Chapter 8:

PERFORMING SUBSTANTIVE TEST

 Determine
Set desired Assess Assess Acceptable
Level of Inherent Control Level of
Risk Risk Risk Detection
Risk

Audit Planning Audit Planning Audit Planning

(Chapter 5) (Chapter 6) (Chapter 8)
 Reporters

Once Ortiz Torrecampo

Substantive Test

-are audit procedures designed to substantiate the account balances or to detect material
misstatements in the financial statements

* Test of Detail *Substantive Analytical Procedures

Substantive Analytical Procedures
Involves comparison of financial information with
auditor’s expectations to determine the
reasonableness of an account reported in financial
statements.

Performed to enable auditor to obtain corroborative

evidence about a particular assertion.
 Using Analytical Procedures as
Substantive Tests

Develop Expectations
about Financial Statements

Compare the Financial

Using Statements with the
Analytical Expectations Developed
Procedures as
Substantive
Test

Conduct
further
No investigation

Yes

Accept the account as

reasonable
 The effectiveness of analytical procedures applied as substantive tests
is affected by many factors:

• Nature of assertions
• Reliability of data used to develop expectations
Suitability of
Substantive
• Precision of expectations
Analytical • Predictability of the account balances
Procedures

Substantive
The following
analytical
generalizations
procedures
mayare
begenerally
helpful inmore
assessing
applicable
the predictability
to large volumes
of theof
accounts: that tend to be predictable over time.
transactions
 The following generalizations may be helpful in
assessing the predictability of the accounts:

❑Income statement account are likely to be more predictable

compared to Statement of financial position accounts.
Suitability of
Substantive ❑Accounts that are not subject to management discretion such
Analytical as payroll expense are generally considered more
Procedures
predictable.
❑Relationships in a stable environment are more predictable
than those in a dynamic or unstable environment.
Substantive Analytical Procedures
Test of Detail

Involves examining the actual details making up the various accounts.

These tests focus on specific details within the financial records to ensure
their reliability and to detect potential errors or irregularities.

Test of details of balances Test of details of transactions

 Test of details of balances Test of details of transactions

Involves direct testing of the ending balances of an Involves testing the transactions which give rise to
account the ending balance of an account

Cash
Test of details Beginning balance 1,000,000
of balances
vs. Test of Cash receipts during the year 12,000,000 Cash disbursement during the year 11,500,000
details of Ending balance 1,500,000
transactions
To substantiate the validity of the cash account, the The substantiate the validity of the cash account
auditor may directly test the ending balance of cash balance, auditor will test the details of the
by counting the cash on hand and testing the bank transactions affecting the account during the year.
reconciliation prepared by the client.
Used when account balances are affected by large Useful if account balances are comprised by small
volumes of relatively immaterial transactions volume of transaction representing relatively
material amounts.
 The potential effectiveness of the auditor’s substantive
test is affected by:
Effectiveness of
Substantive
Tests ➢Nature
➢Timing
➢Extent
Nature of The nature of substantive test relates to the quality of evidence.
Substantive The auditor should determine the appropriate quality of evidence
Test needed to support the desired level of detection risk.
 Substantive tests may be performed at interim dates or at year end.

❖Interim procedures are generally considered less effective due

to incremental audit risk involved when auditing interim
balances.
Timing of
substantive ❖Performing audit procedures at interim dates assists the auditor
in identifying significant matters at an early stage of the audit.
test
❖Performing interim procedures allows the auditor to spread the
work throughout the year thereby minimizing the load during
the peak period.
Extent of The extent of substantive test relates to the amount of evidence
substantive needed to satisfy a particular objective. It is based on the auditor’s
test judgment after considering materiality, the assessed risk and the
degree of assurance the auditor plans to obtain.
Test of Detail
Relationship between Substantive Test and Test of Control

Test of control provides evidence that indicates a misstatement is likely to

occur. Substantive test, on the other hand, provides evidence about the
existence of misstatements in an account.

When auditing financial statements, the auditor may design a test of controls
to be performed concurrently with a test of details on the same transaction.
Audit Evidence

All the information, whether obtained from audit procedures or other sources,
that is used by the auditor in arriving at the conclusions on which the auditor’s
opinion is based. (Auditing Standard No. 15)
 ❖Underlying Accounting Data
-refers to accounting records underlying the financial
statements

Audit ❖ Corroborating Information

evidence - documents and other information supporting the
consists entity’s accounting data obtained from client and other
of: sources.

