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CHAPTER 12

AUDIT PROCEDURES IN RESPONSE TO
ASSESSED RISKS: SUBSTANTIVE TESTS
Learning Check
12-1. The three steps involved in assessing the risk of material misstatement are:
1. Evaluate the type of potential misstatement(s) that may occur, such as evaluating
whether a risk is a financial statement level risk or an assertion level risk.
2. Evaluate the magnitude of the potential misstatement(s). For example, the auditor is
attempting to determine if the magnitude could of misstatement could aggregate to a
material amount.
3. Evaluate the likelihood of potential misstatement(s). This is a matter of determining
whether the probability of misstatement is very probable or the probability of
misstatement is remote.
12-2. If there is a significant risk of material misstatement due to financial statement level risks
the auditor will increase the level of substantive testing for many assertions. For
example, if management communicates the message that it is critical that the company
meet its financial targets, the auditor might increase the level of substantive testing for
revenue recognition, the completeness and classification of expenditures, as well as for
many accounting estimates in the financial statements. If the risk of material
misstatement is limited to one assertion, such a poor controls over the collection of
receivables, the auditor will increase the level of substantive testing specifically related to
the valuation and allocation assertion for receivables.
12-3. Following are examples of risks of material misstatement that might be found while
performing various risk assessment procedures.
Risk Assessment Procedure
a. Understanding the entity and its
environment
b. Performing analytical procedures

Risk of Material Misstatement
a. A company’s most significant product is at
a mature stage and sales are beginning to
decline. This may affect the net realizable
value of inventory.
b. A company may report flat sales,
increasing levels of inventory, and
increasing gross profit margins. This may
indicate a problem with the existence and
occurrence of inventory.

c. Understanding the risk of fraud

d. Understanding inherent risks

e. Understanding the entity’s system
of internal control

12.4.

c. A company may be very close to not
meeting its debt covenants. This might
increase the risk that company might
engage in fraudulent financial reporting to
report that it in fact met debt covenants.
d. The calculations associated with the
valuation of a large retail inventory using
the retail method represents a significant
inherent risk that is focused on the
valuation assertion for inventory.
e. A owner-managed company might allow
the bookkeeper to write and sign check
with little supervision or review by the
owner. This would increase the risk for
the existence and occurrence assertion for
expenditures.

The following bullets summarize each preliminary audit strategy, the appropriate level of
planned detection risk, the planned audit procedures that provide significant assurance,
and whether a higher or a lower level of assurance is needed from substantive tests.
 A Primarily Substantive Approach requires a low planned level of detection risk for
tests of details, audit assurance is needed primarily from tests of details of transaction
or tests of details of balances, and the level of assurance needed from substantive tests
is high.
 A Lower Assessed Level of Control Risk Approach usually results in a high planned
level of tests of details risk due to the fact that significant assurance is obtained from
tests of controls. As a result, the level of assurance that is needed from substantive
tests is low.
 Emphasis on Inherent Risk and Analytical Procedures represents an audit strategy
associated with assertions where inherent risk is assessed below the maximum and the
planned tests of details risk is moderate or high. Evidence is needed from risk
assessment procedures to support an inherent risk assessment below the maximum
and substantive tests are performed using analytical procedures. The planned level of
assurance from substantive test of details is often moderate, as the auditor obtains
assurance from analytical procedures and the auditor’s knowledge of the business and
industry.

12-5. A revised or final acceptable level of detection risk is determined for each assertion after
(1) assessing inherent risk, (2) performing analytical procedures in audit planning, (3)
assessing the risk of fraud for an assertion, and (4) making a final assessment of control
risk for relevant controls. A risk matrix or the audit risk model can be used to solve for
the revised acceptable level of detection risk associated with analytical procedures and
tests of details based on the actual assessed levels of inherent and control risk and the
auditor's specification of audit risk.

12-6. The following table compares and contrasts tests of controls and substantive tests.
Tests of Controls
Tests of the control environment
Tests of the client’s risk assessment system
Tests of the information and communication
system
Tests of control activities
Tests of the monitoring system
Tests of antifraud programs and controls

a.

Types

b.

Purpose

c.

Nature of test
measurement
Applicable audit
procedures

d.

Determine effectiveness of design and operation
of internal controls
Frequency of deviations from designed controls
Inquiring, observing, inspecting, reperforming,
and computer assisted audit techniques.

e.

Timing

Primarily interim work1

f.
g.

Audit risk component
Primary fieldwork
standard
Required by GAAS

Control Risk
Second.

h.

Substantive Tests
Initial procedures
Analytical procedures
Tests of details of transactions
Tests of details of balances
Tests of details of accounting
estimates
Substantive tests required by GAAS
Tests of details of disclosures
Determine fairness of significant
financial statement assertions.
Monetary errors in transactions and
balances.
Same as tests of controls, plus
analytical procedures, counting,
confirming, tracing, and vouching.
At balance sheet date or one or two
months prior to year-end.2
Detection Risk
Third

When audit risk cannot be reduced to a
Yes
sufficiently low level by substantive tests alone.
Concurrent tests of controls are performed in audit planning with procedures to obtain an understanding of the system
of internal control. Additional tests of controls are performed during interim fieldwork.
2
Tests of details of transactions may also be performed with test of controls as dual-purpose tests during fieldwork.

12-7. a.

b.

The purpose of substantive tests is to provide evidence about the fairness of each
significant financial statement assertion, or conversely, to reveal monetary errors
or misstatements in the recording or reporting of transactions and balances.
As detection risk increases substantive tests should be more effective and auditors
should seek more reliable evidence related to the assertion.

12-8. There are several types of initial procedures that are performed before proceeding to
other substantive tests. First, it is important for the auditor to have an understanding of
the economic substance of the transactions that are subject to audit. Second, it is
important to trace beginning balances in the general ledger to the audited balances in the
prior year’s financial statements.
Two initial procedures that require special consideration in a first time audit are (1)
determining the propriety of the account balances at the beginning of the period being
audited, and (2) ascertaining whether the accounting principles used in the preceding
period are the same as those used in the current period as a basis for determining the
consistency of application of principles. This is normally accomplished by reference to
the working papers of a predecessor auditor. In a continuing engagement this can be
accomplished by reference to the prior year’s working papers.
1
2

12-9. a.

b.

