THE UNIVERSITY OF DODOMA

DEPARTMENT OF ACCOUNTING AND FINANCE

ADVANCED AUDITING AND ASSURANCE SERVICES - AF 316

TOPIC 1: AUDIT TESTING

1.0 General Overview

An audit test is a procedure performed by either an external or internal auditor in order to assess the
accuracy of various financial statement assertions. The two common forms of audit tests are substantive
tests and internal controls tests. Both types of tests are used in external and internal audits in order to reach
established audit objectives, as can be outlined in audit checklists or determined based on the results of
audit questionnaires. Audit tests typically are performed on a sample basis over an existing group of similar
transactions. Sampling approaches can either be statistical or non-statistical, with the ultimate goal being to
obtain the most representative sample of the population before testing begins.

2.0 The purpose of audit tests

The purpose of audit tests, or audit procedures, is to allow the auditor to collect sufficient and appropriate
audit evidence to be able to conclude with reasonable assurance that the financial statements (FS) are free
of material misstatement. If sufficient and appropriate audit evidence cannot be obtained, or the evidence
points to a material misstatement in the FS, the auditor will have to issue a modified audit opinion.

3.0 Risks Associated with Material Misstatements

Misstatements will find their way into published financial statements only if:
1. An error is made in the first place. The risk of that happening is known as „inherent risk‟, and
assessing that is a very big part of audit planning.
2. The client‟s internal control system does not prevent, identify or correct the error. This is known as
„control risk‟.
3. The auditor does not detect the error during the audit. This is known as „detection risk‟.

4.0 The Magnitude of Auditor’s Work with Regard to System Control

There are two lines of defense preventing an error that has occurred from ending up in the published FS:
 If the client‟s internal control system is good, there is a reduced likelihood that there will be an
error in the FS and the auditor will reduce the amount of audit work to be carried out.
 If the internal control system is poor, the auditor will have to perform much more work as the audit
is the only defense left against a material misstatement appearing in the published FS.

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5.0 Defense on Material Misstatements
The auditor must perform either of the following before reporting any material misstatement:
1. Assess the effectiveness of the internal control system. This means investigating both its design and
its operation. The operation of the internal controls is assessed by carrying out tests of control.
2. Obtain additional, direct evidence about the amounts shown in the FS. This evidence is obtained
using substantive testing.

5.1 Test of Control

Tests of control can be grouped into:
i. Enquiry and confirmation. This is a relatively weak source of evidence because it might be
associated with defense and exaggeration of efforts.
ii. Inspection. Examining the transactions and entries as part of scrutiny.
iii. Observation. For example, observing workers at work.
iv. Re-calculation and re-performance. Checking the accuracy.

Even when internal control systems are very good, the auditor will always have to carry out tests on the
figures in the FS. The work has to address all the assertions made by each material figure. For example,
valuation, completeness, existence etc.

5.2 Substantive Tests

A procedure used during auditing to check for errors in balance sheets and other financial statements and
supporting documents. A substantive test might involve checking a random sample of transactions for
errors, comparing account balances to find discrepancies, or analysis and review of procedures used to
execute and record transactions.
Substantive tests consist of:
 Analytical procedures. This is part of substantive tests.
 Tests of details such as getting confirmations from third part and/or tracing by inspection.
Remember if the tests of control show that controls are not operating correctly, the auditor will have to
increase the substantive tests.

5.2.1 Analytical Procedures

ISA 520 defines the term “analytical procedures” as the evaluations of financial information through
analysis of plausible relationships among both financial and non-financial data. Analytical procedures also
encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent
with other relevant information or that differ from expected values by a significant amount.

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Analytical procedures consist of the analysis of significant ratios and trends including the resulting
investigation of fluctuations and relationships that are inconsistent with other relevant information or
deviate from predictable amounts. It entails the use of comparisons and relationships to determine whether
account balances or other data appear reasonable. Such procedures allow the auditor to look at things in
overview and answer the question: Do the numbers make sense?

An example is to compare actual interest expense for the year (a financial statement amount) with an
estimate of what that interest expense should be. The estimate can be found by multiplying a reasonable
interest rate times the average balance of interest bearing debt outstanding during the year (the auditor's
expectation). If actual interest expense differs significantly from the expectation, the auditor explains the
difference in audit documentation.

