C HAPTER 12

Audit Procedures in Response to Assessed

Risks: Substantive Tests

Learning Objectives

Chapter 12 focuses on planning appropriate substantive tests. The learning objectives for Chapter
12 have been stated in terms of Auditor Knowledge that the student should understand and
important Audit Decisions that the student should be able to make. They are:

Auditor Knowledge
After studying this chapter you should understand the following aspects of an auditor’s
knowledge base:
1. Know the difference between tests of controls and substantive tests.
2. Understand the general framework for developing audit programs for substantive tests.

Audit Decisions
1. What key steps should be performed in the process of assessing the risk of material
misstatement in the financial statements?
2. How do various how risk factors relate to the type of potential misstatement?
3. What is process for evaluating the planned level of substantive tests as specified in the
preliminary audit strategy?
4. How can the auditor use information technology to support various substantive tests?
5. How is the nature, timing, extent and staffing of substantive tests are varied to achieve an
acceptable level of detection risk?
6. What special considerations should be addressed in designing substantive tests for selected
types of accounts?

Chapter Outline

1. Chapter-opening Vignette: The Importance of Risk Assessment Procedures and Audit

Programs, 513
2. Preview of Chapter 12, 514
3. Focus on Auditor Knowledge, 514
4. Focus on Audit Decisions, 514
5. Assessing the Risk of Material Misstatement, 515

Instructor’s Manual to Modern Auditing: Copyright © 2005, John Wiley and Sons, Inc. 12-1
 5.1. Steps for Assessing the Risk of Material Misstatement, 515……..(Figure 12-1: Steps for
Assessing the Risk of Material Misstatement)
5.1.1. The Type of Potential Misstatement, 515……(Figure 12-2: Example of Risk
Assessment Procedures and the Type of Potential Misstatements that May Occur)
5.1.2. The Magnitude of Potential Misstatements, 516
5.1.3. Likelihood of Material Misstatements, 517
5.1.4. Determining Detection Risk, 518…………….(Figure 12-3: Preliminary Audit
Strategy, Planned Detection Risk, and Planned Emphasis on Audit Tests)
6. Designing Substantive Tests, 520
6.1. Performing Further Audit Procedures, 520
6.2. Comparison of Test of Controls and Substantive Tests, 520 …….(Figure 12-4: A
Comparison of Tests of Controls and Substantive Tests)
6.3. Using Information Technology to Support Substantive Tests, 520
6.3.1. Generalized Audit Software, 520
6.3.2. Reconcile Detail Audit Data with the General Ledger, 521
6.3.3. Selecting and Printing Audit Samples, 522
6.3.4. Testing Calculations and Making Computations, 522
6.3.5. Testing the Entire Population,522
6.3.6. Summarizing Data and Performing Analyses, 522
6.4. Audit Choices in the Design of Substantive Tests, 523
6.4.1. Nature of Substantive Tests, 523 ………..(Figure 12-5 Nature of Substantive
Tests)
6.4.1.1.Initial Procedures, 523
6.4.1.2.Substantive Analytical Procedures, 524
6.4.1.3.Tests of Details of Transactions, 525
6.4.1.4.Tests of Details of Balances, 527
6.4.1.5.Tests of Details of Accounting Estimates, 528
6.4.1.6.Tests of Details of Disclosures, 529
6.4.2. Timing of Substantive Tests, 530
6.4.3. Extent of Substantive Tests, 531…….(Figure 12-6: Factors that Influence Sample
Size for a Substantive Test)
6.4.4. Staffing of Substantive Tests, 532
6.4.5. Summary of Relationships among Audit Risk Components and the Nature,
Timing and Extent of Substantive Tests, 532 ……(Figure 12-7: Relationships
among Audit Risk Components and the Nature, Timing, Extent and Staffing of
Substantive Tests)
6.5. Special Considerations in Designing Substantive Tests, 533
6.5.1. Auditing Balance Sheet and Income Statement Accounts, 533
6.5.2. Accounts Involving Related Party Transactions, 533
7. Developing Audit Programs for Substantive Tests, 535

Instructor’s Manual to Modern Auditing: Copyright © 2005, John Wiley and Sons, Inc. 12-2
 7.1. A General Framework for Developing an Audit Program for Substantive Tests, 535
7.1.1. The Nature of Procedures to Be Performed, 535 ….(Figure 12-8: Illustrative
Audit Program for Substantive Tests of Inventories)
7.1.2. Addressing All Assertions, 536…….(Figure 12-9: Inventory Audit Objectives
and Example Substantive Tests)
8. Focus on Auditor Knowledge and Auditor Decisions, 540
........ (Figure 12-10: Summary of Auditor Knowledge Discussed in Chapter 12)
…… (Figure 12-11: Summary of Audit Decisions Discussed in Chapter 12).
9. Objective Questions, online at www.wiley.com/college/boynton
10. Comprehensive Questions, 542
11. Professional Simulation, 550

