Substantive Test
While obtaining audit evidence the auditor will determine the direction of testing. The direction of testing may either be
from source documents to amounts reflected in financial statements balances or from financial statements to source
documents. The appropriate direction will depend upon the purpose of a particular audit test. For example, in carrying
out test of controls, the auditor is basically interested in verifying completeness assertions and would initiate with the
source documents; in substantive tests, the focus is on measurement and valuation, and the auditor would start with
the balances reported in financial statements and verify through underlying documents.
Under directional testing, the auditor looks for overstatement of assets and understatement of revenues. Also the
auditor looks for understatement of liabilities and overstatement of expenses. This is because if the auditor is satisfied
that assets are not overstated, it implies that revenues have not been overstated. So he looks for understatement of
revenues so that the relevant accounts are verified from both the directions, overstatement and understatement.
Likewise, if the auditor is satisfied that liabilities have not been understated, it automatically implies that expenses have
not been understated. So the auditor looks for overstatement of expenses.
What do you understand by the technique of re computation? Give some example.
This is a technique whereby the auditor re computes calculations and reconciliation made by the client. Examples are:
– Computing accumulated depreciation
– Computation of prepaid expense.
– Internal controls may be inadequate
– Lack of segregation of duties.
What are the audit assertions about account balances at year end that cannot be usually addressed by the following
audit procedures.
1) External confirmation of trade debt
2) Physical count of inventory
3) Verification of title documents of fixed assets.
Audit assertions about account balances at year end that cannot be usually addressed by the following audit procedures
are:
1) External confirmation of trade debt
– Cut-off
– Completeness.
2) Physical count of inventory
– Valuation
– Rights and obligations.
3) Verification of title documents of fixed assets
– Existence
– Completeness.
Which financial statement assertions are fulfilled through following audit procedures;
• Debtors balance confirmation
• Physical inspection of inventory
• Review of bank reconciliation statements
• Confirmation from the legal advisors
• Verification of title deeds of fixed assets.
What is sufficient and appropriate audit evidence depends upon auditor’s judgments. What factors influence such
judgment?
The auditor considers following factors in ascertaining what is sufficient and appropriate audit evidence:
(a) Assessment of inherent and control risk
(b) Materiality
(c) Previous experience
(d) Results of tests performed
(e) Source and refiability of data
(f) Cost versus benefits
(g) Timeliness of financial reporting.
ISA 500 states that reliability of audit evidence is influenced by its source and by its nature. Comment on the following
external confirmation.
1. Bank confirmation
2. Receivable confirmation
3. Confirmation from consignee for inventory held on behalf of client
4. Confirmation from lawyers.
1. Bank confirmation
Bank confirmation is a strong evidence as regards existence, ownership and valuation assertion as it is external
confirmation directly received by the auditor.
The limitation is that it does not provide evidence of completeness assertion for those accounts not disclosed by the
client.
2. Receivable confirmation
Receivable confirmation provides strong evidence as regards existence and ownership, because it is external evidence,
directly obtained by auditor.
However the confirmation does not provide evidence as regards ability of the customer to payoff the amount due.
Accordingly, valuation assertion may not be evidenced. Also, evidence is not provided for completeness assertion.
Another limitation is that the customer may confirm the balance without verification. In case of negative confirmation
further limitation is that non receipt of response may persuade the auditor to believe that the customer agrees with the
balance, although he may disagree and the auditor may not receive response due to postal problems.
3. Confirmation from consignee for inventory held on behalf client
Confirmation for inventory on consignment is fairly reliable evidence as to the quantities and condition of inventory held
on behalf of entity.
Depending on materiality of this inventory the auditor would consider following:
(a) Integrity and independence of consignee
(b) Visiting site
(c) Arranging another auditor to observe physical inventory
(d) Inspecting documents regarding inventory shipped to consignee.
4. Confirmation from lawyers
Confirmation with entity’s lawyers is a fairly reliable evidence to assess auditor in obtaining sufficient appropriate audit
evidence as the completeness of material litigation and claims and the valuation assertion for management’s estimates
of the financial implications.
