Chap 9 Substantive Tests of Transactions and Balances)

Page 363
CHAPTER 9
Substantive tests of transactions and balances
LEARNING OBJECTIVES (LO)

9.1 Identify and distinguish between tests of controls, substantive
tests of transactions and substantive tests of balances.
9.2 Identify and understand when the auditor will undertake
substantive audit procedures in response to specific assessed
risks of material misstatement.
Explain the specific audit objectives and the common substantive audit
procedures traditionally used to address risks of material misstatement for:
9.3 cash, cash receipts and cash payments

9.4 sales, cash receipts and accounts receivable
9.5 purchases and inventories
9.6 accounts payable, payments and payroll
9.7 non-current assets
9.8 non-current liabilities and owners’ equity.
9.9 Identify the different substantive test approaches that may be

used for account balances included in the income statement.
9.10 Describe and understand the use of audit software techniques,
Copyright © 2018. McGraw-Hill Australia. All rights reserved.
including advanced data analytics, in substantive testing.
Gay, Grant E., and Roger Simnett. Auditing and Assurance Services in Australia, McGraw-Hill Australia, 2018. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/adelaide/detail.action?docID=5729228.
Created from adelaide on 2021-05-23 11:13:14.
RELEVANT GUIDANCE
ASA 315/ISA 315 Identifying and Assessing the Risks of Material

Misstatement through Understanding the Entity and Its
Environment
ASA 330/ISA 330 The Auditor’s Responses to Assessed Risks
ASA 500/ISA 500 Audit Evidence
ASA 501/ISA 501 Audit Evidence—Specific Considerations for Inventory

and Segment Information/Audit Evidence—Specific
Considerations for Selected Items
ASA 505/ISA 505 External Confirmations
ASA 520/ISA 520 Analytical Procedures
ASA 540/ISA 540 Auditing Accounting Estimates, Including Fair Value

Accounting Estimates, and Related Disclosures
ASA 560/ISA 560 Subsequent Events
ASA 620/ISA 620 Using the Work of an Auditor’s Expert
GS 016 Bank Confirmation Requests
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CHAPTER OUTLINE
As outlined in Chapter 4 , tests of controls and substantive tests of
transactions and balances are two of the main evidence-gathering procedures
used by the auditor, and the auditor should plan to undertake the most efficient
and effective combination of these procedures.
Chapter 8 outlines the tests of controls that the auditor can undertake in
response to specific risks. This chapter outlines the substantive response, or
evidence that the auditor needs to collect that allows them to assess the likely
dollar amount of possible material misstatements, in order to appropriately
respond to assessed risks of material misstatement. For example, if the auditor
determines that there is a risk that profits will be overstated, and this is likely to
be done by overstating sales, or understating cost of sales, this chapter
provides a description of the evidence that the auditor is likely to collect.
The auditor needs to coordinate the audit approach detailed in the audit
program to ensure that the most efficient and effective combination of these
audit procedures is used. Substantive tests of transactions and balances and
substantive analytical procedures are used to reduce detection risk, so that the
desired level of audit risk can be achieved. Substantive tests of transactions are
designed to substantively verify the dollar value of transactions. Substantive
tests of balances and substantive analytical procedures are audit tests that
determine the amount of material misstatement and substantiate the ending
balance of a general ledger account.
All general ledger accounts will be either separately reported (if material) or
consolidated into a line item (financial report component) in the financial report.
For each financial report component, the risk of material misstatement will be
assessed at the assertion level. Audit procedures in the form of tests of controls
(discussed in Chapter 8 ) and substantive tests are undertaken in response to
an assertion that is assessed as being at risk of material misstatement. The

substantive tests are aimed at identifying monetary misstatement of these
components. In designing audit programs for account balances, the auditor is
concerned with whether the component balance is overstated or understated
by a material amount.
No matter what audit strategy (combination of tests of controls, substantive tests
of transactions and balances and substantive analytical procedures) is adopted,
the auditor must undertake substantive tests. There is almost exclusive reliance
on such procedures in some audits, such as the audit of the financial reports of
small businesses where it is difficult to establish reliance on control systems.
The following discussion of substantive tests considers their objectives and the
related substantive procedures. For each assertion for each major financial
report component, the specific audit objectives are explained and the common
substantive tests undertaken to achieve them are discussed. The components
are considered in the following order: cash; accounts receivable; inventories;
accounts payable; non-current assets and liabilities and owners’ equity; and the
income statement.
This chapter covers substantive tests of transactions and balances in a financial

report audit, as illustrated in Figure 9.1 , an expansion of part of the flowchart
provided in Chapter 1 .
Page 365
FIGURE 9.1 Flowchart of response to assessed risks: substantive tests of transactions and balances
Page 366
LO 9.1 Relationship between evidence-gathering

procedures
The auditor has to obtain sufficient appropriate evidence to be able to draw reasonable
conclusions on which to base the auditor’s opinion (ASA 500/ISA 500). Tests of controls
(discussed in Chapter 8 ) and substantive tests of transactions and balances (discussed
in this chapter) are two of the main evidence-gathering procedures, and the auditor selects
the most efficient and effective combination of audit procedures that will allow them to
achieve the audit objective.
As outlined in Chapter 4 , the auditor uses assertions for classes of transactions and
events and related disclosures, and account balances and related disclosures, to help them
in their assessment of risk of material misstatement. The advantage of identifying
assertions at risk of material misstatement is that this will direct the auditor’s evidence-
gathering procedures in appropriately responding to these risks.
As outlined in Chapter 8 , because most internal controls are structured around

transaction or event flows, the auditor uses the most efficient and effective combination of
tests of controls and substantive tests of transactions. Tests of controls were discussed in
Chapter 8 .
The amount of substantive testing that needs to be undertaken is directly affected by the
testing of controls that has been undertaken, as is the basis of the audit risk model
described in detail in Chapter 4 . There are three main types of substantive tests: substa
ntive tests of transactions , substantive tests of balances and substantive analytic
al procedures (introduced in Chapter 4 and described for specific account balances
in this chapter). Substantive testing of transactions and substantive testing of balances
together are called substantive tests of details . Substantive testing of transactions is
where the auditor inspects underlying documents associated with the flow of a transaction
through the system, to detect material misstatements at the assertion level. Substantive
testing of balances is where the auditor tests amounts resulting from the summation of a
number of transactions (for example, accounts receivable is increased by credit sales and
decreased by associated receipts of cash—the summation of these transactions can be
either at the total accounts receivable balance or at the individual debtor balance).
Substantive analytical procedures involve undertaking analytical procedures to determine
the amount of misstatement in an account balance. Details of different types of analytical
procedures available were discussed in Chapter 5 in relation to the planning stage of
the audit. The relationship between the different audit procedures was discussed earlier in
Chapter 4 and illustrated in Figure 4.11 , and is repeated in Figure 9.2 .
FIGURE 9.2 Types of audit procedures
Page 367
As account balances are the sum of related transactions, the extent of one type of
substantive testing will reduce the extent of testing required for the other type of
substantive testing. The relationship between substantive tests of transactions and
substantive tests of balances will be discussed later in this learning objective. Substantive
tests of disclosures are primarily considered towards the end of the audit and will be
discussed in Chapter 11 .
Relationship between tests of controls and

substantive tests of transactions

Tests of controls, as discussed in Chapter 8 , establish the reliance to be placed on the
internal control system. However, tests of controls do not directly measure monetary
misstatement in accounting records. Substantive tests are performed to detect material
misstatements in the financial report assertions (ASA 330.4/ISA 330.4). Irrespective of the
assessed risks of material misstatement, the auditor is required to design and perform
substantive procedures for each material class of transactions, account balances and
disclosures (ASA 330.18/ISA 330.18). These substantive tests are a combination of tests of
details of classes of transactions, account balances and disclosures, and substantive
analytical procedures.
Accounting records provide the underlying evidence for financial reports. The auditor’s
objective in undertaking substantive tests of transactions is to obtain reasonable assurance
that the accounting records are accurate and reliable. The auditor’s approach in substantive
tests of transactions is to inspect underlying documents, to trace the flow of transactions
through the system and to recalculate for clerical accuracy.
The assertion being tested determines the direction of the testing. For example, tracing
from a source document to the accounting record provides evidence of completeness of the
recording of transactions; that is, it provides evidence that all transactions are recorded and
detects errors of understatement of the accounting records. Testing from the accounting
record to the source document (commonly called vouching to the source document)
provides evidence of occurrence of the transactions; that is, it provides evidence that all
recorded transactions occurred and detects errors of overstatement of the accounting
records. Usually some testing in both directions is undertaken. The extent of testing in a
particular direction depends on the auditor’s assessment of the risk of material
misstatement. When a misstatement is detected, the auditor needs to consider the cause of
the misstatement and determine whether any change is called for in the planned nature and
extent of testing.
Dual-purpose tests
Since both tests of controls and substantive tests of transactions can involve inspection of
the same documents for individual transactions, they are commonly performed
simultaneously on the sample of documents chosen. Dual-purpose tests are specifically
planned to provide direct evidence of both controls and substantive matters.
Different procedures are performed to satisfy different objectives, but they are performed
using the same documents at approximately the same time. For example, controls in the
processing of purchase invoices may require a clerk to compare the data with supporting
documents, check the classification in the purchases journal, recalculate amounts and
initial the invoice to indicate performance of the procedures. The auditor inspects
documents for the clerk’s initials—the test of controls—and recalculates and retraces the
clerk’s other procedures, which satisfies several substantive objectives.
On the other hand, if controls are absent or not functioning, there will be no testing of
controls, and more extensive substantive testing of details (either transactions or balances)
will be necessary. Thus, in practice, a sample of transactions selected to test controls will
virtually always be a dual-purpose test; alternatively, a sample of transactions may be
selected for substantive testing only.
Relationship between substantive tests of

transactions and substantive tests of balances
Substantive tests of transactions can also be distinguished from substantive tests of
balances. If the account balance is affected by many relatively small transactions, the
auditor designs substantive tests of balances directed to selected items (such as Page 368
individual customers or inventory items) which are an aggregate of a number of
transactions and which aggregate to create the ending account balance. This commonly
occurs for the accounts receivable and inventory balances.
The balance of accounts receivable would be composed of the balances of many customers.
Consider Global example 9.1 , an extract of an accounts receivable subsidiary ledger. In
this example customer Able’s year-end balance of $5000 is composed of three transactions.
If the auditor verifies the $5000 ending balance (such as through external confirmation
procedures, discussed later in this chapter), this is a substantive test of balances. If the
auditor verifies the dollar value of the three individual transactions comprising the $5000
(such as by verifying the two sales invoices and the remittance advice associated with the
cash receipts transaction), this is a substantive test of transactions.
GLOBAL EXAMPLE 9.1 Extract of an accounts receivable
subsidiary ledger
Customer Transactions for Able Year-end balance
Able Sale 2000
Receipt (1000)
Sale 4000 5000
Baker 500
Chan 1000
Tests of transactions (both tests of controls and substantive tests of transactions) are usually
performed for major classes of transactions that are repetitive and large in volume. The
major classes of transactions—sales, purchases, cash receipts and cash disbursements—
affect statement of financial position accounts in the manner shown in
Global example 9.2 .
GLOBAL EXAMPLE 9.2 Effect of sales, purchases, cash receipts

and cash disbursements on statement of financial position
accounts
Accounts Cash Accounts

receivable payable
Beginning balance Beginning balance Beginning

balance
Additions (DR to Additions

accounts (purchases, DR
receivable, CR to to inventory, CR
sales) to accounts
payable)
Reductions (cash ↔ Additions (cash

receipts, DR to receipts, DR to cash,
cash, CR to CR to accounts
accounts receivable)
receivable)
Reductions (cash ↔ Reductions

disbursements, DR (cash
to accounts disbursements,
payable, CR to cash) DR to accounts
payable, CR to
cash)
Ending balance Ending balance Ending balance
Page 369
In the abstract, if beginning balances were tested in the previous year, it would be
possible to indirectly test the major transactions by substantively testing the ending
balances of these accounts. Substantive tests of balances of statement of financial position
accounts are commonly preferred because there are fewer ending balances than there are
transactions that affect a balance, and there is generally more persuasive evidence available
to support the ending balance.
Note also that the substantive tests of balances of statement of financial position accounts
indirectly test the related income statement account balances (sales and expenditure). For
example, the testing of accounts receivable will verify the sales that gave rise to this asset.
It is possible to plan an audit that consists primarily of substantive tests of balances of
statement of financial position accounts, with selected tests of transactions for specific
audit assertions.
This kind of audit—with emphasis on substantive tests of balances of statement of

financial position accounts—is, in fact, the approach typically used for small businesses. It
is also used when a large entity has material deficiencies in the processing of particular
classes of transactions. This approach is called the substantive approach to an audit.

Generally, it is the most efficient and effective means of auditing the financial report of a
small business. It is especially efficient if the auditor designs effective substantive
analytical procedures for those specific audit objectives such as income statement, account
classification and those related to the completeness assertion that are not achieved by
substantive tests of balances. For a large business, however, the substantive approach is
often not cost-effective, for the following reasons:
The number of items in ending balances, while still fewer than the number of transactions
that affect the balances, is relatively large.
The accounting system and related internal controls for major classes of transactions is
generally well designed and produces more reliable accounting data, because
management in a large entity has to rely extensively on the accounting data to monitor
and control the business.
There are generally enough employees to achieve effective separation of duties.
In these circumstances, by testing the processing of transactions, the auditor can restrict the
substantive tests of balances that would otherwise have been undertaken.
QUICK REVIEW
1. Substantive tests comprise tests of details (of classes of transactions,
account balances and disclosures) and substantive analytical procedures.
2. Substantive tests are performed to detect material misstatements in the
financial report assertions. Irrespective of the assessed risks of material
misstatement, the auditor is required to design and perform substantive
procedures for each material class of transactions, account balances and
disclosures.
3. Dual-purpose tests are specifically planned to provide direct evidence
concerning both controls and substantive matters, in order to satisfy
different audit objectives. They are performed using the same transactions
and events at approximately the same time.
4. In practice, if transactions and events are selected to test controls, they will
virtually always be examined to achieve substantive testing objectives, so
these are classed as dual-purpose tests. Transactions and events may
also be selected with no intention of testing controls (for substantive
purposes only); these are classed as substantive tests of transactions.
5. Account balances are composed of a series of transactions. It is possible
to substantively verify either the transactions comprising the account
balance or the account balance itself.
LO 9.2 Overall responses, financial report assertions and
substantive audit procedures
The auditor is required to design and implement an appropriate audit response to address
the assessed risks of material misstatement at the overall (financial report) level (ASA
330.5/ISA 330.5). As discussed in Chapter 6 , these are risks that relate Page 370
pervasively to the financial report as a whole and potentially may cause many
misstatements; they include risks such as concerns about the integrity of management or a
deficient control environment (ASA 315.A122–A125/ISA 315.A122–A125). The auditor’s
appropriate response to such risks of material misstatement may include:
emphasising the need for the audit team to maintain professional scepticism
assigning more experienced staff to the audit, or providing more supervision for less
experienced staff
incorporating greater unpredictability into the audit procedures
making general changes to the nature, timing and extent of audit procedures, such as
undertaking substantive procedures at period end rather than at an interim date (ASA
330.A1/ISA 330.A1).
The auditor is also required to develop specific audit procedures that are responsive to
assessed risks of material misstatement for classes of transactions, account balances and
disclosures (ASA 330.6/ISA 330.6). Financial report assertions, introduced in
Chapter 4 , provide the link between these risks and the auditor’s response. The risks
are assessed at the assertion level for each financial report component, and there are logical
procedures to undertake once an assertion for a financial report component has been
identified as containing a risk of material misstatement. Assertions about transactions and
events were discussed in Chapter 8 , but are also relevant for substantive testing of
transactions. Assertions about account balances are discussed below, with the emphasis in
this chapter on the substantive evidence-collection procedures undertaken in response to
the assessed risks of material misstatement.
Assertions about account balances and related

disclosures at period end (statement of financial
position accounts) and audit procedures
Existence In designing substantive tests for the assertion of existence, the auditor selects
from items contained in the accounting records and obtains evidence that supports them.
The logical procedures to accomplish such objectives include physical examination,
external confirmation and vouching. Note that these are tests for overstatement of the
balance.
As shown in Global example 9.3 , procedures to achieve the objective relating to
existence for accounts receivable should also aid in achieving the objective relating to
occurrence for sales. Directly testing the accounts receivable balance for overstatement
(existence) simultaneously indirectly tests the occurrence of sales.
GLOBAL EXAMPLE 9.3 Relationship between existence and

occurrence
The relationship between specific audit objectives for related account

balances can be demonstrated by an example from the sales cycle. For
example, if a credit sale that is not deemed to be a sale (perhaps it failed the
revenue recognition test) is recorded, perhaps because the client wished to
overstate profit, this will result in the auditor questioning the existence of the
accounts receivable (the recorded debit) and the occurrence of the sale (the
recorded credit). The financial report assertions of existence and
occurrence are related to specific audit objectives as follows:
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Specific audit objectives
Statement of
financial
position Income statement
Financial report assertion (existence) (occurrence)
Existence, occurrence Accounts Reported sales to

receivable are customers actually
authentic occurred during the
obligations owed period covered by
by customers at the income
the balance date statement
Rights and obligations In designing substantive tests for the assertion of 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. Although possession may be accepted as
evidence for ownership of some assets, the auditor must take further steps in ascertaining
that many of the recorded assets are in fact owned/controlled by the client in accordance
with the accounting framework that was used to prepare the financial report (see
Global example 9.4 ).
GLOBAL EXAMPLE 9.4 Difficult areas associated with rights and

obligations
Inventories held by the client under consignment arrangements exist, but

may not be owned by the client. The auditor must therefore determine that
inventories as represented on the statement of financial position do not
contain significant amounts of consigned inventories owned by others. It is
also possible that inventories out on consignment at distributors at the time
of counting stock may still be owned by the audit client at the time of the
audit, as identified by the terms of the consignment. The auditor will have to
carefully consider rightful ownership of the inventory in these circumstances.
Completeness In designing substantive tests for the assertion of completeness, the

auditor identifies evidence indicating items that should be included in the account
balance, and investigates whether they are in fact included. A logical procedure is to trace
from documentary evidence of origination, to the account balance. In other words, the
direction of the testing is the opposite of that for objectives related to the existence
assertion. Note that these are tests for understatement of the balance.
Accuracy, valuation and allocation In designing substantive tests for the assertion of
accuracy, valuation and allocation, the auditor needs to consider the basis of accuracy
and valuation of the asset or liability in terms of approved accounting standards and the
basis of any allocation of this valuation across accounting periods. If the basis is
historical cost less accumulated depreciation or amortisation, the likely procedure to
accomplish the audit objective of valuation is vouching the cost to historical records, and
the likely procedure for allocation is enquiry to determine the basis and recalculation of
the depreciable amount. If the basis is net realisable value, or something similar, the
procedures may include enquiry and substantive analytical procedures to assess the
reasonableness of the recorded market value, or inspection of external information on
market prices. Naturally, omission of items (completeness) or inclusion of improper items
(existence) will also affect accuracy and valuation. However, because the cause of these
types of misstatements is usually different, they are considered separately under those
specific assertions.
Classification In designing procedures for substantive tests the auditor needs to consider
whether assets, liabilities and equity interests have been recorded in the proper accounts.
For example, are assets likely to be converted to cash during the next accounting period,
which will determine current or non-current status.
Presentation In designing procedures for presentation the auditor will need to Page 372
consider the level of aggregation, and the relevance and understandability of the related
notes disclosures. For example, if assets are valued at fair value, are all the required
disclosures included, and are they understandable.
Nature of the item and available evidence