New to the 8th Edition

The 8th edition has several new features:

1. Chapter-opening vignette that discusses the failure to obtain sufficient, competent evidence
in the audit of Gas and Oil Technologies, Inc.
2. Focus on audit knowledge and audit decisions at the beginning of the chapter, in the margin
throughout the chapter and an end of chapter summary that focus on important auditor
knowledge and audit decisions covered in the chapter.
3. The chapter includes a summary discussion of the steps involved in assessing the risk of
material misstatement. Figure 12-2 provides a number of examples of risk factors and the
associated type of potential misstatements that may occur in an audit.
4. Figure 12-3 reemphasizes preliminary audit strategies and how they respond to the assessed
level of detection risk.
5. Discussion of the auditor’s choices regarding substantive tests that is then tied into a
framework for developing an audit program for substantive tests.
6. Figure 12-6 provides examples of the factors that generally influence sample size.
7. A CPA exam style professional simulation has been added at the end of the chapter.

Focus on Audit Decisions

An explicit focus on audit decisions is new to the 8th edition. Chapter Twelve addresses six
decisions associated with the design of substantive tests.

The first decision addresses the steps in assessing the risk of material misstatement in an
assertion. Figure 12-1 (page 515) summarizes these steps.

The next decision focuses on help students understand how auditors relate various risk factors to
the type of potential misstatement that can occur. Figure 12-2 (page 516) provides a number of
examples of items that might surface while performing various risk assessment procedures along

Instructor’s Manual to Modern Auditing: Copyright © 2005, John Wiley and Sons, Inc. 12-3
with the types of potential misstatements that are associated with each risk factor. The remaining
discussion provides examples of how the auditor might assess the magnitude of potential
misstatements and the likelihood of potential misstatements.

The third decision addresses the process of evaluating the planned level of substantive tests.
Figure 12-3 (page 519) relates detection risk to various preliminary audit strategies and the
planned level of substantive tests.

The fourth decision focuses on how the auditor might use the power of information technology
in the audit process. The discussion explain generalized audit software and how it might be used
to reconcile audit data with the general ledger, select audit samples, test calculations, test the
entire population, and summarize data and perform analyzes.

The fifth decision addressed in the chapter involves how the auditor might make various
decisions about the nature, timing, extent and staffing of substantive tests. Figure 12-5 (page
523) introduces a classification of various types of audit procedures that are used throughout the
remainder of the book. Figure 12-6 (page 531) explains the factors that generally influence audit
decisions about sample size. Figure 12-7 (page 532) summarizes how each of these factors
related to decision about detection risk.

The final decision focuses on special consideration when designing substantive tests. A critical
area discussed here is how the auditor might take steps to ensure at related party transactions are
identified during the audit. This section also explains how tests of balances often provide
evidence about the fair presentation of transactions.

Key Questions for Students

Following is a list of common questions for students that instructors might want to weave into
class discussion of Chapter 12 topics.
o Assessing the Risk of Material Misstatement
o Explain the three steps associated with assessing the risk of material misstatement.
o How would the auditor change the audit strategy if a risk is a financial statement level
risk vs. an assertion level risk?
o Develop an example of a risk of material misstatement that might be found during
each of the following risk assessment procedures.
▪ Understanding the entity and its environment.
▪ Performing analytical procedures
▪ Understanding the risk of fraud
▪ Understanding inherent risks
▪ Understanding the entity’s system of internal control
o When and how does an auditor determine a revised or final acceptable level of
detection risk for an assertion?
o Designing Substantive Tests
o Assume that the auditor is performing a test of a sales transaction as a dual purpose
test. Explain the difference between tests of controls and substantive tests.