5.2.1.1 Types of Analytical Procedures

Generally analytical procedures include trend analysis, ratio analysis, statistical and data mining analysis,
and reasonableness tests.

 Trend analysis is the analysis of changes in an account balance or ratio over time. Trend analysis
could compare last year‟s account balance to the current year unaudited balance or balances in many time
periods. Trend analysis works best when the account or relationship is fairly predictable (e.g. rent expense
in a stable environment). It is less effective when the audited entity has experienced significant operating or
accounting changes.
 Ratio analysis is the comparison of relationships between financial statement accounts, the comparison
of an account with non-financial data, or comparison of relationships between firms in an industry. Another
example of ratio analysis, common size analysis, is to set all the account balances as either a percentage of
total assets or revenue. Ratio analysis is most appropriate when the relationship between accounts is fairly
predictable and stable.

There are five types of ratio analysis used in analytical procedures;-

 Ratios that compare client data and industry data
 Ratios that compare client data with similar prior period data
 Ratios that compare client data with client-determined expected results
 Ratios that compare client data with auditor-determined expected results
 Ratios that compare client data with expected results using non- financial data

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 Reasonableness testing is analysis of account balances or changes in account balances within an
accounting period in terms of their “reasonableness” in light of expected relationship between accounts.
This involves the development of an expectation based on financial data, non – financial data, or both.
 Data mining is a set of computer – assisted techniques that use sophisticated statistical analysis,
including artificial intelligence techniques, to examine large volume of data with the objective of indicating
hidden or unexpected information or patterns. For these tests auditors generally use computer-assisted audit
software (CAATs).

5.2.1.2 When to Use Analytical Procedures

The auditor should apply analytical procedures at the planning and overall review stages of the audit.
Analytical procedures may also be applied at substantive testing.

 In the planning stage, the purpose of analytical procedures is to highlight risk areas to narrow the
focus of planning the nature, timing, and extent of auditing procedures.
 In the overall review stage, the objective of analytical procedures is to assess conclusions reached and
evaluate the overall financial statement presentation. It may be used to detect material misstatements that
other tests can overlook, such as fraud or understatement errors.
 In substantive testing stage of the audit, analytical procedures are used to see “the big picture”, i.e.
obtain evidence to identify misstatements in account balances and thus to reduce the risk of misstatements.

5.2.2 Test of Internal Controls

Internal control tests are focused on key controls, such as management reviews or standardized templates
that are designed to prevent and detect material misstatements.
Under an internal control testing approach, an auditor would assess the systems generating the reports,
consider the experience level of the personnel on the premises that manage the inventory, and review
shipping and receiving documents for the appropriate sign-offs instead of counting the actual inventory on
the premises.
Prior to testing the operations of the internal control, an auditor will assess the design of the control for its
effectiveness. Conclusions on effectiveness are drawn after a sample population of a control is walked
through, or re-performed, with the personnel responsible for the regular operation of the control. If the
auditor's inquiries and observations about the control are adequately addressed, the audit test of the internal
control is considered to be designed effectively and can then be tested for its operating effectiveness by
selecting a larger sample of the control and re-performing each of the steps. In contrast, if an audit test
suggests that internal controls are not designed or operating effectively, substantive testing usually must be
completed.

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6.0 Scope of Auditing
Both internal and external audits have the ultimate goal of assuring users of financial statements that
information is presented and disclosed fairly, exists at the time the information is dated, complete and
rightfully included, valued accurately according to Generally Accepted Accounting Principles (GAAP),
and that the company has rights and obligations to the financial data as reported.
The scope of the audit, or the structure and volume of the audit tests that will be performed over the
financial transactions, is determined as a result of the risk assessment that is completed during the planning
stages of an audit. Generally, the higher the audit risk assessment is, the lower the materiality threshold will
be for selecting accounts and transactions for testing. Audit staff will use such a risk assessment to develop
audit programs that will outline specific audit test steps to be followed in order to address the audit risk and
summarize the accuracy of the transaction. Test results usually are tracked by auditors in either manual
working papers or audit management software.