The primary advantage of analytical procedures is that they are very cost effective
and they are also reasonably effective at identifying accounts that may contain
unintentional misstatements. The primary disadvantage is that analytical
procedures are usually considered less effective than tests of details. They are
also less effective at identifying accounts that are intentionally misstated as the
balances have usually been misstated to appear reasonable.
The auditor should consider the following matters when designing substantive
analytical procedures:

The suitability of the substantive analytical procedure given the assertion.

The reliability of the data, whether internal or external, from which the
expectation of recorded amounts or ratios is developed.

Whether the expectation is sufficiently precise to identify a material
misstatement at the desired level of assurance.

The amount of any difference of recorded amounts from expected values
that is acceptable.
In some cases where substantive analytical procedures are effective, they may
also add to the efficiency of the audit. For example, for public utilities and cable
companies, relatively small amounts of revenue are billed to and collected from
many thousands of customers each month. Tests of details of these high-volume,
low-value revenue transactions would be very tedious and costly. On the other
hand, revenues in such cases can often be estimated with a fair degree of precision
using independent variables such as number of subscribers, billing rates for
various types of services, temperature data (for electric and gas utilities), and so
on. Alternatively, total sales commissions expense could normally be estimated
from total sales revenues rather than examining the details of entries to sales
commissions.

c.

In some cases the auditor can obtain good nonfinancial information about the
underlying drivers of revenues and expenses and use that information to estimate
revenues or expenses. The following table provides several examples.
Account
Hotel room revenue
Tuition revenue
Wages expense
Gasoline expense
Commission Expense

Analytical Procedure
Number of rooms x Occupancy rate x Average
room rate.
Number of equivalent fulltime students x Tuition
rate for a fulltime student
Average number of employees per pay period x
Average pay per period x Number of pay
periods.
Number of miles driven ÷ Average miles per
gallon x Average per gallon cost.
Sales x Commission Rate

Income statement accounts may be tied directly to an underlying economic driver
(cost driver). Balance sheet accounts are subject to transactions that cause both
increases and decreases and may be less predictable. Hence, analytical
procedures may provide more assurance about the fair presentation of income
statement accounts.
12-10. a.

Tests of details of transactions primarily involve tracing and vouching to test for
understatements and overstatements, respectively. Other procedures may also be
used such as inquiring and reperforming calculations.

b.

Tests of details of transactions are typically more time consuming and thus more
costly to perform than analytical procedures, but less costly than tests of details of
balances. Their cost-efficiency is enhanced when performed concurrent with tests
of controls as dual-purpose tests.

c.

Tests of details may be applied directly to income statement accounts when
evidence obtained from tests of related balance sheet accounts does not reduce
detection risk to an acceptably low level. This may include situations in which:
 Inherent risk is high, such as when (1) nonroutine transactions or (2)
management’s judgments and estimates affect assertions.
 Control risk is high either because (1) related internal controls for nonroutine
and routine transactions are ineffective, or (2) the auditor elects not to test the
internal controls.
 Analytical procedures reveal unusual relationships and unexpected
fluctuations.
 An account requires analysis because it (1) requires special disclosures in the
income statement, (2) contains information needed in preparing tax returns or
reports for regulatory agencies such as the SEC, or (3) has a general account
title that suggests the likelihood of misclassifications and errors.

12-11. a.

Tests of details of balances focus on obtaining evidence directly about an account
balance (e.g., accounts receivable) rather than the individual debits and credits
comprising the balance. Testing the individual debits and credits is a test of
transactions.

b.

12-12. a.

Tests of details of balances often involve the use of external documentation and/or
the direct personal knowledge of the auditor. Therefore, they can be very
effective. They also tend to be the most costly to perform.
Tests of accounting estimates involve understanding the entity’s process of
estimating future outcomes (e.g., the receivables that will not be collected in the
future or the costs of providing warranty coverage in the future) of past
transactions. This requires significant knowledge of the business, industry, and
economy.

b.

12-13. a.

When evaluating the reasonableness of an accounting estimate the auditor should
determine that
 All accounting estimates that could be material to the financial statements
have been developed.
 The accounting estimates are reasonable in the circumstances.
 The accounting estimates are presented in conformity with applicable
accounting principles and are properly disclosed.
As detection risk for test of details decreases, the auditor should perform
substantive tests of balances closer to, or at, year-end.

b.

The decision whether to perform substantive tests prior to the balance sheet date
should be based on whether the auditor can:
 Control the added audit risk that material misstatements existing in the
account at the balance sheet date will not be detected by the auditor. This risk
becomes greater as the time period remaining between the date of the interim
tests and the balance sheet date is lengthened.
 Reduce the cost of substantive tests necessary at the balance sheet date to
meet planned audit objectives so that testing prior to the balance sheet date
will be cost effective.

c.

The potential added audit risk can be controlled if substantive tests for the
remaining period can provide a reasonable basis for extending the audit
conclusions from the tests performed at the interim date to the balance sheet date.
Conditions contributing to the control of this risk are:
 The internal controls during the remaining period are 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 client's accounting system will provide information concerning
significant unusual transactions and significant fluctuations that may occur in
the remaining period.

12-14. As a general rule, detection risk and the extent of substantive test are inversely related;
i.e., the lower the acceptable level of detection risk, the more extensive the substantive
tests should be. Note however, that the auditor has choices between substantive tests
involving analytical procedures and substantive tests involving tests of details.
12-15. Traditionally, account balance assertions focus on the balance sheet and transaction
assertions focus on the income statement and statement of cash flows. However, when
performing tests of account balance assertions the auditor often learns about the fair
presentation of transactions. For example, if the auditor learns that inventory is
overstated, it usually implies that cost of sales is understated. If accounts receivable is
overstated, sales might also be overstated.

12-16. a.

b.

12-17. a.

