selected types of accounts. The following discussion focuses on two
special considerations:
(1) the relationship between auditing balance sheet and income statement accounts, and
(2) the implications of related party transactions.

Auditing Balance Sheet and Income Statement Accounts

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.
Auditors learn about the occurrence of sales when testing the existence of accounts
receivables.

Accounts Involving Related Party Transactions

Generally recognized auditing standards (AU 334) require auditors to detect related party
transactions in audit planning. Related party transactions involve associated corporations,
equity-accounted entities, major owners, and management. The auditor worries that these
transactions may not be arms-length.
In auditing related party transactions, the auditor seeks evidence of their purpose, nature, and
impact on financial statements. Evidence should go beyond management inquiry.substantive
tests should:
- 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 intercompany 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.
In auditing identified related party transactions, the auditor is not expected to determine whether
a particular transaction would have occurred if the parties had not been related or what the
exchange price and terms would have been. The auditor is required, however, to determine the
economic substance of the related party transactions and their effects on the financial
statements.

3. Developing Audit Programs for substantive tests

3.A. A GENERAL FRAMEWORK FOR DEVELOPING AN AUDIT PROGRAM FOR

SUBSTANTIVE TESTS
The auditor’s decisions regarding the design of substantive tests are required to be documented
in the working papers in the form of written audit programs (AU 311.09). An audit program is a
list of audit procedures to be performed. 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).

The Nature of Procedures to be Performed

When disclosing the nature of audit tests, Decisions about the timing, extent, and staffing of
audit procedures are documented in the audit working papers themselves. The substantive
audit programs throughout the remainder of this text are organized according to the nature of
the substantive test, which is as follows:
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
In practice, auditors hold different views on the extent of detail to be shown in an audit program.
In any case, 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

Addressing All Assertions

It is essential that every substantive audit program cover all relevant financial statements
assertions. The audit objectives are helpful because different audit objectives usually need
different tests. This framework also ensures that the auditor plans audit tests for every assertion
in the financial statements.