Instructor’s Manual to Modern Auditing: Copyright © 2005, John Wiley and Sons, Inc. 12-4
 o What is the relationship between the acceptable level of detection risk and the nature
of substantive tests?
o Explain the purpose of initial procedures and explain the special concerns that the
auditor has in a first year audit.
o What are the advantages and disadvantages of using analytical procedures as
substantive tests?
o What factors affect the expected effectiveness and efficiency of analytical procedures
as substantive tests?
o Explain the circumstances that usually result in applying tests of details directly to
income statement accounts?
o Contrast the focus of tests of details of balances versus tests of details of transactions.
o What factors should be considered in evaluating the reasonableness of accounting
estimates?
o What is the relationship between the acceptable level of detection risk and the timing
of substantive tests?
o What factors should be considered by the auditor in deciding whether to perform
substantive tests prior to the balance sheet date?
o How should the auditor control the potential added audit risk for the period from the
date of testing to the balance sheet date?
o What is the relationship between the acceptable level of detection risk and the extent
of substantive tests?
o Explain how an auditor may obtain evidence about transaction class assertions when
performing tests of balance sheet accounts. Provide an example.
o What are the auditor’s objectives in auditing related party transactions?
o Developing Audit Programs for Substantive Tests
o What is an audit program?
o Identify two tasks that need to be accomplished in the framework for developing an
audit program.
o What essential information that is generally documented in an audit program?
o List six types of substantive audit procedures that are normally included in a
substantive audit program.
o Explain the relationship between audit programs and audit assertions.

Teaching Notes

Chapter 12 addresses three major topics:

1. Assessing the Risk of Material Misstatement
2. Designing Substantive Tests
3. Developing Audit Programs for Substantive Tests

The first part of the chapter focuses Phase II of the audit – assessing the risk of material
misstatement in an assertion. This builds on material that was covered in chapters 6 through 11.

Instructor’s Manual to Modern Auditing: Copyright © 2005, John Wiley and Sons, Inc. 12-5
In assessing the risk of material misstatement the auditor should:
1. Evaluate the type of potential misstatements that can occur in an assertion.
2. Evaluate the magnitude of potential misstatements in an assertion.
3. Evaluate the likelihood of material misstatements in an assertion.
Figure 12-2 provides a number of examples of risk factors and how they might relate to the type
of potential misstatement that might occur in an assertion. By the type the student reaches this
chapter, they should be able to relate risk factors such as these, to the types of assertions that
might be misstated.

The section then goes on to explain how the auditor uses this information in making risk
assessments and determining detection risk. The auditor’s assessment of detection risk then sets
up a discussion of choices about performing substantive tests in an audit.

Part 2 of the chapters focuses on decisions about substantive tests. This section begins with a
discussion about the difference between tests of controls and substantive tests. It is often useful
to discuss how the auditor might perform dual purpose tests of a transaction (such as a credit
sale) and have the students distinguish between the character of a test of controls and of a
substantive test in this context.

The chapter then goes on to discuss how auditors use computer technology and generalized audit
software to perform an effective audit. It may be useful to discuss how auditors use generalized
audit software to reconcile details to the general ledger, select samples, test calculations, and
perform procedures on an entire audit population. Chapter 14 includes a case where students
can use the Idea audit software on a sales and accounts receivable population.

A key portion of the discussion of substantive tests revolves around the nature of substantive
tests that may be performed. This chapter discusses six types of substantive test that would be
included in a substantive audit program.
o Initial procedures, such as understanding the economic substance of the transaction being
auditing, or tying out detail subsidiary balances to a control total in the general ledger.
o Performing substantive analytical procedures. A number of examples are provides of
how analytical procedures may be useful when auditing revenues and expenses.
o Tests of details of transactions which are procedures performed to audit transaction class
audit objectives.
o Tests of details of balances which are procedures performed to audit account balance
audit objectives.
o Test of details of accounting estimates which focus on unique aspects of auditing
accounting estimates. A general discussion is provided of the factors that should be
consider when auditing accounting estimates based on SAS 57, Auditing Accounting
Estimates.
o Tests of details of disclosures which are procedures performed to audit disclosure audit
objectives.

The chapter then discusses the timing of substantive tests, which emphasizes the guidance
provided by SAS 45, Substantive Tests Prior to Balance Sheet Date. This section addresses the

Instructor’s Manual to Modern Auditing: Copyright © 2005, John Wiley and Sons, Inc. 12-6
issue of determining the risk that material misstatements may occur during between and interim
date and year-end, if the auditor wants to perform a substantive test at interim.

The chapter then provides an overview of making decisions about sample size, or extent of audit
procedures. Figure 12-6 might prove useful in discussing the factors that influence decisions
about sample size in a substantive test.

Figure 12-7 may prove useful in relating the risk of material misstatement to decisions about the
nature, timing, extent and staffing of substantive tests.

The final part of the chapter focuses on the development of an audit program. The audit needs to
(1) make decisions about the type of procedures to be performed and (2) make sure that
procedures provide evidence that is relevant to each audit objective (or assertion) for the account
balance or transaction class. A detailed example is provided in the context of auditing inventory
(See Figures 12-8 and 12-9).

Instructor’s Manual to Modern Auditing: Copyright © 2005, John Wiley and Sons, Inc. 12-7