Fundamentals of Auditing
Lecture 12
AUDIT TESTS
Audit evidence through Audit Procedures
The auditor needs to generate sufficient appropriate audit evidence that will allow a conclusion
to be reached based on this. Audit evidence, is obtained from audit procedures performed
during the course of audit, such as:
•
Test of control (compliance test)
•
Test of details (substantive test)
•
Analytical procedures (substantive test)
Audit Procedures based on the understanding of Internal Control
Auditor’s understanding of the control environment, determines the audit procedures.
A strong control environment would provide more confidence about the effectiveness of
internal control and the reliability of audit evidence generated internally within the entity and
thus, for example, allows the auditor to conduct some audit procedures at an interim date rather
than at period end.
If there are weaknesses in the control environment, the auditor ordinarily conducts more audit
procedures at period end rather than at an interim date, seeks more extensive audit evidence
from substantive procedures, modifies the nature of audit procedures to obtain more persuasive
audit evidence, or increases the number of locations to be included in the audit scope.
Appropriate Audit Approach
The auditor’s understanding of the internal control would enable him to select an appropriate
audit approach. These audit approaches may be as follows:
1. Apply tests of control only for a particular assertion.
2. Apply substantive procedures only for a particular assertion may be because auditor
failed to identify any effective controls relevant to assertion.
3. Combined approach i.e. applying both tests of operating effectiveness of control’s
and substantive procedures for the same assertion.
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However, irrespective of the approach selected, the auditor designs and performs substantive
procedures for each material class of transactions, account balance and disclosures.
In the case of very small entities, there may not be control activities and auditor may have to
apply only substantive procedures.
Considering the Nature, Timing and Extent of Audit
Procedures Nature
The nature refers to:
• the purpose i.e. (tests of controls or substantive procedures) and
• their type, i.e. inspections, observation, inquiry confirmation, recalculation, reperformancesor analytical procedures.
Timing
Timing refers to when audit procedures are performed or the period or date to which the audit
evidence applies.
Extent
Extent refers to sample size or number of observations of a control activity (quantity of audit
evidence). It depends on auditor’s judgment after considering materiality, the assessed risk and
the degree of assurance the auditor plans to obtain.
Nature
The nature refers to the purpose i.e. (tests of controls or substantive procedures) and their type,
that is, inspections, observation, inquiry confirmation, recalculation, re-performances or
analytical procedures. Certain audit procedures may be more appropriate for some assertions
than others.
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Fundamentals of Auditing
The types of procedures to be performed and their combination would be affected by the
auditor’s assessment of the risk. The higher the risk, the more reliable audit procedure would
be required.
In determining the audit procedures to be performed, auditor considers inherent and control
risks associated with the particular account balance or class of transactions.
Auditor is required to obtain audit evidence about the accuracy and completeness of
information produced by the entity’s information system when that information is used for
performing audit procedures.
Timing
Timing refers to when audit procedures are performed or the period or date to which the
audit evidence applies.
Tests of control and substantive procedures may be performed either at an interim date or at
period end. The higher the risk of material misstatement, the more likely it is that the auditor
may consider it more effective to perform substantive procedures near to or at the period end
rather than at an earlier date or to apply audit procedures unannounced or at unpredictable
times. On the other hand performing audit procedures before the period end may assist the
auditor in identifying significant matters at early stage of the audit, which in turn would help in
resolving them or developing an effective audit strategy.
In considering when to perform audit procedures, the auditor also considers such matters as the
following:
•
The control environment
•
When relevant information is available (for example, electronic files may subsequently
be overwritten or procedures to be observed may occur only at certain times).
•
The nature of the risk (for example, if there is a risk of inflated revenues to meet
earnings expectations by subsequent creation of false sales agreements, the auditor may
wish to examine contracts available on the date of the period end).
•
The period or date to which the audit evidence relates.
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Certain audit procedures can be performed only at the period end.
Examples are:
•
Agreeing the financial statements to the accounting records.
•
Examining adjustments made during the course of preparing the financial statements.
•
To cover the risk of overstatement the auditor ordinarily inspects transaction near the period
end.
Extent
Extent refers to sample size or number of observations of a control activity (quantity of
audit evidence). It depends on auditor’s judgement after considering materiality, the assessed
risk and the degree of assurance the auditor plans to obtain. Extent of audit procedures is
increased when the risk of material misstatement increases.
The use of computer-assisted audit techniques (CAATs) may enable more extensive testing of
electronic transaction and account files. Such techniques can be used to select sample
transaction from key electronic files, to sort transactions with specific characteristics or to test
an entire population instead of a sample.
Valid conclusions may be drawn using sampling approaches. However, in certain
circumstances examination of entire population may be more appropriate to reach a valid
conclusion about that population.
Test of Control
The auditor is required to perform tests of controls when the internal controls are operating
effectively or when substantive procedures alone do not provide sufficient appropriate audit
evidence at the assertion level. Tests of controls comprise of testing three things:
1. Design – that the internal controls are properly designed to cover the risk it is meant
for. (examined through ICQs and ICECs)
2. Implementation – that the internal controls have been put into operation.(examined
through a walk through test with a little sample)
3. Operating effectiveness – that the systems of internal control were operating
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effectively at relevant times during the period. ( examined through compliance tests
based on a judgmental sample)
Nature of Tests of Controls
These are as follows:
•
Inquiry and observation (e.g. inquiry about and observation of controls over opening of
mail to verify controls over cash receipts).