Note: Accounting Data + Corroborative Information = Evidence

Qualities of Result of performing tests of control (assessed level of
Evidence control risk) and substantive tests (acceptable level of
detection risk).
 SUFFICIENCY

- Amount of evidence that the auditors should accumulate

Qualities of Factors to be considered:

Evidence
❑The competence of evidence
❑The materiality of the item being examined
❑The risk involved in a particular account.
 appropriateness

Measure of the quality of audit evidence and its relevance

to a particular assertions and its reliability.

f ❖ Relevance- relates to the timeliness of evidence and its ability to

satisfy the audit objective.

❖ Reliability- relates to the objectivity of evidence and is influenced

by its sources and by its name.
 appropriateness

The following may help the auditor in assessing the

reliability of audit evidence:

of ❖ Audit evidence obtained from independent sources outside the

e entity.
❖ Audit evidence generated internally is more reliable when the
related accounting and internal control systems are effective.
❖ Audit evidence obtained directly by the auditor is more reliable
than that obtained indirectly;
❖ Audit evidence in the form of documents and written
representations is more reliable than oral representations.
Cost/ Benefit - An auditor works within economic limits.
consideration
when obtaining - Audit evidence is persuasive rather than conclusive.

evidence.
Audit Evidence
Audit Documentation/ Working Papers

✓Working papers- records kept by the auditor that documents

the procedures applied, information obtained, and conclusions
reached.

✓PSA 230 requires the auditor to document matters that are

important to support an opinion on FS, and evidence that the
audit was conducted in accordance with PSA.
 Working papers are prepared Secondarily, working papers
primarily to: also assist the auditor in:

❖Support the auditor’s opinion ❖ Planning future audits

Functions on financial statements. ❖ Providing information useful
of the ❖Support the auditor’s in rendering other services
working representation as to ❖ Providing adequate defense
paper compliance with PSA in case of litigation
❖Assist the auditor in the
planning, performance,
review and supervision of
the engagement
 ❑ The nature, timing, and extent of the audit
procedures performed to comply with PSAs and
Form, Content applicable legal and regulatory requirements
and Extent of
Audit ❑ The results of the audit procedures and the audit
Documentation evidence obtained
❑ Significant matters arising during the audit and the
conclusion reached thereon.
 Normally, audit documentation
requires:

❖Discussions of significant matter with management and others in a timely manner

❖In exceptional circumstances, when the auditor judges it necessary to depart from
basic principle or an essential procedure that is relevant in the circumstances of
ontent the audit
ent of ❖In documenting the nature, timing and extent of audit procedures performed, the
auditor should record:
ntation - Who performed the audit work and the date such work was completed
- Who reviewed the audit work performed and the date and extent of such
review
 Permanent File Current File

Contains information of Contains evidence gathered and

continuing significance to the conclusions reached relevant to
auditor in performing recurring the audit of a particular year
audits.
This includes: This includes:
Classification
of working - Copies of the articles of - copy of the financial
papers incorporation and by-laws statements
- major contracts - audit program
- engagement letters - working trial balance
- organizational charts - lead schedules
-analyses of long-term - detailed schedules
accounts - correspondence with other
- internal control analyses parties
Ownership
Working papers are the property of the auditor and the
of working
client has no right to the working papers prepared by the
papers
auditor.
Confidentiality It cannot be shown to third parties without the client’s permission.
of working
papers Code of Ethics for Professional Accountants requires the CPA to
respect the confidentiality of information obtained during the
course of performing professional services.