The nature of the item has an important influence on the auditor’s selection of audit
procedures. For example, the preceding discussion indicates that, for audit objectives
related to the existence assertion, likely audit procedures are physical examination, external
confirmation and vouching. For the procedure of physical examination to be useful, the
item must have a physical existence and be present. An auditor can count cash on hand or
inspect equipment, but must confirm an accounts receivable balance with the customer or
cash in a bank account with the client’s bank.
Another aspect of the nature of the item is the size and volume of transactions during the
period covered by the financial report. If an account balance is affected by only a few large
transactions, the auditor may design substantive tests directed to the individual transactions
that increase or decrease the balance (assuming that the beginning balance was
substantiated last year) in order to substantiate the ending balance. For example, account
balances for property and equipment, long-term debt and shareholders’ equity are often of
this nature. This is referred to as, and understood by auditors to be, a substantive test of
balances, even though it uses a transactions approach. Thus, substantive tests of balances
using the transactions approach can be distinguished from tests of transactions (as outlined
earlier in this chapter) by identifying whether the concern is with specific isolated
transactions or with an entire class of transactions.
The available evidence also influences the selection of procedures to achieve audit
objectives. For example, to confirm accounts receivable with individual customers, the
auditor needs a detailed list of the amount owed by each customer. The availability of
evidence may influence the auditor’s selection of procedures to achieve specific audit
objectives. If a common audit procedure cannot be applied because the evidence is

unavailable, an alternative procedure may be selected. Thus, for example, if the auditor was
unable to confirm the existence of an outstanding balance with a debtor, the existence of
this balance may be confirmed by a subsequent payment or by inspecting accompanying
documentation of the sale.
QUICK REVIEW
1. The auditor is required to respond to assessed risks of material
misstatement at both the financial report level and the assertion level.
2. Integrity of management is an example of a risk of material misstatement
at the financial report level (covering multiple account balances and
assertions), and appropriate auditor responses include maintaining a
higher level of professional scepticism and assigning more experienced
staff to the audit.
3. Tests of transactions and events consist of tests of controls and
substantive tests of transactions, and are aimed at gathering audit
evidence for the financial report assertions about classes of transactions
and events and related disclosures for the period under audit (discussed in
Chapter 8 ).
4. Substantive tests of balances are audit tests that substantiate account
balances at period end. They will be affected by the amount of tests of
controls and substantive tests of transactions that are undertaken. They
are aimed at gathering audit evidence for the financial report assertions
about account balances and related disclosures at the period end, which
include existence, rights and obligations, completeness, accuracy,
valuation and allocation, classification and presentation.
5. These financial report assertions provide the link between these risks and
the auditor’s response, being their evidence-collection procedures.
Page 373
LO 9.3 Cash, cash receipts and cash payments

The account balance cash is directly affected by both the cash receipts and cash payments
systems. As these are both routine and major transaction systems, the auditor commonly
undertakes tests of controls of both these systems (discussed in Chapter 8 ). The auditor
would be most worried about the assertions of occurrence and completeness of transactions
when undertaking substantive testing of these transactions systems. Accuracy of the dollar
value will become an assertion of concern if transactions involve foreign currencies.
When undertaking substantive tests of balances, the essential feature for the account
component cash (or commonly ‘bank’), as recorded in the statement of financial position,
is substantiation of the client’s bank reconciliations to achieve specific audit objectives
related to existence and completeness. Accuracy, valuation and allocation may become an
assertion of concern if the cash balance at year end includes amounts converted from
foreign currencies. Thus, most of the direct tests of the cash balance make use of
information obtained directly from banks. Usually, cash on hand is clearly immaterial and
not counted. However, in industries that require substantial amounts of cash on hand, such
as banks or casinos, a cash count may be an important and time-consuming audit
procedure.
It may be necessary to undertake both tests of transactions and tests of balances. Some
errors that ultimately affect cash may be better assessed by tests of controls and substantive
tests of transactions. For example, not invoicing a customer, invoicing the wrong amount,
paying a supplier’s invoice twice or paying for goods or services not received are not as
easily detected by substantive tests of cash balances. However, errors confined to cash
receipts and cash payments may be detected in tests of cash transactions or by cash balance
procedures. For example, omission of a payment from recorded cash payments or inclusion
of cash received after year end in cash receipts of the current period might be detected by
examining cash transactions or testing bank reconciliations.
Assertions, objectives and procedures

The financial report assertions, specific audit objectives and common audit procedures
traditionally used to achieve the objectives for auditing cash are summarised in
Table 9.1 . The primary procedures are:
external confirmation of balances and related information for all general bank accounts
tests of the client’s bank reconciliations.
TABLE 9.1 ASSERTIONS, OBJECTIVES AND SUBSTANTIVE
PROCEDURES FOR CASH BALANCES
Common substantive audit

Financial Specific audit procedures to achieve
report assertion objective objectives
Assertions about classes of transactions and events, and related

disclosures (cash receipts and cash payments)
Occurrence The transactions giving Inspect supporting

rise to cash receipts documentation
and cash payments For cash receipts, inspect
occurred during the remittance advice; for
cash payments, inspect
period documents supporting
payment (e.g. goods
received note and
supplier’s invoice)
Completeness All transactions and Undertake sequence

events giving rise to check of transaction
details and remittance
cash receipts and cash advices
payments that should
have been recorded
have been recorded
Accuracy Cash receipts and Inspect supporting

payments are documents to verify dollar
amount of transactions
recorded in the correct
amount
Cut-off Cash receipts and Check that last cash

payments are receipts and cash
payments before balance
recorded in the correct date and first cash
period receipts and cash
payments after balance
date are recorded in the

correct period
Classification Cash receipts and Check that cash receipts

payments are and cash payments
recorded correctly in
recorded in the proper accordance with the chart
accounts of accounts
Presentation Cash receipts and Check that cash receipts
payments are and cash payments
presentations are
appropriately approved and in
aggregated and clearly accordance with the
accounting framework
described, and related (particularly for the
disclosures are statement of cash flows)
relevant and
understandable
Assertions about account balances, and related disclosures (cash)
Existence Cash in the statement Request and examine

of financial position bank confirmation
exists at the balance Undertake tests of bank
date reconciliations
Rights and obligations Cash in the statement Request and examine

of financial position is bank confirmation,
especially for evidence of
owned by the entity restrictions on use of cash
and not restricted or or cash commitments
committed
Completeness Cash in the statement Undertake tests of bank

of financial position reconciliations
includes all cash items
at the balance date
Accuracy, valuation Cash in the statement Undertake tests of bank

and allocation of financial position is reconciliations
stated at the correct Test conversion rates for
any foreign currency
amount balances
Classification Cash has been Check that cash, and related

recorded in the proper items including overdrafts,
are correctly classified
accounts
Presentation Cash is clearly Read draft financial report

described and all to ensure clear description
and understandable
related disclosures are disclosures
understandable
Page 374
External confirmation of bank balances
The auditor commonly confirms the year-end cash balance by direct correspondence with
all banks with which the client has held accounts during the period. External confirmation
procedures provide evidence that the cash in the statement of financial position exists at the
balance date and that it is owned by the entity and is not restricted or committed. Page 375
Audit guidance on bank confirmation procedures is provided in Australia by GS
016 Bank Confirmation Requests. Bank confirmation requests ask a bank to provide
independent confirmation of the audit client’s account balances and other information held
by the bank on behalf of the client, including securities, treasury management instruments
and documents. The following two standard bank confirmation request forms have been
developed in conjunction with the Australian Bankers’ Association and are recommended
by the AUASB for use by auditors:
1. Bank confirmation—audit request (general) The information requested on this form

relates to the normal banking activities and is used to confirm cash. A standard form is
contained in Appendix 1 to GS 016.
2. Bank confirmation—audit request (treasury operations) The information requested
on this form relates to the entity’s treasury operations and use of treasury management
instruments. A standard form is contained in Appendix 2 to GS 016.
The standard bank confirmation—audit request (general) requests:
details of all account balances in favour of the client at a certain date (usually balance
date). This includes details of any current accounts, interest-bearing deposits, foreign
currency accounts, convertible certificates of deposit and money market accounts
details of all account balances owed by the client to the bank at a certain date (usually
balance date) in respect of overdraft accounts, bank loans and term loans, and details of
repayment terms
promissory notes and bills of exchange held for collection on behalf of the audit client
the audit client’s other liabilities to the bank
items held as security for the audit client’s liabilities to the bank
financing lease commitments

accounts opened or closed during the 12 months prior to confirmation date
defaults or breaches during the period
all available unused limits and facilities as at confirmation date
any other details relating to any financial relationships not dealt with by the above points.
The auditor should complete all known details on the confirmation request form before
forwarding the request to the bank. The bank is required to confirm all details provided by
the auditor as to correctness, to list all other relevant information from details contained in
its records and to ensure that all details supplied are correct as at the confirmation date.
Electronic bank confirmation procedures through email and third-party service providers
are becoming more common, and are an acceptable form of audit evidence (GS 016.59–
66).
Tests of a client’s bank reconciliations

The essential objective of testing a client’s bank reconciliations is to substantiate that the
balance confirmed with the bank agrees with the client’s cash accounting records.
Differences are caused by deposits in transit, outstanding cheques and other reconciling
items. The auditor’s objective is to obtain reasonable assurance that reconciling items are
authentic, complete and treated accurately.
The extent of testing of the client’s reconciliations varies depending on the assessed level
of control risk. Recall that the auditor normally plans for three assessment levels: low,
medium or high. Possible procedures for a client’s reconciliation are as follows:
1. Compare amounts on the reconciliation with totals in the bank statement, general ledger
and cash receipts and cash payments records, including a comparison of the balance per
bank with the amount confirmed by the bank.
2. Test the clerical accuracy of the reconciliation.
3. Compare deposits in transit on the reconciliation with deposits appearing in the
subsequent period’s bank statement and consider whether the time lag between the end of
the period and recording by the bank is reasonable.
4. Vouch other reconciling items in the reconciliation to supporting documents and test the
completeness of the list of reconciling items, especially unpresented cheques or
unreconciled direct debits or credits.
5. Consider the need to investigate reconciling items that have not been cleared. Page 376
(Large or unusual items should always be investigated.)
When the level of control risk is assessed as low, substantive procedures might be confined
to scanning the client reconciliations and comparing balances per bank to bank
confirmations. A medium assessed level of control risk might result in ensuring that the
procedures listed above are applied at year end.
If the level of control risk is assessed as high, the auditor extends the substantive
procedures in testing the client’s reconciliation by examining the individual details of
reconciling items. The individual supporting documents are examined and traced to the
cash accounting records. Outstanding cheques that did not clear are traced to cash payment
records, and old or unusual items are thoroughly investigated and resolved.
Extended cash procedures

When control risk for cash is assessed as high because of deficiencies in internal control,
there is usually a greater risk of fraud. A high control risk is unusual because most clients,
if they are going to maintain any controls, tend to maintain at least moderately effective
controls over cash. In cases of high control risk, a common audit procedure is the
preparation and review of a bank transfer schedule . A bank transfer schedule lists all
transfers and the dates of recording on the books and bank statements, and is most
commonly used to list those transfers around balance date. One of the more common frauds
involving cash is kiting (described in Chapter 8 ). Such a schedule is used when there is
a serious risk of kiting because cash controls are deficient and there are many bank
accounts and many bank transfers. When there are few bank accounts and few transfers, the
auditor scans the bank statements and cash records to determine whether deposits and
withdrawals between bank accounts are recorded in the same, and the correct, period.
QUICK REVIEW
1. The major assertions of interest to the auditor in testing the account
balance of cash are existence and completeness, and accuracy, valuation
and allocation if foreign currencies are included.
2. The major assertions of interest to the auditor in testing the associated
transactions of cash receipts and cash payments are occurrence,
completeness and cut-off (and accuracy if transactions involve foreign
currencies).
3. The main substantive test of the cash balance is substantiation of the
client’s bank reconciliations.

4. The standard bank confirmation request forms are used to help confirm
information from the client’s bank(s).
5. Cash on hand is usually immaterial and not counted.
LO 9.4 Sales, cash receipts and accounts receivable
Accounts receivable are significant current assets for many types of companies (such as
wholesale companies that sell goods or merchandise to retailers). The nature of the
account, with potentially many credit customers, and a usually significant risk of
misstatement (an overstatement of sales to increase profits is commonly associated with an
overstatement of accounts receivable), means that this is a transactions cycle that receives
considerable audit attention. When undertaking substantive tests for accounts Page 377
receivable, the assertions at greatest risk of material misstatement and therefore of
most interest to the auditor are existence and accuracy, valuation and allocation (when
overstatement of profits and, related to it, overstatement of assets are the major risks). For
the related transactions of sales and cash receipts, the equivalent assertions of interest are
occurrence, accuracy and cut-off. In practice there is commonly an emphasis on
substantive tests of balances, primarily for reasons of audit efficiency. These are achieved
primarily by external confirmation directly with customers for the existence assertion
(although recently there has been an increased emphasis on reviewing subsequent receipts
rather than direct confirmations), and by audit work based on a review of the aged trial
balance of accounts receivable for the accuracy, valuation and allocation assertion (also
aided by reviewing subsequent receipts). As explained in more detail later, the aged trial
balance is the basic work paper schedule in the receivables area because of audit efficiency
considerations.

Table 9.2 summarises the financial report assertions, specific audit objectives and
common audit procedures traditionally used to achieve the objectives for accounts
receivable and the related class of transaction account, sales (credit sales increasing
accounts receivable). Cash receipts, which increase cash and decrease accounts receivable,
were discussed in the previous learning objective. The common audit procedures listed are
the primary procedures traditionally used to achieve the related specific audit objective. As
applied in the accounts receivable area, the procedures have the following features:
ASSERTIONS, OBJECTIVES AND SUBSTANTIVE PRO
TABLE 9.2
AND ACCOUNTS RECEIVABLE
Financial report
assertion Specific audit objective Common substantive audit procedure
Assertions about classes of transactions and events, and related disclosures (sale
Occurrence The transactions giving Vouch entries in sales journal to supp

rise to sales occurred of sale (invoice, delivery note)
during the period
Completeness All sales transactions Test from supporting documentation (

and events that should to sales journal or subsidiary ledger
have been recorded
have been recorded
Accuracy Sales amount and other Verify prices, quantity and computatio
data are recorded prices verified to master price list, qua
shipping documentation
appropriately
Cut-off Sales are recorded in Check last sales invoices recorded be

the correct period first sales invoices recorded after bala
in the correct period; consider when d
of shipping documents
Classification Sales are recorded in Check that sales recorded correctly in

the proper account chart of accounts
Presentation Sales are appropriately Check that presentation of sales is in

aggregated or accounting framework
disaggregated and
clearly described, and
related disclosures are
relevant and
understandable
Assertions about account balances, and related disclosures (accounts receivable)
Existence Accounts receivable in Undertake debtors confirmation proc

the statement of Review subsequent receipts
financial position exist
at balance date
Rights and Accounts receivable in Undertake debtors confirmation proc
obligations the statement of Review minutes and contracts for evid
financial position are receivables, factoring or other liens
owned by the entity Enquire about related-party transactio
and not restricted or with non-standard sales terms
committed
Completeness Accounts receivable in Review subsequent receipts

the statement of Undertake sequence check of all sale
financial position
includes all accounts
receivable at the
balance date
Accuracy, Accounts receivable in Review aged trial balance and undert

valuation and the statement of procedures for amounts overdue, suc
subsequent receipts, discussions abo
allocation financial position is to pay
stated at the correct Test conversion rates for any foreign
amount receivable
Classification Sales have been Check that sales, and related items, in
recorded in the proper are correctly classified
accounts
Presentation Sales are clearly Read draft financial report to ensure c

