CHAPTER 11
DETECTION RISK AND THE DESIGN OF
SUBSTANTIVE TESTS
Learning Check
11-1.
The following bullets summarize each preliminary audit strategy, the appropriate level
of planned detection risk, the planned audit procedures that provide significant
assurance, and whether a higher or a lower level of assurance is needed from substantive
tests.
 A Primarily Substantive Approach Emphasizing Tests of Details requires a low
planned level of detection risk, audit assurance is needed primarily from tests of
details of transaction or tests of details of balances, and the level of assurance needed
from substantive tests is high.
 A Lower Assessed Level of Control Risk Approach usually results in a high planned
level of detection risk due to the fact that significant assurance is obtained from tests
of controls. As a result, the level of assurance that is needed from substantive tests is
low.
 A Primarily Substantive Approach Emphasizing Analytical Procedures also requires a
low planned level of detection risk. Under this strategy important audit assurance is
obtained from analytical procedures and the auditor’s knowledge of the business and
industry. The level of assurance needed from substantive tests is high, and a great
deal of this assurance is obtained from analytical procedures, with some assurance
coming from tests of details.
 Emphasis on Inherent Risk and Analytical Procedures represents an audit strategy
associated with assertions where inherent risk is assessed below the maximum and the
planned detection risk is moderate or high. Evidence is needed to support an inherent
risk assessment below the maximum and substantive tests are preformed using
analytical procedures. The Planned level of substantive test is often moderate,
representing the assurance needed from analytical procedures and the auditor’s
knowledge of the business and industry.
11-2. The auditor evaluates the planned level of substantive tests after (1) assessing inherent
risk, (2) performing analytical procedures in audit planning, and (3) comparing the actual
or final assessed level of control risk with the planned assessed level. If the final assessed
level is the same as the planned assessed level of control risk, the auditor may proceed to
design specific substantive tests, including both further analytical procedures and
substantive tests of details, based on the planned level of substantive tests specified as the
fourth component of the preliminary audit strategy. Otherwise the level of substantive tests
must be revised before designing specific substantive tests to accommodate a revised
acceptable level of detection risk.
11-3. A revised or final acceptable level of detection risk is determined for each assertion after
(1) assessing inherent risk, (2) performing analytical procedures in audit planning, and (3)
making a final assessment of control risk for relevant controls. A risk matrix or the audit
risk model can be used to solve for the revised acceptable level of detection risk
associated with analytical procedures and tests of details based on the actual assessed
levels of inherent and control risk and the auditor's specification of audit risk.
11-4. It may be appropriate to use a higher level of detection risk for a particular substantive
test of an assertion (analytical procedures or tests of details) when evidence obtained
from one or more previously performed substantive tests (analytical procedures or tests
of details) of the same assertion has already reduced the risk of a material misstatement
remaining undetected in the assertion.
11-5. a.
b.
11-6. a.
11-7.
The purpose of substantive tests is to provide evidence about the fairness of each
significant financial statement assertion, or conversely, to reveal monetary errors
or misstatements in the recording or reporting of transactions and balances.
Designing substantive tests involves determining the nature, timing, extent and
staffing of the tests necessary to meet the acceptable level of detection risk for
each assertion.
As substantive tests, analytical procedures may be more or less effective than tests
of details depending on the application and other factors discussed in part b to this
question. A major advantage is that they are generally the least costly type of
substantive test to perform and they draw on the auditor’s knowledge of the
business and industry.
b.
The expected effectiveness and efficiency of analytical procedures depends on
the:
 Nature of the assertion.
 Plausibility and predictability of the relationship.
 Availability and reliability of the data used to develop the expectation.
 Precision of the expectation.
a.
Tests of details of transactions primarily involve tracing and vouching to test for
understatements and overstatements, respectively. Other procedures may also be
used such as inquiring and reperforming calculations.
b.
Tests of details of transactions are typically more time consuming and thus more
costly to perform than analytical procedures, but less costly than tests of details of
balances. Their cost-efficiency is enhanced when performed concurrent with tests
of controls as dual-purpose tests.
11-8. a.
11-9.
Tests of details of balances focus on obtaining evidence directly about an account
balance rather than the individual debits and credits comprising the balance.
b.
Tests of details of balances often involve the use of external documentation and/or
the direct personal knowledge of the auditor. Therefore, they can be very
effective. They also tend to be the most costly to perform.
c.
Tests of accounting estimates usually involve understanding the entity’s process
of estimating future outcomes (e.g., the receivables that will not be collected in
the future or the costs of providing warranty coverage in the future). This
requires significant knowledge of the business, industry, and economy. Tests of
details of balances involve testing the historical accuracy of past transactions such
as testing the existence of inventory by observing inventory which may be more
susceptible to more clear cut, right or wrong determinations.
a.