The limitation of such evidence is that the lawyers may hesitate to respond to general inquiry unless a list of litigation is
furnished.
Explain the meanings, practical application and limitations of the following procedures for obtaining audit evidence:
a. Inspection
b. Observation
c. Inquiry
d. Confirmation
e. Analytical procedures.
a. Inspection
Meanings
Examining records or documents and physical examination of the assets.
Practical application
Inspection of initials of payroll manager evidencing approval of payroll sheets.
Limitations
The auditor should be alert of the source and reliability of evidence, for example:
– Audit evidence is generally more reliable if obtained from external source, than from the client
– Effectiveness of internal control will affect reliability of audit evidence generated internally
– Cautious should be used in accepting photocopies as evidences rather than originals.
Although the auditor is not expected to be expert in authentication of documents, evidence less than persuasive should
not be accepted.
If the evidence obtained from one source is inconsistent from another, the auditor should perform additional
procedures to resolve the inconsistency.
b. Observation
Meanings
Watching a procedures being performed by others.
Practical application
Observation of physical count of inventories.
Limitations
– Observation is limited to the point in which the observation takes place.
– The auditor should be alert that the act of being observed may affect how the process is performed.
c. Inquiry
Meanings
Obtaining information from entity’s personnel and outsiders.
Practical application
Basis for making provision for warranty claims.
Limitations
– Consider integrity and competence of management regarding responses received
– Response from related parties are not as strong evidence as responses from independent third party
– Inquiry alone does not provide sufficient audit evidence to detect a material misstatement
– Also, inquiry alone is not sufficient for performing test of controls.
In the case of inquiry about management intent, the information available to support the management intent may be
limited. In these case understanding of management’s past history of its intentions with respect to assets or liabilities,
management’s ability to peruse a particular action should be considered.
d. Confirmation
Meanings
Obtaining a representation of an existing information from outsiders.
Practical application
Confirmation from client’s customers.
Limitations
– Confirmation from debtors may provide audit evidence for existence and right and obligation assertions, but not for
valuation – The auditor should be alert of the possibility that the customer may sign the confirmation without
verification form the books
– Confirmation from creditors may not be effective to verify completeness assertion
– Confrrmation request should be directed to appropriate individual
– Certain parties may not provide objective or unbiased response to a confirmation request
– The auditor should also consider the respondent’s competence, knowledge, ability and willingness to respond to
confirmation request
– The auditor should be alert whether there are any indications that the confirmation received may not be reliable. The
reliability of response should be considered and audit procedures should be performed to dispel any concern. The
auditor may choose to verify the source and contents of a response in a telephone call to the purported sender.
e. Analytical procedures
Analytical procedures consist of evaluations of financial information through analysis of possible relationships among
data.
Practical application
Comparison of current year for Gross Profit margin with last year and investigation of fluctuations.
Limitations
– When information produced by the entity is used by the auditor to perform analytical procedures, the auditor should
be alert about completeness and accuracy of the information.
– Reliance should not be placed on analytical procedures only in case of material accounts.
– The auditor should be alert that analytical procedures may identify relationships as expected, when, in fact, a material
misstatement may exist.
– Analytical procedures are applicable only when the accuracy with which expected results may be predicted. For
example, analytical procedures are no appropriate in comparing’ research and development or advertising expenses
from one period to another.
– A comparison with budget is not appropriate if budgets- are not attainable but have been set as goals to be achieved.
State that difference between auditor’s expert and management’s expert.
Auditor’s expert is a person possessing expertise in a particular field (other than accounting and auditing) whose work is
used by the auditor in obtaining audit evidence. The expert may be from firms’ personnel outsider.
Management’s expert is a person possessing expertise in a particular field (other than accounting and auditing) whose
work is used by the entity to assist in preparing financial statements.
Discuss the methods for selecting items for testing to obtain audit evidence.
1. Selecting all items
It is appropriate to select all items where:
(a) Population consists of small number of high value items, for example there may be a few additions to fixed
assets during the year.
(b) Excessive inherent and control risk
(c) Auditor suspects a fraud
(d) The use of computer may make it feasible to verify 100% items if the population is of a repetitive nature.