Some instances, the duty of confidentiality is overridden by

statute of law.
Retention
Should be retained by the auditor for a period of
of working time sufficient to meet the needs of his practice and
papers to satisfy any pertinent legal requirements of record
retention
Guideline
Should be properly organized to facilitate their
for the review.
preparation
of working
papers
 Heading

ne
Each working paper must be properly identified
with such information as the name of the client, type
ation of working paper, a description of its content and the
king date or period covered by the examination.
 Indexing

ne
Refers to the use of lettering or numbering system.
Each working paper must be indexed to aid in cross-
ation referencing essential information
king
 Cross-indexing/Cross Referencing

ne
It is important to provide a trail useful to supervisors
in reviewing the working papers.
ation
king
 Tick Marks

ne
It is important to provide a trail useful to supervisors
in reviewing the working papers.
ation
king
Audit Documentation/ Working Papers
Attendance at Physical Inventory Count

✓If inventory is material to the Financial Statement, the auditor

is required under PSA 501 to attend at physical inventory
counting, and to test the accuracy of the entity’s final
inventory records.

It involves:
❑ Inspecting the inventory to ascertain its existence and
evaluate its condition
❑ Performing test counts
 ❖In some instances, the physical inventory count is
conducted at a date other than the date of the financial
statements. When this occurs, auditor should perform
additional audit procedures to obtain audit evidence about
Physical
Count whether. changes in inventory during the intervening
Conducted periods are properly recorded.
Before or
After Year-
end
Attendance at If attendance at physical inventory counting is
Physical Count impracticable, the auditor should perform alternative
is Impracticable
audit procedures to obtain sufficient appropriate audit
evidence regarding the existence and condition of
inventory.
Inventory held Auditor should obtain confirmation from the third party and/or
by a third part inspecting documentation regarding the inventory held by third
parties, such as, delivery receipts or receiving reports.
Attendance at Physical Inventory Count
Auditing Accounting Estimates

As defined by PSA 540, “accounting estimate’ mens an

approximation of the amounts of an item in the absence of a
precise means of measurement.

It is often made in conditions of uncertainty regarding the

outcome of events that have occurred or are likely to occur and
involve use of judgement
Auditing Accounting Estimates

Examples include:

➢ Allowance for credit losses

➢ Warranty obligation
➢ Inventory obsolescence
➢ Depreciation and amortization
➢ Loss contingencies
➢ Percentage of completion income on construction contracts
➢ Fair value of securities that are not publicly trades
 The auditor’s responsibility is to obtain sufficient appropriate
evidence as to whether:
Auditor’s
Responsibility
❖ Accounting estimate is properly accounted for and
disclosed
❖ Accounting estimate is reasonable in the circumstances
 ❖ Accounting estimate is properly accounted for and
disclosed

It requires knowledge of the clint’s business and

r’s
nsibility application of applicable financial reporting
framework.

❖ Accounting estimate is reasonable in the circumstances

 ❖ Accounting estimate is reasonable in the circumstances

When evaluating reasonableness, the auditor concentrates

on assumptions or factors that are:
r’s
nsibility
➢Significant to the estimate
➢Sensitive to variation
➢Apparent deviations from historical patterns
➢Subjective and susceptible to bias or misstatement
 The auditor should obtain an understanding of the procedures
and methods, including the accounting and internal control
systems, used by the management in making the accounting
estimates.

r’s The auditor can obtain satisfaction about the

nsibility
reasonableness of the accounting estimates through:

➢Review and test the process used by the management to

develop the estimate
➢Make an independent estimate
➢Review subsequent events which confirm the estimate
made
 Review and test the process used by
the management to develop the
estimate

This will often involve:

➢ Evaluating data and management assumptions

r’s
nsibility ➢ Testing of calculations
➢ Comparing prior periods estimates with actual results
➢ Considering management approval procedures
 Make an independent estimate

r’s The auditor may make or obtain an independent estimate

nsibility
and compare it with the accounting estimate prepared by
management.
 Review subsequent events which
confirm the estimate made

r’s Transactions and events which occur after period end, but
nsibility
prior to completion of the audit, may provide sufficient
appropriate evidence regarding an accounting estimate
made by management.
Auditing Accounting Estimates
 Related Parties

The term related party refers to persons or entities that may have dealings with
one another in which one party has the ability to exercise significant influence
or control over the party in making financial and operating decision.
 Related Parties
It includes:

➢ Any person or other entity that has control or significant influence, directly
or indirectly through one or more intermediaries, over the reporting entity

➢ Another entity over which the reporting entity has no control or significant
influence, directly or indirectly through 1 or more intermediaries

➢ Another entity that is under common control with the reporting entity
through having:

