Week 5 Lecture

Topic 5 Auditors response to

assessed risk
 Audit Plan & Risk

Audit Plan
- Details the audit procedures to be used when testing controls and when conducting detailed
substantive procedures

Inherent Risk
- The susceptibility of an assertion to a misstatement that could be material, either individually
or when aggregated with other misstatements, assuming there are no related controls.

Control Risk
- The risk that a client’s system of internal control will not prevent or detect a material
misstatement.

Audit Risk
- The risk that an auditor expresses an inappropriate audit opinion when a financial report is
materially misstated.

Test of Controls
- The audit procedures designed to evaluate the operating effectiveness of controls in
preventing, or detecting and correcting, material misstatements at the assertion level.

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 Substantive Procedures (Substantive Testing or Test of details)
“Audit procedures designed to detect material misstatements at the assertion
level.”

Assertions:

1. Occurrence – transactions and events that have been recorded have occurred and pertain to the entity.

2. Completeness – all transactions, events assets, liabilities and equity items that should have been
recorded have been recorded.

3. Accuracy – amounts and other data relating to recorded transactions and events have been recorded
appropriately.

4. Cut-off – transactions and events have been recorded in the correct accounting period.

5. Classification – transactions and events have been recorded in the proper accounts.

6. Existence – recorded assets, liabilities and equity interests exist.

7. Rights and Obligations – the entity holds or controls the rights to assets, and liabilities are the
obligations of the entity.

8. Valuation and allocation – assets, liabilities and equity interests are included in the financial report at
appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.

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 Designing Substantive Procedures

The auditor “must plan and perform the audit to reduce the audit risk to an
acceptably low level that is consistent with the objective of an audit (ISA 200).

The audit risk depends on: Inherent, Control and Detection Risk.

Quantified Audit risk: AR=IR x CR x DR, therefore: DR = AR

IR x CR

The design of Substantive Procedures will depend on the level of the detection
risk. A low level of detection risk will require a predominantly substantive audit
strategy.

Relationship between audit strategy, detection risk and level of substantive procedures

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 Designing Substantive Procedures
Assessing control risk for account balances
Internal control systems usually applies controls at the time the relevant transaction is first
recognized and recorded. Consequently, control risk is assessed by reference to transaction
classes, i.e. the substantive procedure is applied to account balances.

Account balance assertions for a single transaction class

Such transaction classes are most of the P&L accounts (sales, purchases, expenses). This is
relatively simpler.

Account balance assertions for multiple transaction classes

Most balance sheet accounts are affected by more than one transaction class (cash,
receivables, payables etc). Thus the control risk assessment for the valuation assertion of the
cash balance is based on the control risk assessments for the accuracy for both cash receipts
and cash payments.

Relevant control risk assessments for transactions classes affecting the cash balance

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 Designing Substantive Procedures

Effects of preliminary audit strategies

After making a preliminary assessment of the risk of material misstatement the auditor needs
to determine the appropriate strategy for the audit. These can be either a predominantly
substantive approach or a lower assessed level of control risk approach. In either case the
auditor needs to identify types of potential misstatement in the assertions.

Predominantly substantive approach

Adopted in cases of high control risk, i.e. when:
 There are no significant control procedures that pertain to the assertion
 Relevant control procedures are ineffective
 It would not be efficient to perform tests of controls
This may occur more often in smaller entities, which do not implement appropriate controls
or apply ineffective control, usually due to lack of duties segregation.

Lower assessed level of control risk

The auditor must first test the control procedures.

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 Designing Substantive Procedures

Designing Substantive Procedures

Having determined the audit strategy, the auditor must design the relevant procedure.
These will either provide evidence that supports the truth and fairness of the financial
statements or they will reveal monetary errors or misstatements in the recording or reporting
of transactions and balances. Designing substantive procedures should consider:
 Nature
 Timing and
 Extent

Nature
Refers to the type and effectiveness of the auditing procedures, i.e.
 Analytical procedures
 Tests of details of transactions
 Tests of details of balances

Analytical procedures
These involve detailed, analytical controls. For example in a hotel audit, where most revenue
is billed to many customers and in many instances, appropriate tests should be applied,
although they may be tedious and costly. At an aggregate level these can be estimated a a
multiple of room occupancy and average customer spending. At a detailed level it may be
necessary to conduct sample audits to specific time periods and departments.

