Exam Revision

Introduction to Substantive Tests

• Auditors must gather sufficient, appropriate audit evidence to support their opinion.

• Evidence can be gathered through:

  • Tests of controls (covered in the previous topic).

  • Substantive tests (the focus of this topic).

• Auditors need to select the most efficient and effective combination of procedures to achieve their objectives.

Relationship Between Tests of Controls and Substantive Tests

• The extent of substantive testing is influenced by the results of tests of controls.

• Auditors determine how much reliance they can place on internal controls.

  • If control risk is low, the auditor relies on the controls and performs tests of controls.

  • If the auditor does not rely on internal controls, they perform substantive procedures to form an opinion on the financial report's accuracy.

Substantive Procedures

• Two main types:

  • Substantive tests of details.

    • Substantive test of balances (STOB).

    • Substantive test of transactions (STOT).

    • Substantive test of disclosures (STOD).

  • Substantive analytical procedures.

• Tests of controls focus on internal control procedures and whether they are being followed.

• Substantive tests directly examine the financial report items, independent of the controls.

  • STOB: Focuses on dollar amounts in the balance sheet.

  • STOT: Focuses on dollar amounts in the income statement.

  • STOD: Focuses on information in the note disclosures.

Assertions

• Assertions help auditors assess the risk of material misstatement and guide audit procedures.

• Substantive tests are performed on items in the balance sheet, income statement, and note disclosures to substantiate their inclusion in the financial report.

• Auditors need reasonable assurance that accounting records are accurate and reliable.

Substantive Analytical Procedures

• These involve analyzing relationships between data, such as ratio analysis and comparisons.

• Auditors analyze items within the financial report against other items, including non-financial data.

Tests of Controls vs. Substantive Tests

• Tests of Controls

  • Done when control risk is assessed as low.

  • A low control risk means the auditor believes there is a low risk that internal controls will fail to prevent or detect material misstatements.

  • Transactions are selected to test whether controls are working and safeguarding financial integrity.

  • Do not directly measure monetary error in accounting records.

• Substantive Tests

  • Transactions and account balances are selected to determine whether there are material misstatements in monetary items.

  • Directly measure monetary error in accounts through inspection of underlying documents.

  • Involve tracing transactions, recalculating for accuracy, among others.

Dual-Purpose Tests

• Address both control and substantive matters.

• For example, vouching and tracing, which require inspection of a documentary trail, can be done together.

Relationship Between STOT and STOB: Example

• Accounts receivable ledger extract:

  • Customer: Able

  • Year-end balance: $5,000$

• STOB: Verifying the $5,000$ year-end balance focuses on the balance sheet.

• STOT: Verifying the components of the balance:

  • Sale of $2,000$

  • Receipt of $1,000$

  • Sale of $4,000$

  • If these transactions are accurate, the $5,000$ balance must also be accurate.

Preference Between STOB and STOT

• Typically, more reliance is placed on STOB than STOT.

• STOB is often preferred because:

  • There are fewer ending balances in the balance sheet compared to transactions in the income statement.

  • STOB gives a higher quality of evidence.

  • There are often general ledger accounts and sub-ledger accounts for significant items.

• Small Business Audits: STOB is the most efficient and effective approach.

• Large Businesses: There is a higher reliance on tests of controls because they enable testing of more transactions.

Indirect Testing

• STOB indirectly tests income statement balances due to the double-entry accounting system.

• STOT is used for accounts with a relatively low volume of transactions and a low risk of misappropriation.

Financial Report Assertions

• The focus depends on whether it is a STOT or STOB.

  • STOT: Focuses on income statement assertions (related to transactions and events).

  • STOB: Focuses on balance sheet assertions (related to account balances).

Key Concept: Direction of Testing

• The direction of testing determines whether the audit is testing the existence/occurrence assertion or the completeness assertion.

• Existence/Occurrence:

  • Ensures that items within the balance sheet are real and bona fide.

  • Occurrence is the income statement equivalent of existence.

  • Example: Checking for fictitious sales.

• Completeness:

  • Ensures that nothing is missing from the financial report.

• Vouching for Existence:

  • Going from the accounting records out to the source documents.

• Tracing for Completeness:

  • Going from the source documents back to the accounting records.

Examples

• Fixed Asset Register:

  • Existence: Start with an asset listed in the fixed asset register and check if the asset physically exists.

  • Completeness: Start with a physical asset and check if it is included in the fixed asset register.

• Payroll:

  • Completeness: Compare all employees' names to the payroll system and check if everyone who should be in the payroll system is actually included.

  • Existence: Start with the payroll system and verify if listed employees physically exist.