described and all understandable disclosures
related disclosures are
understandable
Page 378
External confirmation Requests are sent directly to selected customers, asking
them to confirm an amount owed at a date specified in the request. This procedure has
lost prominence in recent years, because of its failure to adequately address the important
assertion of accuracy, valuation and allocation. However, because it is still relatively
important in many audits, and demonstrates the evidence-gathering technique of external
confirmations in general, it is further explained later in this learning objective.
Subsequent receipts review The auditor verifies whether the amount in outstanding
receivables is subsequently received (after year end but before the completion of the
audit). This is part of a subsequent events review, in accordance with ASA 560 (ISA 560)
Subsequent Events, and provides the auditor with evidence of the existence of the debt,
and evidence of the amount that was collectible (accuracy, valuation and allocation
assertion). As it covers both of the major assertions for accounts receivable, in many
cases it is preferred to external confirmation procedures. Because of the growing
importance of this technique, it is also discussed later in this learning objective.
Cut-off Audit procedures addressing the cut-off assertion are designed to determine that
all significant transactions of the current period are recorded and no significant
transactions of the next period are recorded, as of a specified date. For accounts
receivable, cut-off tests are concerned with the shipping of sales and cash collections.
The auditor identifies the numbers of the last pre-numbered shipping document and the
last pre-numbered sales invoice for the period, and determines that lower numbers are
recorded in the current period and higher numbers in the next period. If Page 379
documents are not pre-numbered, or if the sequence is not accounted for, the
auditor examines all sales transactions above a specified amount within a few days before
and after the end of the period, to test proper cut-off. Cash collection cut-off is tested by
identifying the last cash receipt recorded in the period and comparing the date to the date
of deposit in the bank. The ‘as of’ date for cut-off tests for receivables should be the same
as that used for debtors confirmation. A review of credit notes issued after the end of the
period is also undertaken in order to identify transactions from the previous period that
may require adjustment.
Substantive analytical procedures In the accounts receivable area, these include
comparison of amounts and ratios for relationships between sales and receivables,
allowance accounts and sales, and sales and cost of sales. Comparisons are made to
previous periods, budgets and information on unit quantities (units shipped to units
billed).
Tests of sales transactions Tests of sales transactions are usually dual-purpose tests, as
described earlier in this chapter, having both control and substantive elements. With
regard to substantive testing, they can be especially useful for testing assertions that are
not well tested by other audit procedures, in particular the completeness assertion. This is
because the primary evidence-gathering procedures in this area—external confirmation
and subsequent receipts review—are directed to other assertions, particularly existence
and accuracy, valuation and allocation. The auditor may rely on controls to ensure that
all transactions that should be included are actually included. If the audit approach does
not include tests of controls related to completeness of sales transactions (see
Chapter 8 ), the auditor must consider the need for transaction testing as part of direct
tests of the receivable balance. The transactions test that is relevant to completeness of
receivables is tracing from shipping documents to sales invoices. In practice, analytical
tests of sales and receivables, combined with consideration of the results of audit
procedures applied to inventory, are often considered sufficient for the assertion of
completeness. (Note that unrecorded sales should also result in inventory shrinkage.)
Review of aged trial balance An aged trial balance of receivables lists all customer
balances as of a specified date, and shows the total balance for each customer and the
components of the overall balance by age category, such as 30 days or below, 31 to 60
days, 61 to 90 days, and over 90 days. A periodic ageing is used by an entity’s financial
management to monitor collectibility and for cash management. This aged analysis is of
great interest to the auditor when addressing risk of material misstatement for the
accuracy, valuation and allocation assertion, as the accounting standards require
accounts receivable to be recorded at the amount the entity expects to receive, not the
amount owed. The auditor reviews the aged trial balance as of the balance date with the
credit manager as part of the evaluation of the reasonableness of the allowance for
doubtful debts. The older the debt, the greater the risk of the debt not being paid, thus the
greater the likelihood that an allowance needs to be made for non-payment. Since the
aged trial balance is usually prepared by the client, the auditor needs to test the accuracy
of the ageing by footing (independently adding up the outstanding amounts for each
ageing category in the aged trial balance) and tracing the total amount for the aged trial
balance to the general ledger figure for debtors and vouching individual debtors’ amounts
back to supporting documentation.
Other procedures These procedures, such as reading of minutes and contracts, are
usually applied separately to the audit, rather than in relation to specific balances.
However, the results of these procedures are considered in relation to the balances
affected. For receivables, the relevant information would concern the existence of
pledging, factoring or other liens on receivables (addressing the rights and obligations
assertion). Other procedures also include enquiries about the existence of related-party
transactions and transactions with non-standard sales terms (consignment sales or other
rights of return), and examination of source documents related to these transactions.
External confirmation procedures

ASA 505 (ISA 505) covers all external confirmation procedures, which are defined as
the obtaining of audit evidence in the form of a direct written response to the auditor from
a third party, following a request by the auditor.
In determining whether to use external confirmations when undertaking the Page 380
testing of accounts receivable, the auditor should consider materiality, the assessed
risk of material misstatement, and how the evidence from other planned audit procedures
will reduce audit risk to an acceptably low level for the financial report assertions
identified as containing a risk of material misstatement. While undertaking external
confirmation procedures is still very common in practice, and accounts receivable is the
account balance where confirmation procedures are most commonly used, auditors are
commonly cautioned about over-relying on them for specific assertions requiring audit
attention when compared with other audit procedures. In particular, while a debt confirmed
by a debtor is strong evidence of the existence of the debt, it does not provide evidence of
intention of the client to pay (accuracy, valuation and allocation assertion). Other
procedures, such as review of subsequent receipts, are considered more appropriate tests
for the accuracy, valuation and allocation assertion, as these clearly show the amount paid
attributable to amounts outstanding at balance date.
If it is decided that an accounts receivable confirmation is an appropriate procedure, then

there are two alternative methods of requesting an external confirmation: positive (more
commonly used) and negative debtor’s confirmation .
1. Positive form of debtor’s confirmation Once a debtor has been selected for positive
confirmation, the auditor must obtain evidence on the account balance, either through a
response to the confirmation or through alternative procedures. The positive form asks
the debtor to respond, whether or not the debtor agrees with the information on the
amount owed in the request. The receipt of a response from the debtor provides evidence
of the existence of the receivable. It provides no positive evidence of collectibility but
may help to detect a disputed amount, which indicates doubtful collectibility. Some
auditors provide all details of the transaction except the amount, and request that
recipients of the confirmation provide the balance or invoice amounts owed.
2. Negative form of debtor’s confirmation The negative form of request asks the
debtor to respond only if there is disagreement with the information given. Generally, the
negative form provides less reliable evidence, as a non-response may be for reasons other
than the client agreeing with the balance, such as difficulty of reconciling. For this reason
the number of negative confirmation requests sent should be greater than the number of
positive requests that would be sent in similar circumstances. If the number of
confirmations returned as undeliverable is more than expected, the auditor may suspect
the possibility of fictitious receivables.
A combination of positive and negative forms may be used. For example, where the total
accounts receivable balance comprises a small number of large balances and a large
number of small balances, the auditor may decide to confirm all or a sample of the large
balances with positive confirmation requests, and a sample of the small balances or the
remaining other balances using negative confirmation requests.
Exhibit 9.1 shows a positive debtor’s confirmation letter. Generally, auditors have
found that the response rate is improved when the request accompanies a regular monthly
statement to the customer. Note that the request comes from the client, and the auditor
should ensure that adequate control over external confirmations is maintained.
Page 381
FORMAT OF POSITIVE ACCOUNTS RECEIVABLE C
EXHIBIT 9.1
WITH ITEMISED STATEMENT ENCLOSED

[Client’s letterhead]
[Date]
[Debtor’s name and address]
Dear ____________________,
Our auditors, [name], are making an annual audit of our financial report. Please co
[date], which is shown on our records and on the enclosed statement as $ _____
Please indicate in the space below whether this is in agreement with your record
please provide any information that will assist our auditors in reconciling the diffe
Please sign and date your response and mail your reply directly to [auditor’s nam
enclosed return envelope.
PLEASE DO NOT MAIL PAYMENTS ON YOUR ACCOUNT TO THE AUDITORS.
Yours sincerely,
[Officer’s signature and title]
[Client’s name]
_______________________________________________________________
To: [auditor’s name]

The balance due [client’s name] of $ __________ as of [date] is correct with the f
_______________________________________________________________
_______________________________________________________________
_______________________________________________________________
Signature: ___________________
Title: _______________________
Date: _______________________
The external confirmation process has to be started early enough during the audit to allow
adequate time to mail initial requests, send second requests if necessary or undertake other
follow-up work, and analyse responses.
When planning the accounts receivable confirmations, the auditor considers the following:
Prior experience Experience with the client or with similar clients may have shown
poor response rates or other indications that external confirmations are ineffective. Is
enough information provided to help the recipient to respond? Is the confirmation request
being directed to the correct person?
The nature of the information being confirmed Should invoices or balances be
confirmed? For example, if most of the debtor’s accounting systems track individual
invoices rather than balances, it is ineffective to send a balance confirmation.
Whether there have been any unusual transactions, such as large sales at or near
year end The auditor might design the confirmation by asking additional questions
aimed at identifying inflated sales for the period, such as through transactions where
merchandise is invoiced to distributors with a right of return if not sold (‘channel
stuffing’, as described in Chapter 8 and expanded upon in
Auditing in the global news 9.1 ), in order to inflate sales for a particular accounting
period. If so, the external confirmation should request information on the terms of such
types of agreements.
The respondent Care should be taken to direct external confirmations to the individuals
knowledgeable about the transactions or arrangements.
Page 382
9.1 Auditing in the global news ...
Substantive tests for channel-stuffing fraud

As outlined in Auditing in the global news 8.1 , in Chapter 8 , one of
the more tempting and insidious forms of accounting manipulation is
‘channel stuffing’. This practice involves selling more product to distributors
than they can realistically sell to the market. As inventory is not cheap for
distributors to carry, companies usually offer incentives such as discounts,
better credit terms or right of return on the products to persuade distributors
to play along.
A number of companies have been caught channel stuffing, including Bristol-

Myers Squibb, where two executives in the company—including the former
chief financial officer—allegedly began selling ‘excessive amounts’ of drugs
to their wholesale distributors in early 2000 in order to help the company
meet increasingly high Wall Street sales and earnings estimates. The
company guaranteed a specific rate of return on the inventory until it was
sold to consumers. The scheme continued for two years and ultimately
resulted in a US$2.5 billion restatement of Bristol-Myers’ financials, and a
total of at least US$750 million in fines and shareholder restitution. As
outlined in Chapter 8 , the practice continues today. A recent article on
Bloomberg accused General Motors (GM) of channel stuffing, whereby
excess inventory was ‘sold’ to dealerships so that GM could record those
sales on its books, creating the false appearance of revenues, even while
those cars remained unsold on dealer lots. Other companies identified as
having undertaken this practice include Krispy Kreme and Sunbeam. In
certain industries, such as the computer industry, it is believed to be
common.
Why is it a problem?
As discussed in Chapter 8 , if revenue is permitted to be recognised

under this method, then accounting numbers can be manipulated to
whatever management wants, simply by placing whatever quantity of
inventory is desired with a distributor/retailer under this arrangement before
year end. Thus, accounting numbers become meaningless for determining
either financial performance or financial position.
What should the auditor do?
The risk of this type of material misstatement is unlikely to be reduced by
internal control systems, as they are not normally designed for this type of
misstatement. Thus, if the auditor suspects such a situation, they should
undertake not tests of controls but substantive procedures.
The risk-identification procedures should include:
enquiries of management regarding the terms and conditions associated

with the sales
scanning the accounting records for large or unusual transactions,
particularly those recorded late in the period
identification of related parties and consideration of whether material
transactions may involve parties with an undisclosed relationship
undertaking analytical procedures to identify unusual revenue or gross
profit changes that produce unexplained spikes at year end
reviewing the levels and details of sales returns. (For the first year of this
practice, there may not be an unusual level of returns until after the auditor
has completed the audit.)
The response-to-assessed-risk procedures should include:
reviewing the details of contracts of sale for sales to distributors

designing external confirmations not only to confirm outstanding amounts,
but also to confirm the details of the sales agreements, including date, any
rights of return and delivery terms. The auditor might find it effective to
supplement such external confirmations with enquiries of non-financial
personnel within the entity regarding any changes in sales agreements and
delivery terms.
In evaluating the responses received, the auditor considers whether disagreements Page 383
noted by debtors merely indicate discrepancies caused by timing, such as those

caused by mailing time for cash receipts or by shipping time for shipments, or are a result
of actual clerical errors or disputed amounts. The auditor does not want to project
monetary misstatement for timing discrepancies or isolated errors, so the qualitative
analysis of confirmation responses is extremely important.
Once a debtor has been selected for positive confirmation, there must be follow-up
procedures, such as further requests, if an initial positive request does not result in a
response. The reason for this is that the lack of response may be an indication of fictitious
receivables or a bad debt, and these possibilities must be pursued.
If management requests that the auditor not confirm certain accounts receivable balances,
the auditor should consider whether there are valid grounds for such a request. Such a
request might be justified if, for example, the particular account is in dispute and
communication on behalf of the auditor might jeopardise sensitive negotiations between
the entity and the debtor. Before accepting a refusal as justified, the auditor should examine
any available evidence to support management’s explanations, such as correspondence
between management and the debtor. In such cases, alternative procedures should be
applied to the accounts receivable not subjected to external confirmation.
ASA 505.15 (ISA 505.15) states that negative confirmations may be used to reduce the risk
of material misstatement to an acceptable level when:
1. the assessed risk of material misstatement (a combined inherent and control risk
assessment) is low
2. a large number of small balances is involved
3. a substantial number of errors is not expected
4. the auditor has no reason to believe that the confirmation recipients will not seriously
consider the requests.
Alternative procedures to external confirmation

As outlined earlier, the use of external confirmations has decreased in practice as auditors
have determined that other procedures are a more appropriate form of audit evidence (in
particular with regard to the accuracy, valuation and allocation assertion). These
alternative procedures may include examination of evidence of subsequent cash receipts, or
examination of sales and shipping documents. Generally, subsequent cash receipts are
considered to be a superior form of evidence because sales and dispatch documents
originate in the client’s system, and substantiating subsequent collection simultaneously

achieves the audit objectives related to assertions at risk: existence and accuracy, valuation
and allocation. (Also, a cash receipt may cover more than one sales transaction to that
customer.) But on the other hand, subsequent receipts may not be timely enough, especially
if there is a short deadline for completing the audit. The alternative procedure of
examination of sales and shipping documents is essentially the same as that used in tests of
transactions: vouching, tracing and recomputing of source documents. However, instead of
a representative sample of source documents, the auditor applies procedures to the specific
documents for selected account balances.
These alternative procedures can also be applied to non-respondents to a positive debtors

confirmation procedure in order to gain sufficient appropriate audit evidence. The auditor
also needs to consider the qualitative characteristics of the non-responses. Is there a
systematic characteristic, such as a tendency to be the year-end transactions?
Materiality
Materiality is used primarily to identify individually significant customer accounts for
testing, through either external confirmation or alternative procedures. Examples of
customer accounts that might be identified as individually significant include:
large dollar balances

significant balances past their due dates
significant balances as a result of sales near the end of the accounting period Page 384
accounts with unusual names

related-party balances
credit balances.
Often the recorded amount that remains after identification of individually significant
items is in total a very large dollar amount, and audit sampling is necessary (audit sampling
procedures will be discussed in Chapter 10 ). In fact, external confirmation of accounts
receivable is one of the most frequent audit sampling applications among substantive tests
of balances.
QUICK REVIEW
1. The major assertions of interest to the auditor in substantive tests of
balances for accounts receivable are existence and accuracy, valuation
and allocation.
2. The major assertions of interest to the auditor in substantive tests for the
related transactions of sales and cash receipts are occurrence and
accuracy.
3. The main audit procedures are confirming balances directly with the
customers, reviewing subsequent receipts and reviewing the aged trial
balance of accounts receivable.
4. There are two types of accounts receivable confirmation: the positive form,
in which the debtor is asked to respond, whether or not the debtor agrees
with the information on the amount owed in the request; and the negative
form, in which the debtor is asked to respond only if there is disagreement
with the information given.
LO 9.5 Purchases and inventories
Inventories consist of goods to be sold, or to be used in the production of saleable goods, in
the ordinary course of business. The transactions involving inventory are an increase when
goods are purchased and a decrease when goods are sold. Usually, especially for retail and
manufacturing entities (but not for service entities), inventory is a material and complex
area of the audit. The nature of the account, with potentially many inventory lines,
significant auditor judgments (such as valuation at lower of cost and net realisable value)
and a usually significant risk of misstatement (profits are impacted by whether inventory is
deemed to be on hand (asset) or sold (expense)), means that this is a transactions cycle
which receives considerable audit attention. The form of inventory varies depending on the
nature of the business. A manufacturer will have inventories of raw materials, work-in-
progress and finished goods. A retailer or wholesaler will have goods acquired for resale.
The related transactions cycles are purchases of raw materials (manufacturer) or of finished
goods (retailer), and cash payments. This discussion is generalised to apply to both types of
inventory, identifying any significant differences at relevant points. Some types of service
industries, such as hospitals or repair services, also have supplies that can be inventoried,
and while inventories are usually less material in these situations, if considered material the
audit approach is generally similar.
Differences from the sales and expenditures

cycles
The inventory area of the audit is sometimes referred to as the production or conversion
function, and there is a relationship between inventory and the sales and expenditures
cycles. For example, for a manufacturer, the sales cycle includes the shipment of finished
goods and the expenditures cycle includes the acquisition of raw materials, direct labour
(payroll) and overhead expenses. However, the inventory area is different in nature for
reasons explained in the following discussion.
Nature and frequency of reconciliations
Recall that for the sales and expenditures cycles, reconciliations are usually important
control activities, used as a basis for the auditor’s assessment of control risk. For example,
the accounts receivable subsidiary ledger is reconciled to the general ledger Page 385
control account, prelists of cash receipts are reconciled to deposits and accounting
postings, and cash in bank accounts is reconciled to cash accounting records. Also, outside
parties may provide information that is used when reconciling. Monthly statements are
mailed to customers and complaints are independently resolved. Suppliers’ statements may
be reconciled with accounts payable balances.
These reconciliations are usually performed at least monthly; many are performed more
frequently. Almost invariably, these reconciliation activities are control activities that are
important for achieving specific control objectives that permit the auditor to reduce the
assessed level of control risk.
For inventories, the undertaking of a physical inventory count, or stocktake by the
client, and the comparison to accounting records, is a most important procedure. This
reconciliation commonly occurs only once a year, and it is essentially a stand-alone
procedure—its effectiveness depends on procedures that are applied only when the
inventory is counted. In practice, there are usually two ways of counting inventory. In a co
mplete inventory count , operating activity largely stops and all inventory is counted at
one time. In a cycle count , periodic counts of selected inventory items are made during
the year, with all items counted at least once each year. Auditors’ procedures regarding
inventory counts are considered dual-purpose tests (see under Relationship between evide
nce-gathering procedures , earlier in this chapter), because the auditor is concerned
with both the accuracy of the physical count and the effectiveness of the control activities
over the client’s counting and pricing.
Importance of accounting principles
As discussed earlier, audit problems associated with the sales and expenditures cycles tend
to be those related to high-volume clerical processing rather than complex accounting
principles. Accounting principles cannot be totally ignored: for example, the auditor needs
to be concerned with classification and recording in the proper period. However, in the
inventory area there may be both a large number of items and complex matters of
accounting principle.
Generally, the auditor is concerned with application of accounting principles in the

