Chapter 11 Substantive Tests OF Income Statement Accounts PDF

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Chapter 11 SUBSTANTIVE TESTS OF INCOME STATEMENT ACCOUNTS Risk and substantive procedures Differences between auditing income statement and balance sheet accounts • Balance sheet accounts typically represent only recent transactions, or one-off transactions – Balance sheet accounts are ‘permanent’ and their balance is carried forward from one period to the next. • Income statement accounts reflect sum of entire reporting period transactions – Income statement accounts are ‘temporary’ and their balance is closed to the income account at the end of each financial year. • Testing balance sheet accounts do not provide much assurance about income statement accounts • Difference in nature of account is reflected in difference in testing – Typically use analytical procedures for income statement accounts rather than confirmations etc Extent of substantive procedures • As discussed for balance sheet accounts, extent of testing determined by risk assessment for each significant account or disclosure – High IR, CR: do not rely on and test controls, use significant amount of substantive testing to reduce DR – Low IR, CR: testing controls shows them to be effective, limited substantive testing required Timing of substantive procedures • Dependent on risk assessment of the account in question. Apart from the risk assessment of the significant account there are additional opportunities for influencing the timing of the work performed. Including: can perform some types of work prior to year-end, leverage off internal audit etc.

Revenue Issues: • • • •

Purchases are understated Not recording all purchase transactions Fraudulent purchases for private uses Incorrect quantities, damaged goods or incorrect items received

Substantive Testing A. Pressure to achieve sales targets creates risk of overstatement • High overall inherent risk, e.g. risk of manipulation to meet the sales targets, fraud B. Also significant because: • Material size • High volume of transactions C. Auditors usually either use only substantive testing techniques, or use controls testing supplemented with high-level analytical procedures Important Assertions 1. OCCURRENCE: Test recorded sales are bona fide and have occurred 2. ACCURACY: Sales are recorded at correct amount, not overstated 3. CUT-OFF: Risk that sales occur after year-end are recorded early (Test: to vouch the sale to the delivery document – if delivered prior to year-end record as sales) COMPLETENESS is not usually significant, except if pressure to increase next year’s sales Total Revenue Typically made up of: sales revenue, interest, dividend income, They are tested by: Sales Revenue: projects delivered to services that are not yet delivered to customers Interest: Recalculation of expected interest income Dividend Income: tested by vouching the dividends back to the dividend statement and the back statements Other items not usually material

Income statement sales Sales Returns Bad Debts expense

Balance Sheet Accounts receivable Allowance for doubtful debts Cash

Issues and risks Overstatement of sales Fictitious Sale Significant due to size and volumn of transaction Revenue reconitiogn Audit Procedures Occurance - sales are genuien Cutt off - record in correct period Accuracy - record correct amount

Sales Process Principle Objectives

Impacting Processes Types of Transactions: Sales and Sales returns and allowances  These procedures would only be considered when the auditor has been unable test and rely upon controls or they have determined that it is more efficient to test balances substantively o Sales and sales returns and allowances o Consider evidence from interim testing, control testing phase

o

If substantive testing required, use detailed testing such as vouching, tracing of documents, recalculating pricing and discounts, testing postings

Procedures for Auditing   

An almost limitless number of substantive procedures can be designed for the testing of account balances Some procedures are always preformed – regardless of risk assessment the auditor reaches for the significant account While others are additionally selected in response to address any remaining detection risk that is still evident after control test has been performed

Cost of Sales and Other Significant Expenses Substantive Testing Issues: • Payment to factious employees • Terminated employees still of payroll • Directors and executive remuneration Key assertions ACCURACY •

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• •

Verify by vouching recorded amounts to documents or underlying account, e.g. • Depreciation – tested as part of verifying PPE balance • Bad debts – part of verifying receivables balance Cost of sales is verified to: • Opening stock balance (last year closing balance) • Purchases and payables • Closing stock balance part of inventory valuation Purchases typically subjected to additional testing through controls testing, and if necessary, vouching to supplier documentation Payroll expense vouched to time cards, employee lists • Consider employees who leave during period

COMPLETENESS AND CUT-OFF • Assertions combined – auditor to verify that client has not understated expenses and cost of sales by deferring recording expenses to next period • Examine invoices around year-end to verify dates CLASSIFICATION can be important for special disclosure requirements • E.g. interest expense, depreciation OCCURRENCE not typically significant

Principle Objectives

Impacting Processes Types of Transactions: Purchases and Payroll 

These procedures would only be considered when the auditor has been unable test and rely upon controls or they have determined that it is more efficient to test balances substantively

Procedures for Auditing   

An almost limitless number of substantive procedures can be designed for the testing of account balances Some procedures are always preformed – regardless of risk assessment the auditor reaches for the significant account While others are additionally selected in response to address any remaining detection risk that is still evident after control test has been performed

ASSESSING RESULTS OF SUBSTANTIVE PROCEDURES Other costs or expenses that could be significant include: – Administration costs – Selling expenses – Audit fees – Advertising and marketing costs – Impairment charges – Nature of tests similar to purchases and payroll – Use risk assessment based on knowledge of client and professional judgement to determine timing and extent of testing Auditor’s objective is to determine if there are misstatements within the account balance and to quantify the amount of any misstatement • If error identified: • Understand why it occurred • Consider increase to sample size • Consider additional testing • Continue testing until error can be accurately quantified or balance fully tested to ensure no error remains...