The decision whether to perform substantive tests prior to the balance sheet date
should be based on whether the auditor can:
 Control the added audit risk that material misstatements existing in the
account at the balance sheet date will not be detected by the auditor. This risk
becomes greater as the time period remaining between the date of the interim
tests and the balance sheet date is lengthened.
 Reduce the cost of substantive tests necessary at the balance sheet date to
meet planned audit objectives so that testing prior to the balance sheet date
will be cost effective.
b.
The potential added audit risk can be controlled if substantive tests for the
remaining period can provide a reasonable basis for extending the audit
conclusions from the tests performed at the interim date to the balance sheet date.
Conditions contributing to the control of this risk are:
 The internal controls during the remaining period are effective.
 There are no conditions or circumstances that might predispose management
to misstate the financial statements in the remaining period.
 The year-end balances of the accounts examined at the interim date are
reasonably predictable as to amount, relative significance, and composition.
 The client's accounting system will provide information concerning
significant unusual transactions and significant fluctuations that may occur in
the remaining period.
11-10. As a general rule, detection risk and the extent of substantive test are inversely related;
i.e., the lower the acceptable level of detection risk, the more extensive the substantive
tests should be. Note however, that the auditor has choices between substantive tests
involving analytical procedures and substantive tests involving tests of details.
11-11. a.
Generalized audit software refers to software packages that assist the auditor in
carrying out a variety of auditing procedures on computer files produced under a
variety of data organization and processing methods.
b.
In substantive testing, generalized audit software can be used for (1) selecting and
printing audit samples, (2) testing calculations and making computations, (3)
summarizing data and performing analyses, and (4) comparing audit data with
computer records.
11-12. a.
The overall objective of a financial statement audit is the expression of an opinion
on whether the client's financial statements are presented fairly, in all material
respects, in conformity with GAAP.
b.
For each account, the auditor develops numerous specific audit objectives based
on the five categories of financial statement assertions. In designing substantive
tests, the auditor should determine that appropriate tests have been identified to
achieve each of the specific audit objectives pertaining to each assertion.
11-13. The auditor's decisions regarding the design of substantive tests are required to be
documented in the working papers in the form of written audit programs.
11-14. a.
An audit program is a list of audit procedures to be performed.
b.
In addition to listing audit procedures, each audit program should have columns
for (1) cross-references to other working papers containing the evidence obtained
from each procedure (when applicable), (2) the initials of the auditor(s) who
performed each procedure, and (3) the date performance of the procedure was
completed.
c.
Audit programs should be sufficiently detailed to provide:
 An outline of the work to be done.
 A basis for coordinating, supervising, and controlling the audit.
 A record of the work performed.
11-15. a.
Eight steps in completing the preliminary planning for an audit program for
substantive tests are:
1. Identify the financial statement assertions to be covered by the audit program.
2. Develop specific audit objectives for each category of assertions.
3. Obtain an understanding of the client’s business and industry.
4. Assess inherent risk for the assertion.
5. Assess control risk for the assertion.
6. Determine the final acceptable level of detection risk for each assertion
consistent with the overall level of audit risk and applicable materiality level.
7. From knowledge acquired from procedures to obtain an understanding of
relevant internal controls, envision the accounting records, supporting
documents, accounting process (including the audit or transaction trail), and
financial reporting process pertaining to the assertions.
8. Consider options regarding the design of substantive tests, including the
nature, timing, extent and staffing of tests, the use of generalized audit
software, the possible types of corroborating evidence, and the possible types
of audit procedures.
b.
Eight steps in the general framework for specifying substantive tests to be
included in an audit program include:
1. Obtain an understanding of the business and industry and determine:
 The significance of the transaction class and account balance to the entity.
 The key economic drivers that influence the transaction class and account
balance.
2. Specify initial procedures to:
 Trace beginning balance to prior year’s working papers (if applicable).
 Review activity in applicable general ledger accounts and investigate
unusual items.
 Verify totals of supporting records or schedules to be used in subsequent
tests and determine their agreement with general ledger balances, when
applicable, to establish tie-in of detail with control accounts.
3. Specify analytical procedures to be performed.
4. Specify tests of details of transactions to be performed.
5. Specify tests of details of balances to be performed.
6. Specify tests of details of balances involving accounting estimates to be
performed.
7. Consider whether there are any special requirements or procedures applicable
to assertions being tested in the circumstances such as procedures required by
SAS (for example, observation of inventories) or by regulatory agencies that
have not been included in (3) and (4) above.