following respects:
assignment of costs to inventory in accordance with an acceptable accounting method,

such as first in, first out (FIFO) or average cost, and the consistency of the accounting
method and the methods of application
identification and proper accounting treatment of obsolete, slow-moving, excess or
defective inventory items
reduction of inventory items to replacement cost or net realisable value (lower of cost or
net realisable value).
It can be very difficult to assign costs to inventory. A manufacturer may use a standard cos
t system , in which case the auditor must be concerned with whether the adjustments to
standard cost result in a reasonable approximation of actual cost. A retailer may use the ret
ail inventory method , in which case the auditor must be concerned with whether the
adjustment of inventory at selling price approximates actual cost (or net realisable value if
this is lower).
For a manufacturer, the auditor must be concerned with conformity with regulations on the
proper allocation of overhead expenses. Approved accounting standards require the use of
absorption costing, where both fixed and variable production overhead related to bringing
inventories to their present location and condition are allocated to inventory.
Materiality and method of allocation
In accounting, the process of apportioning costs incurred between expenses of the current
period and assets that benefit future periods is broadly referred to as allocation. The
general accounting records accumulate the totals of costs incurred for inventory, such as
purchases and payrolls. Source documents provide a record of units purchased (receiving
reports) and units sold (shipping reports), or, as in a perpetual inventory system, a separate
record of units may be maintained.
At the end of the accounting period, the costs incurred for inventory during the Page 386
period must be allocated between units sold and units on hand. This is the function
of the cost accounting system. The term cost accounting system is usually applied to
manufacturers. However, even a merchandiser who acquires goods for resale often needs a
system for assigning costs of acquiring and storing goods, such as freight and warehousing,
to inventory. Inventory costs are seldom confined to the supplier’s invoice price.
Cost accounting systems vary greatly in complexity and sophistication, but whether the
costing approach is sophisticated or rudimentary, the resulting allocation between the
current period and future periods can commonly have a material effect on profit. Cost of
sales is often 60 per cent or more of sales, the largest expense in the income statement.
Also, inventory is usually material to the statement of financial position and a very
material component of current assets. Thus, the misstatement of the allocation between
cost of sales and inventory can cause a material misstatement of the operating results and
financial position.
The substantiation of both cost of sales and ending inventory is usually dependent on direct
tests of the ending inventory balance, combined with tests of transactions for the
expenditures cycle or direct tests of balances of accounts related to that cycle. In a
continuing engagement, beginning inventory has been substantiated in the previous period.
The amount of cost of sales is, in effect, a residual of the following activity analysis:
Beginning inventory
plus Expenditure for goods and services for inventory
less Ending inventory
equals Cost of sales
It is usually tested indirectly by tests of inventory and expenditures.
The significance of ending inventory to the determination of net profit, combined with the
high volume of activity and accounting complexities, often creates a high risk of material
misstatement. The inventory area is particularly susceptible to intentional misstatements
designed to manipulate profit, and it is important for the auditor to maintain professional
scepticism. If the auditor’s procedures detect discrepancies between accounting records and
supporting documentation or other corroborating information, the auditor should consider
the possibility of material misrepresentations by management.

The essential feature of substantive tests of balances for inventories is emphasis on specific
audit objectives related to the existence and accuracy, valuation and allocation assertions,
achieved primarily by observation of physical inventory and tests of pricing and
summarisation. ASA 501 Audit Evidence—Specific Considerations for Inventory and
Segment Information (ISA 501 Audit Evidence—Specific Considerations for Selected

Items) establishes standards and provides guidance on obtaining sufficient appropriate
audit evidence regarding these two assertions. The financial report assertions, specific
audit objectives and common audit procedures to achieve these objectives are summarised
in Table 9.3 . As applied in the inventory area, these procedures have the following
features:
Observation of physical inventory This term is used to describe the combination of
observation, enquiry and physical examination (test counts) that provides the basis for
achieving several specific audit objectives for inventory. It will be explained further later
in this chapter.
Substantive analytical procedures In the inventory area these include computation of
ratios for inventory turnover and detailed gross margin (by product type or code and
location), and comparison to previous periods. For a manufacturer, computation of the
ratio of overhead to materials and labour and comparison to previous periods may be an
important substantive test. If a standard cost system is used, it is usually important to
study variance reports and consider the reasonableness of explanations for variances.
Sales forecasts and marketing plans may provide information relevant to the net realisable
value of inventory. In general, substantive analytical procedures usually receive more
emphasis in the inventory area than in many other audit areas.
Cut-off Procedures relating to this assertion are directed to the control over Page 387
shipping and receiving activities around the end of the accounting period.
Usually, the auditor identifies the numbers of the last pre-numbered shipping and
receiving documents at the time of the observation of physical inventory. These numbers
are used for cut-off tests for accounts receivable and accounts payable recording. The
document numbers are also used to determine whether the related inventory items were
properly included in or excluded from the physical inventory count and, if perpetual
records are maintained, the inventory records. The inclusion or exclusion of inventory
items in transit should ideally be based on the passage of title as determined by the
shipping terms ‘free on board’ (FOB), where title passes at the shipping point, and ‘cost,
insurance and freight’ (CIF), where title passes at destination. However, unless the
difference would be material, sales are often recorded when shipped and purchases when
received.
Tests of accuracy, valuation and allocation This term is used to describe the
combination of vouching and recalculation procedures used to test the client’s pricing and
summarisation of inventory counts. It will be explained further later in this chapter.
Other procedures These procedures include reading of minutes, debt instruments and
agreements, to find indications of liens or pledging of inventory, unrealised losses on
purchase commitments or inventories held on consignment. There are also discussions
with management and reviewing of perpetual records or of other records or reports of
inventory usage and movement concerning obsolete, excess or slow-moving inventory.
ASSERTIONS, OBJECTIVES AND SUBSTANTIVE PRO
TABLE 9.3
PURCHASES AND INVENTORY
Financial report
assertion Specific audit objective Common substantive audit procedure
Assertions about classes of transactions and events, and related disclosures (purc
Occurrence The transactions giving Select transactions from purchases jo

rise to purchases supporting documentation (e.g. good
occurred during the
period
Completeness All purchases Test from supporting documentation (

transactions and events goods received note) to purchases jo
ledger
that should have been
recorded have been
recorded
Accuracy Purchases amount and Check dollar value of purchases to su

other data are recorded documentation (purchase invoice), an
as supplier’s name recorded accurate
appropriately
Cut-off Purchases are recorded Check that last purchases recorded b

in the correct period first purchases recorded after balance
the correct period; consider when rec
goods received note
Classification Purchases are recorded Enquire and scan to determine that p

in the proper accounts correctly in accordance with the chart
Presentation Purchases are Check that purchases and cost of goo

appropriately accordance with the accounting fram
aggregated and clearly
described, and related
disclosures are relevant

and understandable
Assertions about account balances, and related disclosures (inventory)
Existence Inventories included in Inspect physical inventory (check from

the statement of physical stock)
financial position Undertake substantive analytical proc
physically exist and Confirm stock held at other locations
represent items held for
sale in the ordinary
course of business
Rights and Inventory in the Enquire about legal ownership of goo

obligations statement of financial entity and any goods on consignmen
supporting documentation
position is owned by
the entity and excludes
items billed to
customers or owned by
others
Completeness Inventory in the Inspect physical inventory (check from

statement of financial inventory records)
position includes all Undertake substantive analytical proc
inventories on hand at Enquire about stock held at other loc
balance date, or in purchase documents for shipping term
transit
transit or at other
locations, that are the
property of the entity
Accuracy, Inventory in the Undertake tests of pricing and summa

valuation and statement of financial Undertake substantive analytical proc
allocation position is stated at the Observe physical inventory (look for o
correct amount with items)
respect to: Enquire of management and scan inv
cost determined by an identify any obsolete, excess or slow-
acceptable method Check subsequent sales prices and c
consistently applied
slow-moving, excess,
defective and obsolete
items identified are
reduced to net realisable

value if lower than cost
Classification Purchases have been Check that purchases are correctly cl

recorded in the proper
accounts
Presentation Purchases (and COGS) Read draft financial report to ensure c

are clearly described understandable disclosures
and all related
disclosures are
understandable
Page 388
Observation of physical inventory

The following list highlights some points that are often misunderstood about observation of
physical inventory:
1. The client’s taking of the physical inventory is a control activity, but it is a stand-alone
activity and its effectiveness is not dependent on control over processing transactions.
Thus it is one of the very few areas where controls are directed towards account balances,
rather than being associated with transaction or event flows.
2. The procedures the auditor uses are a combination of observation, enquiry and physical
examination (undertaking test counts of the client’s counts).
3. The auditor’s goal is to obtain reasonable assurance that the client’s methods of Page 389
counting inventory result in an accurate count, which is a test of controls. The
auditor undertakes test counts as an aid in making this assessment, as well as gathering
other substantive evidence while inspecting inventory.
4. In most circumstances there are no satisfactory alternative procedures to making or
observing some counts of items in inventory for verifying the ending inventory.
When inventory is material, the auditor is required to obtain sufficient appropriate audit
evidence regarding its existence and condition by attendance at a physical inventory count
unless it is impractical (ASA 501/ISA 501). In exceptional circumstances, the auditor may
judge it necessary to depart from this procedure in order to achieve the same objective
more effectively; the justification for this departure should be documented in the audit
working papers.
In planning attendance at the physical inventory count, the auditor considers:

inherent, control and detection risks and materiality related to inventory

whether adequate procedures are expected to be established and proper instructions
issued for physical inventory counting
the timing of the count
the locations at which inventory is held
whether an expert’s assistance is needed.
In determining the need to use an expert, the auditor would consider the materiality of the
inventory, the nature and complexity of the items and other evidence that is available.
Situations in which experts are normally required include where minerals are stored in
stockpiles or where the client is in the business of selling items that require expert
valuation, such as gemstones or paintings. If an expert is required, the auditor follows the
standards and guidance outlined in ASA 620 (ISA 620) Using the Work of an Auditor’s
Expert, as discussed in Chapter 4 .
The desirable features of client procedures for taking a physical inventory include:
a written plan of instructions for inventory counting, which is communicated to all

relevant staff
proper arrangement of inventory items to facilitate counting
procedures for the identification and recording of obsolete or excess inventory
numerical control of inventory tags (tags placed on inventory after counting to show that
items were included in the count) or count sheets, and accounting for all used and unused
tags or sheets
personnel on inventory count teams being independent of inventory storekeeping
supervision of counting by internal auditors or supervisory personnel who re-count on a
test basis.
To obtain assurance that management procedures are adequately implemented, the auditor
observes employee procedures and performs test counts. When performing counts the
auditor may test both the completeness and the existence of inventory, by vouching items
selected from the records to the physical inventory (existence), and tracing items selected
from the physical inventory to the count records (completeness). The auditor considers the
extent to which copies of such count records need to be retained for subsequent testing and
comparison. The auditor also considers cut-off procedures, including details of the
movement of inventory just before, during and after the count, so that the accounting for
such movements can be checked at a later date.
A physical inventory count conducted at a date other than period end is usually adequate
for audit purposes only when control risk is assessed as less than high. The auditor assesses
whether, through the performance of appropriate procedures, changes in inventory between
the count date and period end are correctly recorded. When the entity operates a perpetual
inventory system which is used to determine the period-end balance, the auditor would
assess, through the performance of additional procedures, whether the reasons for any
significant differences between the physical count and the perpetual inventory records are
understood, and whether the records are properly adjusted.
Sometimes the inventory balance may be material, but attendance at an inventory count is
impractical because of the nature or location of the inventory; in exceptional
circumstances, the auditor may be able to justify not attending the physical inventory
counting (for example, the counting of cattle roaming around a Northern Territory Page 390
cattle station). In these circumstances the auditor should consider whether
alternative procedures provide sufficient appropriate audit evidence of existence and
condition (related to accuracy, valuation and allocation) to conclude that they need not
make reference to a scope limitation in the auditor’s report (see Chapter 12 ). For
example, the auditor may not be engaged until after the client’s physical inventory count. A
potential alternative procedure is for the auditor to make test counts at a later date and, by
examining the documentation of inventory receipts, issues, movements and shipments, to
work back to the quantities on hand at the count date and make comparisons to the client’s
counts. This means the client must maintain good records of inventory movements for the
period between the count date and the auditor’s test counts. In order to test the
completeness assertion for inventory, the auditor needs to make enquiries about stock held
at locations other than the client’s. Incomplete inventory may also be detected using
substantive analytical procedures such as the ratio of sales to cost of sales to discover
irregularities.
If inventory is under the custody and control of a third party, the auditor ordinarily obtains
a confirmation from the third party as to the quantities and condition of inventory held on
behalf of the entity. Depending on the materiality of this inventory, the auditor would also:
consider any apparent lack of integrity and independence of the third party
observe, or arrange for another auditor to observe, the physical inventory count
obtain another auditor’s report on the adequacy of the third party’s internal control for
ensuring that the inventory is correctly counted and adequately safeguarded
inspect documentation regarding inventory held by third parties (for example, warehouse
receipts), or obtain external confirmation from other parties when such inventory has
been pledged as collateral.
Tests of accuracy, valuation and allocation

The auditor is required to evaluate the bases used by management in the accuracy,
valuation and allocation of inventory, and to perform audit procedures designed to obtain
sufficient appropriate audit evidence regarding these bases. Audit sampling may be used in
verifying cost of inventory by vouching cost price back to suppliers’ invoices or cost
accounting records. The auditor may also vouch unit prices to suppliers’ invoices, current
supplier price lists or published prices, and review records of internal usage and movement
of inventory. The auditor also needs to ensure that the inventory flow assumption used to
assign costs to inventory are in accordance with an acceptable accounting method, such as
FIFO or average cost, and check the consistency of the accounting method and the methods
of application.
With inventory required to be valued at the lower of cost and net realisable value, there
needs to be testing for obsolete, excess or slow-moving items. If the entity has adopted
specific criteria, such as a reduction in cost for all items for which they have more than a
year’s supply on hand and all items that have not been sold or used within six months, the
auditor evaluates the reasonableness of the criteria and tests the client’s application.
Materiality
The auditor uses materiality in the inventory area primarily as a means of identifying
individually significant inventory items and regards items as individually significant
because of their dollar size. The auditor usually includes these items among the items test
counted and determines the number of test counts to make on the basis of risk and
materiality considerations. The risk and materiality considerations will be influenced by
whether the physical arrangement of items facilitates observation and accurate counting,
and the extent of the client’s planning, supervision and testing of the counts.
QUICK REVIEW
1. Due to the significance of inventory to the determination of net profit, and
the associated high levels of activity and accounting complexities,
inventory is often one of the most complex and high-risk areas to audit.
2. The main assertions of interest to the auditor in undertaking tests Page 391
of balances for inventory are existence and accuracy, valuation
and allocation.
3. When inventory is material, the auditor is required to attend a physical
inventory count unless this is impractical. To obtain assurance that
management procedures for the inventory count are adequately
implemented, the auditor observes employee procedures and performs
test counts.
4. The auditor tests the summarisation of quantities from the inventory count
to obtain reasonable assurance that all items counted are included in the
inventory list, and that no items have been inappropriately added.
5. The auditor tests accuracy, valuation and allocation by vouching items to
suppliers’ invoices and cost accounting records, and examines the client’s
review of obsolete, excess and slow-moving items.
LO 9.6 Accounts payable, payments and payroll
A major part of accounts payable is trade creditors, which is related to the
purchases/inventory/cash payments cycle. When shipments of raw materials and finished
goods are received and placed in inventory, this gives rise to an equivalent liability—trade
creditors—until payment is made. Accounts payable also comprises other suppliers (such
as suppliers of electricity or other items not used in production or resale), sometimes
termed ‘other creditors’. An essential feature of substantive tests of balances for accounts
payable is emphasis on the specific audit objective related to completeness. This is a
reflection of the fact that the auditor’s major risk is in understatement of this account
(given that overstatement of profits, which can be achieved by understatement of expenses
and liabilities, is the major risk). The completeness objective is achieved primarily by a
search for unrecorded payables, a review for any goods received and included in inventory
but not taken up as a liability, and analytical tests of related expense account balances. The
understating of liabilities can also be achieved by including the liability on the list of
payables at year end but at an amount below the appropriate value, and thus the accuracy,
valuation and allocation assertion is also of interest to the auditor.