I. Coomon controlling ownership

II. Owners who are close family members
III. Common key management
 Related Parties
Auditors needs to be aware of related party because:

❖ Most financial reporting frameworks require disclosure in the financial

statements of certain related party relationships and transaction

❖ A related party transaction may be motivated by other than ordinary

business considerations such as profit sharing or even fraud

❖ The nature of related party relationships and transaction may, in some

circumstances, give rise to higher risks of material misstatement of the
financial statements than transactions with enrelated parties.
 Management is responsible for the identification and
disclosure of related parties and transactions with such
Management’s parties.
responsibility
❖requires
It management
Accounting estimate to implement
is properly adequatefor
accounted accounting
and
anddisclosed
internal control systems.
 According to SAS 460, the auditor should perform
audit procedures designed to obtain sufficient
Auditor’s
appropriate audit evidence regarding the identification
responsibility and disclosure by directors and senior management of
related parties and the effect of related party
transactions that are material to the financial
statements.
 According to SAS 460, the auditor should perform
audit procedures designed to obtain sufficient
Auditor’s
appropriate audit evidence regarding the identification
responsibility and disclosure by directors and senior management of
related parties and the effect of related party
transactions that are material to the financial
statements.
 Inquiries from management regarding:

➢ The identity of the entity’s related parties, including

charges from the prior period

ity ➢ The nature of the relationships between the entity

and these related parties

➢ Whether the entity entered into any transactions

with these related parties during the period and, if
so, the type and purpose of the transactions.
 Conditions in which related party
transaction are likely to include:

➢ Transaction which have abnormal terms of trade

➢ Transaction which lack an apparent logical
business reasons for their occurrence
ity ➢ Transactions in which substance differs from form
➢ Transactions not processed in an unbiased manner
➢ High volume or significant transactions with
certain customers or suppliers compared with
others
➢ Unrecorded transactions such as the receipt or
provision of management services at no charges
 If identified transactions were outside
the entity’s normal course of business,
auditor should:

➢ Obtain understanding of the business rationale as

well as the terms of the transactions, to evaluate
whether the transactions have been properly
ity accounted for and disclosed
➢ Obtain audit evidence that the transactions have
been appropriately authorized and approved.
 The auditor should obtain a written representations from
Written management concerning for completeness of information
Representation provided regarding the identification of related parties and
adequacy of related party disclosures in the financial
statements
Related Parties
Using the Work of an Expert

Auditor is not expected to have the expertise required to practice

other profession or occupation. During the audit, the auditor may
need to obtain audit evidence in the form of reports, opinions,
valuations and statements of an expert.

* Expert is a person or firm possessing

special skill, knowledge and
experience in a particular field other
than accounting or auditing.
Using the Work of an Expert

Common examples of an expert’s works are:

❖ Valuation of precious stones, works of arts, real estate, and

other specialized assets
❖ Determination of amount using specialized techniques like
actuarial computations
❖ Interpretation of technical requirements, regulations, or
contracts such as legal documents
Using the Work of an Expert

PSA 620 identifies 2 kinds of experts:

Auditor’s Expert Management’s Expert

An individual or An individual or
organization possessing organization possessing
expertise in a field other expertise in a field other
than accounting or than accounting or
auditing, whose work in auditing, whose work in
that field is used by the that field is used by the
auditor. entity.
 When determining the need to use the work of an expert, the
auditor would consider:

✓ Whether management has used a management’s expert in

Determining preparing the financial statements
the need for ✓ The nature and significance of the matter, including its
an Auditor’s
Expert ❖ complexity
Accounting estimate is properly accounted for and
✓ The risk of material misstatements on the matter
disclosed
✓ The expected nature of procedures to respond to identified
risks
 The auditor should obtain a written
representations from management
After concluding that the help of the auditor’s expert is
concerning for completeness of
needed to assist the auditor in obtaining sufficient appropriate
Evaluating the information
evidence, the auditorprovided
must: regarding the
Auditor’s
Report identification
Assess
Assess
1. Assess
the competence
2. Understand
of
the competence
the competence
ofand
the field of
and
the
related
objectivity
expertise
ofparties
the expert. and
and objectivity
objectivity
of the expert.
expert.of auditor’s expert.
adequacy
3. Establish the of
termsrelated party
of the agreement disclosures
with the
4. Evaluate the results of the work of the expert.
expert.

in the financial statements

 Assess the competence and objectivity
of the expert.