8. Specify procedures to determine conformity of presentation and disclosure
with GAAP.
11-16. In initial engagements, the detailed specification of substantive tests in audit programs is
generally not completed until after the study and evaluation of internal controls has been
completed and the auditor has a significant understanding of the business and industry.
Until then the auditor may not have a reasonable basis for specifying appropriate
detection risk levels which affect the design of substantive tests for significant financial
statement assertions. In contrast, in recurring engagements the auditor has access to audit
programs used in the preceding period(s) and the working papers pertaining to those
programs. In such cases, needs to understand major changes in the business, but the
auditor's preliminary audit strategies are often based on a presumption that the risk levels
and audit programs for substantive tests used in the previous period may be appropriate
for the current period. Thus, the audit programs for the current engagement are often
prepared before the auditor completes the evaluation of the internal controls with the
understanding they may subsequently require modification.
11-17. Tests of income statement accounts may rely more heavily on analytical procedures and
less on tests of details because many income statement accounts and the assertions
pertaining to them are linked to specific balance sheet accounts and assertions. Evidence
obtained from tests of details on the related balance sheet accounts may provide a basis
for extending inferences to the related income statement accounts, thereby reducing
detection risk for the income statement assertions to a level that can be achieved by
applying analytical procedures only.
11-18. Tests of details may be applied directly to income statement accounts when evidence
obtained from tests of related balance sheet accounts does not reduce detection risk to an
acceptably low level. This may include situations in which:
 Inherent risk is high, such as when (1) nonroutine transactions or (2) management’s
judgments and estimates affect assertions.
 Control risk is high either because (1) related internal controls for nonroutine and
routine transactions are ineffective, or (2) the auditor elects not to test the internal
controls.
 Analytical procedures reveal unusual relationships and unexpected fluctuations.
 An account requires analysis because it (1) requires special disclosures in the income
statement, (2) contains information needed in preparing tax returns or reports for
regulatory agencies such as the SEC, or (3) has a general account title that suggests
the likelihood of misclassifications and errors.
11-19. a.
b.
11-20. a.
b.
The auditor's objective in evaluating accounting estimates is to obtain sufficient
competent evidential matter to provide reasonable assurance that:
 All accounting estimates that could be material to the financial statements
have been developed.
 The accounting estimates are reasonable in the circumstances.
 The accounting estimates are presented in conformity with applicable
accounting principles and are properly disclosed.
To evaluate the reasonableness of accounting estimates, the auditor should
normally concentrate on the key factors and assumptions used by management
including those that are (1) significant to the accounting estimate, (2) sensitive to
variations, (3) deviations from historical patterns, and (4) subjective and
susceptible to misstatement and bias.
The auditor's objectives in auditing related party transactions are to obtain
evidential matter as to (1) the purpose, nature, and extent of these transactions and
(2) their effect on the financial statements.
Substantive tests that may be used in auditing related party transactions include
the following:
 Obtain an understanding of the business purpose of the transaction.
 Examine invoices, executed copies of agreements, contracts, and other
pertinent documents, such as receiving reports and shipping documents.
 Determine whether the transaction has been approved by the board of
directors or other appropriate officials.
 Test for reasonableness the compilation of amounts to be disclosed, or
considered for disclosure, in the financial statements.


Arrange for the audits of inter-company account balances to be performed as
of concurrent dates, even if the fiscal years differ, and for the examination of
specified, important, and representative related party transactions by the
auditors for each of the parties, with appropriate exchange of relevant
information.
Inspect or confirm, and obtain satisfaction concerning, the transferability and
value of collateral.
11-21. Tests of controls and substantive tests may be contrasted on the indicated variables as
follows:
Tests of Controls
Substantive Tests
a. Types
 Tests of management controls or  Analytical procedures.
other manual controls over
 Tests of details of
computer output.
transactions.
 Tests of computer controls.
 Tests of Details of Balances
 Tests of manual follow-up.
 Tests of Details of Accounting
Estimates.
b. Purpose
Determine effectiveness of design
and operation of internal controls.
Determine fairness of significant
financial statement assertions.
c. Nature of test
measurement
Frequency of deviations from
prescribed internal controls.
Monetary errors in transactions
and balances.
d. Applicable audit
procedures.
Inquiry, observing, inspecting,
reperforming and CAATs.
Inquiry, observing, inspecting,
reperforming, analytical
procedures, counting, confirming,
tracing, and vouching.
e. Timing
Primarily interim work
Primarily at or near balance sheet
date.
f. Audit risk
component
Control risk


g. Primary
fieldwork
standard
h. Required by
GAAS
Second
Third
No.
