Chapter 11

Designing
substantive
procedures
©2019 John Wiley & Sons Australia Ltd
 Learning objectives

After studying this presentation, you should be able to:

11.1 describe how various risk factors relate to the type of
potential misstatement
11.2 explain the process for determining the appropriate
level of substantive procedures based on the
assessment of detection risk, inherent risk and control
risk
11.3 explain how the auditor designs substantive
procedures for each audit and uses the nature, timing
and extent of substantive procedures to achieve an
acceptable level of detection risk
 Learning objectives

11.4 describe and apply a general framework for

developing audit programs for substantive procedures and
explain which substantive procedures may normally be
included in an audit program
11.5 understand special considerations when designing
substantive procedures.
Steps for assessing the risk of material
misstatement
 The type of potential misstatement

• Audit process involves recognising risk factors

• Linking those factors to assertions that are likely to be
misstated
• Risk factors can affect the potential for misstatements in
the financial statements in two ways:
– Some risk have a pervasive effect on the financial
statements and influence multiple account balances
and assertions (financial statement level risks)
– Other risk factors are assertion-specific (assertion level
risks).
Example of risk assessment procedures and the type
of potential misstatement that may occur
Example of risk assessment procedures and the type
of potential misstatement that may occur
Example of risk assessment procedures and the type
of potential misstatement that may occur
Example of risk assessment procedures and the type
of potential misstatement that may occur
 The magnitude of potential misstatements

• Some potential misstatements are more significant than

others.
• Audit time and resources are limited.
• Auditors allocate more audit attention to the assertions
that can have a potential material effect:
– Individually or in aggregate on the financial
statements.
 The likelihood of material misstatement

• Auditor identifies various business risks, inherent risks, and

fraud risks that might affect the financial statements
• Auditor should consider the adequacy of the system of
internal controls
• The greater the effectiveness of controls a company puts in
place, the less the likelihood of material misstatement
• Auditor needs to test controls they rely upon
• The higher the likelihood of material misstatement, the
more the auditor should respond with substantive tests to
obtain reasonable assurance that material misstatements
can be detected and corrected
 Determining detection risk

• Detection Risk (DR) is the risk that the auditor’s

substantive procedures will not detect a material
misstatement
• It is directly related to the substantive procedures
performed in an audit:
DR = AR
(IR x CR)
• For a given level of Audit Risk (AR) specified by the
auditor, DR is inversely related to the assessed levels of
Inherent Risk (IR) and Control Risk (CR)
Rain cloud analogy
 Predominantly substantive approach

• Auditor may assess control risk as being high and adopt

the predominantly substantive approach when:
– There are no significant control procedures that relate
to the assertion
– Any relevant control procedures are unlikely to be
effective.
 Predominantly substantive approach

• Auditor may assess control risk as being high and adopt

the predominantly substantive approach when:
– It would not be efficient to obtain evidence to evaluate
the effectiveness of relevant control policies or
procedures
• Costs of performing the higher level of substantive
procedures are less than the combined costs of
performing sufficient tests of controls to support a
lower assessed level of control risk approach.
 Designing substantive procedures

• Substantive tests are procedures that:

– provide evidence which supports the fairness of each
of management’s financial statement assertions
– reveal monetary errors or misstatements in recording
or reporting of transactions and balances.
• Refer ASA 330 The Auditor’s Responses to Assessed Risks
– The auditor shall design and perform further audit
procedures whose nature, timing, and extent are
based on and are responsive to the assessed risks of
material misstatement at the assertion level.
 Nature of substantive procedures

• Nature refers to type and effectiveness of audit

procedures to be performed
• If the assessed detection risk is low, the auditor would
need to use more effective and more costly procedures
• If the assessed detection risk is high, the auditor can use
less effective and less costly procedures
• Types of substantive procedures are:
– Analytical procedures
– Tests of details of transactions
– Tests of details of balances.
 Analytical procedures

• ASA 520 Analytical Procedures defines analytical

procedures as evaluations of financial information made
by a study of plausible relationships among both financial
and non-financial data
• Encompasses investigation of identified fluctuations and
relationships that are inconsistent with other relevant
information
• APs are the least costly to perform
 Analytical procedures

• APs are used in audit planning, as substantive procedures

to reduce detection risk, and at the overall review stage of
the audit
• APs are less effective than tests of details so used to
supplement tests of details
• the extent of reliance on APs depends on:
– Materiality
– Other audit procedures
– Accuracy of predicted results
– Inherent and control risks.
 Tests of details of transactions

• Used to obtain evidence of a sample (or all) of the

individual debits and credits that make up an account:
– to reach a conclusion about the account balance
• Mainly involve tracing and vouching
• Cut-off tests are a special category of tests of details of
transactions:
– related to closing balances
• such as electricity, telephone, gas, wages etc
• Purpose is to ensure completeness and occurrence
Tests of details of transactions – tracing

Mainly involves tracing and vouching

SUPPORTING/
ACCOUNTING
SOURCE TRACING
DOCUMENT BOOKS

e.g. Remittance (risk of e.g. Cash

advices understatement)
Receipts Journal
Tests of details of transactions – vouching

Mainly involves tracing and vouching

SUPPORTING/ ACCOUNTING
SOURCE VOUCHING
DOCUMENT BOOKS
(risk of e.g. Purchases
e.g. Supplier
overstatement)
Invoice Journal
 Tests of details of balances

• Focuses on obtaining evidence directly about an ending

account balance
• Effectiveness of these tests depends on the particular
procedure performed and type of evidence obtained

• Main way of collecting evidence for the balances that

make up the balance sheet
 Timing

• The timing of substantive procedures is dependent on the

level of detection risk
• If detection risk is HIGH, then certain procedures may be
performed a few months before the end of the year then
at end of year, conduct roll-forward testing to verify
account balance at year-end
• If detection risk is LOW, all substantive procedures relating
to account balances will be performed at or near the
balance date
 Timing

