Substantive tests of transactions and balances Chapter 10 Substantive tests of transactions and balances Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 1: Relationship between evidence-gathering procedures Auditor has to obtain sufficient appropriate evidence to support the audit opinion. Tests of controls (Ch 9) and substantive tests of transactions and balances are the main evidence-gathering audit procedures. Auditor selects the most efficient and effective combination of audit procedures that allows them to achieve audit objective. Assertions are used to help them in their risk assessment of material misstatement, and to direct their audit procedures in responding to these risks. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Relationship between tests of controls and substantive tests of transactions Most controls are built around transaction flows. Tests of controls: transactions selected to test whether related controls are working. Does not directly measure monetary error in accounting records. Substantive test of transactions: transactions selected to determine whether monetary errors have occurred. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Dual purpose tests These are tests of transactions that address both control and substantive matters simultaneously. Very common in practice since both tests of controls and substantive tests of transactions commonly involve inspection of documents. It is efficient to perform tests of control and substantive tests on transactions selected simultaneously, e.g. select document and check evidence of authorisation (test of control) and recompute amount (substantive test of transaction). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Relationship between substantive tests of transactions and balances Objective of substantive tests is to reduce detection risk to an acceptable level. Substantive tests of transactions focus on the individual transactions that make up the balance. Substantive tests of balances substantiate the ending balance of an account (which is comprised of multiple transactions). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Distinguishing between substantive tests of transactions and substantive tests of balances The $5000 balance for Able could be verified by confirming this balance with customer (substantive test of balances) or verifying to supporting documentation the three transactions comprising this balance (substantive tests of transactions). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 2: Financial report assertions and substantive audit procedures The auditor develops specific audit procedures to evaluate and address the risk of material misstatement for both classes of transactions and events, and account balances. The risk associated with each assertion is assessed, and substantive audit procedures are directed at specific assertions based on this assessment. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions about transactions and events Occurrence: in testing whether transactions that generated financial report accounts actually occurred. Completeness: the auditor identifies evidence indicating items that should be included in the class of transactions and investigates whether they are, in fact, included. Accuracy: relates to determining the appropriate recording of the dollar value and other information of transactions. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions about transactions and events (cont.) Cutoff: involves checking that transactions are recorded in the correct period. Classification: in designing substantive tests for the assertion of classification, the auditor considers the appropriate classification of the item in the financial report. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions about account balances Existence: the auditor selects from items contained in the accounting records and obtains evidence that supports them. Rights and obligations: the auditor must ascertain that the assets are owned/controlled by the client and that the liabilities are those of the client. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions about account balances (cont.) Completeness: the auditor identifies evidence indicating items that should be included in the account balance and investigates whether they are in fact included. Valuation and allocation: the auditor considers the appropriateness of the basis of valuation of the asset or liability and the basis of any allocation of this valuation across accounting periods. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Existence/occurrence and completeness assertions Note that the direction of testing determines whether existence/occurrence or completeness assertion is tested. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Cash receipts/payments Learning objective 3: Cash, cash receipts and cash payments: assertions of interest These are primarily: Cash Cash receipts/payments Existence; Completeness; and possibly Valuation and allocation (if foreign currency balances). Occurrence Accuracy (if foreign currency transactions). — since these are areas where misstatements are most likely to occur. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Approach in auditing cash balances Determined by assessing level of control risk in bank and cash handling procedures. Much of this information will come from evaluations and tests of controls in the sales and cash receipts system, and the purchases and cash payments system. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for cash receipts and payments (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for cash Table 10.1 (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Cash: key procedures These are: Obtaining confirmation of bank balances from client’s bankers Testing of client’s bank reconciliation. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 4: Sales, cash receipts and accounts receivable Occurrence Accuracy Existence Valuation and allocation Assertions of interest — as these are areas in which misstatements are most likely to occur Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Accounts receivable: key audit procedures Confirmation Subsequent receipts review Cutoff Analytical procedures Tests of sales transactions Review of aged trial balance Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for sales Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for accounts receivable Table 10.2 Assertions, objectives and substantive procedures for accounts receivable (p. 465) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Accounts receivable confirmation and other procedures Auditor may obtain confirmation from debtors using: Positive form — once debtor has been selected, auditor must obtain evidence and asks client to respond, whether or not they agree with information as to amount owed in request. There will be follow-up procedures such as second request, checking invoices to shipping documents to prove sale for any non-response. Negative form — requests client to respond when they disagree with amount shown. Auditor should also consider other procedures such as examining evidence of subsequent cash receipts, and examining sales and shipping documents. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Format of positive accounts receivable confirmation requests Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Confirmation procedure versus subsequent cash receipts testing Subsequent cash receipts testing is commonly viewed as a superior form of evidence compared with confirmation procedures because it achieves both key assertions. Confirmation Subsequent cash receipts testing Existence YES Valuation and NO allocation Existence YES Valuation and YES Confirmation still requires further tests of likelihood of payment (doubtful debts provision), which is part of valuation and allocation. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 5: Purchases and inventory Inventory consists of goods to be sold or used in the production of saleable goods. Major transactions involving inventory: increase to inventory when goods purchased and decrease to inventory when goods sold. Inventory is generally considered high risk because it: Is significant to determination of income Involves a high volume of activity Involves accounting complexities Is susceptible to manipulation. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Inventory: assertions of interest Two key assertions of inventory are generally: Existence Valuation and allocation. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Inventory: key procedures Observation of physical inventories Analytical procedures Cutoff Tests of pricing and summarisation Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for purchases Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for inventory Table 10.3 Assertions, objectives and substantive procedures for inventory (p. 473) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Inventory: observation of physical inventory — stocktake Where inventory is considered material, auditor should attend a physical inventory count (stocktake), unless impractical. When attending stocktake, auditor uses a combination of observation, inquiry and making test counts. If inventory is outside auditor’s area of expertise, he/she should consider utilising services of expert. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Inventory: tests of pricing and summarisation of count procedures The auditor uses a combination of vouching, tracing and recomputation evidence-gathering procedures. In performing these procedures the auditor’s main concerns are: Identifying obsolete, excess and slow-moving items That inventory is counted correctly and that the results of inventory count are updated correctly That prices for goods are applied appropriately That inventory is appropriately valued at the lower of the cost and net realisable value Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 6: Accounts payable and payments A primary assertion of concern is completeness, as the most likely form of misstatement is understatement. Confirmation is a common audit procedure that addresses this assertion. A search for unrecorded liabilities and analytical procedures performed on related expense account balances are also common procedures for completeness. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for purchases Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Table 10.4 (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for accounts payable Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 7: Non-current assets The balances of non-current asset accounts are usually affected by a few relatively large transactions each year. For this reason, it is usually efficient for auditors to verify account balances by performing tests on individual transactions. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Property, plant and equipment Assertions of interest are generally: Existence Rights and obligations Valuation and allocation. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Property, plant and equipment: key procedures Substantiating additions and identifying retirements Considering any revaluations Analytically testing and recomputing related expense accounts such as depreciation Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for property, plant and equipment Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Investments and intangible assets Assertions generally of interest are: Rights and obligations Existence Valuation and allocation. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures for investments Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Intangibles — use of experts Assertions in relation to existence, valuation and allocation for intangible assets are particularly subjective given the nature of intangible assets. Auditor may consider the use of experts where issues are outside of auditor’s own expertise. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Investments and intangibles: key procedures Physical examination Confirmation Inspection of legal documents Recomputation, vouching, tracing Specialised valuation procedures Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 8: Non-current liabilities and owners’ equity: key procedures Key assertion: Completeness Key procedures: Confirmation Reading minutes of meetings Examination of contracts and agreements Inspection of share registers. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Assertions, objectives and procedures: non-current liabilities Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 9: Income statement accounts: assertions of interest In a double-entry accounting system, testing one side of a transactions automatically tests the other side. A procedure that achieves an audit objective for one side of a transaction should achieve a comparable audit objective for the other side. For example, if the auditor verifies the existence of an accounts receivable balance, this will verify the occurrence of the related sales transactions. For this reason the extent of substantive tests of transactions is negatively related to the amount of substantive testing of balances that is undertaken. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Audit procedures for income statement accounts Substantiation indirectly by simultaneous tests of accounts, e.g. sales  accounts receivable Substantiation directly in conjunction with balance sheet accounts, e.g. plant & equipment  depreciation Substantiation directly by analytical procedures, e.g. relationships following a predictable pattern such as sales  sales commission Substantiation directly by separate tests of individually significant transactions, events or account balances, e.g. discontinued operations Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Learning objective 10: Auditing by computer: testing clients’ files The major way the auditor uses the computer for substantive tests involves using audit software to read clients’ master files and/or transactions files. Major advantages: Directs auditor’s attention to items of risk and/or materiality Undertakes routine audit tasks efficiently. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Functions of audit software This software can interrogate clients’ files in order to: Select sample items Identify records meeting specified criteria (exception reporting) Test and make calculations Compare data in separate fields or on separate files Summarise data Write reports. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett

Auditing by computer: four major techniques Generalised audit software: audit interrogation software used with many clients Specialised audit software: audit interrogation software especially written for client, task or industry Utility programs: software or hardware designed to accomplish common routine tasks e.g. sort, merge Systems management programs: enhanced productivity tools (e.g. data retrieval software) typically part of sophisticated operating systems environments. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 3r by Grant Gay and Roger Simnett Slides prepared by Roger Simnett