•
Re-performance (e.g. preparation of bank reconciliation statement);
•
Inspection of documentation relevant to performance of controls;
•
Applying CAATs.
•
Tests of controls and tests of details may be applied simultaneously on the same
transaction; tests of control see whether e.g. invoice is approved and tests of details to
detect material misstatement in that invoice.
Timing of Tests of Controls
These may be performed at
1. a particular time or
2. on the information relating to the entire audit period.
– If performed at a particular time, it would provide evidence of operating
effectiveness ofcontrols at that particular time. Such evidence may be sufficient
for the auditor e.g. observation of counting of inventories.
– However, if auditor wants to obtain evidence about the effective operation of
controlsthroughout the period under audit, then tests of control’s should be
applied on transactions of the entire period.
If auditor wants to rely on controls tested in prior periods, he should make inquiry that
there is no change in such controls. If these controls have changed, these should be tested for
operating effectiveness first before relying on these.
The auditor may not test all the controls every audit if there is no change in them. However,
such controls must be tested at least every third audit.
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Extent of tests of controls
The auditor designs tests of controls to obtain sufficient appropriate audit evidence that the
controls operated effectively throughout the period of reliance. Matters the auditor may
consider in determining the extent of the tests of controls include the following:
1. The frequency of the performance of the control by the entity during the period.
2. The length of time during the audit period that the auditor is relying on the operating
effectiveness of the control.
3. The relevance and reliability of the audit evidence to be obtained in supporting that the
control prevents, or detects and corrects, material misstatements.
4. The extent to which the auditor plans to rely on the effectiveness of the control (and
thereby reduce substantive procedures based on the reliance on such control).
5. The expected deviation from the control.
Substantive Procedures
Substantive procedures are performed in order to detect material misstatements at the
assertion level, and include tests of details of classes of transactions, account balances and
disclosures and substantive analytical procedures.
The auditor plans and performs substantive procedures to be responsive to the related
assessment of the risk of material misstatement.
Irrespective of the assessment of risk of material misstatement, the auditor should design
and perform substantive procedures for each material class of transactions, account balance,
and disclosure.
The auditor’s substantive procedures should include the following audit procedures related
to the financial statement closing process:
•
Agreeing the financial statements to the underlying accounting records; and
•
Examining material journal entries and other adjustments made during the course of
preparing the financial statements.
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Fundamentals of Auditing
When the auditor has determined that an assessed risk of material misstatement at the
assertion level is a significant risk, the auditor should perform substantive procedures that
are specifically responsive to that risk.
Nature of Substantive Procedures
Substantive analytical procedures are applied on large volume of transactions, which are
predictable over time. Tests of details are ordinarily more appropriate to obtain audit
evidence regarding certain assertions about account balances, including existence and
valuation.
In designing substantive analytical procedures, the auditor considers such matters as the
following:
•
The suitability of using substantive analytical procedures given the assertions.
•
The reliability of the data, whether internal or external from which the expectation
of recorded amounts or ratios is developed.
•
Whether the expectation is sufficiently precise to identify a material misstatement at
the desired level of assurance.
•
The amount of any difference in recorded amounts from expected values that is
acceptable.
Timing of Substantive Procedures
When substantive procedures are performed at an interim date, the auditor should perform
further substantive procedures or substantive procedures combined with tests of controls to
cover the remaining period that provide a reasonable basis for extending the audit
conclusions from the interim date to the period end.
In considering whether to perform substantive procedures at an interim date the auditor
considers such factors as the following:
•
The control environment and other relevant controls.
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•
The availability of information at a later date that is necessary for the auditor’s
procedures.
•
The objective of the substantive procedure.
•
The assessed risk of material misstatement.
•
The nature of the class of transactions or account balance and related assertions.
•
The ability of the auditor to perform appropriate substantive procedures or
substantive procedures combined with tests of controls to cover the remaining
period in order to reduce the risk that misstatements that exist at period end are not
detected.
If substantive procedures are performed at an interim date, the auditor may sometimes
consider applying tests of controls also on the transactions of remaining period while
extending his substantive procedures from interim date to the period end.
In situations of actual or expected fraud, auditor may prefer applying substantive procedures
at period end. If misstatements are detected in classes of transactions or account balances at
an interim date, the auditor ordinarily modifies the related assessment of risk and the
planned nature, timing or extent of the substantive procedures covering the remaining
period.
Substantive procedures applied in a prior period are not sufficient to address a risk of
material misstatement in the current year except in certain circumstances.
Extent of performance of substantive procedures
Greater the risk of material misstatement due to weaknesses in the system of internal
control, the greater would be the risk of material misstatement in the financial statements.
In designing tests of details, the auditor may use either audit sampling or may choose to
select items to be tested by some other selective means of testing.
Adequacy of Presentation and Disclosure
The auditor should perform audit procedures to evaluate whether the overall presentation
of the financial statements, including the related disclosures, are in accordance with the
applicable financial reporting framework.
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