• Substantive procedures commonly performed before the

end of the reporting period are:
– Confirmation of accounts receivable
– Observation of physical inventory
– Physical inspection of investments.
• Early testing of account balances is not done unless:
– Tests of controls have provided convincing evidence
that the internal control structure is operating
effectively.
• Interim testing does not eliminate the need for substantive
procedures at the end of reporting period
 Extent

• The amount of evidence can vary by changing the extent

of substantive procedures
• ‘Extent’ means the number of items or sample size used
for the test or procedure
• It is dependent on the level of detection risk
– If level of detection risk is LOW (HIGH), then more
(less) evidence is needed.
 Computer-assisted audit techniques as
substantive procedures
• In designing substantive audit procedures, the auditor may
decide that it is effective and efficient to use computer
assisted audit techniques (CAATs) as an audit tool
• Examples of substantive auditing procedures that can be
performed or helped by the use of CAATs, include:
– recalculating interest or the extraction of invoices over a
certain value from computer records
– identifying inconsistencies or significant fluctuations
– sampling programs to extract data for audit testing
– re-performing calculations performed by the entity’s
accounting systems.
 Computer-assisted audit techniques as
substantive procedures
• Three main categories of audit software used to perform
substantive audit testing are:
– Generalised audit software
• Most commonly used in Australia
• Aka package programs – ACL and IDEA.
– Customised audit software
• Aka purpose-written programs.
– Utility programs
• Generally part of the client’s computer system
• Not specifically designed for audit purposes.
 Generalised audit software

• Generalised audit software can be used in performing

calculations, selecting samples, identifying records
meeting specified criteria, comparing data in different
fields, and producing reports:
– examples in practice include checking the
ageing of accounts receivables (30/60/90 days
and over) and selecting accounts for
confirmation.
 Framework for developing audit programs

• An audit program is a list of auditing steps to be performed

• A framework for developing audit programs for substantive
procedures includes:
– Complete preliminary planning such as:
• Develop specific audit objectives for each assertion
relating to closing balances
• Assess inherent and control risk
• Consider options regarding the design of SPs
• Consider whether it is effective and efficient to use
CAATs.
– Specify substantive procedures to be included in audit
program.
 Audit programs in initial engagements

• ASA 510 Initial Audit Engagements – Opening Balances

identifies 2 matters for special consideration:
– Whether opening balances contain misstatements
that materially affect the current period’s financial
report.
– Whether appropriate accounting policies reflected in
the opening balances have been consistently applied
in the current period’s financial report, or changes in
policies are appropriately accounted for an adequately
presented, and disclose in accordance with the
applicable financial reporting framework.
Special considerations when designing
substantive procedures

• Income statement accounts

• Accounting estimates including fair value
• Related parties
• Inventory and segment information
• External confirmations.
 Income statement accounts

• Tests of details of balances focus more on financial

statement assertions that refer to balance sheet accounts
than on income statement accounts
• Each income statement account is inextricably linked to
one or more balance sheet accounts
• Evidence obtained through substantive procedures
applied to balance sheet accounts provides evidence for
income statement balances
– Thus, analytical procedures are often all that is needed.
Tests of details of balances
 Analytical procedures for income statement
accounts
• Analytical procedures may be used directly or indirectly:
– Direct tests occur when a revenue or expense account
is compared with other relevant data to determine the
reasonableness of its balance
– Indirect tests occur when evidence concerning income
statement account balances can be derived from
analytical procedures applied to related balance sheet
accounts
Tests of details for income statement accounts

• When evidence obtained from analytical procedures and tests

of details of related balance sheet accounts does not reduce
detection risk to an acceptably low level – direct tests of details
of assertions relating to income statement accounts are
necessary
• May be case when:
– Inherent risk is high
– Control risk is high
– Analytical procedures reveal unusual relationships and
unexpected fluctuations
– The account requires analysis.
 Accounts involving accounting estimates

• An accounting estimate is an approximation of a financial

statement item in the absence of exact measurement
– Depreciation, allowance for bad debts, warranty
expense
– Management’s responsibility.
• To obtain sufficient appropriate audit evidence, auditors
should:
– Review and test the processes used by management to
develop the estimate
– Use an independent estimate for comparison
– Review subsequent events.
 Fair value accounting estimates and
related disclosures

• Recording balances at fair values is more relevant but they

are generally less reliable and require special
considerations by the auditor.
• In an active market, fair value based on
– published price quotations.

• If no active market, fair value may be based on

– a discounted cash flow analysis
– comparative transaction model.
 Related parties

• ASA 550 Related Parties

• Higher than average risk of irregularities
• Auditors should perform specific substantive procedures
with respect to related parties:
– Existence of related parties
• Review previous period working papers, shareholder
records and minutes of shareholders and directors’
meetings.
– Transactions with related parties
• Review information provided by management
identifying related party transactions and be alert for
other material related party transactions.
 Specific considerations for inventory and
segment information

• ASA 501 Audit Evidence – Specific Considerations for

Inventory and Segment Information
– Auditors must attend the stocktake unless
impracticable – existence and condition of inventory

• High risk of misstatement associated with inventory due

to:
– A large number of relatively small items
– Subjectivity associated with the provision for
obsolescence.
 External confirmations

• Written responses to confirmation requests that the

auditor has sent to third parties.
• Reliability of audit evidence is determined by its source and
nature
– External written evidence – strong form of audit
evidence
– Expensive and time-consuming to collect.
• ASA 505 External Confirmations
– Bank balances, accounts receivable balances, inventory
held with third parties and property title deeds.