The financial report assertions, the specific audit objectives and the common audit
procedures traditionally used to achieve the objectives for accounts payable and related
accounts are summarised in Table 9.4 . As applied in the accounts payable area, these
procedures have the following features:
External confirmation External confirmation procedures for accounts payable balances

are less common in practice than external confirmation of accounts receivable. External
confirmation is generally considered relevant to achieving specific audit objectives
related to existence, rights and obligations and to some extent accuracy, valuation and
allocation, and can be an efficient and effective procedure for achieving these specific
audit objectives. However, some auditors use external confirmation procedures for
accounts payable balances when control objectives related to occurrence and accuracy of
associated transactions have serious deficiencies. External confirmation requests are sent
to suppliers with whom the entity has done a relatively large volume of business during
the period. The auditor is concerned with what should be recorded rather than with what
is recorded, so the emphasis is placed on selecting suppliers who are likely to have large
balances. The accounts payable balances selected may therefore include zero and small
recorded balances. The normal form of external confirmation request for payables is
positive, and asks the supplier to state the balance due from the client. The auditor’s
analysis of responses is similar to that for external confirmation of receivables. A
distinction must be made between discrepancies caused by payments and shipments in
transit, such as a cheque drawn before year end that the supplier does not receive until
after year end, and those caused by clerical errors, disputes and unrecorded invoices.
Vouching Some auditors regard vouching recorded payables balances to Page 392
suppliers’ statements as being equivalent in reliability to external confirmation
because the evidence from the supplier’s statement originates outside the client’s
accounting system. Vouching is effective when recorded accounts payable are reconciled
to monthly statements received from suppliers. However, if the client’s system does not
include an accounts payable subsidiary ledger or a suppliers master file, such a
reconciliation can be time consuming and difficult.
Search for unrecorded liabilities The emphasis of this procedure is on identifying
obligations that should have been recorded at the balance date. It directly tests the
accounts payable balance for completeness (understatement). As it is the central
procedure in the accounts payable area, it will be explained further later in this chapter.
Cut-off The auditor determines the last receiving report, last voucher and last payment
of the current period by reference to the pre-numbered sequence for those documents, and
then checks that the transactions immediately before and after cut-off are recorded in the
correct period.
Substantive analytical procedures Comparison of expenses, budgets and level of
activity in the current period with similar information from previous periods can provide
evidence for recorded expense and liability balances. In some cases an analytical
procedure can substantiate the total expense and related accrued liability. For example,
sales commission expense and accrued commissions payable can usually be reliably
estimated based on recorded sales and knowledge of the terms for commissions.
Recalculation Some accrued liabilities, such as electricity and telephone accounts, can
be substantiated by examining payments in the subsequent period and calculating the
portion attributable to the previous period under audit. In general, recalculation is used
for accruals and deferrals that are recurring adjustments in closing the accounting
records.
Other procedures Unrecorded liabilities may arise from matters such as commitments
under contracts, legal claims against the entity or other loss contingencies. The auditor
normally relies on reading of minutes, contracts, loan agreements and leases to detect
unrecorded liabilities for which no indication exists in the accounting records or source
documents. For example, the minutes of meetings of the board of directors may reveal a
potential legal liability. The auditor will also enquire of management and scan the
accounting records to identify matters relevant to the description, classification and
related disclosure of liabilities in the statement of financial position. For example,
enquiry and scanning may identify related-party payables or losses under sales or
purchase commitments.
ASSERTIONS, OBJECTIVES AND SUBSTANTIVE
TABLE 9.4 PROCEDURES FOR ACCOUNTS PAYABLE AND
RELATED ACCOUNTS
Common substantive
Financial report audit procedures to
assertion Specific audit objective achieve objectives

disclosures (purchases)
Occurrence The transactions giving Select transactions

rise to accounts payable from accounts
payable listing and
occurred during the agree to supporting
period documentation (e.g.
suppliers’ invoices)
Completeness All purchase transactions Test from supporting

and events that should documentation
(supplier’s invoice,
have been recorded goods received note)
have been recorded to purchases journal
or subsidiary ledger
Review for any
unmatched receiving
reports and suppliers’

invoices
Accuracy Purchase amounts and Verify prices, quantity

other data are recorded and computation on
suppliers’ invoices;
appropriately quantity purchased
verified to goods
received notes
Cut-off Purchases and expenses Check last suppliers’
are recorded in the invoices recorded
before balance date
correct period and first suppliers’
invoices recorded
after balance date are
recorded in the
correct period
(consider when goods
received/services
provided by
reviewing goods
received/services
provided
documentation)
Classification Purchases and expenses Enquire and scan to

are recorded in the determine that
purchases and
proper accounts expenses are
recorded in
accordance with the
chart of accounts
Presentation Purchases and expenses Check that purchase

are appropriately and expense
presentations are
aggregated and clearly approved and in
described, and related accordance with the
accounting
disclosures are relevant framework
and understandable
Assertions about account balances, and related disclosures (accounts

payable)
Existence Accounts payable and Confirm with

accrued liabilities are suppliers
valid obligations to Vouch to supporting
suppliers at the balance documentation (e.g.
suppliers’ invoices
date and monthly
statements)
Rights and obligations Accounts payable and Confirm with

accrued liabilities are suppliers
obligations owed by the Vouch to supporting
entity documentation (e.g.
suppliers’ invoices
and monthly
statements)
Completeness Accounts payable and Confirm with
accrued liabilities include suppliers
all obligations owed at Undertake out-of-
the balance date period liability search
Review for any
unmatched receiving
reports and suppliers’
invoices
Undertake
substantive analytical
procedures
Enquire of
management, read
minutes of meetings,
and review contracts,
including loan
agreements and
leases
Accuracy, valuation and Accounts payable in the Agree dollar value of

allocation statement of financial accounts payable to
supporting
position is stated at the documents (e.g.
correct amount suppliers’ invoices)
Undertake
substantive analytical
procedures
Classification Purchases and expenses Check that purchases

have been recorded in and expenses are
correctly classified
the proper accounts
Presentation Purchases and expenses Read draft financial

are clearly described and report to ensure clear
description and
all related disclosures are understandable
understandable disclosures
Page 393
Page 394
Search for unrecorded liabilities

This procedure is also sometimes called ‘the out-of-period liability search’ or ‘the review
of subsequent payments’. This audit procedure is invariably included in audit programs for
substantive tests of the completeness assertion of the accounts payable balance.
The potential for unrecorded liabilities arises from both errors and irregularities. Errors
result because of practical problems in closing the accounting records. Invariably some
goods or services received before the end of the period do not become known and recorded
until the next period. For trade creditors, controls over suppliers’ invoices and receiving
reports, matching of these source documents and investigation of unmatched items can
minimise this problem. The auditor’s objective is to obtain reasonable assurance that
material liabilities have not been omitted.
Intentional omission of liabilities that exist at balance date does not change the auditor’s
objective. In fact, the same audit procedures should detect material omissions whether they
are inadvertent or intentional. Goods or services received will ultimately have to be paid for
in the next period to avoid disputes with suppliers, loss of credit lines or litigation with
creditors.
The auditor selects from cash payments recorded in the subsequent period and traces them
to the schedule of accounts payable outstanding at balance date, identifying those payments
that pertain to the period under audit. Those identified payments not included in the
schedule are unrecorded liabilities. The auditor also reviews and selects from unmatched
receiving reports and suppliers’ invoices received by balance date and suppliers’ invoices
received in the subsequent period, in order to detect liabilities that should have been
recognised at balance date.
Any suppliers’ invoices representing unrecorded liabilities at balance date that are not
received or paid before the auditor applies these procedures would not be detected. Thus,
effectiveness is improved by undertaking the search for unrecorded liabilities relatively late
in the audit. External confirmation of accounts payable balances is not subject to this
disadvantage. It can therefore be an important complement to the search for unrecorded
liabilities, particularly when the audit is scheduled for completion relatively close to
balance date.
Payroll
As outlined in Chapter 8 , a common, efficient and effective audit approach for payroll
expenses and associated end-of-year account balances (such as the liability account,
accrued wages and salaries) is to undertake a high level of tests of controls and substantive
analytical procedures associated with a lower level of substantive tests of details.
The tests of controls for payroll were outlined in Chapter 8 . As discussed there,
effective substantive analytical procedures are often possible for many payroll systems, due
to the fact that periodic payrolls (weekly, fortnightly or monthly) can be compared and
analysed, and explanations sought for significant fluctuations. In undertaking such
comparisons the auditor would need to establish that the base payroll to which other
payrolls are compared is appropriate. If the auditor finds that any variances from this
established base are expected and therefore immaterial, then they have some evidence that
payroll costs are not materially misstated.
Substantive analytical procedures could also be used for end-of-year account balances. For
example, if accrued wages and salaries represent payroll for three days, the auditor can
multiply the established base weekly payroll by 60% (3 ÷ 5). If this calculation is close to
the amount recorded for accrued wages and salaries, then no further audit work may be
required on this account.
If, however, the auditor finds that they cannot rely on the key controls in order to reduce
the risk of material misstatement to an acceptable level, they will need to undertake more
substantive testing of details, consisting of a combination of substantive testing of payroll
transactions and of account balances. These assertions, the specific audit objectives and the
common substantive audit procedures traditionally used to achieve the objectives for
payroll expenses and related account balances are summarised in Table 9.5 . The key
risk for payroll transactions is understatement of the payroll expenses (and therefore
overstatement of profits); therefore, the key assertions containing risk of material
misstatement are completeness, accuracy and cut-off. The associated risk for the Page 395
payroll liability accounts, including both payments outstanding to employees and
associated payments to tax agencies, is understatement (that the client does not record the
expenses and the associated end-of-year liability); therefore, the key assertions containing
risk of material misstatement are completeness and accuracy, valuation and allocation.
TABLE 9.5 PROCEDURES FOR PAYROLL EXPENSES AND
RELATED ACCOUNTS
Common substantive
Financial report audit procedures to
Assertions about classes of transaction and events, and related disclosures

(payroll expenses)
Occurrence The transactions giving Select transactions

rise to payroll expenses from payroll listing
and agree to
occurred during the supporting
period documentation (e.g.
time sheets)
Completeness All payroll expenses and Test from supporting

events that should have documentation (time
sheets, department
been recorded have records) to payroll
been recorded journal or subsidiary
ledger
Review for unmatched
reports and staff
records
Accuracy Payroll amounts and Verify times, amounts

other data are recorded and computation on
time sheets to payroll
appropriately and employment
records
Cut-off Payroll expenses are Check that last payroll

recorded in the correct records before
period balance date, and first
payroll records after
balance date, are
recorded in the
correct period
Classification Payroll expenses are Enquire and scan to

recorded in the proper determine that payroll
expenses are
accounts recorded in
accordance with the
chart of accounts
Presentation Payroll expenses are Check that

appropriately presentation of payroll
expenses are
aggregated and clearly approved and in
described, and related accordance with the
accounting framework
disclosures are relevant
and understandable
Assertions about account balances, and related disclosures (accrued wages

and salaries)
Existence Payroll and accrued Vouch selected

liability are valid amounts to
supporting
obligations at the documentation (e.g.
balance date details of tax
obligations owing at
year end to tax
returns)
Rights and obligations Accrued wages and Review supporting

salary liabilities are valid documentation to
determine that the
obligations to staff at the entity is legally
balance date obligated to pay the
liability
Completeness Accrued wages, salaries Search for

and taxes payable unrecorded liabilities

include all obligations Review client
owed at the balance calculation of number
of days of wages and
date salaries worked
during year but not
paid by year end, to
check completeness
and accuracy
Ensure all tax
obligations arising
through relevant
legislation are
included
Accuracy, valuation and Accrued wages, salaries Obtain an account

allocation and taxes payable in the analysis schedule for
accrued payroll
statement of financial liabilities, foot
position are stated at the schedule and agree
to general ledger
correct amount
Check calculations of
taxes payable are in
accordance with
legislative obligations
Classification Accrued wages and Check that accrued

salaries have been wages and salaries
are correctly classified
recorded in the proper
accounts
Presentation Accrued wages and Read draft financial

salaries are clearly statements for clear
description and
described and all related understandable
disclosures are disclosures
understandable
Page 396
QUICK REVIEW
1. The main assertions of interest to the auditor when undertaking
substantive tests of accounts payable are completeness and
accuracy, valuation and allocation.
2. The main audit procedures are a search for unrecorded accounts payable,
external confirmations and substantive analytical procedures on related
expense account balances.
3. For payroll, the auditor commonly undertakes a high level of tests of
controls and substantive analytical procedures associated with a lower
level of substantive tests of details. If key controls cannot be relied on,
substantive tests of detail are undertaken. If the major risk of material
misstatement is an overstatement of profit, the key assertions at risk for
payroll expenses are completeness, accuracy and cut-off. For the payroll
liability accounts, the key assertions at risk are completeness and
LO 9.7 Non-current assets
The audit approaches for all of the account balances that comprise non-current assets are
generally similar. The account balances are usually affected by a few large transactions, and
amounts from previous periods have continuing significance; that is, the account does not
turn over frequently. Therefore, a common approach to substantive tests for account
balances in this category is to directly test the transactions that affected the account during
the period, thus indirectly substantiating the ending balance. The related revenue and
expense accounts are normally examined in conjunction with the statement of financial
position accounts. For example, depreciation expense is tested in conjunction with the
testing for property, plant and equipment.
Property, plant and equipment

The asset category of property, plant and equipment generally includes land, buildings and
manufacturing equipment. It may also include office equipment, furniture and fixtures.
Even when these assets are classified separately the audit approach is generally the same as
for property, plant and equipment.
The essential feature of substantive tests of balances for property, plant and Page 397
equipment is emphasis on specific audit objectives related to the existence, rights
and obligations and accuracy, valuation and allocation assertions, which is achieved
primarily by substantiating additions and identifying retirements during the period,
considering any revaluations undertaken during the year and analytically testing or
recomputing related expense and allowance accounts. The occurrence of the transactions
associated with purchases of property, plant and equipment is covered by verifying the
existence of the additions to property, plant and equipment. Cut-off is not an issue because
there is no continuous flow of transactions relating to this account. Testing whether the
recording takes place in the correct period is usually achieved when testing for existence or
completeness.
Table 9.6 summarises the financial report assertions, the specific audit objectives and
the common audit procedures traditionally used to achieve the objectives for property, plant
and equipment and related account balances. As applied in the property, plant and
equipment area, these procedures have the following features. (Note that in Table 9.6 ,
the assertions about classes of transactions and events are not included. This is because, as
discussed above, the account balances are usually affected by a few large transactions, and
therefore addressing the account balance assertions will effectively address the assertions
about transactions and events.)
Vouching This procedure consists of inspecting the supporting documentation for

additions, retirements and changes in valuation or allocation methods during the period.
For example, the auditor examines the supplier’s invoice and the receiving report for new
equipment, and considers the appropriateness of capitalisation in light of entity policy
and accounting principles. If assets are revalued, the new values may need to be sourced
back to supporting evidence such as an independent expert’s opinion.
Physical examination The auditor obtains knowledge of additions and retirements by
making enquiries of client personnel, reviewing accounting records and physically
inspecting the additions (or, if many, a sample of them).
Substantive analytical procedures Several substantive analytical procedures are useful
for detecting misclassified additions, unrecorded retirements and miscalculation of
depreciation expense. The auditor compares property, plant and equipment balances and
depreciation expense with amounts of previous years and budgets, and current additions
to the capital budget. Also, the auditor computes the ratio of depreciation expense and
accumulated depreciation to equipment balances in the current and previous periods. The
auditor also relates changes in property, plant and equipment balances to expected related
changes in insurance expense, land taxes and repairs and maintenance expense.
Recalculation The auditor recalculates depreciation expense and considers whether
depreciation has been calculated in accordance with an acceptable accounting method
consistently applied. Usually, the auditor does not need to make a detailed recalculation
when depreciable assets are voluminous. Depreciable assets may be grouped in categories
with similar lives and the same depreciation method, and the calculation made on an
overall basis. Technically, this is a substantive analytical procedure.
Other procedures The auditor asks operating management and personnel about actual
additions and retirements. Enquiries of executive management, reading of minutes and
inspection of debt agreements may identify significant changes in the composition or
valuation of property, plant and equipment and related liens and mortgages requiring
disclosure, or reveal where revaluations have taken place. The auditor also asks
management about decisions such as adding or discontinuing a product or a line of
business, or revaluing a class of assets that affect additions and retirements or an asset
valuation. A scan of the accounting records for proceeds resulting from the sale of retired
equipment may be undertaken in circumstances where the auditor considers that this
amount may be potentially material.
Page 398
TABLE 9.6 PROCEDURES FOR PROPERTY, PLANT AND
EQUIPMENT
Financial
report Specific audit Common substantive audit procedures to
assertion objective achieve objectives

disclosures
Because transactions and events comprise the movements in account

balances, these assertions will be addressed by addressing the assertions
about account balances.
Assertions about account balances, and related disclosures
Existence Property, plant Vouch to invoices

and equipment Physically examine additions
included in the Undertake substantive analytical
statement of procedures
financial Vouch to legal title documents
position
physically exists
Retirements are
removed
Rights and The entity has Enquire of management and scan for
obligations legal title or any conditions on ownership
equivalent Vouch to legal title documents
ownership rights
to property,
plant and
equipment
included in the
statement of
financial
position, and the
related lease
obligation of
capitalised
leased assets is
recognised
Completeness Property, plant Enquire of management to ensure that

and equipment all property, plant and equipment and
related costs are included
includes all
Scan repairs and maintenance for items
capitalisable
that were expensed rather than
costs capitalised
(capitalisable
costs are not
expensed)
Accuracy, Property, plant Recalculate depreciation or depletion

valuation and and equipment calculations
allocation is appropriately Undertake substantive analytical
valued, and procedures
Vouch costs to invoices
allowances for
depreciation or Enquire about revaluations
depletion are Test clerical accuracy of property, plant
computed on and equipment listing
the basis of For any accounting estimates, test how
acceptable and management made the estimates and
check the reasonableness of the data
consistent and assumptions on which they are
methods based
Additions
include only the
capitalisable
cost of assets
purchased,
constructed or
leased
Classification Property, plant Enquire about intention to sell, to
and equipment identify whether items of property, plant
and equipment are correctly classified
items have been as current or non-current assets
recorded in the
proper accounts
Presentation Property, plant Read draft financial statements to

and equipment ensure clear description and
understandable disclosures
is clearly
described and
all related
disclosures are
understandable
Page 399
Substantiation of additions
The auditor uses a combination of vouching (inspecting supporting documentation),

