Chapter 9Substantive Procedures and the

Financial Statement Audit

Prepared by Richard J. Campbell

Copyright 2011, Wiley and Sons

Learning Objectives1. Recognize the audit associations of

transaction cycles, account balances, management assertions, and audit steps.

2. Understand the reasons an audit opinion is limited to reasonable assurance.

3. Learn to draw conclusions from the results of audit tests of account balances.

4. Understand the audit documentation appropriate for substantive tests and procedures.

Chapter 9 -1

Learning Objectives5. Become familiar with specific topics that

are particularly important to financial statement audits, for example, estimation processes, going-concern considerations, and period-end cutoff.

6. Learn the substantive tests and procedures that are important for the various financial statement accounts.

Chapter 9 -2

TRANSACTION CYCLES AND ACCOUNT BALANCES

Learning Objective #1Chapter 9 -3

Transaction cycles can be defined differently for different businesses and industries, but generally most businesses have a cycle dealing with• Sales or sources of revenue and cash receipts• Purchases or acquisitions and cash disbursements• Human resources• Production or inventory, which, when necessary includes cost accounting• Activities that are financing related, such as investment, debt, and equity transactions

Substantive Procedures on Accounts and Disclosures

Chapter 9 -4 Learning Objective #1

EXHIBIT 9-1

MATERIALITY AND REASONABLE ASSURANCE

Chapter 9 -5 Learning Objective #2

Sampling is used for tests of details of balances

Errors in audit tests and procedures are either nonsampling or sampling errors

Sampling error can also occur on an audit when the selected sample does not represent the population

MATERIALITY AND REASONABLE ASSURANCE

Chapter 9 -6 Learning Objective #2

Analytical Procedures, Fluctuation Analysis

Learning Objective #2Chapter 9-7

EXHIBIT 9-2

Audit Risk Model

Chapter 9 -8 Learning Objective #2

AR stands for audit riskRMM is the risk of material financial statement misstatementIR stands for inherent risk CR stands for control risk

DR stands for detection risk.TD is the risk that a material misstatement will be missed by the auditor’s tests of details of balances.

AP is the risk that a material misstatement is missed by the audit’s analytical procedures

PERFORMING SUBSTANTIVE TESTS AND PROCEDURES

Chapter 9 -9 Learning Objective #2

Auditors perform substantive tests using tests of details of balances and substantive analytical procedures

A general description of the initial steps for a test of details of balances using a sample is as follows:

1. Determine which account and assertion is being evaluated

2. Decide what audit procedure needs to be used to test the assertion

3. Decide on the sampling method.4. Decide on the sampling frame, or physical

population from which the sample is selected, and the sampling unit.

PERFORMING SUBSTANTIVE TESTS AND PROCEDURES (Part 2)

Chapter 9 -10 Learning Objective #2

5. Determine the method to select the sample, such as utilizing identifying numbers produced by a random number generator, systematic sampling with a random start, or haphazard sampling.

6. Determine the sample size needed.7. Select the sample, perform the test, and

identify discrepancies8. Evaluate the sample results.

Conclusions as a Result of Substantive Tests and Procedures:Evaluating Results

Steps to evaluate an account balance based on an audit test of a sample are summarized as follows:

1. Determine the recorded amount of the sample.2. Using evidence collected from the sample,

investigate the misstatements.3. Using the sample as a basis, estimate the “true”

account balance.4. Set a tolerable misstatement5. Evaluate whether the account balance is

materially misstated and requires an adjustment6. Consider the impact of the audit findings on

other accounts, fraud risk, and ICFR.

Learning Objective #3Chapter 9 - 11

Quantitative Evaluation of Sample Results

Learning Objective #3Chapter 9-12

EXHIBIT 9-3

Quantitative Evaluation of Fishtrackers’ Inn Outcome

Learning Objective #3Chapter 9-13

EXHIBIT 9-4

Quantitative Evaluation of Fishtrackers’ Inn Outcome

Learning Objective #3Chapter 9-14

EXHIBIT 9-4

AUDIT DOCUMENTATION

Learning Objective #4Chapter 9-15

Lead schedule is the term for the audit work paper that lists and specifies the components

that make up the line item on the working trial balance.