2. Selecting specific items
For example selecting all receivables over Rs. 100,000 for sending confirmation letters.
3. Audit sampling
Selecting less than 100% population in away that all items in the population have equal change of being selected.
The auditor should obtain sufficient appropriate audit evidence in order to be able to form an audit opinion.
Required
(a) Identify the situations which restrict the auditor’s ability to obtain sufficient appropriate audit evidence. Give two
examples for each situation.
(b) List three reasons why audit evidence is considered to be persuasive rather than conclusive.
(a) The auditor’s inability to obtain sufficient appropriate audit evidence may arise from:
(i) Circumstances beyond the control of the entity
(ii) Circumstances relating to the ‘nature or timing of the auditor’s work
(iii) Limitations imposed by management.
Examples of factors identified
Circumstances beyond the control of the entity
(i) The entity’s accounting records have been destroyed.
(ii) The accounting records of a significant component have been seized indefinitely by governmental authorities.
Circumstances relating to the nature or timing of the auditor’s work
(i) The timing of the auditor’s appointment is such that the audit is unable to observe the counting of the physical
inventories.
(ii) The auditor determines that performing substantive procedure alone is not sufficient, but the entity’s controls are
not effective.
(iii) The entity is required to use the equity method of accounting for an associated entity, and the auditor is unable to
obtain sufficient appropriate audit evidence about the latter’s financial information to evaluate whether the equity
method has been appropriate applied.
Limitations imposed by management
(i) Management prevents the auditor from observing the counting of the physical inventory.
(ii) Management prevents the auditor from requesting external confirmation of specific account balances.
(b) Audit .evidence is persuasive rather than conclusive because of the following reasons:
(i) The auditor gathers evidence on a test basis (the sample may or may not be representative).
(ii) People make mistakes (both client and auditor).
(iii) Documents could be forged (increasingly easy with digital technology).
(iv) The client’s personnel may not always tell the truth.
Direct communication with an entity’s external legal counsel assists auditor in obtaining sufficient appropriate audit
evidence regarding ‘potentially material litigations and claims’ and in assessing the management’s estimates of the
financial implications thereof.
Required
Explain the different manners in which an auditor may communicate with the entity’s external legal counsel.
Following modes of communication are available to the auditor with the
legal counsel:
Letter of general inquiry
Under this method, a letter of general inquiry requests the entity’s ‘legal counsel to inform the auditor:
(a) of any litigation and claims that the counsel is aware of,
(b) together with an assessment of the outcome of the litigation and claims, and
(c) an estimate of the financial implications, including costs involved.
Letter of specific inquiry
This method is used when it is unlikely that the entity’s external legal counsel will respond appropriately to a letter of
general inquiry. A letter of specific inquiry includes:
(a) a list oflitigations and claims;
(b) where available, management’s assessment of the outcome of each of the identified litigation and claims and its
estimate of the financial implications, including costs involved; and
(c) a request that the entity’s external legal counsel to:
(i) confirm the reasonableness of management’s assessments and
(ii) provide the auditor with further information of the list is considered by the entity’s external counsel to be
incomplete or incorrect.
Meeting with legal counsel
In certain circumstances, the auditor also may judge it necessary to meet with the entity’s external legal counsel to
discuss the likely outcome of the litigation or claims. This may be the case where:
(a) the auditor determines that the matter is’ a significant risk
(b) the matter is complex..
(c) there is disagreement between management and the entity’s external legal counsel.
Ordinary such meetings require management’s permission and are held with a representative of management in
attendance.
Enumerate sources of audit evidence.
Some of significant sources of audit evidence are:
(a) Accounting records
(b) Audit procedures performed to test accounting records
(c) Information obtained during the audit of previous years
(d) Audit firm’s quality control procedures for acceptance of audit
(e) Work of management’s expert
(f) Confirmations from third parties
(g) Comparable data of other companies engaged in the same industry
(h) Written representations from management to support other evidences obtained during the audit.
Explain with examples, various stages of an audit.