Yes.
Analytical procedures risk
Tests of details risk
Objective Questions
11-22.
11-23
11-24.
1. d
1. b
1. c
2. a
2. d
2. d
3. b
3. d
3. d
4. b
4. b.
5. b
5. d
Comprehensive Questions
11-25. (Estimated time - 15 minutes)
a.
If the final assessed levels of control risk for the specified assertions are the same
as the planned assessed levels, the auditor may proceed to design specific
substantive tests based on the planned level of substantive tests specified as the
fourth component of the preliminary audit strategy for each of the specified
assertions. Otherwise, the level of substantive tests must be revised before
designing specific substantive tests for each assertion in order to accommodate a
revised acceptable level of detection risk that correlates with the final assessed
level of control risk.
b.
Determining a revised acceptable level of detection risk for an assertion can be
accomplished by using the final assessed level of control risk in either a risk
matrix or the audit risk model and re-solving for detection risk. Usually this is
done by considering both analytical procedures risk and test of details risk.
c.
No. When evidence obtained from one substantive test or group of tests reduces
the risk of a material misstatement remaining undetected in an assertion, it may be
appropriate to use a higher acceptable level of detection risk for any additional
substantive tests performed to gather evidence for that assertion.
11-26. (Estimated time - 15 minutes)
a.
Substantive tests provide evidence about the fairness of each significant financial
statement assertion. They are the primary means of obtaining sufficient competent
evidential matter to establish a reasonable basis for the auditor's opinion on the
client's financial statements.
b.
The factors pertaining to substantive tests that can be varied to accommodate
different acceptable levels of detection risk are (1) nature, (2) timing, (3) extent
and (4) staffing. When a low versus a high acceptable level of detection risk must
be achieved:
 The nature of the tests selected should be more effective rather than less
effective.
 The timing of the tests will more often be at year-end rather than at an interim
date.


c.
The extent of the tests (e.g., sample size) will be greater.
Staffing selected will be more experienced rather than less experienced.
The four types of substantive tests and brief explanations of each are:
 Analytical procedures which consist of evaluations of financial information
made by a study of plausible relationships among both financial and
nonfinancial data. Such procedures range from simple comparisons to the use
of complex mathematical and statistical models involving many relationships
and data elements.
 Tests of details of transactions which primarily involve tracing and vouching
using documents available in the client's files. In these tests, the auditor uses
evidence obtained about the individual debits and credits in an account to
reach a conclusion about the account balance.
 Tests of details of balances which often involve the use of external
documentation and/or the direct personal knowledge of the auditor. These
procedures focus on obtaining evidence directly about an account balance
rather than the individual debits and credits comprising the balance.
 Tests of accounting estimates designed to obtain sufficient competent
evidential matter to provide reasonable assurance that:
 All accounting estimates that could be material to the financial statements
have been developed.
 The accounting estimates are reasonable in the circumstances.
 The accounting estimates are presented in conformity with applicable
accounting principles and are properly disclosed.
The effectiveness of analytical procedures depends on (1) the nature of the assertion, (2) the
plausibility and predictability of the relationship, (3) the availability and reliability of the data
used to develop the expectation, and (4) the precision of the expectation. The effectiveness of
tests of details of transactions depends on the particular procedure and documents used. When
these tests involve the use of internally generated documents that have not been circulated
externally, they may be less effective than tests involving the use of externally generated
documents or internally generated documents that have been circulated externally. The
effectiveness of tests of details of balances is usually high because they typically involve (1) the
use of external documentation received directly by the auditor or (2) the direct personal
knowledge of the auditor. The effectiveness of tests of accounting estimates depend on the
auditor’s knowledge of (1) the underlying drivers that influence the accounting estimate and (2)
the business, industry and economy.
Analytical procedures are generally the least costly tests to perform. Tests of details of
transactions are typically more time consuming and thus more costly than analytical procedures.
The cost-efficiency of tests of details of transactions is enhanced when performed concurrent
with tests of controls as dual-purpose tests. Tests of details of balances tend to be the most costly
to perform because of their focus on external documentation or the auditor's direct personal
knowledge. Tests of accounting estimates requires significant professional judgment and may
be more costly due to the need for more experience staff to perform audit procedures.
11-27. (Estimated Time – 20 minutes)
a.
An audit program is a list of auditing procedures to be performed. Each program
should have columns for the initials of the individuals who performed each
procedure, the dates the procedures were completed, and cross-references to other
working papers containing evidence obtained from the procedures. Audit
programs should be sufficiently detailed to provide:
 An outline of the work to be done.
 A basis for coordinating, supervising, and controlling the audit.