The auditor's objectives in auditing related party transactions are to obtain
evidential matter as to (1) the purpose, nature, and extent of these transactions and
(2) their effect on the financial statements.
Substantive tests that may be used in auditing related party transactions include
the following:
 Obtain an understanding of the business purpose of the transaction.
 Examine invoices, executed copies of agreements, contracts, and other
pertinent documents, such as receiving reports and shipping documents.
 Determine whether the transaction has been approved by the board of
directors or other appropriate officials.
 Test for reasonableness the compilation of amounts to be disclosed, or
considered for disclosure, in the financial statements.
 Arrange for the audits of inter-company 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.
 Inspect or confirm, and obtain satisfaction concerning, the transferability and
value of collateral.
An audit program is a list of audit procedures to be performed.

b.

The general framework for developing an audit program must accomplish two
tasks.
1) It should describe the nature of procedures to be performed.
2) It should ensure that audit evidence is obtained for all financial statement
assertions (audit objectives).

c.

Audit programs should be sufficiently detailed to provide:
 An outline of the work to be done.
 A basis for coordinating, supervising, and controlling the audit.
 A record of the work performed.
In addition to listing audit procedures, each audit program should have columns
for (1) cross-references to other working papers containing the evidence obtained
from each procedure (when applicable), (2) the initials of the auditor(s) who
performed each procedure, and (3) the date performance of the procedure was
completed.

12-18. a.

Six types of substantive audit procedures that are normally included in an audit
program are:
1) Initial procedures.
2) Substantive analytical procedures.
3) Tests of details of transactions.

4) Tests of details of balances.
5) Tests of detail of accounting estimates.
6) Tests of details of disclosures.
b.

Audit programs describe the nature of audit procedures to be performed. A well
designed audit program should include audit procedures to obtain sufficient,
competent evidence about each relevant financial statement assertion (or audit
objective).

Comprehensive Questions
12-19. (Estimated time - 15 minutes)
Example Risk Factor
1.

The company is in an industry that is experiencing
economic difficulty and intense price competition.
2. The company has recently changed the nature of its
product and is bundling software with other services
to customize and implement software and related
controls.
3. Analytical procedures for a manufacturer show a
significant increase in both profit margins and
inventory turn days.
4. Analytical procedures for a retailer show significant
decreases in both profit margins and inventory turn
days.
5. Senior management has sent a very strong message,
and offered increased incentives, to middle
managers to meet financial targets.
6. An employee in a small to medium sized business
responsible for cash disbursements did not receive
an expected promotion and pay increase.
7. A construction industry client uses the percentage of
completion method to recognize revenue and
expense on current projects.
8. A company is experiencing working capital and
going-concern problems.
9. The client has a strong control environment and
good controls over the existence of inventory.
10. The client has weak computer general controls
including poor controls over the approval of system
changes.

Audit Strategy
1. Primarily Substantive Approach
2. Primarily Substantive Approach

3. Primarily Substantive Approach
4. Primarily Substantive Approach
5. Primarily Substantive Approach
6. Primarily Substantive Approach
7. Primarily Substantive Approach
8. Primarily Substantive Approach
9. A Lower Assessed Level of Control Risk
Approach
10. Primarily Substantive Approach

12-20. (Estimated Time – 30 minutes)
Example Risk Factor
1.
2.
3.

4.

5.
6.

The client has a strong control
environment and good controls over the
existence of inventory.
The client is in an industry that has both
significant regulatory oversight and
complex regulations.
The client has recently experienced
turnover in its information technology
group resulting in decreased segregation
of duties and a deterioration of computer
general controls.
The client is a private university with
primarily full time students, a small
amount of receivables at year-end, and
good internal controls over revenues.
A company’s business plans are
dependent on the success of entering new
foreign markets with existing products.
The client has used significant borrowing
to fund expansion in a competitive
industry and has a narrow tolerance range
regarding debt covenants.

7.

Analytical procedures for a manufacturer
show significant increases in both profit
margins and inventory turn days.
8. Inventory items are small in size and high
in value.
9. The telecommunications client is in a
capital intensive industry and fixed assets
additions involve complex accounting
issues.
10. The audit team has experience several
attempts by management to justify
marginal or inappropriate accounting on
the basis of immateriality.
11. Analytical procedures for a manufacturer
show significant increases in both revenue
growth and accounts receivable turn days.

Type of Potential
Misstatement
Controls are relevant to the
existence of inventory

A lower assessed level of
control risk approach

Misstatements may occur in
many assertions or accounts

A primarily substantive
approach.

Misstatements may occur in
many assertions or accounts

A primarily substantive
approach.

Issues relate primarily to the
occurrence of revenues and
the existence of receivables.

Predictability of
transactions may allow for a
response to lower inherent
risk and analytical
procedures.
A primarily substantive
approach.

Issues relate primarily to the
occurrence of revenues and
the existence of receivables.
Issues relate both to the
disclosure assertion for longterm debt and to other
assertions affected by debt
covenants.
The existence of inventory.
The existence of inventory.

Audit Strategy

A primarily substantive
approach.

A primarily substantive
approach.

Valuation and allocation for
fixed assets.

A primarily substantive
approach.
A primarily substantive
approach.

Issues may have a pervasive
impact on multiple assertions

A primarily substantive
approach.

Revenue recognition or the
net realizable value of
receivables.

A primarily substantive
approach.

12-21 (Estimated Time: 15 minutes)
a.

If the final assessed levels of control risk for the specified assertions are the same
as the planned assessed levels, the auditor may proceed to design specific
substantive tests based on the planned level of substantive tests of details
specified as the fourth component of the audit risk model for each of the specified

assertions. Otherwise, the level of substantive tests must be revised before
designing specific substantive tests for each assertion in order to accommodate a
revised acceptable level of detection risk that correlates with the final assessed
level of control risk.
b.

Determining a revised acceptable level of detection risk for an assertion can be
accomplished by using the final assessed level of control risk in either a risk
matrix or the audit risk model and re-solving for detection risk. Usually this is
done by considering both analytical procedures risk and test of details risk.

c.