Detailed work papers support the information on the lead schedule, providing information about the audit tests performed on each component of the trial balance line item and results of the tests.

Work Paper Examples

Learning Objective #4Chapter 9-16

EXHIBIT 9-5

Work Paper Examples

Learning Objective #4Chapter 9-17

IMPORTANT CONSIDERATIONS IN A FINANCIAL STATEMENT AUDIT

Learning Objective #5Chapter 9-18

Estimates

Fair Value Measurements and Disclosures

Learning Objective #5Chapter 9-19

Illegal Acts

Learning Objective #5Chapter 9-20

Related Party Transactions

Learning Objective #5Chapter 9-21

Going Concern

Learning Objective #5Chapter 9-22

AREAS ADDRESSED IN A FINANCIAL STATEMENT AUDIT

Learning Objective #6Chapter 9-23

Examples of AuditSteps for Cash

EXHIBIT 9-6

AREAS ADDRESSED IN A FINANCIAL STATEMENT AUDIT

Learning Objective #6Chapter 9-24

Receivables

Learning Objective #6Chapter 9-25

Receivables

Learning Objective #6Chapter 9-26

Inventory

Learning Objective #6Chapter 9-27

Inventory

Learning Objective #6Chapter 9-28

Investments, Emphasis on Marketable Securities

Learning Objective #6Chapter 9-29

EXHIBIT 9-9

Investments, Emphasis on Marketable Securities

Learning Objective #6Chapter 9-30

Current Payables

Learning Objective #6Chapter 9-31

Examples of AuditSteps for AccountsPayable

EXHIBIT 9-10

Long-Term Debt

Learning Objective #6Chapter 9-32

Examples of AuditSteps for Long-TermDebt

EXHIBIT 9-11

Long-Term Debt

Learning Objective #6Chapter 9-33

SUMMARY OF SUBSTANTIVE TESTS AND PROCEDURES

Learning Objective #6Chapter 9-34

APPENDIX A: STATISTICAL TECHNIQUES AND TESTS OF DETAILSOF BALANCES

Appendix AChapter 9-35

Characteristics andSample Size

EXHIBIT A9-1

APPENDIX A: STATISTICAL TECHNIQUES AND TESTS OF DETAILSOF BALANCES

Chapter 9-36

Confidence Coefficients

EXHIBIT A9-2

Appendix A

APPENDIX A: STATISTICAL TECHNIQUES AND TESTS OF DETAILSOF BALANCES

Learning Objective #3Chapter 9-37

Results of the Sampleand Audit Analysis

EXHIBIT A9-3

Review Question

Chapter 9-38

Which of the following audit processes will the auditor have to wait until the end of the fiscal year, or after, to perform?(a) Observing the inventory count(b) Testing the operating effectiveness of the yearend closing and reporting process(c) Inquiring of the client and identifying related parties(d) Evaluating the possibility of illegal acts

Review Question

Chapter 9-39

Regarding illegal acts, which of the followingis not true?(a) The auditor is more likely to become aware of illegal acts that have a direct impact on the financial statements.(b) The auditor does not have to follow up onmaterial illegal acts that he or she becomesaware of as long as they do not have a directeffect on the financial statements.(c) Illegal acts are one of the topics that is covered in the management representations letter.(d) All of the above are true.

Review Question

Chapter 9-40

Which of the following is not important tothe auditor regarding related party transactions?(a) Adequacy of disclosure of material related party transactions(b) Material misstatement of any of the transactions because they are not arms length(c) Identifying all the related parties so that the related party transactions and financial statement disclosure can be evaluated(d) All of these are important to auditing related party transactions.

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