 A record of the work performed.
b.
Eight steps in the general framework for specifying substantive tests to be
included in an audit program include:
1. Obtain an understanding of the business and industry and determine:
 The significance of the transaction class and account balance to the entity.
 The key economic drivers that influence the transaction class and account
balance.
2. Specify initial procedures to:
 Trace beginning balance to prior year’s working papers (if applicable).
 Review activity in applicable general ledger accounts and investigate
unusual items.
 Verify totals of supporting records or schedules to be used in subsequent
tests and determine their agreement with general ledger balances, when
applicable, to establish tie-in of detail with control accounts.
3. Specify analytical procedures to be performed.
4. Specify tests of details of transactions to be performed.
5. Specify tests of details of balances to be performed.
6. Specify tests of details of balances involving accounting estimates to be
performed.
7. Consider whether there are any special requirements or procedures applicable
to assertions being tested in the circumstances such as procedures required by
SAS (for example, observation of inventories) or by regulatory agencies that
have not been included in (3) and (4) above.
8. Specify procedures to determine conformity of presentation and disclosure
with GAAP.
c.
In initial engagements, the detailed specification of substantive tests in audit
programs is generally not completed until after the study and evaluation of
internal controls has been completed and the auditor has a significant
understanding of the business and industry. Until then the auditor may not have a
reasonable basis for specifying appropriate detection risk levels which affect the
design of substantive tests for significant financial statement assertions. In
contrast, in recurring engagements the auditor has access to audit programs used
in the preceding period(s) and the working papers pertaining to those programs. In
such cases, needs to understand major changes in the business, but the auditor's
preliminary audit strategies are often based on a presumption that the risk levels
and audit programs for substantive tests used in the previous period may be
appropriate for the current period. Thus, the audit programs for the current
engagement are often prepared before the auditor completes the evaluation of the
internal controls with the understanding they may subsequently require
modification.
11-28. (Estimated Time – 25 minutes)
Objective
1.
2.
3.
4.
5.
6.
7.
Assertion
C
EO
PD
VA
VA
RO
RO
Objective
8.
9.
10.
11.
12.
13.
14.
Assertion
C
EO
PD
VA
PD
PD
PD
11-29. (Estimated Time – 20 minutes)
a
The techniques or procedures of gathering audit evidence, in addition to the
example, are as follows (note - student is required to identify and describe only
five):
Technique or
Description
Audit Procedures
Analytical procedures
An auditor examines the relationships among data,
such as the relationship between quantities
produced, quantities sold, and the amount of ending
inventory.
Inspecting
An auditor examines documents relating to
transactions and balances, such as shipping and
receiving records to establish ownership of
inventory.
Confirming
An auditor obtains acknowledgments in writing
from third parties of transactions or balances, such
as inventory in public warehouses or on
consignment.
Inquiring
An auditor questions client personnel about events
and conditions such as obsolete inventory.
Counting
An auditor makes test counts of inventory items
during the inventory observation as a check on the
accuracy of the counts made by client personnel.
Tracing
An auditor traces test counts to the client's
inventory listing as a test of its completeness.
Vouching
An auditor vouches the unit cost shown on the
inventory listing to vendor invoices or price lists as
Technique or
Audit Procedures
Reperforming
Computer-assisted audit
techniques
b.
Description
part of the evaluation of whether inventory is priced
at the lower of cost or market.
An auditor recalculates certain amounts, such as the
(recalculating) multiplication of quantity times
price to determine inventory amounts.
The auditor might use generalized audit software to
select a sample for detail testing, or to scan the
inventory file to identify all items where the prices
have changed by more than 10%.
Substantive auditing procedures that would satisfy the five general assertions
regarding a client's inventory balance include the following (note - student is
required to describe only one substantive auditing procedure for each assertion):
Assertion
Existence or
occurrence





Completeness





Rights and
obligations




Valuation or
allocation

Substantive Auditing Procedure
Observe physical inventory counts.
Obtain confirmation of inventories at locations outside the
entity.
Test cutoff procedures for purchases, movement of goods
through manufacturing, and sales.
Review perpetual inventory records, production records, and
purchasing records for indications of current activity.
Compare inventories with a current sales catalog and
subsequent sales and delivery reports.
Observe physical inventory counts.
Account for all inventory tags and count sheets used in
making the physical inventory counts.
Analytically review the relationship of inventory balances to
recent purchasing, production, and sales activities.
Test cutoff procedures for purchases, movement of goods
through manufacturing, and sales.
Obtain confirmation of inventories at locations outside the
entity.
Observe physical inventory counts.