No. When evidence obtained from one substantive test or group of tests reduces
the risk of a material misstatement remaining undetected in an assertion, it may be
appropriate to use a higher acceptable level of detection risk for any additional
substantive tests performed to gather evidence for that assertion.

12-22. (Estimated time - 15 minutes)
a.

Substantive tests provide evidence about the fairness of each significant financial
statement assertion. They are the primary means of obtaining sufficient competent
evidential matter to establish a reasonable basis for the auditor's opinion on the
client's financial statements.

b.

The factors pertaining to substantive tests that can be varied to accommodate
different acceptable levels of detection risk are (1) nature, (2) timing, (3) extent
and (4) staffing. When a low versus a high acceptable level of detection risk must
be achieved:
 The nature of the tests selected should be more effective rather than less
effective.
 The timing of the tests will more often be at year-end rather than at an interim
date.
 The extent of the tests (e.g., sample size) will be greater.
 Staffing selected will be more experienced rather than less experienced.

c.

The four types of substantive tests and brief explanations of each are:
 Analytical procedures which consist of evaluations of financial information
made by a study of plausible relationships among both financial and
nonfinancial data. Such procedures range from simple comparisons to the use
of complex mathematical and statistical models involving many relationships
and data elements.
 Tests of details of transactions which primarily involve tracing and vouching
using documents available in the client's files. In these tests, the auditor uses
evidence obtained about the individual debits and credits in an account to
reach a conclusion about the account balance.
 Tests of details of balances which often involve the use of external
documentation and/or the direct personal knowledge of the auditor. These

procedures focus on obtaining evidence directly about an account balance
rather than the individual debits and credits comprising the balance.
Tests of accounting estimates designed to obtain sufficient competent
evidential matter to provide reasonable assurance that:
 All accounting estimates that could be material to the financial statements
have been developed.
 The accounting estimates are reasonable in the circumstances.
 The accounting estimates are presented in conformity with applicable
accounting principles and are properly disclosed.

The effectiveness of analytical procedures depends on (1) the nature of the
assertion, (2) the plausibility and predictability of the relationship, (3) the
availability and reliability of the data used to develop the expectation, and (4) the
precision of the expectation. The effectiveness of tests of details of transactions
depends on the particular procedure and documents used. When these tests
involve the use of internally generated documents that have not been circulated
externally, they may be less effective than tests involving the use of externally
generated documents or internally generated documents that have been circulated
externally. The effectiveness of tests of details of balances is usually high because
they typically involve (1) the use of external documentation received directly by
the auditor or (2) the direct personal knowledge of the auditor. The effectiveness
of tests of accounting estimates depend on the auditor’s knowledge of (1) the
underlying drivers that influence the accounting estimate and (2) the business,
industry and economy.
Analytical procedures are generally the least costly tests to perform. Tests of
details of transactions are typically more time consuming and thus more costly
than analytical procedures. The cost-efficiency of tests of details of transactions is
enhanced when performed concurrent with tests of controls as dual-purpose tests.
Tests of details of balances tend to be the most costly to perform because of their
focus on external documentation or the auditor's direct personal knowledge.
Tests of accounting estimates requires significant professional judgment and may
be more costly due to the need for more experience staff to perform audit
procedures.
12-23. (Estimated Time – 20 minutes)
a.

An audit program is a list of auditing procedures to be performed. Each program
should have columns for the initials of the individuals who performed each
procedure, the dates the procedures were completed, and cross-references to other
working papers containing evidence obtained from the procedures. Audit
programs should be sufficiently detailed to provide:
 An outline of the work to be done.
 A basis for coordinating, supervising, and controlling the audit.
 A record of the work performed.

b.

Eight steps in the general framework for specifying substantive tests to be
included in an audit program include:
1. Obtain an understanding of the business and industry and determine:
 The significance of the transaction class and account balance to the entity.
 The key economic drivers that influence the transaction class and account
balance.
2. Specify initial procedures to:
 Trace beginning balance to prior year’s working papers (if applicable).
 Review activity in applicable general ledger accounts and investigate
unusual items.
 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 tie-in of detail with control accounts.
3. Specify analytical procedures to be performed.
4. Specify tests of details of transactions to be performed.
5. Specify tests of details of balances to be performed.
6. Specify tests of details 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
SAS (for example, observation of inventories) 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.

c.

In initial engagements, the detailed specification of substantive tests in audit
programs is generally not completed until after the study and evaluation of
internal controls has been completed and the auditor has a significant
understanding of the business and industry. Until then the auditor may not have a
reasonable basis for specifying appropriate detection risk levels which affect the
design of substantive tests for significant financial statement assertions. In
contrast, in recurring engagements the auditor has access to audit programs used
in the preceding period(s) and the working papers pertaining to those programs. In
such cases, needs to understand major changes in the business, but 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 may be
appropriate for the current period. Thus, the audit programs for the current
engagement are often prepared before the auditor completes the evaluation of the
internal controls with the understanding they may subsequently require
modification.

12-24. (Estimated Time – 25 minutes)
Objective
1.
2.
3.
4.
5.
6.
7.

Assertion
C
EO
PD
VA
VA
RO
RO

Objective
8.
9.
10.
11.
12.
13.
14.

Assertion
C
EO
PD
VA
PD
PD
PD

12-25. (Estimated Time – 20 minutes)
Note: The student is required to list only one type of test, type of evidence, and assertion for each
auditing procedure. In some cases, alternative answers are indicated in the tabulation below.
1.

Audit Procedure
Count cash on hand

Type of Test
T of D of balances

2.

Confirm accounts receivable.

T of D of balances

Audit Objective
Existence, Completeness,
Valuation and allocation
Existence

3.

Vouch plant asset additions to
purchase documents.
Recalculate accrued interest on
notes payable.
Inquire of management about
pledging of plant assets as
security for long-term debt.
Compute inventory turnover
ratio.
Vouch ending inventory pricing
to purchase invoices.
Review client-prepared bank
reconciliation.