The following factors must be considered when assessing the

competence of the expert:
ting the
r’s ❑Professional certification or licensing by, or membership in, an
appropriate professional body

❑Experience and reputation in the field in which the auditor is

seeking audit evidence
 Understand the field of the expertise
of auditor’s expert

ting the
r’s This understanding should enable the auditor to determine the
nature, scope and objectives of that expert’s work; and evaluate
the adequacy of that work for the auditor’s purposes.
 Establish the terms of the agreement
with the expert

Auditor and expert should agree on matters such as:

ting the ✓ Nature, scope and objectives of the expert’s work
r’s ✓ Their duties and responsibilities
✓ Timing of completion
✓ The need for the auditor’s expert to observe confidentiality
requirements
 Evaluate the results of the work of the
expert

Auditor should assess the appropriateness of the expert’s work as

audit evidence regarding the financial statement assertions being
ting the considered
r’s
Auditor’s expert work should enable the auditor to satisfy the
auditor’s objective.
 PSA 500 requires the auditor to:

Evaluating 1. Evaluate the competence, capabilities and objectivity

Management’ of management’s expert
s Expert 2. Obtain an understanding in expert’s field
3. Evaluate the appropriateness of that expert’s work as
audit evidence for the relevant assertion.
 The auditor has sole responsibility for the audit opinion expressed,
and that responsibility is not reduced by the auditor’s use of the
work of an expert. Thus, the auditor should not refer to the work
of an expert in an auditor’s report containing an unmodified
Effect of the
opinion
Reliance on
Expert’s Work
When an auditor’s report contains a modified opinion, the auditor
on the Audit
can make reference to the expert’s work if the auditor believes
Report
that such reference is necessary in order for the readers to
understand the reason for expressing a modified opinion.
Using the Work of an Expert
Considering the work of Internal Auditors

Internal audit is a function of an entity that performs assurance and consulting

activities designed to evaluate and improve the effectiveness of the entity’s
governance, risk management and internal control processes.

External auditor should obtain sufficient understanding of the internal audit

function to assist in planning the audit and developing an effective audit
approach
Considering the work of Internal Auditors

Considering the work of internal auditor involves two important phases:

1. Making a preliminary assessment of internal auditing
2. Evaluating and testing the work of internal auditing
 Preliminary Assessment of the Internal Audit Function
For this purpose, the external auditor should consider the
Preliminary internal auditor’s:
Assessment
of the Internal 1.❖Competence
Competence
Accounting estimate is properly accounted for and
Audit Function
2. Objectivity
disclosed
3. Due Professional Care
 Competence

ary refers to the attainment and maintenance of knowledge and

ent
ternal
skills at the level required to enable assigned task to be
nction ❖ Accounting
performed estimate
diligently andisinproperly accounted
accordance for and
with applicable
disclosed standards.
professional
 Objectivity

ary
ent refers to the ability to perform those tasks without allowing
ternal
nction ❖ Accounting
bias, conflict of estimate
interest or
is undue
properly
influence
accounted
of others
for andto
override
disclosed
professional judgments.
 Due Professional Care

ary
ent
achieved when the internal audit function has a systematic
ternal and disciplined approach to planning, performing,
nction ❖ Accounting estimate is properly accounted for and
supervising, reviewing and documenting the internal audit
disclosed
activities
 The auditor should obtain a written
representations
For this purpose, PSA 620from management
requires the external auditor to:

Evaluating and
concerning
❑ read the reportsfor
of the completeness of
internal audit function relating to the
work of the function that the external auditor plans to use
Testing the information provided
to obtain an understanding regarding
of the nature the
and extent of audit
Work of procedures it performed and the related findings
Internal identification
Assess the competence
of
Assess the competence
ofand
related parties
and objectivity
theobjectivity
expert. of the expert.
and
Auditors ❑ perform sufficient audit procedures to determine the
adequacy
adequacy ofof related
the internal party
audit work disclosures
for purposes of the
audit
in the financial statements
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