physical examination (touring the plant) and substantive analytical procedures to
substantiate additions to property, plant and equipment. The vouching includes both
additions recorded in property, plant and equipment accounts and items recorded in the
repairs and maintenance expense account. In reviewing the charges to repairs and
maintenance expense, the auditor is concerned with the specific audit objective related to
completeness for property, plant and equipment. Repairs and maintenance expense may
contain costs that should be capitalised rather than expensed. Whether the item is
capitalised or expensed depends on conformity with approved accounting standards and
adherence to entity policy.
Identification of retirements
In achieving the specific audit objective relating to existence for property, plant and
equipment, the auditor is concerned with detecting significant unrecorded retirements.
Generally, the auditor uses a combination of vouching, physical examination and
substantive analytical procedures to identify them.
When vouching additions, the auditor notes whether the item is new or a replacement, and
traces the replacements to the recording of a retirement. A study of relationships between
related accounts, such as property insurance, land taxes and miscellaneous revenue, may
also disclose unrecorded retirements. For example, the proceeds from the sale of retired
equipment as scrap may be recorded as miscellaneous income. Also, the auditor’s
knowledge of the business can be an important factor in identifying unrecorded
retirements. For example, the auditor’s knowledge of the discontinuance of a particular
product, combined with knowledge that certain equipment was used exclusively for making
that product, would lead the auditor to expect to see a recorded retirement or
reclassification for that equipment.
Valuation and impairment of property, plant and equipment
The auditor must be satisfied that the property, plant and equipment is valued in
accordance with the accounting standards. AASB 116 (IAS 16) Property, Plant and
Equipment permits either the cost method or the revaluation method to be used for valuing
assets. Under both methods of valuation, the auditor must consider whether there is any
impairment of the carrying value of the asset. To determine whether an item of property,
plant and equipment is impaired, an entity applies AASB 136 (IAS 36) Impairment of
Assets. That standard explains how an entity reviews the carrying amounts of its assets,
how it determines the recoverable amount of an asset, and when it recognises, or reverses
the recognition of, an impairment loss. There are three principal ways of finding evidence
of impairment: observing obsolete, damaged or underutilised units during a tour of the
plant; identifying assets associated with discontinued activities but not yet disposed of; and
enquiry of management as to budgets and forecasts and the checking of future cash flows
in relation to the carrying value of assets.
When the revaluation model is used, property, plant and equipment items are required to be
valued at their fair value (less any subsequent accumulated depreciation and subsequent
accumulated impairment losses). Revaluations to fair value are required with sufficient
regularity to ensure that the carrying value does not differ materially from fair value. ASA
540 (ISA 540) Auditing Accounting Estimates, Including Fair Value Accounting Estimates,
and Related Disclosures outlines that audit procedures would normally involve (ASA
540.12–18/ISA 540.12–18):
evaluating the data on which the estimate is made by management with regard to their
accuracy, completeness and relevance
testing management’s significant assumptions, the value model and the underlying data
testing the calculation procedures used by management
comparing accounting estimates made in prior periods with actual results to try to obtain
evidence about the reliability of the entity’s estimating procedures and methods
making or obtaining an independent estimate to compare with the appropriateness of
management’s estimate.
Guidance for the consideration of whether specialised skills or knowledge are Page 400
required is contained at ASA 540.A96–A101 (ISA 540.A96–A101). If the
valuation is undertaken by an independent expert, the auditor needs to be satisfied as to
their skill, competence and objectivity. The auditor vouches the valuer’s report, paying
regard to the basis of valuation, and considers its appropriateness as a basis for determining
the carrying amount of that class of assets in the financial report. Major revaluations
should be discussed by the board of directors or audit committee, and the auditor should
review the minutes of such discussions. If classes of assets are revalued, the auditor must
ensure that there is adequate disclosure, including the basis of revaluation and, if an
independent valuer was used, the name and qualifications of this person. In all situations in
which the auditor considers obtaining an independent expert valuation, the standards and
guidance outlined in ASA 620 (ISA 620) Using the Work of an Auditor’s Expert, discussed
in Chapter 4 , need to be followed.
These areas of impairment and fair value testing are becoming more common and complex
with recent and forthcoming changes to accounting standards. As outlined
in Auditing in the global news 9.2 , impairment and fair value testing are areas that the
auditing profession has found challenging. In its 2015–16 Audit inspection program report,
the Australian Securities and Investments Commission (ASIC) found that the audit of asset
values, particularly impairment of non-financial assets—including challenging the
reasonableness of any forecasts and key assumptions, and the basis of valuation—was one
of the major areas that auditing firms needed to pay greater attention to. As a result we see
that ISA 540 and ASA 540 are on the work programs of the IAASB and AUASB,
respectively.
In the property, plant and equipment area, account balances are relatively more susceptible
to misstatement caused by misapplication of accounting principles. The accounting
principles for determining the proper costs to include in acquisition cost and the proper
accounting treatment of significant repairs, improvements and similar matters are relatively
complex. Also, the accounting standard related to capitalisation of leased assets (AASB
16/IFRS 16 Leases) is relatively complex, increasing the associated risk.
Audit evidence: impairment testing and fair value measurement
Regarding impairment of non-financial assets, we continued to find instances

where the auditor did not:
(a) adequately consider the appropriateness and reasonableness of

forecast cash flows and key assumptions used in discounted cash flow
models, taking into account matters such as historical cash flows, and
economic and market conditions ...
(b) ensure that the carrying amount and recoverable amount were
calculated on a consistent basis, such as including projected cash
flows in the recoverable amount calculation but not including all
related assets in the carrying amount. Other examples were excluding
capital expenditures, corporate costs and corporate assets from
impairment calculations;
(c) assess the appropriateness of the cash-generating units used and
whether they were identified at an appropriately low level of
independent cash flows;
(d) perform a valuation cross-check to assess the reasonableness of the
assumptions underpinning the recoverable amount calculation ...
(e) regarding sensitivity testing:
(i)
perform adequate sensitivity testing of significant assumptions
such as prices, margins and volumes;
(ii)
perform the test on year one budgeted cash flows; and
(iii)
address inaccuracies in the model used to test sensitivities;
(f) when testing an asset’s fair value:
(i)
use a valuation technique for which sufficient data and/or
observable inputs were available;
(ii) Page 401
evidence a reliable exit price from the perspective of a
market participant or consider whether management’s

assumptions would be those used by market participants;
(iii)
consider the legal ability to use an asset in its purported highest
and best use;
(iv)
perform valuation cross-checks; and
(v)
include analyst reports used to support key impairment
assumptions on the engagement file or refer to where they could
be obtained.
(g) consider the adequacy of disclosures in the financial report.
Source: © Australian Securities & Investments Commission. Reproduced with permission. Report 534:
Audit inspection program report for 2015–16, June 2017, pp. 27–8, http://download.asic.gov.au/medi
a/4331127/rep534-published-29-june-2017.pdf.
Investments and intangible assets

The audit approach and the audit problems for investments and intangibles are similar to
those for property, plant and equipment. The auditor tests the account balances, directly
testing the transactions that affect the balances during the period, and conformity with
approved accounting standards is very important. However, investments at balance date are
normally substantiated directly.
Investments
The form of investments can vary considerably. Investments may be in debt or equity
securities; the securities may be marketable or non-marketable; the entities whose
securities are held may be associated or non-associated. Also, an investment may be a loan
or an advance rather than a security. This discussion focuses on long-term investments.
However, the primary distinction between long-term investments and investments
classified as current assets is management’s intention and ability to hold the investment for
longer than one year. Thus, the discussion generally applies to most investments.
The financial report assertions, specific audit objectives and common audit procedures
traditionally used to achieve the objectives for investments are summarised in
Table 9.7 . The essential features of direct tests of balances for long-term investments
are emphasis on specific audit objectives related to existence and rights and obligations,
achieved primarily by physical examination or external confirmation and vouching; and
emphasis on specific audit objectives related to accuracy, valuation and allocation,
achieved by a combination of recalculation, vouching and other specialised procedures.
The occurrence of the transactions associated with investments is covered by verifying the
existence of the investments at balance date.
TABLE 9.7
PROCEDURES FOR INVESTMENTS
Common substantive
Financial report Specific audit audit procedures to
assertion objective achieve objectives

disclosures

balances, these assertions will be addressed by addressing the assertions
about account balances.
Existence Investments in Check to supporting

securities (shares, documentation of
purchase/acquisition
bonds, notes) exist
Undertake external
and loans and confirmation
advances exist
Rights and obligations The entity owns or Vouch to legal title

has ownership rights documents
to all investments Undertake external
included in the confirmation
statement of
financial position
Completeness All investments are Enquire of

included in the management
statement of Review minutes and
financial position legal title
documents
Accuracy, valuation and Investments are Recalculate, vouch

allocation valued properly in and trace
accordance with the Inspect market
accounting quotations or review
investee’s financial
standards statements
Test clerical
accuracy of listing of
investments
Classification Investments have Enquire about

been properly intention to sell, to
identify correct
classified as current classification
or non-current
assets
Presentation Investments are Read the draft

clearly described financial report to
ensure clear
and all related descriptions and
disclosures are understandable
disclosures
understandable
Page 402
If the investment has a physical existence and is in the client’s possession, such as
debt instruments that were purchased, physical examination is appropriate. If the
investment has no physical existence, such as shares purchased through an online platform,
a loan or an advance, or is held in safekeeping by an independent custodian, then the
auditor should examine any documentary evidence, such as a share purchase/sale note or
loan agreement, and also consider sending a confirmation request to the investment
custodian.
The difficult accounting and auditing issues in the long-term investment area usually relate
to the accuracy, valuation and allocation assertion. Generally, the relevant auditing
procedures are determined largely by the method of valuation and allocation that is most
appropriate under the accounting standards. Whether investments in securities are carried
at cost or at market value depends on their nature and classification. Cost is substantiated
by vouching the acquisition price in the accounting records, and market price is
substantiated by comparing with published market quotations.
The substantive tests of balances for investments also include tests of the related investment
income and of gains or losses in investment transactions. For marketable securities, the
auditor can substantiate dividend and interest income on investments and the trading price
at the time of purchase or sale of securities by reference to the financial press.
Intangible assets
A variety of items fall into this asset category: patents, copyrights, intellectual property,
organisational costs, franchise fees and goodwill acquired in a business combination. The
essential feature of direct tests of balances for intangibles is emphasis on specific audit
objectives related to existence and accuracy, valuation and allocation, achieved primarily
by vouching, inspection of legal documents and recalculation or substantive analytical
procedures. The primary risk of material misstatement arises from misapplication of
principles set out in the approved accounting standards.
The accounting issues generally relate to whether or not a cost may properly be deferred,
and the appropriate amortisation period. For example, research and development costs
must be accounted for in accordance with AASB 138 (IAS 38) Intangible Assets, Page 403
and the cost of research cannot be deferred, with expenditure on research being
recognised as an expense when it is incurred. However, the standard does allow other types
of internally developed intangible assets to be recognised as such if they meet specific
criteria.
QUICK REVIEW
1. The main assertions of interest to the auditor when undertaking tests of
balances for property, plant and equipment are existence, rights and
obligations, and accuracy, valuation and allocation.
2. The main audit procedures for property, plant and equipment are
substantiating additions and identifying retirements during the period,
using procedures such as physical inspection, checking supporting
documentation for changes in valuation and allocation and establishing
substantive analytical procedures for related expense and allowance
accounts.
3. The main assertions of interest to the auditor when undertaking
substantive tests of balances for investments are existence, rights and
obligations, and accuracy, valuation and allocation.
4. The main audit procedures for the verification of existence and rights and
obligations of investments are physical examination or external
confirmation and vouching. Evidence for accuracy, valuation and allocation
may be gained by recalculation, vouching and tracing or other specialised
procedures.
balances for intangibles are existence and accuracy, valuation and
allocation.
6. The main audit procedures for intangible assets are vouching, inspection
of legal documents and recalculation or substantive analytical procedures.
LO 9.8 Non-current liabilities and owners’ equity
Non-current liabilities
Generally, non-current liabilities include loans, bonds and notes payable, and lease
liabilities that are due after one year from the balance date. The current portions of
otherwise long-term obligations are classified as current liabilities, but are commonly
examined in conjunction with non-current liabilities. Also, interest expense and other
related account balances are commonly examined in conjunction with non-current
liabilities.
The essential feature of direct tests of balances for non-current liabilities is the emphasis on
the specific audit assertion of completeness, achieved primarily by external confirmations,
substantive analytical procedures and other procedures such as reading the minutes of
meetings of the board of directors and reviewing debt agreements.
The financial report assertions, specific audit objectives and common audit procedures that
are traditionally used to achieve those objectives for non-current liabilities are summarised
in Table 9.8 . As applied to non-current liabilities, these procedures have the following
features:
External confirmation Normally, the auditor confirms the balance and related details,
such as security held, interest rate and terms, and interest paid and accrued, directly with
all significant debt holders. The form of confirmation is similar to that which is used for
accounts payable. Where a trustee keeps the detailed records of debt holders and makes
interest payments to them, the confirmation request is sent to the trustee. The standard
bank confirmation form can be used for banks that are holders of debt. Details of
compensating balances, lines of credit and contingent liabilities are also separately
confirmed with the bank. Care should be taken to achieve the specific audit objectives
related to completeness as well as those related to existence.
Substantive analytical procedures Substantive analytical procedures for non- Page 404
current liabilities include comparison of balances with the previous period, and
comparison of new debt proceeds and principal repayments with cash flow projections.
Also, the auditor considers the reasonableness of the entity’s average interest rate
incurred (interest expense divided by the average of the beginning and ending debt
balances). An unreasonably high average interest rate incurred might indicate unrecorded
debt, and therefore concerns about the completeness assertion for non-current liabilities.
Recalculation and vouching The auditor tests interest expense by recomputing the
amount based on the outstanding balance, interest rate and fraction of the year
outstanding, with these details being agreed to loan documentation. Interest payments are
vouched to cash payments records, and the proceeds of new issues are vouched to cash
receipts records. The volume of debt transactions is generally low and all items are tested.
If volume is high, substantive analytical procedures may be used.
Other procedures The most important other evidence-gathering procedures are reading
the minutes of meetings of the board of directors and reviewing debt agreements. The
auditor is concerned with ascertaining that all obligations are authorised by the board of
directors. Debt agreements are extremely important because violation of the terms may
result in automatic acceleration of the due date on which the debt has to be repaid. When
the debt is reclassified as current, this may materially affect the entity’s financial position
and its ability to meet its obligations on a timely basis. Debt agreements often contain
provisions requiring maintenance of specified working capital and debt to equity ratios
and restricting the payment of dividends or other financing activities. Also, the debt may
be secured by either specific or floating charges over assets of the entity. The
classification of debt as current or non-current may depend on the intent and ability of
management to refinance obligations. The auditor substantiates this ability by examining
evidence of actual refinancing in the subsequent period or the non-cancellability of
financing agreements. The auditor also makes enquiries of management to corroborate
intent. Some obligations, such as obligations that arise when a decision is made to
dispose of a segment of a business, are recognised before a liability is legally incurred,
and it is important to ask management about such obligations.
TABLE 9.8
PROCEDURES FOR NON-CURRENT LIABILITIES
Financial Common substantive audit

report procedures to

disclosures

balances, these assertions will normally be addressed by addressing the
assertions about account balances.
Existence Debt and similar obligations Confirm identified liabilities

in the statement of financial with debt holders
position exist at the balance Read minutes of meetings
date and review debt
agreements
Rights and Debt and similar obligations Read minutes of meetings

obligations are legal or specific and and review debt
agreements
definite obligations of the
Enquire
entity
Completeness The statement of financial Read minutes of meetings

position includes all debt and and review debt
agreements
similar obligations incurred at
Undertake analytical
the balance date
procedures
Accuracy, Debt and similar obligations Recalculate, vouch and

valuation and are presented at the proper trace to debt instruments
allocation amounts Test clerical accuracy of
listing of non-current
liabilities
Classification Non-current liabilities have Enquire about the intention

been classified properly to repay in order to identify
that properly classified
Check management’s
history of prior
classifications for evidence
that stated intentions can
be relied on
Presentation Non-current liabilities are Read the draft financial

clearly described and related statements to ensure clear
description and
disclosures are understandable disclosures
understandable
Page 405
Owners’ equity
Equity accounts differ depending on the form of organisation. This discussion focuses on
shareholders’ equity in a company.
The specific audit objectives and common audit procedures for shareholders’ equity are
substantially the same as for non-current liabilities, so a separate table summarising them is
not presented. The primary differences for particular procedures are as follows:
External confirmation Many companies use the services of independent share registry
offices to maintain detailed records of shareholders. In that case, confirmation requests
are sent to those agents. If a company keeps its own share records, the auditor examines
the records rather than sending confirmation requests to the share registry. The auditor’s
chief concern when the company keeps shareholder records is with the specific objective
related to completeness. The auditor examines the shareholder register and observes
company procedures to ensure that all issued shares are recorded.
Recalculation, vouching and tracing The auditor’s procedures for dividends are similar
to those for interest payments.
Other procedures In addition to reading the minutes of meetings of the board of
directors, the auditor would read the company’s constitution. The description of shares as
presented in the financial report should correspond to the information in the company’s
constitution. Authorisation of dividends should be in the minutes of board meetings.
QUICK REVIEW
balances for non-current liabilities are completeness and
2. The main audit procedures are external confirmations, reading the minutes
of meetings of the board and examining debt agreements.
balances for owners’ equity are completeness and accuracy, valuation and
allocation.
4. The main audit procedures are inspection of shareholder registers or
confirmation with an independent share registry, and reviewing the
minutes of meetings of the board of directors.
LO 9.9 Income statement
This section explains the relationship between specific audit objectives for income
statement account balances and those for statement of financial position accounts. This is
also an area where controls, such as budgets and variance analyses, are very important in
undertaking tests of balances.
In a double-entry accounting system, testing one side of a transaction automatically tests

the other side. Thus, a procedure that achieves an audit objective for one side of a
transaction should achieve a comparable audit objective for the other side. For Page 406
example, if the auditor verifies the existence of an accounts receivable balance,
this will verify the occurrence of the sales transactions that comprise the accounts
receivable balance. For this reason, the extent of substantive tests of transactions is
inversely related to the amount of substantive testing of balances that is undertaken.
Audit procedures for income statement accounts

The account balances in the income statement are generally tested by one of the following
procedures:
Substantiation by simultaneous tests This category includes those income statement

account balances that are tested indirectly as a result of substantive tests of related
statement of financial position accounts. As outlined in this chapter, the auditor therefore
realises that, for example, audit tests of sales transactions also provide evidence for the
verification of the accounts receivable balance. It is for these reasons that the related
transactions and balances have been discussed together within this chapter. The primary
income statement account balances that usually fall into this category are sales, cost of
sales and many of the expense accounts.
Substantiation directly in conjunction with statement of financial position accounts
Some income statement account balances are verified when undertaking substantive tests
of related statement of financial position balances. Examples of these account balances
(with the related statement of financial position accounts shown parenthetically) include:
depreciation expense (property, plant and equipment)
amortisation expense (intangible assets)

investment income (investments)
interest expense (loans or notes payable).
Substantiation directly by substantive analytical procedures The auditor usually
applies several analytical tests to income statement account balances as additional overall
tests of reasonableness, or to provide necessary assurances on appropriate classification
or completeness. Income statement account balances are compared with amounts of
previous periods and budgets. Also, the relationships of amounts that are expected to
follow a predictable pattern are considered. For example, a relationship should exist
between the amount of sales, cost of sales, accounts receivable and doubtful debts
expense. When there are significant variances from logical or historical relationships, the
auditor should obtain explanations, consider whether they are reasonable and follow up
information gained through these explanations, as required by ASA 520 (ISA 520) and by
law (refer to the Pacific Acceptance Corporation case in Chapter 2 ). Substantive
analytical procedures may be particularly important for considering the appropriate
classification of expenses.
Substantiation directly by separate direct tests Some income statement account
balances are usually substantiated by separate direct tests of balances. Generally, these
fall into two broad categories: individually significant transactions or events, and account
balances of intrinsic interest.
Individually significant transactions or events