T of D of transactions

Occurrence, Accuracy

T of D of balances

Existence, Completeness,
Valuation and allocation
Completeness of disclosures

Verify accuracy of accounts
receivable balance and
agreement with subsidiary
ledger.
Obtain details of accounts
receivable subsidiary ledger and
reconcile to the general ledger.
Compare statement disclosures
for leases with GAAP.

Initial procedures

Review adequacy of client’s
provision for uncollectible
accounts.
Examine certificates of title for
delivery equipment.
Confirm receivables.

Tests of accounting
estimates

4.
5.
6.
7.
8.
9.

10.
11.

12.
13.
14.

T of D of disclosures
Analytical procedure
T of D of balances
T of D of balances

Existence, completeness,
valuation and allocation
Valuation and allocation
Existence, Completeness,
Rights and obligations,
Valuation and allocation
Accuracy, Valuation and
allocation

Initial procedures

Accuracy, Valuation and
allocation

T of D of disclosures

Completeness of presentation
and disclosure, Occurrence
and rights and obligations of
disclosures
Valuation and allocation

T of D of
Balances
Analytical procedure

Rights and obligations
Existence, Completeness,
Valuation and allocation

15.
16.
17.
18.

Audit Procedure
Trace bad-debt write-off
authorizations to accounts
receivable.
Observe client’s inventory
taking.
Trace unpaid vendors’ invoices
to accounts payable at year-end.
Compare pension disclosures to
a disclosure check list.

Type of Test
T of D of transactions

Audit Objective
Occurrence, Accuracy

T of D of balances

Existence, Completeness,
Valuation and allocation
Completeness

Test of details of
transactions
T of D of disclosures

Completeness of presentation
and disclosure, Occurrence
and rights and obligations of
disclosures

12-26. (Estimated time - 25 minutes)
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.

Assertion
Valuation or allocation
Completeness
Existence or occurrence
Valuation or allocation
Presentation and disclosure
Existence or occurrence
Rights and obligations
Presentation and disclosure
Completeness
Rights and obligations
Completeness
Presentation and disclosure
Completeness
Presentation and disclosure
Valuation or allocation

Substantive Test
C, J
A, B, E, F
C, D
I, K
L
A, B
A, B, E, H, I
M
B, E, H
E, H
F
L
E
L
I, K

12-27. (Estimated Time – 20 Minutes)
a.

Before applying principal substantive tests to General's balance sheet accounts at
April 30, 20X6, Cook should consider whether it is possible to control the added
audit risk that material misstatements existing in the accounts at the balance sheet
date will not be detected. Conditions that contribute controlling this risk are:
 Internal controls during the remaining period are 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 client's accounting system will provide information concerning significant
unusual transactions and significant fluctuations that may occur in the
remaining period.

b.

Substantive tests for the remaining period ordinarily should include (1)
comparison of the account balances at June 30 and April 30 to identify amounts
that appear to be unusual and investigation of any such amounts, and (2) such
other analytical procedures or other substantive tests of details as the auditor
considers necessary to provide a reasonable basis for extending the interim audit
conclusions to the balance sheet date.

12.28. (Estimated Time – 30 minutes)
a.

The auditor may perform substantive tests prior to the balance sheet date when he
or she can:
 Control the added audit risk that material misstatements existing in the
account at the balance sheet date will not be detected by the auditor.
 Reduce the cost of substantive tests necessary at the balance sheet date to
meet planned audit objectives so that testing prior to the balance sheet date
will be cost effective.
In practice, early substantive testing of account balances is not done unless tests
of controls have provided convincing evidence that internal controls are operating
effectively. Moreover, it is unlikely that the auditor will perform substantive tests
prior to the balance sheet date on all assertions pertaining to an account.

b.

The potential added audit risk can be controlled if substantive tests for the
remaining period can provide a reasonable basis for extending the audit
conclusions from the tests performed at the interim date to the balance sheet date.
Conditions contributing to the control of this risk are:
 Internal controls during the remaining period are 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 client's accounting system will provide information concerning
significant unusual transactions and significant fluctuations that may occur in
the remaining period.

c.

Substantive tests for the remaining period ordinarily should include:
 Comparison of the account balances at the two dates to identify amounts that
appear to be unusual and investigation of such amounts.
 Other analytical procedures or other substantive tests of details to provide a
reasonable basis for extending the interim audit conclusions to the balance
sheet date.

d.

As compared with substantive tests of balance sheet accounts, tests of income
statement accounts rely more heavily on analytical procedures and less on tests of
details of transactions and balances. Each income statement account is
inextricably linked to one or more balance sheet accounts (e.g., sales and accounts

receivable, and cost of goods sold and inventories). Thus evidence obtained from
tests of details performed on balance sheet accounts also pertains to the related
income statement accounts, reducing the need for additional tests of details.
e.

Analytical procedures arc used both directly and indirectly in obtaining evidence
about income statement accounts. Direct tests occur when a revenue or an
expense account is compared with other relevant data to determine the
reasonableness of its balance (e.g., the ratio of sales commissions to sales can be
compared with the results of prior years and budget data for the current year).
Indirect tests occur when evidence concerning income statement balances can be
derived from analytical procedures applied to related balance sheet accounts (e.g.,
the accounts receivable turnover ratio used in verifying accounts receivable may
also be used in determining whether bad debts expense is fairly stated). In
addition, in applying analytical procedures to income statement accounts, there
are many opportunities for comparing financial information with nonfinancial
information such as using number of employees and number of miles driven to
estimate wages expense and gasoline expense, respectively.

f.

The circumstances that may necessitate performing tests of details of income
statement accounts are as follows:
 Inherent risk is high. This may occur in the case of nonroutine transactions
and management's judgments and estimates.
 Control risk is high. This situation may occur when (1) internal controls for
nonroutine and routine transactions are ineffective or (2) the auditor elects not
to test the internal controls.
 Analytical procedures reveal unusual relationships and unexpected
fluctuations. Examples of this situation include (1) a company exceeding its
sales growth target in spite of an unexpected downturn in its industry and the
economy as a whole and (2) an unexplained increase in the inventory turnover
ratio.
 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.