Obtain confirmation of inventories at locations outside the
entity.
Examine paid vendors' invoices, consignment agreements,
and contracts.
Test cutoff procedures for purchases, movement of goods
through manufacturing, and sales.
Review activity in general ledger accounts for inventories
and investigate unusual items.
Assertion












Presentation
and disclosure




Substantive Auditing Procedure
Verify extensions of quantities times unit prices and totals of
inventory records, and agreement with general ledger.
Trace test counts recorded during the physical inventory
observation to the inventory listing.
Test the clerical accuracy of inventory listings.
Reconcile physical counts to perpetual records and general
ledger balances and investigate significant fluctuations.
Examine paid vendors' invoices.
Review direct labor rates.
Test computation of standard overhead rates and standard
costs, if applicable.
Examine analyses of purchasing and manufacturing standard
cost variances.
Inquire of production and sales personnel concerning
possible excess or obsolete inventory items.
Examine an analysis of inventory turnover.
Review industry experience and trends.
Analytically review the relationship of inventory balances to
anticipated sales volume.
Obtain current market value quotations.
Review drafts of the financial statements.
Compare the disclosures made in the financial statements to
the requirements of generally accepted accounting principles.
Obtain confirmation of inventories pledged under loan
agreements.
11-30. (Estimated Time – 20 minutes)
Note: The student is required to list only one type of test, type of evidence, and assertion for each
auditing procedure. In some cases, alternative answers are indicated in the tabulation below.
Also, the following abbreviations are used in the "Assertion" column: EO - Existence or
Occurrence- C - Completeness; R - Rights and Obligations; VA - Valuation or Allocation and
PD - Presentation and Disclosure.
1.
2.
3.
4.
5.
6.
7.
8.
9.
Type of Test
T of D of balances
T of D of balances
T of D of transactions
T of D of balances
T of D of balances
Analytical procedure
T of D of balances
T of D of balances
T of D of balances
Type of Evidence
Physical, mathematical
Confirmations
Documentary
Mathematical
Oral
Analytical
Documentary
Documentary
Mathematical
Assertion
EO, C, RO, VA
EO
EO, VA
EO, C, RO, VA
PD
EO, C, VA
EO, RO, VA
EO, C, RO, VA
VA
10.
11.
12.
13.
14.
15.
16.
17.
18.
Type of Test
T of D of balances
T of D of balances
Tests of accounting
estimates
T of D of transactions
Analytical procedure
T of D of transactions
T of D of balances
Test of details of
transactions
Analytical procedure
Type of Evidence
Written representation
Documentary
Documentary, mathematical
Assertion
EO, C
PD
VA
Documentary
Analytical
Documentary
Physical
Documentary
RO
EO, C, VA
EO, VA
EO, C, VA
C
Analytical
EO, C, VA
11-31. (Estimated time - 25 minutes)
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
Assertion
Valuation or allocation
Completeness
Existence or occurrence
Valuation or allocation
Presentation and disclosure
Existence or occurrence
Rights and obligations
Presentation and disclosure
Completeness
Rights and obligations
Completeness
Presentation and disclosure
Completeness
Presentation and disclosure
Valuation or allocation
Substantive Test
C, J
A, B, E, F
C, D
I, K
L
A, B
A, B, E, H, I
M
B, E, H
E, H
F
L
E
L
I, K
11-32. (Estimated Time – 20 Minutes)
a.
Before applying principal substantive tests to General's balance sheet accounts at
April 30, 19X6, Cook should consider whether it is possible to control the added
audit risk that material misstatements existing in the accounts at the balance sheet
date will not be detected. Conditions that contribute controlling this risk are:
 Internal controls during the remaining period are effective.
 There are no conditions or circumstances that might predispose management to
misstate the financial statements in the remaining period.
 The year-end balances of the accounts examined at the interim date are
reasonably predictable as to amount, relative significance, and composition.
 The client's accounting system will provide information concerning significant
unusual transactions and significant fluctuations that may occur in the
remaining period.
b.
Substantive tests for the remaining period ordinarily should include (1)
comparison of the account balances at June 30 and April 30 to identify amounts
that appear to be unusual and investigation of any such amounts, and (2) such
other analytical procedures or other substantive tests of details as the auditor
considers necessary to provide a reasonable basis for extending the interim audit
conclusions to the balance sheet date.
11-33. (Estimated Time – 30 minutes)
a.
The auditor may perform substantive tests prior to the balance sheet date when he
or she can:
 Control the added audit risk that material misstatements existing in the
account at the balance sheet date will not be detected by the auditor.