Three stages of an audit are:
(a) Risk assessment procedures
Risk assessment procedures include determining what internal controls exist. Such procedures generally include inquiry
from management. For example:
– Are purchase orders issued for all purchases?
– Are purchase orders authorized?
– Are pre-numbered GRNs issued for all receipts of goods in stores?
– Are suppliers’ invoices matched with purchase orders and GRNs?
– Are suppliers’ invoices checked for arithmetical accuracy?
(b) Test of controls
Test of control involve procedures performed to obtain evidence whether the controls have been effectively operated
throughout the period. For example:
On a test basis, select some purchases throughout the year and perform following procedures:
– Inspect signatures on purchase orders for evidence of authorization.
– Reperform matching of suppliers’ invoices with purchase orders and GRNs as evidence of validity.
– Recompute suppliers’ invoices for evidence of accuracy.
– Inspect serial numbers of purchase orders and GRNs for evidence of completeness.
(c) Substantive procedures’
Evidence obtained to detect material misstatement in the financial statements are referred to as substantive
procedures.
For example:
– Observe physical inventory count to verify existence of inventories.
– Inspect suppliers’ invoices to verify ownership.
– Obtain conformation from receivables to verify existence, rights and obligations.
– Inspect subsequent payments to verify completeness of payables.
What is sufficient audit evidence, depends upon auditor’s judgment. Set out matters which influence such judgment.
Factors that influence judgment as to what is sufficient evidence are:
1. Risk of material misstatement
2. Materiality of the account balance
3. Past experience
4. Misstatements found during audit
5. Source and reliability of data
6. Timeliness of financial reporting
7. Cost verses benefits.
As regards reliance on the work of management’s expert, discuss:
(a) Source of information to judge competence and capability of management’s expert
(b) Matters relevant to evaluate competence and capability
(c) Objectivity of management’s expert
(d) Matters to be considered in obtaining understanding of the work of expert
(e) Appropriateness of the work of expert for particular assertion
(f) Factors to be considered in determining extent of audit procedures in order to evaluate the expert and work
performed by expert.
(A) SOURCE OF INFORMATION TO JUDGE COMPETENCE AND CAPABILITY OF EXPERT
1. Personal experience with previous work of expert
2. Discussions with expert
3. Membership of professional body
4. Published papers or books written by expert.
(B) MATTERS RELEVANT TO EVALUATE COMPETENCE AND CAPABILITY OF EXPERT
1. Whether the expert is committed to technical and ethical standards of the expert’s professional body
2. Expertise in the areas of specialty within expert’s field
3. Knowledge of relevant accounting standards.
(C) OBJECTIVITY OF MANAGEMENTS’ EXPERT
1. Possible threats to objectivity are:
– Self-interest threat
– Advocacy threat
– Familiarity threat
– Self-review threat
– intimidation Method.
2. Safeguards to eliminate or reduce threats.
(D) MATTERS TO BE CONSIDERED IN OBTAINING UNDERSTANDING OF THE WORK OF EXPERT
1. Whether the auditor has expertise to evaluate the work of expert or whether the auditor needs an auditor’s expert to
obtain understanding
2. Whether the assumptions used the expert are acceptable within the expert’s field and financial reporting purposes.
3. Review the engagement letter issued by the management to the expert, for scope and objectives of the work of
expert, and responsibilities of the expert.
(E) MATTERS TO BE CONSIDERED TO EVALUATE WHETHER THE WORK OF EXPERT IS APPROPRIATE OR OBTAIN
EVIDENCE FOR PARTICULAR ASSERTION
1. Relevance and reasonableness of expert’s findings
2. Relevance and reasonableness of assumptions used by the expert
3. Relevance and reliability of source data used by the expert.
(F) FACTORS TO BE CONSIDERED IN DETERMINING EXTENT OF AUDIT PROCEDURES IN ORDER TO EVALUATE THE
EXPERT AND WORK PERFORMED BY EXPERT
1. Risk of material misstatement
2. Availability of alternative sources of evidence
3. Extent to which management may influence the work of expert
4. Auditor’s previous experience of the work of expert.