• Cash at Bank:

  • Completeness: Compare the bank statement to the accounting records, check for items on the bank statement (source document) that are not in the accounting records.

  • Existence: Check for items in the Cash at Bank general ledger account and confirm that those items are valid.

Auditing Cash, Cash Receipts, and Cash Payments

• The cash account balance is impacted by cash receipts and cash payments systems.

• These systems are often audited using tests of controls due to their routine nature.

• Assertions Most Likely at Risk:

  • Existence of cash

  • Completeness of cash

  • Valuation and allocation (only for foreign currency balances)

• The bank statement is the common source of truth.

Auditing Cash at Bank

• Cash at Bank is an asset, so focus is on balance sheet assertions.

• Audit Objective: Determine whether the cash figure in the balance sheet includes all cash items as at the balance date.

  • Auditors might look for amounts in offshore bank accounts.

• Tests:

  • Tests on bank reconciliation and reconciling items.

  • Reviewing transfers to other accounts.

  • Inquiries and discussions with management.

• Valuation and Allocation Objective: Determine whether the amount listed in the balance sheet is accurate.

• Tests:

  • Tests on bank reconciliation.

  • Recalculation of conversion rates for foreign currency balances.

Auditing Cash Receipts and Payments

• Receipts and payments are transactions, so income statement assertions are also relevant.

• Occurrence Objective: Determine whether the transactions giving rise to the cash receipts and payments are validly authorized transactions.

• Tests:

  • Inspection of remittance advices to verify payments.

• Completeness Objective: Ascertain whether all cash receipts and payments have been recorded.

• Test: Undertake sequence checks of transaction details or remittance advices

  • Example: Looking for missing number between 1,2,3,4,6,7,8,9

• Cutoff Objective: Determine whether cash payments and cash receipts have been recorded in the correct financial year.

• Test: Check the last cash receipt and payment before and after the balance date.

• Classification Objective: Determine whether cash receipts and cash payments have been recorded in the correct account as per the chart of accounts.

• Test: Check sample of receipts and payments against the chart of accounts.

External Confirmation of Bank Balances

• Provides evidence that cash in the balance sheet exists at the balance date.

• Confirms ownership and lack of restrictions.

• Auditor must go to the bank to verify the information.

Testing a Client's Bank Reconciliation

• Bank reconciliations are a key control.

• Objective: Substantiate that the balance confirmed with the bank agrees with the client's cash accounting records.

• Extent of testing depends on the level of assessed control risk.

  • Low Control Risk: Scanning the client reconciliation and comparing balances to the bank confirmation.

  • High Control Risk: Testing the client's reconciliation and the individual reconciling items.

Substantively Auditing Sales, Cash Receipts, and Accounts Receivable

• Assertions Most Likely at Risk:

  • Occurrence of the sale or the existence of the accounts receivable.

  • Accuracy, valuation, and allocation of both.

  • Cutoff of the sale.

Common Substantive Procedures

• Debtor's Confirmation:

  • A letter sent by the auditor to the client's debtor asking them to reply directly to the auditor as to whether or not they agree or disagree with the balance at the balance date.

  • Two Types

    • Positive Form: The debtor is asked to respond whether or not they agree with the amount owed. Follow-up procedures are required for non-response, such as checking invoices to shipping documents.

    • Negative Form: The debtor is asked to respond only if they disagree with the amount. Non-replies are assumed to indicate agreement.

• Benefits: Testing existence or the occurrence of sales.

• Limitations Doesn't test the valuation and allocation.

• Subsequent Receipt Review/Testing

  • Check what sales were paid for after the balance date.

Benefits

• Helps verify the existence of debtors.

• Helps assess their ability to pay.

  • Cutoff Testing

    • Focuses on what was processed either side of balance date.

    • Aims to determine whether income or expenses were processed in the correct financial reporting year.

    • Test the cutoff assertion

  • Debtor's Age Trial Balance:

    • A report that categorizes accounts receivable balances by the length of time they have been outstanding.

Benefits

• Aids in assessing the likelihood of doubtful or bad debts.

• Provides a basis for determining the allowance for doubtful debts.

• Tool for cash control.

Purchases and Inventory Substantive Tests

• Inventory Definition: Goods used or sold in production.

• Audit Focus: Significant income determination, high activity volume, complexities (lower of cost or net realizable value), manipulation risk.

• Assertions at Risk:

  • Existence: Risk of fraudulent theft.

  • Valuation and Allocation: Accounting complexities in determining lower of cost and net realizable value.

  • Occurrence: Risk of classic disbursement fraud. Validity of authorized transactions. Dollar amount correct, cutoff adherence (correct financial reporting year).