Some income statement items that enter into the determination of net profit are
individually significant, and the auditor applies separate substantive tests to these items.
Examples of items that are individually significant include the following:
Discontinued operations The results of discontinued operations and any related gain or
loss are reported separately from continuing operations. Usually, the amount is very
material and complex accounting issues are involved in the recognition of gain or loss.
Accounting principle changes The cumulative effect of changing to a new accounting
principle also needs to be considered. The auditor needs to obtain evidence to evaluate
management’s justification for the change, the accounting effect and treatment of the
change, the acceptability of the new accounting principle and the adequacy of the
disclosures associated with the change.
These items commonly involve complex accounting issues. The auditor uses Page 407
recalculation to test the proper application of accounting principles, but audit
procedures are also usually necessary to substantiate the underlying transactions or event.
In specific circumstances, other transactions or events, such as a sale of land and buildings,
may be individually significant and would be tested directly.
Account balances of intrinsic interest

Some account balances are analysed and the details of items in the balance are vouched to
supporting documents because there is some interest in the account balance that is out of
proportion to the effect of the balance on net profit. For example, travel and entertainment
expenses and officers’ salaries often fall into this category because of the income tax
implications and specific disclosure requirements associated with these items. Another
common example is legal fees. The auditor is concerned with identifying all solicitors
consulted by management during the period. An analysis of the legal fees account is a good
way to identify the solicitors consulted and why they have been consulted. Because
separate disclosures of all auditors’ fees and directors’ fees are required for all listed
entities, transactions underlying these accounts may also be separately vouched.
QUICK REVIEW
1. Some income statement accounts are substantiated when undertaking
tests of related statement of financial position accounts. These include
sales, cost of sales and many expenses.
2. Some income statement accounts are substantiated directly in conjunction
with tests of balances of related statement of financial position accounts.
These include investment income, depreciation, amortisation and interest
expenses.
3. Necessary assurances on many income statement accounts are provided
by substantive analytical procedures. These are account balances where
the relationship of amounts is expected to follow a predictable pattern,
and account balances that individually are not of sufficient risk or
materiality.
4. Some income statement account balances are individually significant
because of their nature or size. These include discontinued operations,
specific significant revenues and expenses from ordinary activities, and
items of intrinsic interest such as travel and entertainment expenses and
legal, auditors’ and directors’ fees. Details of items in these accounts are
usually vouched to supporting documents.
LO 9.10 Using audit software, including advanced data
analytics, to aid the undertaking of substantive tests
If client files are voluminous, it is usually efficient to apply computer-assisted audit
techniques (CAATs)—in the form of audit software (computer programs), including
advanced data analytics—to machine-readable records. Advanced data analytics for
substantive procedures involves discovering and analysing patterns, deviations and
inconsistencies, and extracting other useful information in the data, through analysis,
modelling and visualisation as a form of substantive audit evidence. For example, a very
large entity may have master files with hundreds of thousands of individual records in
applications such as inventory and accounts receivable. In these circumstances it is usually
more efficient for the auditor to use audit software to automate the auditing procedures and
provide greater efficiency and effectiveness.
Using a traditional audit approach, audit software can be used with master files or
transaction files, so the audit procedures may be tests of details of transactions (if testing
transactions files) or balances (if testing master files). However, these traditional views of
audit software are currently being challenged by some of the more advanced data analytics,
as described in Auditing in the global news 9.3 .
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Advanced data analytics and substantive testing
As outlined by the IAASB’s Data Analytics Working Group, when using the
current approach of assessing risk (Chapter 7 ), and responding to
assessed risk (Chapter 8 and this chapter), there are a number of
questions about the audit evidence provided by advanced data analytics that
need to be addressed:
Is the difference between tests of controls and substantive procedures

relevant in an audit using advanced data analytics, or should the ASAs/ISAs
be clear into which of those categories advanced data analytics fits?
Under a risk-based audit methodology, substantive testing of transactions
and account balances is reduced when reliance is placed on controls. But
is this still appropriate when auditors analyse 100% of the transactions in a
particular area of the audit?
How should the iterative nature of data analytics be reflected in the
ASAs/ISAs? Is it a substantive analytical procedure or is there perhaps
another category of audit evidence generated from advanced data
analytics?
In this chapter we continue to use the categorisations of audit software

commonly used to date, while we wait for the IAASB’s Data Analytics
Working Group to recommend the best ways to reflect advanced data
analytics in the auditing standards. One of the main ways is to use a program
that is designed to read the data existing on a client’s file and undertake
auditing tasks on this data, including identifying items deemed to be at risk
of material misstatement, in order to undertake further substantive testing.
How this is undertaken is described in more detail below.
Generalised audit software (GAS)

The most widely used form of audit software, still used across a range of audit clients, is ge
neralised audit software (GAS) , which includes package programs . A software
package (program) is used to perform specific audit tasks, such as footing and comparing
items, on a computer-readable file. A generalised program that can perform several audit
tasks for many clients is commonly more efficient for auditors to use than writing, trusting
and becoming familiar with programs specially written for particular clients and tasks.
However, a generalised package is not an all-purpose device. The auditor’s software must
be capable of reading the format of the client’s files, or of understanding how data is stored
on that particular system. Large auditing firms have developed their own packages, and
some software vendors offer audit packages, with the two most dominant generalised audit
software packages being ACL and IDEA. In addition, recent sophisticated advanced
data analytic offerings from Inflo, Caseware Analytics, TeamMate Analytics and
Mindbridge offer purpose-built ‘guided analytics’—collections of pre-defined analytics
and visualisations to support the auditor’s audit testing. Auditors may also use generally
available spreadsheets, such as Excel, to carry out some of these functions, as is discussed
in more detail in Global example 9.6 , later in this section.
Since there are a number of different audit software packages, this discussion describes the
general features of this type of software. The two aspects of generalised audit software are
as follows:
1. Ability to accurately read client file formats Client file formats vary considerably. For
example, the number, type and size of fields in a record on an accounts receivable master
file differ widely from client to client. One of the advantages of generalised audit
software is its ability to deal with different file formats. The file format is defined by the
auditor as part of the input specification. Some packages reformat the data in a
standardised manner. The auditor specifies the file layout and the fields and their location
in the file.
2. Facility to select the audit tests to be undertaken Generalised audit software is Page 409
designed to perform several types of audit tasks. The software provides the
means for the auditor to determine the particular tasks to be performed. Several
approaches are used, including the selection of common auditing tasks from a menu.
Generalised audit software programs that are currently available perform an extensive
range of functions, including:
selecting sample items (for example, selecting customer balances for positive and
negative confirmation)
identifying records that meet specified criteria (exception reporting) (for example,
identifying customer balances over credit limit)

testing and making calculations (for example, recalculating interest charges)
comparing data in separate fields or in separate files (for example, comparing change in
balance of an account with details on transactions files)
summarising and visualising data (for example, summarising accounts receivable by age
(one month, two months, etc.)), and outlining populations for identification of
transactions or accounts that are outliers, or contain risks of material misstatements,
requiring auditor attention
generating reports (for example, an accounts receivable confirmation letter or work paper
account analysis).
A description of how audit software can be used to aid in verifying the existence and
accuracy, valuation and allocation assertions of a debtors master file is contained in
Global example 9.5 . Note that, in general, audit software is used to test data
(transactions and balances). It is difficult to test system logic, except implicitly by the
results that appear in the data files. These programs contain no explicit testing of
programmed controls. The existence of controls may be inferred. For example, take a
programmed control that does not allow the account balance to exceed the credit limit. By
undertaking an exception report, and observing no records where the account balance is
greater than the credit limit, the existence of this control may be inferred. However, the
control has not been directly tested—this would require the use of one of the auditing
through the computer techniques outlined in Chapter 8 .
GLOBAL EXAMPLE 9.5 Use of audit software
You are auditing the accounts receivable of your client. The accounts
receivable master file contains the following fields:
Field Field title
1 Debtor number
2 Debtor name
3 Debtor address
4 Credit limit
5 Outstanding balance
6 Balance < 30 days
7 Balance 30–60 days
8 Balance > 60 days
9 Total dollar value of

transactions this year
10 Date of last transaction
Page 410
Required
Describe how the auditor may use audit software to aid in verifying the
existence and accuracy, valuation and allocation assertions of the debtors
master file.
Solution
The main way in which the auditor verifies existence is to undertake a

debtors confirmation procedure or verify subsequent receipts from the
debtors. Both of these techniques involve the auditor selecting a group of
outstanding balances to be tested. Thus, the auditor could use the sampling
function of the audit software.
In testing for the accuracy, valuation and allocation assertion, a main
objective of the auditor is to identify accounts where there may be a difficulty
with payment. This will involve the auditor using the exception reporting
function of the audit software. Some of the exception reports may include:
1. accounts with outstanding balance (field 5) greater than credit limit (field 4)
2. accounts with amounts outstanding > 60 days (field 8 > 0)
3. accounts where total dollar value of transactions (field 9) is less than
outstanding balance (field 5).
If these accounts are identified, they too may be included in the debtors
confirmation procedure or review of subsequent receipts.
To make effective use of generalised software, the auditor needs to plan carefully. Specific
audit objectives remain the same whether audit procedures are applied manually or with
generalised software. The starting point in both cases is to develop specific audit objectives
for financial report assertions containing a risk of material misstatement. However, in using
generalised software, it is extremely important to specify objectives and criteria in advance
of testing. The auditor who manually selects specified items from the accounting records
may notice other unusual items. When generalised software is used, an item will not be
selected unless the auditor has specified all the necessary criteria for its selection in
advance.
Specialised audit software (SAS)

If generalised audit software cannot be used on a particular client’s computer, the auditor
might consider having a program written to accomplish specific audit tasks. Specialised au
dit software (SAS) is also commonly referred to as purpose-written programs .
Alternatively, there is currently available a wide range of SAS for specific industries that is
more efficient for major routines in those industries. For example, in the insurance industry
there are purpose-written programs for the calculation of premium income and reinsurance
premiums, which are major issues in that industry. Another example of an application for
purpose-written programs is municipal council audits, where the calculation of rates is a
major issue.
Specialised software can be written by auditors, outside programmers, software vendors or
client programmers. In deciding how to develop it, there is a trade-off between cost and
independence. Use of client programs or programmers, while normally cheaper, is less
independent.
Utility programs
Software and hardware vendors have developed software designed to accomplish common
tasks and routines, such as sorting records or merging files. These types of routines are
commonly available in most major applications. The auditor can use a utility program
to print the entire contents of a file, merge files or sort records in a file into a sequence
useful for an audit task (such as from largest to smallest dollar amount, or by location, to
aid physical verification).
Page 411
Systems management programs

Systems management programs are enhanced productivity tools that are typically part of a
sophisticated operating system’s environment, such as data retrieval software or code
comparison software. These programs are sometimes suitable to assist with the auditor’s
objectives, performing functions such as retrieving data that meet specific criteria.
Management also has an interest in identifying and following up on records that are large
or unusual, for example, debtors that have not paid for more than 60 days, and this can be
aided by such programs.
GLOBAL EXAMPLE 9.6 Using Excel as audit software
Today’s auditors are able to quickly access data to perform such tasks as
sorting files, sampling, exception reporting and substantive analytical
procedures.
Audit software is being used to analyse large data files, identify anomalies,
compare fields, perform queries, develop reports and document audit steps.
More importantly, tests performed with the aid of audit software can be
performed on entire populations, rather than just samples. For example,
audit software may assist an auditor in comparing an accounts payable file, a
payroll file and a contractor file, to determine whether any current
employees are being paid as contractors. Similarly, lists of vendor addresses
can be compared to employee address files to see whether employees are
paying invoices to companies that they own or operate. Finally, auditors can
play a consultative role by instructing clients on how to use audit software for
their own benefit.
Most widely used audit software packages have been developed from
standard spreadsheet applications, such as Excel, with which many students
are already familiar.
QUICK REVIEW
1. The major technique for testing the client’s files involves the use of audit
software that is under the auditor’s control. The software, including
advanced data analytics, can be used to read the client’s files and identify
areas where the auditor may wish to concentrate audit testing, and also to
automate many time-consuming processes.
2. Auditing with the computer techniques includes the use of:
generalised audit software—used with many clients
specialised audit software—programs especially written for a
particular client, task or industry
utility programs—software designed to accomplish common tasks
for many clients
systems management programs—enhanced productivity tools—are
typically associated with sophisticated systems’ environments.
3. The functions that can be performed by such software include selecting
sample items, exception reporting, testing and making calculations,
comparing data, summarising data and generating reports.
4. Advanced data analytics, a form of audit software, involves discovering
and analysing patterns, deviations and inconsistencies, and extracting
other useful information in the data through analysis, modelling and
visualisation, for the purpose of planning or performing the audit.
Summary
The auditor undertakes the most efficient and effective combination of tests of controls,
substantive tests of details (transactions and balances) and substantive analytical
procedures to achieve a required level of audit risk. For each of the major account balances
or classes of transactions and events, and related disclosures, this chapter has identified the
relative importance of the assertions and the substantive audit procedures that Page 412
would be used to gather audit evidence for those assertions. In particular, attention
has been paid to the major evidence-gathering techniques used in practice, such as debtors
confirmation procedures and inventory observation. The chapter has also outlined the audit
software and advanced data analytics techniques that can be used in the gathering of audit
evidence when undertaking substantive testing.
Key terms
bank confirmation requests
bank transfer schedule
complete inventory count
cost accounting system
cycle count
debtor’s confirmation
dual-purpose tests
external confirmation
generalised audit software (GAS)
negative form of debtor’s confirmation
package programs
physical inventory count, or stocktake
positive form of debtor’s confirmation
purpose-written programs
retail inventory method
specialised audit software (SAS)
standard cost system
substantive analytical procedures
substantive tests of balances
substantive tests of details
substantive tests of transactions
tracing
utility programs
vouching
References and additional readings
Australian Securities and Investments Commission (ASIC) (2017) Report 534: Audit
inspection program report for 2015–16, June, Melbourne.
Caster, P., Elder, R.J. and Janvrin, D.J. (2008) ‘A summary of research and enforcement
release evidence on confirmation use and effectiveness’, Auditing: A Journal of
Practice & Theory, November, pp. 253–80.
Green, W.J. (2013) ‘Key considerations in the audit of inventory: a practice-oriented
learning case utilizing “diamonds”’, Issues in Accounting Education, November, pp.
945–64.
Hanes, D.R., Porco, B.M. and Thibodeau, J.C. (2014) ‘Simply Soups Inc.: a teaching case
designed to integrate the electronic cash confirmation process into the auditing
curriculum’, Issues in Accounting Education, Vol. 29, No. 2, pp. 349–69.
International Auditing and Assurance Standards Board (IAASB) Data Analytics Working
Group (2016) Exploring the Growing Use of Technology in the Audit, with a Focus on
Data Analytics, September, International Federation of Accountants (IFAC), New
York.
Louwers, T.J., Henry, E., Reed, B.J. and Gordon, E.A. (2008) ‘Deficiencies in auditing
related-party transactions: insights from AAERs’, Current Issues in Auditing, Vol. 2,
No. 2, http://aaajournals.org/doi/pdf/10.2308/ciia.2008.2.2.A10 , accessed
December 2017.
Review questions
Relationship between evidence-gathering

procedures
9.1 Explain the differences between substantive tests and tests of controls.
LO 9.1
9.2 Explain the differences between substantive tests of transactions and
substantive tests of balances. LO 9.1
Financial report assertions and substantive audit

procedures
9.3 Explain the objective of cut-off testing, and indicate the classes of
transactions for which cut-off is typically tested. LO 9.2
Page 413
Cash, cash receipts and cash payments

9.4 Explain why the auditor sends a confirmation request to the bank when they
already have access to the client’s copy of the bank statement. LO 9.3
Sales, cash receipts and accounts receivable

9.5 What factors would the auditor consider in determining whether to use the
negative or positive confirmation method for accounts receivable? LO 9.4
Purchases and inventories

9.6 How would an auditor normally obtain sufficient appropriate audit evidence
regarding the existence and condition of inventory? LO 9.5
Accounts payable, payments and payroll

9.7 Explain which assertion is the auditor’s primary concern in tests of balances
for liabilities. LO 9.6
9.8 Outline the major risks in the payroll cycle and the assertions related to each
risk. LO 9.6
Non-current assets
9.9 Explain how the auditor would substantively verify the carrying value of
assets where an entity uses the revaluation method and estimates fair value.
LO 9.7
Non-current liabilities and owners’ equity

9.10 For ordinary shares issued, explain the most likely type of external
confirmation request (positive or negative) and the appropriate recipient.
LO 9.8
Income statement
9.11 Identify three matters that the auditor usually considers in designing
substantive analytical procedures to test account balances in the income
statement. LO 9.9
Using audit software, including advanced data

analytics to aid the undertaking of substantive
tests
9.12 List the functions of generalised audit software that are useful for audit tests.
LO 9.10
9.13 Explain what impact advanced data analytics is likely to have on substantive
testing. LO 9.10
Discussion problems and case studies
Relationship between evidence-gathering

procedures
9.14 EASY You are auditing the financial report of Antique Autos Pty Ltd for the
year ended 30 June 2018. Antique Autos purchases antique vehicles at
auction, restores and repairs them, then sells them to the general public. As
this is the first year that your firm has conducted Antique Auto’s audit, you
meet the owner, Enzo Cattalini, and discover the following:
Antique Autos is a small owner-managed business, with a simple
organisational structure and information system.
Most employees at Antique Autos are related to the owner and, due to the
limited size of the entity, there is very little separation of duties.
Enzo trusts the staff members due to their relationships to him, resulting in
Enzo not paying much attention to the controls at Antique Autos.
Antique Autos has an exclusive focus on sales and market share. Enzo
admitted that at times he has considered the finance department as a bit
of an afterthought.
REQUIRED Page 414
Explain whether you would take a substantive approach or an approach that

uses tests of controls as well as substantive procedures (combined
approach) in undertaking the audit. LO 9.1
Source: This question was adapted from the Chartered Accountants Program of the Institute of
Chartered Accountants in Australia, 2009 (2) audit and assurance module.
9.15 MEDIUM Consider the following two independent situations:

