10-1Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Chapter 10

Substantive Tests of Transactions and Balances

10-2Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Relationship Between Evidence Gathering Procedures

• Auditor has to obtain sufficient appropriate evidence to support the audit opinion.

• Tests of controls (chapter 9) and substantive tests of transactions and balances are the main evidence-gathering procedures.

• Auditor selects 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 to the assessment of these risks.

Learning Objective 1:

10-3Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides 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.

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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 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).

10-5Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Relationship Between Substantive Tests of Transactions and Balances

• Objective of substantive tests is to reduce detection risk.

• 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).

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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 (test of balances) or verifying to supporting documentation the three transactions comprising this balance (tests of transactions).

Extract from Accounts Receivable Subsidiary Ledger Customer Year-end Balance Transactions for Able Able 5000 Sales 2000 Receipts (1000) Sales 4000 Baker 500 Chan 1000

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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.

Learning Objective 2:

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Assertions about Transactions and Events (Income Statement Accounts)

• 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.

• 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.

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Assertions about Account Balances at Period End (Balance Sheet Accounts)

• 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.

• 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.

10-10Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Existence/Occurrence and Completeness Assertions

Note that the direction of testing determines whether existence/occurrence or completeness assertion is tested.

SourceDocuments

existence (of account balance components)/occurrence (of transactions in accounting records)

AccountingRecords

Completeness (of accounts balance components ortransactions in accounting records)

10-11Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Cash, Cash Receipts and Cash Payments: Assertions of Interest

Cash Cash receipts/payments

• Existence;• Completeness; and possibly• Valuation and allocation (if

foreign currency balances).

• Occurrence• Completeness; and possibly• Accuracy (if foreign currency

transactions).

These are primarily:

- since these are areas where misstatements are most likely to occur.

Learning Objective 3:

10-12Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides 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.

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Assertions, Objectives and Procedures for Cash Receipts and Payments

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Assertions, Objectives and Procedures for Cash

Table 10.1 Assertions about account balances (cash)

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Cash – Key Procedures

• These are:– Obtaining confirmation of bank balances from client’s

bankers.– Testing of client’s bank reconciliation.

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Sales, Cash Receipts and Accounts Receivable

Assertions of interest- as these are areas in which misstatements are most

likely to occur

Sales/cash receipts Accounts receivable

• Occurrence• Accuracy

• Existence• Valuation and allocation

Learning Objective 4:

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Accounts Receivable: Key Audit Procedures

• Confirmation• Subsequent receipts review• Cutoff• Analytical procedures• Tests of sales transactions• Review of aged trial balance

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Assertions, Objectives and Procedures for Sales

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Assetions, Objectives and Procedures for Accounts Receivable

Table 10.2 Assertions, objectives and substantive procedures for accounts receivable (p. 465)

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Accounts ReceivableConfirmation 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.

– 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.

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Format of Positive Accounts Receivable Confirmation Requests

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Confirmation Procedure Versus Subsequent Cash Receipts Testing

Subsequent cash receipts testing is commonly viewed as a superior form of evidence to confirmation procedures because it achieves both key assertions.

Confirmation Subsequent cash receipts testing

• Existence YES• Valuation and NO

allocation

• Existence YES• Valuation and YES

allocation

Confirmation still requires tests of likelihood of payment (doubtful debts provision), which is part of valuation and allocation.

10-23Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

Learning Objective 5:

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Risk Assessment of Inventory

• Inventory is generally considered high risk because:– it is significant to determination of income;– it involves a high volume of activity;– it involves accounting complexities;– it is susceptible to manipulation.

10-25Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Inventory: Assertions of Interest

• Two key assertions of inventory are generally:– existence– valuation and allocation.

10-26Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Inventory: Key Procedures

• Observation of physical inventories;• Analytical procedures;• Cutoff;• Tests of pricing and summarisation.

10-27Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Assertions, Objectives and Procedures for Purchases

10-28Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Assertions, Objectives and Procedures for Inventory

Table 10.3 Assertions, objectives and substantive procedures for inventory (p. 473)

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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.

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Inventory: Tests of Pricing and Summarisation of Count Procedures

• A combination of vouching, tracing and recomputation. In performing these procedures 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;

10-31Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

Learning Objective 6:

10-32Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Assertions, Objectives and Procedures for Purchases

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Assertions, Objectives and Procedures for Accounts Payable

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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.

Learning Objective 7:

10-35Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Property, Plant and Equipment

• Assertions of interest are generally:– existence– rights and obligations– valuation and allocation.

10-36Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides 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.

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Assertions, Objectives and Procedures for Property, Plant and Equipment

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Investments and Intangible Assets

• Assertions generally of interest are:– Rights and obligations– Existence– Valuation and allocation.

10-39Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Assertions, Objectives and Procedures for Investments

10-40Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides 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.

10-41Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Investments and Intangibles: Key Procedures

• Physical examination• Confirmation• Inspection of legal documents• Recomputation, vouching, tracing• Specialised valuation procedures.

10-42Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Non-Current Liabilities and Owners’ Equity: Key Procedures

• Key assertion:– completeness

• Key procedures:– confirmations– reading minutes of meetings– examination of contracts and agreements– inspection of share registers.

Learning Objective 8:

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Assertions, Objectives and Procedures: Non-Current Liabilities

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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.

Learning Objective 9:

10-45Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides 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

10-46Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

Learning Objective 10:

10-47Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides 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.

10-48Copyright 2006 McGraw-Hill Australia Pty Ltd Revised PPTs t/a Auditing and Assurance Services in Australia 3e by Grant Gay and Roger SimnettSlides 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.