CANADIAN EDITION
AUDITING
A PRACTICAL APPROACH
Prepared by:
Angela Davis CA, CFE, MSc
Booth University College
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CHAPTER 10
SUBSTANTIVE TESTING AND BALANCE
SHEET ACCOUNTS
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
6.
7.
8.
Explain the relationship between the overall risk assessment for a significant
account and the extent and timing of substantive procedures
Design and understand how to execute substantive procedures to address
audit risk related to cash
Design and understand how to execute substantive procedures to address
audit risk related to trade receivables
Design and understand how to execute substantive procedures to address
audit risk related to inventory
Design and understand how to execute substantive procedures to address
audit risk related to property, plant, and equipment
Design and understand how to execute substantive procedures to address
audit risk related to payables
Understand how substantive testing is used for other balance sheet accounts
Understand how to assess the results of substantive procedures to determine
whether additional substantive tests are necessary
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Risk and substantive
procedures
1. Extent of substantive procedures
•
•
•
•
•
Determined by risk assessment
Trivial or immaterial accounts are either ignored
or subjected to analytical procedures only
Audit risk model used to make a risk
assessment on each significant account or
disclosure
High IR, CR: do not rely on and test controls,
use significant amount of substantive testing to
reduce DR to acceptable level
Low IR, CR: testing controls shows them to be
effective, limited substantive testing required
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Risk and substantive
procedures cont’d
2. Timing of substantive procedures
• Also determined by risk assessment
– Lower DR, more work done at year-end
• Audit firm must also consider availability of resources to
conduct procedures around year-end
– Use techniques to influence schedule:
» Review events prior to year-end, e.g. acquisitions
» Review activity in period to date, e.g. review interim
ageing of trade receivables then update at year-end
» Perform general audit procedures prior to year-end,
e.g. read board minutes
» Review provisions prior to year-end, e.g. understand
estimation processes used by management
» Leverage off internal audit (CAS 610)
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Risk and substantive
procedures cont’d
Figure 10.2
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Risk and substantive
procedures cont’d
3. Other matters to consider in designing
substantive procedures
•
Ensure procedures respond to specific risk
faced by client from both IR and CR factors
–
•
•
Different clients may have same overall level of risk
but risk caused by different factors – procedures
would be also different
Take credit for work already done – early work
in audit to assess risk also provides evidence
Set appropriate testing thresholds – what does
auditor consider important for this audit?
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Substantive testing –
Cash
• Most important assertions: existence,
completeness, classification
– Existence
• Usually addressed by bank confirmation (CAS
505)
– Completeness
• Test bank reconciliation and cut-off of cash
transactions
• Verify reconciling items to next period bank
statement
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Substantive testing –
Cash cont’d
– Classification
• Important because of special disclosure
requirements
– Rights and obligations assertion also significant
where clients may pledge assets
• Pledging restricts client’s rights over cash
– Valuation and allocation usually only an issue
when client has significant foreign currency
bank accounts
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Substantive testing –
Cash cont’d
Table 10.1
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Substantive testing –
Cash cont’d
• Processes impacting on the audit of cash
– Auditor assesses evidence obtained from
interim testing on significant transactions,
control testing
– When CR low, unlikely to do additional testing
on cash receipts and payments, focus on
balance
– If CR not low, substantive tests of receipts and
payments may be required
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Substantive
testing –
Cash cont’d
Table 10.2
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Substantive
testing –
Cash cont’d
Table 10.2 (continued)
Substantive testing –
Cash cont’d
• Testing cash account balances always done at
some level, additional procedures required as
risk assessment increases
• Tests include bank confirmations, bank
reconciliation re-performance, analytical
procedures etc
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Substantive testing – Cash cont’d
Table 10.3
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Substantive testing –
Trade Receivables
• Most important assertions: existence, valuation
& allocation
– Existence
• Usually addressed by confirmation (CAS 505)
– Positive confirmation: auditor requests reply in all
circumstances
– Negative confirmation: auditor requests reply only if
debtor disagrees with balance shown
– Confirmations do not provide assurance about
valuation because they do not address recoverability
» Examine receipts of cash by client after year end to
assess valuation at balance date
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Debtor’s confirmation
Substantive testing –
Receivables cont’d
– Valuation & Allocation
• Use subsequent receipts test
• Analytical procedures based on ageing
– Classification assertion can also be important
because of disclosures, such as related parties
and financial instruments
– Rights & obligations can also be important
because of restrictions on trade terms
– Completeness can be addressed through cut-off
testing
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Table 10.4
Substantive testing –
Receivables cont’d
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Substantive testing –
Receivables cont’d
• Processes impacting on trade receivables
– Most important transactions impacting the
balance of receivable are sales, sales returns
and allowances, cash receipts
– Usually, auditor relies on control testing of these
transactions to confirm low CR
– If CR not low, substantive tests required for the
transactions
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Substantive testing –
Receivables cont’d
Table 10.5
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Substantive
testing –
Receivables
cont’d
Table 10.5 (continued)
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Substantive testing – Receivables
cont’d