Major Inventory Procedures

• Physical Stocktake Observation: Combination of observation, inquiry, and physical examination to ensure accurate count.

  • Auditor aims to obtain reasonable assurance that the client's methods of counting inventory results in an accurate count

  • Stocktake serves as a test of control.

  • Alternatives to stocktakes: Substantive analytical procedures, cutoff testing, valuation and allocation tests (audit sampling, purchase tracing, inventory flow assumption evaluation), testing for defective/obsolete/slow-moving/excess (DOSE) items.

Auditing Purchases

• Transactions needing assessment.

  • Occurrence Assertion: Validity of transactions.

  • Substantive Procedures: Select transactions from the purchase journal and trace to supporting documentation such as purchase orders or goods received notes.

  • Accuracy Assertion: Purchases recorded at correct dollar amount.

  • Substantive Procedures: Inspect supporting documents (purchase orders, invoices, goods received documents) to verify dollar amounts.

Inventory Existence

• Objective: Inventory physically exists and held for sale.

• Procedure: Physical sighting of inventory, especially at various locations.

Completeness Assertion

• Objective: Inventory figure includes all inventories.

• Consideration: Inventory in transit with title passed to the client should be included.

• Substantive Procedures:

  • Analytical procedures comparing purchases to prior periods.

  • Inspect physical inventory and compare it with accounting records (trace goods on the warehouse floor to the inventory ledger).

Valuation and Allocation

• Objective: Inventory stated at the correct amount.

• Considerations: Cost as per accounting method; identification and reduction of defective, obsolete, slow-moving, excess (DOSE) items to net realizable value.

• Substantive Procedures:

  • Tests of pricing and summation (recalculation).

  • Walk-through of client premises to observe inventory quality; identify potential DOSE items.

  • Analytical procedures.

Accounts Payable & Payroll

• Accounts Payable:

  • Assertion at Risk: Completeness, due to high likelihood of understatement.

    • Understatement impacts profit (unrecorded expense) and balance sheet (unrecorded liability).

  • Common Audit Procedures:

    • Search for unrecorded liabilities (subsequent payments testing/out-of-period liability search):

      • Review payments made after balance date (e.g., July/August) to identify liabilities that should have been reported as of June 30.

      • Identify instances where invoices are recorded after balance date to manipulate financial health.

      • Client may delay recording invoices to improve profit and balance sheet figures.

• Payroll:

  • Approach: High-level tests of controls and substantive analytical procedures.

  • Periodic payrolls are compared and analyzed for fluctuations.

  • If controls cannot be relied upon, detailed substantive testing of transactions and balances is required.

Auditing Noncurrent Assets

• Property, Plant, and Equipment (PPE), Investments, Intangibles.

• Few large transactions each year, well-suited to substantive tests.

• Efficient to verify account balances via substantive tests of individual transactions.

• Assertions at Risk (PPE): Existence, rights and obligations, valuation, and allocation.

• Key Procedures:

  • Vouching: Verify existence by tracing from accounting records to physical assets.

  • Documentation Inspection: Confirm client's rights to the asset.

  • Physical Examination: Verify existence and assess valuation and allocation, including accumulated depreciation based on scrap value and useful life.

  • Substantive Analytical Procedures: Identify misclassified additions, unrecorded retirements, or depreciation miscalculations.

  • Recalculation: Verify depreciation and accumulated depreciation expenses.

  • Inquiries of Management: About additions, disposals, and retirements.

• Valuation:

  • Ensure PPE is valued per accounting standards (AASB 116): cost model or revaluation model.

    • Test for impairment by:

      • Observing obsolete, damaged, or underutilized units.

      • Identifying assets from discontinued activities.

      • Inquiring with management about budgets, forecasts, and future cash flows.

      • Utilizing work of experts (assessing their work).

Audit Software and Advanced Data Analytics

• Efficient for voluminous client files.

• Types of Software:

  • Generalized Audit Software (GAS):

    • Performs general tasks applicable to various areas: selecting items, identifying records meeting criteria, testing calculations, comparing data, analysis, modeling, visualizations, report generation.

    • Examples: ACL, Idea, Inflow, CaseWare, TeamMate, MindBridge; Excel.

  • Specialized Audit Software/Purpose-Written Programs:

    • Written for specific audit purposes (e.g., insurance premium calculation).

  • Utility Programs:

    • Developed for common tasks like sorting records and merging files (Excel).

  • System Management Programs:

    • Enhanced productivity tools for data retrieval and code comparison (e.g., identifying bidders who haven't paid in >60 days; Excel).