 Reduce the cost of substantive tests necessary at the balance sheet date to
meet planned audit objectives so that testing prior to the balance sheet date
will be cost effective.
In practice, early substantive testing of account balances is not done unless tests of controls have
provided convincing evidence that internal controls are operating effectively. Moreover, it is
unlikely that the auditor will perform substantive tests prior to the balance sheet date on all
assertions pertaining to an account.
b.
The potential added audit risk can be controlled if substantive tests for the
remaining period can provide a reasonable basis for extending the audit
conclusions from the tests performed at the interim date to the balance sheet date.
Conditions contributing to the control of this risk are:
 Internal controls during the remaining period are effective.
 There are no conditions or circumstances that might predispose management
to misstate the financial statements in the remaining period.
 The year-end balances of the accounts examined at the interim date are
reasonably predictable as to amount, relative significance, and composition.
 The client's accounting system will provide information concerning
significant unusual transactions and significant fluctuations that may occur in
the remaining period.
c.
Substantive tests for the remaining period ordinarily should include:
 Comparison of the account balances at the two dates to identify amounts that
appear to be unusual and investigation of such amounts.
 Other analytical procedures or other substantive tests of details to provide a
reasonable basis for extending the interim audit conclusions to the balance
sheet date.
d.
As compared with substantive tests of balance sheet accounts, tests of income
statement accounts rely more heavily on analytical procedures and less on tests of
details of transactions and balances. Each income statement account is
inextricably linked to one or more balance sheet accounts (e.g., sales and accounts
receivable, and cost of goods sold and inventories). Thus evidence obtained from
tests of details performed on balance sheet accounts also pertains to the related
income statement accounts, reducing the need for additional tests of details.
e.
Analytical procedures arc used both directly and indirectly in obtaining evidence
about income statement accounts. Direct tests occur when a revenue or an
expense account is compared with other relevant data to determine the
reasonableness of its balance (e.g., the ratio of sales commissions to sales can be
compared with the results of prior years and budget data for the current year).
Indirect tests occur when evidence concerning income statement balances can be
derived from analytical procedures applied to related balance sheet accounts (e.g.,
the accounts receivable turnover ratio used in verifying accounts receivable may
also be used in determining whether bad debts expense is fairly stated). In
addition, in applying analytical procedures to income statement accounts, there
are many opportunities for comparing financial information with nonfinancial
information such as using number of employees and number of miles driven to
estimate wages expense and gasoline expense, respectively.
f.
The circumstances that may necessitate performing tests of details of income
statement accounts are as follows:
 Inherent risk is high. This may occur in the case of nonroutine transactions
and management's judgments and estimates.
 Control risk is high. This situation may occur when (1) internal controls for
nonroutine and routine transactions are ineffective or (2) the auditor elects not
to test the internal controls.
 Analytical procedures reveal unusual relationships and unexpected
fluctuations. Examples of this situation include (1) a company exceeding its
sales growth target in spite of an unexpected downturn in its industry and the
economy as a whole and (2) an unexplained increase in the inventory turnover
ratio.
 The account requires analysis. Analysis is usually required for accounts that
(1) require special disclosure in the income statement, (2) contain information
needed in preparing tax returns and reports for regulatory agencies such as the
SEC, and (3) have general account titles that suggest the likelihood of
misclassifications and errors.
10-34. (Estimated Time – 25 minutes)
a.
The auditor's objective in auditing accounting estimates is to obtain sufficient
competent evidential matter to provide reasonable assurance that:
 All accounting estimates that could be material to the financial statements
have been developed.
 The accounting estimates are reasonable in the circumstances.
 The accounting estimates are presented in conformity with applicable
accounting principles and are properly disclosed.
The auditor's objective in auditing related party transactions is to obtain evidential
matter as to the purpose, nature, and extent of these transactions and their effect
on the financial statements.
b.
Auditing procedures that may be used to obtain evidence about these two types of
accounts include the following:
Accounts involving accounting estimates
 Review and test management's process in making the estimate.
 Prepare an independent expectation of the estimate.
 Review subsequent transactions and events occurring prior to completing the
audit that pertain to the estimate.
Accounts involving related party transactions
 Obtain an understanding of the business purpose of the transaction.
 Examine invoices, executed copies of agreements, contracts, and other
pertinent documents, such as receiving reports and shipping documents.
 Determine whether the transaction has been approved by the board of
directors or other appropriate officials.
 Test for reasonableness the compilation of amounts to be disclosed, or
considered for disclosure, in the financial statements.
 Arrange for the audits of inter-company account balances to be performed as
of concurrent dates, even if the fiscal years differ, and for the examination of
specified, important, and representative related party transactions by the
auditors for each of the parties, with appropriate exchange of relevant
information.