(i) Elder Care Ltd operates several nursing homes in Victoria. All
residents are charged a fixed fee per week as set by legislation. Due
to the quality of care provided, occupancy rates are always at or very
close to full. You have tested controls surrounding occupancy revenue
and results support a high level of reliance on these controls.
(ii) Cheap Stores Pty Ltd operates a chain of discount stores selling a
large range of continually changing merchandise. Cheap Stores is
majority owned and run by Carole Kee. Carole handles all inventory
purchases for the business, scouring auction houses in order to buy
large lots of liquidated stock at bargain prices. Carole makes all
decisions regarding what stock to purchase, the price to pay and,
given that goods sold at auction have to be paid for immediately, is
the sole signatory to the company’s bank account. While you have
determined that there are no controls over inventory purchases on
which you can place reliance, you do note that Carole keeps all
available documentation, which is passed on to the accountant for
checking and processing.
REQUIRED
You are planning your year-end substantive procedures for each of the two
independent situations above. Explain how the information provided would
affect the nature, timing and extent of substantive procedures for
occupancy revenue in situation (i) and purchases for situation (ii). LO 9.1
Chartered Accountants in Australia, 2006 financial reporting and assurance module.
Financial report assertions and substantive audit

procedures
9.16 MEDIUM Leeanne Harris is the director of Quick Clean Pty Ltd, a family
business that provides cleaning services. As Leeanne is interested in
purchasing some new cleaning equipment for her business, she has
approached a bank for finance. The bank has requested that Leeanne
provide an audited financial report to assist them in considering her loan
request. Leeanne has approached your firm for this service and you have
been allocated the task of auditing Quick Clean for the year ended 30 June
2018. You have undertaken a preliminary review of the business and
determined that a substantive testing approach would be appropriate. You
are now preparing an audit program for the revenue cycle.
The following information has been obtained from your review:
Leeanne usually works 60 hours a week. Part of this time is spent
travelling between clients and is not charged to the clients. The remaining
time is charged at $50 per hour, regardless of the task undertaken.
Customers typically pay Leeanne in cash for the work undertaken, except
for a small number of regular small-business customers. Leeanne allows
these customers to pay on account by bank transfer on a monthly basis.
Leeanne supplies each cash customer with a written receipt, prepared
manually from a receipt book purchased at the local newsagency. The
book contains pre-numbered blank receipts, which are completed in
duplicate.
REQUIRED
For each of the assertions of accuracy, completeness and occurrence,
identify a procedure you could use to audit Quick Clean’s revenue.
LO 9.2
Cash, cash receipts and cash payments

9.17 MEDIUM Digital Solutions Ltd is a large company involved in a number of
technology projects, including mobile networks and digital equipment.
Digital Solutions has created a number of subsidiaries to Page 415
concentrate on specific aspects of Digital Solutions’ activities. While
Digital Solutions and its subsidiaries each have an individual bank account,
all of the main banking activities of the group are undertaken through the
bank account of Digital Solutions. Jacinda Barker, the senior banking clerk
of Digital Solutions, maintains and monitors all of the accounts. Your
preliminary discussions with Jacinda indicate the following:
The proceeds of the technology operations are deposited in the
subsidiaries’ bank accounts.
Digital Solutions pays all expenses of the group, including the costs of the
technology operations.
Each subsidiary reimburses Digital Solutions on a quarterly basis for costs
associated with its activities and also pays it a management fee. Payments
are completed via a direct transfer between the bank accounts. The
transfer is authorised by the chief financial officer (CFO) of Digital Solutions
and the chief executive officer (CEO) of the relevant subsidiary.
Jacinda’s responsibilities include preparing a schedule of transfers each
quarter and reconciling each of the bank accounts.
REQUIRED
(a) Explain which assertions are most likely to be assessed as high risk
for material misstatement for the cash balances of Digital Solutions
and its subsidiaries.
(b) Outline three substantive audit procedures that may be used to test
whether these risks will result in a material misstatement and indicate
the assertion addressed. LO 9.3
Sales, cash receipts and accounts receivable

9.18 EASY You are auditing the financial report of Top Dog Pty Ltd for the year
ended 30 June 2018. You have concluded that your team cannot rely on the
internal controls of Top Dog and that the existence of accounts receivable is
at risk.
REQUIRED
(a) Identify the procedure you could use to test the existence assertion
for accounts receivable.
(b) How would your answer change, if at all, if it was established that the
internal controls of Top Dog were operating effectively? LO 9.4
9.19 MEDIUM No More Stains Ltd (NMS) is a manufacturer and wholesaler of

cleaning products, and you are the audit senior assigned to the audit for the
year ended 30 June 2018. Your assistant has performed a positive accounts
receivable confirmation of 100 of NMS’s accounts receivable, with the
following outcomes:
1. One confirmation letter was returned signed, but with no indication
whether the balance was correct or incorrect.
2. Six accounts receivable confirmation letters have been returned
unopened and marked ‘Return to sender’.
3. Three confirmation letters were received indicating that the balance was
incorrect. Your assistant discussed this matter with the accounts receivable
clerk and was informed that NMS had issued credit notes after year end
and the balance confirmed by the accounts receivable reflected the details
after the credit notes had been posted.
4. No reply has been received for 12 confirmation requests.
REQUIRED
How will the above findings affect your audit approach to accounts
receivable? For each outcome, list the risk that has been highlighted as a
result of the audit testing performed, and indicate any additional procedures
you may perform as a result. LO 9.4
Purchases and inventories

9.20 EASY You are auditing the accounts payable and purchases at Axis Pty Ltd
for the year ended 30 June 2018. One of Axis’ major accounts payable,
Chain Ltd, is very slow in sending out invoices for goods it has delivered.
Also, due to a quality control problem at Chain, a large number of goods
that Chain has supplied to Axis have been deemed faulty and have had to
be returned to Chain with a request for credit.
REQUIRED Page 416
List the key audit assertions at risk for accounts payable and purchases,
and outline the audit procedures you would perform in order to gather
sufficient appropriate audit evidence for each of these assertions. LO 9.5
9.21 MEDIUM You are a senior on the audit for the year ended 30 June 2018 of
Office Supplies Ltd, a Perth-based manufacturer of customised office
furniture. You are carrying out audit checks on cut-off at year end. Office
Supplies maintains details of stock quantities on its computer and these
stock quantities are updated from goods received notes and sales invoices.
Office Supplies conducts a ‘wall-to-wall’ count of inventory when all
operations cease at 30 June, and all inventory is counted in a single
stocktake. The bulk of inventory is held in two adjoining warehouses owned
by Office Supplies. However, a material amount of special desk fittings is
held in a separate warehouse in a different suburb by a third party.
During the planning stage of the audit, you have discovered that the
following potential misstatements may occur or exist:
Obsolete and damaged furniture fittings may be overlooked in the
warehouse.
Some empty containers may have been included in the inventory count
due to poor labelling procedures.
The lower of cost or net realisable value method may have been
incorrectly applied.
Based on your audit procedures completed during the planning stage, you
have concluded that there are no relevant control activities that could
prevent these potential misstatements from occurring.
REQUIRED
(a) Outline one substantive test of detail that will substantiate each of the
potential misstatements.
(b) For each substantive test of detail that you outlined in (a), indicate the
assertion at risk. LO 9.5
Accounts payable, payments and payroll

9.22 EASY You are the auditor for Handy Hardware Ltd, which has a large
number of suppliers of its various hardware items. Your audit assistant Joe
Dias has selected a number of suppliers from the list of accounts payable at
year end and traced balances to supplier invoices and goods received
notes to ensure that goods were received prior to year end. Twenty of the
accounts payable were tested and three of the balances were misstated,
although none of them by a material amount. The audit working papers
have recorded Joe’s opinion that as no material errors were located, the
accounts payable balance should be accepted.
REQUIRED
Explain whether Joe’s conclusion is appropriate and outline additional audit
procedures, if any, that you would perform. LO 9.6
9.23 EASY You are the audit manager for the audit of Starburst Ltd for the year
ended 30 June 2018. While auditing payroll expense, your audit assistant
Amy Waterson has selected a sample of individual pays from the monthly
payroll listings and:
checked the hours worked to authorised time sheets
vouched the pay rates used to the relevant industrial awards
checked the calculations of each pay
traced any annual, sick and other leave to authorised leave forms and
agreed the balance of the payroll listings to the general ledger.
REQUIRED
Identify the audit assertion(s) that relate to each of the above substantive
audit procedures. LO 9.6
9.24 MEDIUM Asian Foods Ltd has been operating for a number of years as a
producer of canned vegetables. Asian Foods imports most of its Page 417
vegetables from Thailand and Vietnam. All overseas shipments to
Asian Foods are invoiced and require settlement in US dollars.
Furthermore, Asian Foods is required to pay for freight and insurance costs.
The insurance covers the period from the day the goods are loaded onto
the ship (i.e. Asian Foods assumes ownership of the goods on the day the
goods are loaded onto ships in the various Asian ports from where the
produce is shipped) until the day they arrive in Asian Foods’ warehouses in
Australia. All shipments arrive in Australia within a 21-day period after
loading onto a ship. All overseas suppliers are settled 30 days after the
date of shipment.
Overseas suppliers now represent 70 per cent of accounts payable. Local
and overseas suppliers are maintained in separate subsidiary ledgers
within the accounting system.
The audit partner has identified that accounts payable is at risk of material
misstatement.
REQUIRED
(a) Outline two key reasons why accounts payable is at risk of material
misstatement.
(b) For each key reason outlined in (a), identify and explain the assertion
most at risk.
(c) For each assertion at risk outlined in (b), describe one substantive
test of detail that is specifically responsive to the risk of material
misstatement. LO 9.6
Non-current assets
9.25 MEDIUM You are conducting the audit of Computer World Ltd for the year
ended 30 June 2018 and are reviewing the audit working papers for
property, plant and equipment (PPE) prepared by your audit assistant
Megan Cartwright. Megan tested the PPE additions and disposals during
the year and recalculated the depreciation. No discrepancies were found in
the testing. As a result, Megan concluded PPE, which is a material balance,
was appropriately valued.
REQUIRED
(a) Explain whether the audit team member has arrived at an appropriate
conclusion.
(b) Describe how your conclusion for part (a) will impact upon the further
conduct of the audit (if at all). LO 9.7
Source: This question was adapted from the Chartered Accountants Program of Chartered
Accountants Australia and New Zealand, 2015 (2) audit and assurance module.
Non-current liabilities and owners’ equity

9.26 MEDIUM You are auditing the share capital of Sports Equipment Ltd (SEL),
a large publicly listed company. SEL uses the services of an independent
share registry office to maintain detailed records of their shareholders. As
part of your preliminary review, you have discovered the following
information:
One month before year end, SEL made a large share issue, which was 75
per cent subscribed.
Prior to the new share issue, SEL declared a dividend to its existing
shareholders. This dividend remains unpaid at year end.
REQUIRED
Explain the audit procedures that you would undertake in order to obtain
sufficient appropriate audit evidence in respect of the share issue and
dividend payment. LO 9.8
Income statement
9.27 EASY As a result of work undertaken during the planning stage and audit
evidence collected for the tests of controls stage of the audit, the audit
senior, Rose Chung, has determined that there is a low risk of material
misstatement (low inherent and control risk) for the following account
balances:
telephone and repairs
sales commission
wages and salaries.
Due to the expected reliability of these controls, Rose has undertaken
extensive testing of the controls regarding these account balances, and has
concluded that the controls are reliable.
REQUIRED Page 418
Identify one audit procedure for each of the income statement account
balances above that will obtain sufficient appropriate audit evidence
regarding the accuracy of that account balance. LO 9.9
Using audit software, including advanced data

analytics, to aid the undertaking of substantive

tests
9.28 EASY Your team has been assigned to the audit of Twilight Years Ltd for
the year ended 30 June 2018. Twilight Years runs nursing homes and its
patient revenue systems are as follows:
patient database—a master file containing personal details of all patients,
as well as the period of their stay, the services provided to them and their
medical insurance details
rates database—a master file of all accommodation billing rates, rebate
discounts and government assistance benefits
billing system—a system that produces invoices to charge patients for
services provided, such as accommodation, medications and medical
services. This software includes a complex formula to allow for
government subsidies, pensioner benefits and private medical insurance.
One of the staff informs you that there has been an unusually high number
of complaints from recently discharged patients that the fee invoiced did
not align with the agreed medical fund and pensioner subsidy rates.
REQUIRED
Identify one relevant and practical computer-assisted audit technique
(CAAT) you could use to assist in gathering evidence on the accuracy of
revenue at Twilight Years. LO 9.10
9.29 MEDIUM Electro Ltd is a large Victorian manufacturer of electronic

components, which it supplies to the automobile industry. Electro maintains
its inventory records on a computer inventory system that includes the
following details for each product:
stock code, which includes a physical location code
product description
quantity on hand
unit cost
total value on hand
date of last sale
quantity sold during the year
sales value of the stock sold during the year.
REQUIRED
List five substantive tests that you could perform using generalised audit
software in relation to the inventory for Electro. LO 9.10
Continuous case study
Background information for the continuous case study, Reliable Printers Ltd (RPL), is
contained in the Appendix to this book.
9.30 EASY Based on a review of the background material contained in the

Appendix , you have identified that RPL has two rules for sales to be
included in the June period. These rules are:
Sales must be invoiced in the system by close of business on 27 June as
the warehouse is closed from 28–30 June.
The stock must have been sent to the customer (that is, it must either be
on a truck, ship or plane on its way to the customer, or it must already
have arrived at the customer’s premises; it must no longer be in RPL’s
warehouse).
REQUIRED Page 419
Describe how generalised audit software could be used to test sales cut-off
at year end. LO 9.10
9.31 MEDIUM During the current year, RPL has expanded its earnings base by
increasing the number of titles available as searchable e-books that can be
downloaded directly by readers, and by acquiring Medical Books Ltd (MBL)
to access the copyright that MBL held over a large range of specialised
medical textbooks.
REQUIRED
(a) Based on the background material contained in the Appendix ,
identify the key assertion at risk for each of deferred e-book storage
revenue and the medical books copyright.
(b) Design an appropriate substantive test of details for each of deferred
e-book storage revenue and the medical books copyright. LO 9.2
Source: This question was adapted from the Chartered Accountants Program of the Institute of Chartered
Accountants in Australia, 2012 (3) audit and assurance module.
Page 420

Chap 9 Substantive Tests of Transactions and Balances)

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Page 363

LEARNING OBJECTIVES (LO)

9.3 cash, cash receipts and cash payments

9.9 Identify the diﬀerent substantive test approaches that may be

including advanced data analytics, in substantive testing.

ASA 315/ISA 315 Identifying and Assessing the Risks of Material

ASA 330/ISA 330 The Auditor’s Responses to Assessed Risks

ASA 500/ISA 500 Audit Evidence

ASA 501/ISA 501 Audit Evidence—Speciﬁc Considerations for Inventory

ASA 505/ISA 505 External Conﬁrmations

ASA 520/ISA 520 Analytical Procedures

ASA 540/ISA 540 Auditing Accounting Estimates, Including Fair Value

ASA 560/ISA 560 Subsequent Events

ASA 620/ISA 620 Using the Work of an Auditor’s Expert

GS 016 Bank Conﬁrmation Requests

an assertion that is assessed as being at risk of material misstatement. The

This chapter covers substantive tests of transactions and balances in a ﬁnancial

LO 9.1 Relationship between evidence-gathering

As outlined in Chapter 8 , because most internal controls are structured around

FIGURE 9.2 Types of audit procedures

Relationship between tests of controls and

substantive tests of transactions

Relationship between substantive tests of

Customer Transactions for Able Year-end balance

Able Sale 2000

Sale 4000 5000

GLOBAL EXAMPLE 9.2 Eﬀect of sales, purchases, cash receipts

Accounts Cash Accounts

Beginning balance Beginning balance Beginning

Additions (DR to Additions

Reductions (cash ↔ Additions (cash

Reductions (cash ↔ Reductions

Ending balance Ending balance Ending balance

This kind of audit—with emphasis on substantive tests of balances of statement of

classes of transactions. This approach is called the substantive approach to an audit.

Assertions about account balances and related

GLOBAL EXAMPLE 9.3 Relationship between existence and

The relationship between speciﬁc audit objectives for related account

Speciﬁc audit objectives

Existence, occurrence Accounts Reported sales to

GLOBAL EXAMPLE 9.4 Diﬃcult areas associated with rights and

Inventories held by the client under consignment arrangements exist, but

Completeness In designing substantive tests for the assertion of completeness, the

Nature of the item and available evidence

objectives. If a common audit procedure cannot be applied because the evidence is

LO 9.3 Cash, cash receipts and cash payments

Assertions, objectives and procedures

TABLE 9.1 ASSERTIONS, OBJECTIVES AND SUBSTANTIVE

Common substantive audit

Assertions about classes of transactions and events, and related

Occurrence The transactions giving Inspect supporting

Completeness All transactions and Undertake sequence

Accuracy Cash receipts and Inspect supporting

Cut-oﬀ Cash receipts and Check that last cash

date are recorded in the

Classiﬁcation Cash receipts and Check that cash receipts

Presentation Cash receipts and Check that cash receipts

Assertions about account balances, and related disclosures (cash)

Existence Cash in the statement Request and examine

Rights and obligations Cash in the statement Request and examine

Completeness Cash in the statement Undertake tests of bank

Accuracy, valuation Cash in the statement Undertake tests of bank

Classiﬁcation Cash has been Check that cash, and related

Presentation Cash is clearly Read draft financial report