12-29. (Estimated Time – 25 minutes)
a.

The auditor's objective in auditing accounting estimates is to obtain sufficient
competent evidential matter to provide reasonable assurance that:
 All accounting estimates that could be material to the financial statements
have been developed.
 The accounting estimates are reasonable in the circumstances.
 The accounting estimates are presented in conformity with applicable
accounting principles and are properly disclosed.

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.
b.

Auditing procedures that may be used to obtain evidence about these two types of
accounts include the following:
Accounts involving accounting estimates
 Review and test management's process in making the estimate.
 Prepare an independent expectation of the estimate.
 Review subsequent transactions and events occurring prior to completing the
audit that pertain to the estimate.
Accounts involving related party transactions
 Obtain an understanding of the business purpose of the transaction.
 Examine invoices, executed copies of agreements, contracts, and other
pertinent documents, such as receiving reports and shipping documents.
 Determine whether the transaction has been approved by the board of
directors or other appropriate officials.
 Test for reasonableness the compilation of amounts to be disclosed, or
considered for disclosure, in the financial statements.
 Arrange for the audits of inter-company 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.
 Inspect or confirm and obtain satisfaction concerning the transferability and
value of collateral.

c.

In auditing identified related party transactions, the auditor is not expected to
determine (1) whether a particular transaction would have occurred if the parties
had not been related or (2) what the exchange price and terms would have been.
The auditor is required, however, to determine the substance of the related party
transactions and their effects on the financial statements.

d.

Management is responsible for establishing the process and controls for preparing
accounting estimates which it includes in the financial statements. The auditor is
responsible for evaluating the reasonableness of accounting estimates made by
management in the context of the financial statements taken as a whole. This
includes (1) considering the relevance, reliability, and sufficiency of the data and
other factors used by management, (2) evaluating the reasonableness and
consistency of the assumptions, and (3) reperforming the calculations made by
management. In some cases, the auditor may find it useful to obtain the opinion of
a specialist regarding the assumptions.

e.

To evaluate the reasonableness of accounting estimates, the auditor should
normally concentrate on the key factors and assumptions used by management
including those that are (1) significant to the accounting estimate, (2) sensitive to
variations, (3) deviations from historical patterns, and (4) subjective and
susceptible to misstatement and bias.

f.

Sources of evidence concerning the reasonableness of accounting estimates
include the following:
 Information supplied by management concerning the process used and
assumptions made.
 Historical data used by management in developing the estimates.
 Recalculation by the auditor of management's estimates.
 Independent expectations developed by the auditor for comparison with
management's estimates.
 Events or transactions that occur subsequent to the date of the balance sheet
but prior to the completion of field work that relate to the key factors and
assumptions used by management.
 Opinions supplied by a specialist.

12-30. (Estimated Time – 60 minutes)
Category
Initial
Procedures

a. Substantive Test
1)

2)

Analytical
Procedures

3)

Obtain an understanding of the business and industry and determine:
a) The significance of plant assets, and changes in plant assets, to the
entity.
b) Key economic drivers that influence the entity’s acquisition of plant
assets.
c) Industry standards for the extent to which the entity is capital intensive
and the impact of plant assets on earnings.
Perform initial procedures on plant assets balances and records that will be
subjected to further testing.
a) Trace beginning balance for plant assets and accumulated depreciation to
prior year’s working papers.
b) Review activity in general ledger accounts plant assets and depreciation
expense and investigate entries that appear unusual in amount or source.
c) Obtain client-prepared schedules of plant asset additions, retirements and
depreciation expense, and determine that they accurately represent the
underlying accounting records from which they were prepared by:
i) Footing and crossfooting the schedules and reconciling the totals
with increases or decreases in the related general ledger balances
during the period.
ii) Testing agreement of items on schedules with entries in related
general ledger accounts.
Perform analytical procedures:
a) Develop an expectation for plant assets using knowledge of the industry
and the entity’s business activity
b) Calculate ratios such as fixed asset turnover, depreciation expense as a
percent of sales, repair and maintenance expense as a percent of sales
and rate of return on assets
c) Analyze ratio results relative to expectations based on prior years,
industry data, budgeted amounts, or other data.

b. Audit
Objectives
EO, C, RO,
VA,PD

VA1

EO, C, VA, PD

Category
Tests of
Details of
Transactions

Tests of
Details of
Balances

a. Substantive Test
4)

Vouch plant asset additions to supporting documentation.

5)

Vouch plant asset disposals to supporting documentation.

6)

Review entries to repairs and maintenance expense.

7)

Inspect plant asset.
a) Inspect plant asset additions.
b) Tour other plant assets and be alert to evidence of additions and
disposals not included on client’s schedules and to conditions that bear on
the proper valuation and classification of the plant assets.
Examine title documents and contracts

8)
Tests of
Details of
Balances:
Accounting
Estimates
Presentation
and
Disclosure

b. Audit
Objectives
EO1, EO2,
C2RO1, VA1,
PD1
EO1, EO2, C2,
RO1, VA1, PD1
EO1, VA1, PD1
EO3,RO1, VA2,
PD4

EO3, RO1

Evaluate the fair presentation of depreciation expense by evaluating the
appropriateness of useful lives and estimated salvage values.
10) Determine if any significant events have resulted in an impairment of the value
of plant assets.

VA2, PD5

11) Compare statement presentation with GAAP.
a) Determine that plant assets and related expenses, gains, and losses are
properly identified and classified in the financial statements.
b) Determine the appropriateness of disclosures related to the cost, book
value, depreciation methods, and useful lives of major classes of plant
assets, the pledging of plant assets as collateral and the terms of lease
contracts.