 Inspect or confirm and obtain satisfaction concerning the transferability and
value of collateral.
c.
In auditing identified related party transactions, the auditor is not expected to
determine (1) whether a particular transaction would have occurred if the parties
had not been related or (2) what the exchange price and terms would have been.
The auditor is required, however, to determine the substance of the related party
transactions and their effects on the financial statements.
d.
Management is responsible for establishing the process and controls for preparing
accounting estimates which it includes in the financial statements. The auditor is
responsible for evaluating the reasonableness of accounting estimates made by
management in the context of the financial statements taken as a whole. This
includes (1) considering the relevance, reliability, and sufficiency of the data and
other factors used by management, (2) evaluating the reasonableness and
consistency of the assumptions, and (3) reperforming the calculations made by
management. In some cases, the auditor may find it useful to obtain the opinion of
a specialist regarding the assumptions.
e.
To evaluate the reasonableness of accounting estimates, the auditor should
normally concentrate on the key factors and assumptions used by management
including those that are (1) significant to the accounting estimate, (2) sensitive to
variations, (3) deviations from historical patterns, and (4) subjective and
susceptible to misstatement and bias.
f.
Sources of evidence concerning the reasonableness of accounting estimates
include the following:
 Information supplied by management concerning the process used and
assumptions made.
 Historical data used by management in developing the estimates.
 Recalculation by the auditor of management's estimates.
 Independent expectations developed by the auditor for comparison with
management's estimates.
 Events or transactions that occur subsequent to the date of the balance sheet
but prior to the completion of field work that relate to the key factors and
assumptions used by management.
 Opinions supplied by a specialist.
Cases
11-35. (Estimated Time – 40 minutes)
Category
Initial
Procedures
a. Substantive Test
1)
2)
Analytical
Procedures
3)
Obtain and understanding of the business and industry and determine:
a) The significance of plant assets, and changes in plant assets, to the
entity.
b) Key economic drivers that influence the entity’s acquisition of plant
assets.
c) Industry standards for the extent to which the entity is capital intensive
and the impact of plant assets on earnings.
Perform initial procedures on plant assets balances and records that will be
subjected to further testing.
a) Trace beginning balance for plant assets and accumulated depreciation to
prior year’s working papers.
b) Review activity in general ledger accounts plant assets and depreciation
expense and investigate entries that appear unusual in amount or source.
c) Obtain client-prepared schedules of plant asset additions, retirements and
depreciation expense, and determine that they accurately represent the
underlying accounting records from which they were prepared by:
i) Footing and crossfooting the schedules and reconciling the totals with
increases or decreases in the related general ledger balances during
the period.
ii) Testing agreement of items on schedules with entries in related
general ledger accounts.
Perform analytical procedures:
a) Develop an expectation for plant assets using knowledge of the industry
and the entity’s business activity
b) Calculate ratios such as fixed asset turnover, depreciation expense as a
percent of sales, repair and maintenance expense as a percent of sales
and rate of return on assets
c) Analyze ratio results relative to expectations based on prior years,
industry data, budgeted amounts, or other data.
b. Assertions
EO, C, RO,
VA,PD
VA
EO, C, VA, PD
Category
Tests of
Details of
Transactions
Tests of
Details of
Balances
4)
Vouch plant asset additions to supporting documentation.
a. Substantive Test
b. Assertions
EO, RO, A,PD
5)
Vouch plant asset disposals to supporting documentation.
EO, RO, A,PD
6)
Review entries to repairs and maintenance expense.
7)
Inspect plant asset.
a) Inspect plant asset additions.
b) Tour other plant assets and be alert to evidence of additions and
disposals not included on client’s schedules and to conditions that bear on
the proper valuation and classification of the plant assets.
Examine title documents and contracts
8)
Tests of
Details of
Balances:
Accounting
Estimates
Presentation
and
Disclosure
EO, C, VA
EO,RO, VA,PD
EO, RO
Evaluate the fair presentation of depreciation expense by evaluating the
appropriateness of useful lives and estimated salvage values.
10) Determine if any significant events have resulted in an impairment of the value
of plant assets.
VA, PD
11) Compare statement presentation with GAAP.
a) Determine that plant assets and related expenses, gains, and losses are
properly identified and classified in the financial statements.
b) Determine the appropriateness of disclosures related to the cost, book
value, depreciation methods, and useful lives of major classes of plant
assets, the pledging of plant assets as collateral and the terms of lease
contracts.
PD
9)
VA
Research Questions
For the reasons specified in the introduction to this manual, solutions are not provided for this
category of questions.