1. MODERN AUDITING 7th Edition
William C. Boynton
California Polytechnic State University at San Luis Obispo
Raymond N. Johnson
Portland State University
Walter G. Kell
University of Michigan
Developed by:
Dr. Raymond N. Johnson, CPA
Gregory K. Lowry, MBA, CPA
John Wiley & Sons, Inc.

2. CHAPTER 11 DETECTION RISK AND THE DESIGN OF SUBSTANTIVE TESTS
Determining Detection Risk
Designing Substantive Tests
Developing Audit Programs for Substantive Tests
Special Consideration in Designing Substantive Tests

3. Determining Detection Risk
Planned detection risk is determined based on the relationships expressed in the following model:
DR = AR ÷ (IR x CR) or
TD = AR ÷ (IR x CR x AP)

4. Evaluating the Planned Level of Substantive Tests
When evaluating the planned level of substantive tests for each significant financial statement assertion, the auditor will consider the evidence obtained from:
1. The assessment of inherent risk.
2. Procedures to understand the business and industry and related analytical procedures that have been completed.
3. Tests of controls including:
a. Evidence about the effectiveness of internal controls gained while obtaining an understanding of internal controls.
b. Evidence about the effectiveness of internal controls supporting a lower assessed level of control risk.

5. Preliminary Audit Strategy, Planned Detection Risk, and Planned Emphasis on Audit Tests Figure 11-1

6. Designing 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, and usually more costly, procedures.
When the acceptable level of detection risk is high, less effective and less costly procedures can be used.

7. Nature of Substantive Tests
Analytical procedures
AU , Analytical Procedures (SAS 56), indicates that the expected effectiveness and efficiency of analytical procedures depends on the:
Nature of the assertion
Plausibility and predictability of the relationship
Availability and reliability of the data used to develop the expectation
Precision of the expectation

8. Analytical Procedures
Analytical procedures are an important way to
quantify the auditor’s understanding of the business
and industry and an entity’s business risks.
Reported
Financial
Performance
Underlying Business Activity

9. Nature of Substantive Tests
Tests of details of transactions primarily involve tracing and vouching in direct tests of transactions.
Tests of details of balances focus on obtaining evidence directly about an account balance rather than the individual debits and credits comprising the balance.

10. Nature of Substantive Tests
Tests of accounting estimates usually involve testing balances, but usually require unique evidence.
AU , Auditing Accounting Estimates (SAS 57), states that the auditor’s objective in evaluating accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that:
1. All accounting estimates that could be material to the financial statements have been developed.
2. The accounting estimates are reasonable in the circumstances.
3. The accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed.

11. Timing of Substantive Tests
The acceptable level of detection risk may affect the timing of substantive tests.
1. If detection risk is high, the tests may be performed several months before the end of the year.
2. When detection risk for an assertion is low, the substantive tests will normally be performed at or near the balance sheet date.

12. Timing of Substantive Tests
The decision to perform substantive tests prior to balance sheet date should be based on whether the auditor can
Control the added risk that material misstatements existing in the account balance sheet date will not be detected by the auditor.
This risk becomes greater as the time period between audit tests and balance sheet date increases.
Reduce the cost of performing substantive tests necessary at balance sheet date.

13. Timing of Substantive Tests
AU 313, Substantive Tests Prior to Balance Sheet Date
Internal control during the remaining period is 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 clients accounting system will provide information concerning unusual transactions and significant fluctuations that may occur during the remaining period.

14. Extent of Substantive Tests
More evidence is needed to achieve a low acceptable level of detection risk than a high detection risk.
Extent is used in practice to mean the number of items or sample size to which a particular test or procedure is applied.

15. Staffing Substantive Tests
The auditor may respond to the risk of material misstatement by the assignment of personnel.
A task such as auditing an accounting estimate (e.g., inventory obsolescence) may require a greater level of industry expertise and experience than performing a test of balances (e.g., observing inventory).

16. Relationships among Audit Risk Components and the Nature, Timing, and Extent of Substantive Tests Figure 11-2

17. Using Information Technology to Support Substantive Tests
One common type of audit software in use today is known as generalized audit software. Such software is adaptable for use by auditors for clients’ computer files produced under a variety of data organization and processing methods.
Selecting and printing audit samples
Testing calculations and making computations
Summarizing data and performing analyses
Comparing audit data with computer records
Screening 100% of a population

18. Illustration of Assertions, Specific Audit Objectives, and Substantive Tests Figure 11-3

19. Illustration of Assertions, Specific Audit Objectives, and Substantive Tests Figure 11-3

20. Developing Audit Programs 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 ). An audit program is a list of audit procedures to be performed.
In addition to listing audit procedures, each audit program should have columns for:
1. A cross-reference to other working papers containing the evidence obtained from each procedure (when applicable),
2. the initials of the auditor who performed each procedure, and
3. the date the performance of the procedure was completed.

21. Developing Audit Programs for Substantive Tests
Audit programs should be sufficiently detailed to provide:
1. An outline of the work to be done
2. A basis for coordinating, supervising, and controlling the audit
3. A record of the work performed

22. Developing Audit Programs for Substantive Tests
We can construct a general framework for developing audit programs for substantive tests. Such an approach is described in Figure 11-5.
The steps listed in the upper portion of Figure 11-5 summarize the application of several important concepts and procedures explained in Chapters 5 through 10.

23. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
Complete Audit Planning
1. Identify the financial statement assertions to be covered by the audit program.
2. Develop specific audit objectives for each category of assertions.
3. Obtain an understanding of the client’s business and industry including such items as the client’s business cycle, management’s goals and objectives, organizational resources, the entity’s products, services market, customers, competition, the entity’s core processes and operating cycle, and the entity’s investing and financing decisions.
4. Assess inherent risk for the assertion.

24. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
5. Assess control risk for the assertion based on:
 Evidence of the effectiveness of controls gained while obtaining an understanding of internal controls.
 Evidence of the effectiveness of management controls or other manual controls over computer output.
 Evidence of the effectiveness of computer control procedures including manual follow-up.
6. Determine the final level of detection risk for each assertion consistent with the overall level of audit risk and applicable materiality level.

25. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
7. From knowledge acquired from procedures to obtain an understanding of relevant internal controls, envision the accounting records, supporting documents, accounting processes (including the audit trail), and financial reporting process pertaining to the assertions.
8. Consider options regarding the design of substantive tests:
 Alternatives for accommodating varying acceptable levels of detection risk:
 Nature — Analytical procedures, Tests of details of transactions, tests of details of balances, Tests of accounting estimates
 Timing — Interim versus year-end

26. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
 Extent — Sample size
 Staffing — Skill and experience of audit staff
 Consider how generalized audit software might make the audit more effective or more efficient.
 Possible types of corroborating evidence available:
Analytical, Electronic, Mathematical, Written Representation, Documentary, Confirmations, Physical, and Oral
 Possible types of audit procedures available:
Analytical procedures, Inquiring, Vouching, Computer-assisted audit techniques, Inspecting, Counting, Observing, Confirming, Tracing, Reperforming

27. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
Specify Substantive Tests to Be Included in Audit Program
1. Obtain an understanding of the business and industry and determine:
a. The significance of the transaction class and account balance to the entity.
b. Key economic drivers that influence the transaction class and account balance that are relevant to evaluating issues of existence, completeness, valuation and allocation, rights and obligations, and presentation and disclosure.

28. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
2. Specify initial procedures to:
a. Trace beginning balance to prior year’s working papers (if applicable).
b. Review activity in applicable general ledger accounts and investigate unusual items.
c. 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 a tie-in of detail with control accounts.
3. Specify analytical procedures to be performed.
4. Specify tests of detail of transactions to be performed.
5. Specify tests of detail of balances to be performed.

29. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
6. Specify tests of detail 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 SASs 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.

30. Developing Audit Programs for Substantive Tests
In an initial engagement, the detailed specification of substantive tests in audit programs is generally not completed until after the auditor:
Obtains an understanding of the business and the industry it operates in.
The study and evaluation of internal control has been completed, and
The acceptable level of detection risk has been determined for each significant assertion.

31. Developing Audit Programs for Substantive Tests
2 matters requiring special consideration in designing audit programs for initial audits are:
Determining the propriety of the account balances at the beginning of the period being audited, and
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.

32. Developing Audit Programs for Substantive Tests
In a recurring engagement, the auditor has access to audit programs used in the preceding period(s) and the working papers pertaining to those programs.
In such cases, 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 will be appropriate for the current period.

33. Special Considerations in Designing Substantive Tests

34. Special Considerations in Designing Substantive Tests
Analytical procedures can be a powerful audit tool in obtaining audit evidence about income statement balances.

35. Special Considerations in Designing Substantive Tests
When the evidence obtained from analytical procedures and from tests of details of related balance sheet accounts do not reduce detection risk to an acceptably low level, direct tests of details of assertions pertaining to income statement accounts are necessary. This may be the case when:
1. Inherent risk is high. This may occur in the case of assertions affected by nonroutine transactions and management’s judgments and estimates.
2. Control risk is high. This situation may occur when (1) related internal controls for nonroutine and routine transactions are ineffective or (2) the auditor elects not to test internal controls.

36. Special Considerations in Designing Substantive Tests
3. Analytical procedures reveal unusual relationships and unexpected fluctuations. These circumstances are explained in a preceding section.
4. 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.
Accounts requiring separate analysis generally include:

37. Special Considerations in Designing Substantive Tests
The auditor should identify related party transactions in audit planning.
These types of transactions are a concern to the auditor because they may not be executed on an arm’s-length basis.
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. The evidence should extend beyond inquiry of management.

38. Special Considerations in Designing Substantive Tests
AU , Related Parties, indicates that substantive tests should include the following:
1. Obtain an understanding of the business purpose of the transaction.
2. Examine invoices, executed copies of agreements, contracts, and other pertinent documents, such as receiving reports and shipping documents.
3. Determine whether the transactions has been approved by the board of directors or other appropriate officials.
4. Test for reasonableness the compilation of amounts to be disclosed, or considered for disclosure, in the financial statements.

39. Special Considerations in Designing Substantive Tests
5. 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.
6. Inspect or confirm and obtain satisfaction concerning the transferability and value of collateral.

40. Summary of Audit Tests Figure 11-6

41. Summary of Audit Tests Figure 11-6

42. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
Specify Substantive Tests to Be Included in Audit Program
1. Obtain an understanding of the business and industry and determine:
a. The significance of the transaction class and account balance to the entity.
b. Key economic drivers that influence the transaction class and account balance that are relevant to evaluating issues of existence, completeness, valuation and allocation, rights and obligations, and presentation and disclosure.

43. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
2. Specify initial procedures to:
a. Trace beginning balance to prior year’s working papers (if applicable).
b. Review activity in applicable general ledger accounts and investigate unusual items.
c. 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 a tie-in of detail with control accounts.
3. Specify analytical procedures to be performed.
4. Specify tests of detail of transactions to be performed.
5. Specify tests of detail of balances to be performed.

44. General Framework for Developing Audit Programs for Substantive Tests Figure 11-5
6. Specify tests of detail 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 SASs 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.

45. CHAPTER 11 DETECTION RISK AND THE DESIGN OF SUBSTANTIVE TESTS

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