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 Designing Substantive Procedures

Test of details of transactions

These include evidence from a sample (or all) of the individual debits and credits that make up an account to
reach a conclusion about the account balance. They should include inspection of documents including tracing
and vouching.
Cutoff tests are applied to closing balances. They are usually applied at critical dates (e.g. balance sheet
closing). It necessary to ensure proper cutoff, since cutoff errors or misstatements can significantly affect
profit.

Tests of details of balances

These are focused on obtaining evidence about account balances rather than on individual transactions. They
may include auditing of customer or supplier balances, or physical inspection of the company’s inventory in the
warehouse.

Detection risk and assertion level for details of balances

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 Designing Substantive Procedures

Examples of analytical procedures for auditing Trade Receivables:

- comparing this year's closing balance in the control account with the prior year's balance, a
budgeted amount or other expected value;
- using the closing balance to determine the percentage of trade receivables to current assets
for comparison with the prior year's percentage or industry data;
- using the closing balance to calculate the trade receivables' turnover ratio for comparison with
the prior year's ratio, industry data or other expected value;

Tests of details of transactions such as:

- vouching a sample of the individual debits and credits in customer accounts, for the
transaction classes indicated, to the entries in journals (for example, vouching the debits to
the sales journal) and supporting documentation (such as sales invoices);
- tracing transactions data from source documents (such as remittance advices) and journals
(such as the cash receipts journal) to the corresponding entries in the customer accounts for
the transaction classes indicated;

Tests of details of balances, such as:

- determining that the closing balances in the individual customer accounts add up to the control
account balance;
- confirming the balances for a sample of customer accounts with the customers.

In the case of trade receivables, it is common to apply each of the three types of substantive
procedure to some extent. For other accounts only one or two of the types of test may be
performed in obtaining sufficient evidence to meet the planned level of detection risk.

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 Designing Substantive Procedures
Examples of analytical procedures for auditing Sales Revenue

In practice, the sales revenue account may show only daily, weekly or monthly totals posted
from the sales journal. In either case, to determine that sales revenue is true and fair,
auditors may obtain evidence from any of the following:

Analytical procedures, such as:

- comparing the closing balance with the prior year's balance, a budgeted amount or other
expected value
- comparing the closing balance with an independent estimate of the closing balance (as
illustrated for a hotel's revenues earlier in the chapter);

Tests of details of transactions, such as:

- vouching the individual credits to the sales journal and to supporting documentation such as
sales invoices, shipping documents and sales orders;
- tracing transactions data from source documents such as shipping documents, to sales
invoices, to the sales journal, and then tracing postings from the sales journal to the sales
account;

Tests of details of balances (this type of test is unlikely to be applicable).

In many cases, both analytical procedures and tests of details are applied to the sales revenue
account to achieve the acceptable level of detection risk. In some cases, analytical
procedures may suffice
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 Designing Substantive Procedures

Timing
Most entities have similar year ends (31st December, 30th June or 31st March). Consequently
the preceding few months are a “busy” period for the auditors. To reduce the pressure
auditors may try to perform as much work as possible in “quieter” periods. In such cases,
certain procedures (typically test of details of transactions and/or balances) can be performed
several months before closing, followed by a roll-forward test to verify account balances at
year end.

Substantive procedures prior to balance sheet date

These should include:
 Confirmation of trade receivables
 Observation of inventory count and
 Physical inspection of investments

Extent
The amount of evidence obtained can vary by changing the extent of substantive procedures.
The extent relates to the size of the samples selected.

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 Designing Substantive Procedures

Risk components and the nature, timing and extent of substantive procedures

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 Thanks
Any Questions ?

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