PD2, PD3,
PD4, PD5

9)

VA2

Related
Party
Transactions
Situation

Accounting
Estimates

Audit
Program

Since this is a first year audit it is clear that related party transactions will be a significant portion
of this audit. The engagement partner has asked you to research the firm’s responsibilities with
respect to related party transactions. Cut and paste the auditing standard sections that explain
the general procedures that should be performed to (1) determine the existence of related parties
and (2) identify transactions with related parties.
AU 334.07 Addresses the procedures to be performed to determine the existence of related
parties.
.07

The auditor should place emphasis on testing material transactions with parties he knows
are related to the reporting entity. Certain relationships, such as parent-subsidiary or

investor-investee, may be clearly evident. Determining the existence of others requires
the application of specific audit procedures, which may include the following:
a.
Evaluate the company's procedures for identifying and properly accounting for
related party transactions.
b.
Request from appropriate management personnel the names of all related parties
and inquire whether there were any transactions with these parties during the
period.
c.
Review filings by the reporting entity with the Securities and Exchange
Commission and other regulatory agencies for the names of related parties and for
other businesses in which officers and directors occupy directorship or
management positions.
d.
Determine the names of all pension and other trusts established for the benefit of
employees and the names of their officers and trustees. fn 4
e.
Review stockholder listings of closely held companies to identify principal
stockholders.
f.
Review prior years' working papers for the names of known related parties.
g.
Inquire of predecessor, principal, or other auditors of related entities concerning
their knowledge of existing relationships and the extent of management
involvement in material transactions.
h.
Review material investment transactions during the period under audit to
determine whether the nature and extent of investments during the period create
related parties.
Au 334.08 explains the general procedures that should be performed to identify transactions with
related parties.
.08

The following procedures are intended to provide guidance for identifying material
transactions with parties known to be related and for identifying material transactions that
may be indicative of the existence of previously undetermined relationships:
a.
Provide audit personnel performing segments of the audit or auditing and
reporting separately on the accounts of related components of the reporting entity
with the names of known related parties so that they may become aware of
transactions with such parties during their audits.
b.
Review the minutes of meetings of the board of directors and executive or
operating committees for information about material transactions authorized or
discussed at their meetings.
c.
Review proxy and other material filed with the Securities and Exchange
Commission and comparable data filed with other regulatory agencies for
information about material transactions with related parties.
d.
Review conflict-of-interests statements obtained by the company from its
management. fn 5
e.
Review the extent and nature of business transacted with major customers,
suppliers, borrowers, and lenders for indications of previously undisclosed
relationships.

f.
g.
h.
i.
j.

Consider whether transactions are occurring, but are not being given accounting
recognition, such as receiving or providing accounting, management or other
services at no charge or a major stockholder absorbing corporate expenses.
Review accounting records for large, unusual, or nonrecurring transactions or
balances, paying particular attention to transactions recognized at or near the end
of the reporting period.
Review confirmations of compensating balance arrangements for indications that
balances are or were maintained for or by related parties.
Review invoices from law firms that have performed regular or special services
for the company for indications of the existence of related parties or related party
transactions.
Review confirmations of loans receivable and payable for indications of
guarantees. When guarantees are indicated, determine their nature and the
relationships, if any, of the guarantors to the reporting entity.
Accounting
Estimates

Situation

Related
Party
Transactions

Audit
Program

AU 342.09 -.14 explain the general procedures that should be performed in evaluating the
reasonableness of an accounting estimate such as the provision for warranties.
.09

.10

.11

In evaluating the reasonableness of an estimate, the auditor normally concentrates on key
factors and assumptions that are—
a.
Significant to the accounting estimate.
b.
Sensitive to variations.
c.
Deviations from historical patterns.
d.
Subjective and susceptible to misstatement and bias.
The auditor normally should consider the historical experience of the entity in making
past estimates as well as the auditor's experience in the industry. However, changes in
facts, circumstances, or entity's procedures may cause factors different from those
considered in the past to become significant to the accounting estimate. fn 4
In evaluating reasonableness, the auditor should obtain an understanding of how
management developed the estimate. Based on that understanding, the auditor should use
one or a combination of the following approaches:
a.
Review and test the process used by management to develop the estimate.
b.
Develop an independent expectation of the estimate to corroborate the
reasonableness of management's estimate.
c.
Review subsequent events or transactions occurring prior to completion of
fieldwork.
Review and test management's process. In many situations, the auditor assesses the
reasonableness of an accounting estimate by performing procedures to test the process

used by management to make the estimate. The following are procedures the auditor may
consider performing when using this approach:
a.
Identify whether there are controls over the preparation of accounting estimates
and supporting data that may be useful in the evaluation.
b.
Identify the sources of data and factors that management used in forming the
assumptions, and consider whether such data and factors are relevant, reliable,
and sufficient for the purpose based on information gathered in other audit tests.
c.
Consider whether there are additional key factors or alternative assumptions about
the factors.
d.
Evaluate whether the assumptions are consistent with each other, the supporting
data, relevant historical data, and industry data.
e.
Analyze historical data used in developing the assumptions to assess whether the
data is comparable and consistent with data of the period under audit, and
consider whether such data is sufficiently reliable for the purpose.
f.
Consider whether changes in the business or industry may cause other factors to
become significant to the assumptions.
g.
Review available documentation of the assumptions used in developing the
accounting estimates and inquire about any other plans, goals, and objectives of
the entity, as well as consider their relationship to the assumptions.
h.
Consider using the work of a specialist regarding certain assumptions (section
336, Using the Work of a Specialist).
i.
Test the calculations used by management to translate the assumptions and key
factors into the accounting estimate.
.12

Develop an expectation.
Based on the auditor's understanding of the facts and
circumstances, he may independently develop an expectation as to the estimate by using
other key factors or alternative assumptions about those factors.

.13

Review subsequent events or transactions. Events or transactions sometimes occur
subsequent to the date of the balance sheet, but prior to the completion of fieldwork, that
are important in identifying and evaluating the reasonableness of accounting estimates or
key factors or assumptions used in the preparation of the estimate. In such circumstances,
an evaluation of the estimate or of a key factor or assumption may be minimized or
unnecessary as the event or transaction can be used by the auditor in evaluating their
reasonableness.