Table 10.5 (continued)
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Substantive testing – Receivables
cont’d
Table 10.5 (continued)
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Substantive testing – Receivables
cont’d
Table 10.6
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Substantive testing – Receivables
cont’d
Table 10.6 (continued)
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Substantive testing –
Inventory
• Most important assertions: existence, valuation
& allocation
– Existence
• Usually addressed by testing client’s annual or
cyclical inventory count (CAS 501)
– Auditor tests client’s verification of physical inventory
with records, and auditor must sight inventory
– If controls not strong or if physically difficult to count
inventory often the inventory count is performed
annually
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Substantive testing –
Inventory cont’d
– Valuation & allocation
• Important inventory recorded at the appropriate
carrying value
• Viewing inventory at the inventory count allows
auditor to assess slow-moving, damaged,
obsolete, impaired, excess inventory which
should be written down
• Typical techniques:
– Vouching to invoices to verify initial cost
– Vouching to sales details to verify cost of sales
– Test provision for impairment calculations
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Substantive testing –
Inventory cont’d
– Completeness not usually a major issue, but
risk of understatement can be issue where
goods sold on consignment
– Rights & obligations also relevant for some
clients due to consignment sales, complex
purchasing contracts
– Classification usually addressed by testing
inventory listing, allowing verification of
disclosures
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Substantive testing –
Inventory cont’d
Table 10.7
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Substantive testing –
Inventory cont’d
• Processes impacting inventory
– Purchasing, cash payments, and inventory
records
– Usually, auditor relies on control testing of these
transactions to confirm low CR
– If CR not low, substantive tests required for the
transactions
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Substantive testing –
Inventory cont’d
Table 10.8
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Substantive testing –
Inventory cont’d
Table 10.8
(continued)
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Substantive testing –
Inventory cont’d
Table 10.8
(continued)
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Substantive testing –
Inventory cont’d
Table 10.8
(continued)
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Substantive testing –
Inventory cont’d
Table 10.8
(continued)
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Substantive testing –
Inventory cont’d
Table 10.9
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Substantive testing –
Inventory cont’d
Table 10.9
(continued)
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Substantive testing –
Inventory cont’d
Table 10.9 (continued)
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Substantive testing –
PPE
• Most important assertions: existence, valuation
& allocation
– Existence
• Verify items recorded in client’s fixed asset
register
• Physically sight assets listed in first audit and
periodically for subsequent audits
• Focus on additions and disposals in later years
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Substantive testing –
PPE cont’d
– Valuation & allocation
• Evidence about condition gathered when sighting
physical assets
• Consider appropriate cost, carrying value or fair
value (IAS 16), and asset impairment
• Change in client operations could impact fair
values
• Vouch initial cost to invoices, contracts
• Vouch disposals to sales contracts, receipts
• Test depreciation through reasonableness testing
of depreciation charge compared to cost base
and useful life of the asset
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Substantive testing –
PPE cont’d
– Completeness not usually major issue
– Rights and obligations – tested during initial
audit then test periodically depending on type of
assets in the register
– Tests include verifying
• Registered titles, registration papers, invoices
• Lease agreements
– Classification - generally addressed by testing
fixed asset register
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Substantive testing – PPE
cont’d
Table 10.10
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Substantive testing –
PPE cont’d
• Processes impacting PPE
– Cash receipts, cash payments, purchasing
– Substantive testing when CR high
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Substantive testing – PPE
cont’d
Table 10.11
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Substantive testing – PPE
cont’d
Table 10.11
(continued)
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Substantive testing – PPE cont’d
Table 10.12
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Substantive testing Payables
• Most important assertions are completeness and
valuation & allocation
• Major risk is understatement
• Use subsequent payments testing
– Vouch payments after balance date to invoices to verify
invoices dated prior to year-end are included in
payables
• Cut-off testing
– Select sample of purchases either side of year-end and
verify that each included or excluded from payables
based on invoice date
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Substantive testing –
Payables cont’d
– Existence and rights & obligations not usually
important because they relate more to risk of
overstatement
– Classification important if there are related party
transactions, lease commitments or other forms
of finance included in the payables balance
– Accruals are treated in same way as payables,
search for unrecorded amounts through
subsequent payments testing
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Table 10.13
Substantive testing –
Payables cont’d
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Substantive
testing –
Payables
cont’d
Table 10.14
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Substantive testing – Payables
cont’d
Table 10.14 (continued)
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Substantive testing – Payables
cont’d
Table 10.15
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Substantive testing –
Other
• Most other accounts are typically audited
substantively because they do not rely on high
volume processes and specific application
controls
• Auditor’s objective is to identify and quantify
any errors
– Understand why error occurred
– Assess need for additional testing
– Make final estimate of misstatement, assess
materiality
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