.14

As discussed in section 312, Audit Risk and Materiality in Conducting an Audit,
paragraph .36, the auditor evaluates the reasonableness of accounting estimates in
relationship to the financial statements taken as a whole:
Since no one accounting estimate can be considered accurate with certainty, the auditor
recognizes that a difference between an estimated amount best supported by the audit
evidence and the estimated amount included in the financial statements may be
reasonable, and such difference would not be considered to be a likely misstatement.
However, if the auditor believes the estimated amount included in the financial
statements is unreasonable, he should treat the difference between that estimate and the

closest reasonable estimate as a likely misstatement and aggregate it with other likely
misstatements. The auditor should also consider whether the difference between estimates
best supported by the audit evidence and the estimates included in the financial
statements, which are individually reasonable, indicate a possible bias on the part of the
entity's management. For example, if each accounting estimate included in the financial
statements was individually reasonable, but the effect of the difference between each
estimate and the estimate best supported by the audit evidence was to increase income,
the auditor should reconsider the estimates taken as a whole.
Audit
Program
Situation

Category
Initial
Procedures

Analytical
Procedures

Related
Party
Transactions

Accounting
Estimates

Substantive Test
1) Obtain an understanding of the business and industry and determine:
a) The significance of revenues and accounts receivable to the entity.
b) Key economic drivers that influence the entity’s sales, margins, and
collections.
c) Standard trade terms in the industry, including seasonal dating, collections
period, etc.
d) The extent of concentration of activity with customers.
2) Perform initial procedures accounts payable balance and records that will be
subjected to further testing.
a) Trace beginning balance for accounts receivable to prior year’s working
papers.
b) Review activity in general ledger account for accounts receivable and
investigate entries that appear unusual in amount or source.
c) Obtain accounts receivable trial balance and determine that it accurately
represents the underlying accounting records by:
i) Footing the trail balance and determining agreement with (1) the total of
the subsidiary ledger or accounts receivable master file, and (2) the
general ledger balance.
ii) Testing agreement of customer and balances listed on the trial balance
with those included in the subsidiary ledger or master file.
3) Perform analytical procedures:
a) Develop an expectation for accounts receivable using knowledge of the
entity’s business activity, market share, normal trade terms, and its history of
accounts receivable turn days.
b) Calculate ratios:
i) Compare sales to the entity’s capacity.
ii) Compare sales growth and receivable growth.
iii) Accounts receivable turn days.
iv) Uncollectible accounts expense to net credit sales
v) Uncollectible accounts expense to accounts receivable write-offs
c) Analyze ratio results relative to expectations based on prior years, industry
data, budgeted amounts, or other data.

Category
Tests of
Details of
Transactions

Tests of
Details of
Balances

Tests of
Details of
Balances:
Accounting
Estimates

Required
Procedures

Substantive Test
4) Vouch a sample of recorded revenue cycle transactions to supporting
documentation.
a) Vouch receivable debits to supporting sales invoices, shipping documents, and
sales orders.
b) Vouch receivable credits to supporting cash receipts and cash prelists.
c) Vouch receivable credits to remittance advices or sales adjustment
authorizations for sales returns and allowance or uncollectible account writeoffs.
5) Trace a sample of revenue transactions from shipments to recording in the sales
journal. Also trace a sample of cash receipts and sales returns to their recording in
the accounting records.
6) Perform cutoff test for sales and sales returns.
a) Select a sample of recorded sales transactions from several days before and
after year-end and examine supporting sales invoices and shipping documents
to determine sales were recorded in the proper period.
b) Select sample of credit memos issued after year-end, examine supporting
documentation such as dated receiving reports and determine that returns
were recorded in the proper period. Also consider whether volume of sales
returns after year-end suggest possibility of unauthorized shipments before
year-end.
7) Perform cash receipts cutoff test.
a) Observe that all cash received through the close of business on the last day of
the fiscal year is included in cash on hand or deposits in transit and that no
receipts of the subsequent period are included, or
b) Review documentation such as daily cash summaries, duplicate deposit slips,
and bank statements covering several days before and after year-end for
proper cutoff.
8) Confirm accounts receivable
a) Determine the form, timing, and extent of confirmation requests.
b) Select and execute sample and investigate exceptions.
c) For positive confirmation requests for which no reply was received, perform
alternative follow-up procedures:
 Vouch subsequent cash receipts identifiable with items comprising
account balance at confirmation date to supporting documentation.
 Vouch items comprising balance at confirmation date to documentary
support such as sale orders and shipping documents.
9) a) Make Inquiries about the sale, factoring, or pledging of accounts receivable.
b) Send confirmations to entities who have purchased accounts receivable or
hold accounts receivable as collateral.
10) Evaluate adequacy of allowance component for each aging category and in the
aggregate.
a) Foot and crossfoot the aged trail balance of receivables and agree total to the
general ledger.
b) Test aging by vouching amounts in aging categories for sample of accounts to
supporting documents.
d) For past–due accounts:
 Examining evidence of collectibility such as correspondence with
customers and outside collection agencies, credit reports, and customers’
financial statements.
 Discuss collectibility of accounts with appropriate management
personnel.
e) Evaluate management’s process for estimating the allowance for doubtful
accounts using hindsight.
f) Evaluate the adequacy of the allowance given information about
 Industry trends.
 Aging trends.
 Collection history for specific customers.
11) Confirmation of receivable included in step 7 above.

Category
Tests of
Details of
Presentation
and
Disclosure

Substantive Test
12) Compare statement presentation with GAAP.
a) Compare disclosures related to existence and rights and obligations of
receivables to the results of tests performed above.
b) Determine that receivables are properly identified and classified as to type
and expected period of realization
c) Determine whether there are credit balances that are significant in the
aggregate and that should be reclassified as liabilities.
d) Determine the appropriateness of disclosures and accounting for related party,
pledged, assigned or factored receivables.
e) Determine the need for disclosures regarding significant customers or sales by
line of business.
f) Evaluate the completeness of presentation and disclosures for receivables in
drafts of financial statements to determine conformity to GAAP by reference
to disclosure checklist.
g) Read disclosures and independently evaluate their understandability.
h) Vouch the accuracy of receivable disclosures to tests performed above.