Chapter 9 - Execution OF THE Audit – Performing Substantive Procedures PDF

Preview

Summary

Download Chapter 9 - Execution OF THE Audit – Performing Substantive Procedures PDF

Description

Chapter 9 - EXECUTION OF THE AUDIT – PERFORMING SUBSTANTIVE PROCEDURES The nature, timing, and extent of audit procedures are determined in response to the risk assessment for each significant account and assertion using the audit risk formula and requires the use of professional judgement

REVIEW – Chapter 4 AUDIT RISK is the risk that an auditor expresses an inappropriate audit opinion when a financial report is materially misstated (ASA 200; ISA 200) INHERENT RISK: Risk that a material misstatement could occur irrespective of any controls that the management puts it place CONTROL RISK: Risk that client’s system of internal controls will not prevent or detect such a material misstatement. Is assessed as High when there are no internal controls put it place. (Control risk and control testing discussed in chapter 8) DETECTION RISK: Risk that the auditor’s testing procedures will not be effective in detecting a material misstatement, should there be one. - The combination of inherent risk and control risk determines the level of detection risk that the auditor to be able to conclude that the financial report is materially correct - Detection risk is reduced or increased in direct proportion to the amount of substantive tests performed Audit Risk

Inherent Risk

Control Risk

Detection Client Risk Low High High Low High Risk High risk Clients: by setting a low detection level an auditor will increase the level of reliance placed on their detailed Substantive Tests which involves intense testing of transactions and Year End Balances High Low Low High Low Risk Client Low Risk Clients: By setting a high detection level and auditor will decrease the amount of substantive testing undertaken (but not eliminate the testing)

FIGURE 9.2: Linkage between IR, CR and DR and how it impacts the amount of substantive testing required to reduce detection risk to an acceptable level

Review of Chapter 5 Assertions: are statements regarding the recognition, measurement, presentation and disclosure of items included in the financial report. -

Auditors Uses assertions for transactions, account balances and presentations and disclosure when assessing the risk of material misstatement and when designing their audit procedures.  ASA 315 (ISA 315) requires auditors to use assertions when assessing the risk of material misstatement and designing audit procedures  This means that auditors need to gather sufficient appropriate evidence about each assertion for each transaction and account balance, or disclosure

ASA 315 Provides auditors with a summary of Assertions to use

OCCURRENCE

Assertions related to transactions and events COMPLETENESS - related to items on the Income Statment

EXISTENCE

OCCURRENCE, RIGHTS AND OBLIGATIONS

Assertions Related to Accont Balances RIGHTS AND (Balance sheet) OBLIGATIONS

PRESENTATION AND DISCLOSURE RELATED COMPLETENESS AUDIT ASSERTIONS

COMPLETENESS

CLASSIFICATION AND UNDERSTANDABILITY

VALUATION AND ALLOCATION

ACCURACY AND VALUATION

ACCURACY CUT-OFF

CLASSIFICATION

Definitions of Substantive testing Substantive Testing: Are designed to obtain direct evidence as to the completeness, accuracy, and validity of data, and the reasonableness of the estimates and other information contained in the financial report -

Substantive tests include: Inspection, observation, confirmation, recalculation, performance and analytical procedures The results from planning and interim procedures allows the auditor to make an overall assessment as to how much detection risk still exists prior to any substantive testing being performed The auditor then designs appropriate substantive testing audit procedures that will allow material errors and exceptions to be identified and rectified before an overall decision is made  These procedures are documented in the AUDIT PROGRAM: typically includes all of the planning and testing procedures with enough details to enable the auditor to understand the nature timing and extent of testing required.

Factors Influencing Nature, Timing and Extent of Substantive Procedures Performed -

Risk of material misstatement Timing considerations affect nature of substantive test (e.g. access during interim periods) Level of assurance necessary (reasonable or limited) Type of evidence required (how persuasive) Complexity of client’s data systems

It is ordinarily more effective to test and rely on controls. -

-

Not always practical – depending on organisation o Smaller organisations – limited segmentation of duties In non-practical situations – auditor will need to perform extensive substantial procedures to provide substantial to provide a sufficient evidence to reach a conclusion. Types of procedures to be performed o Key items testing o Representative testing o Other test of transactions/underlying data o Analytical procedures These procedures reduce to risk to an acceptable level An auditor can use a combination of techniques to perform substantive procedures to provide sufficient and appropriate evidence to conclude on the overall financial report and accounts. Certain substantive procedures are not required to be performed depending on organisation

Relationship Between Risk Assessment, Nature, Timing and extent of Substantive Testing THE NATURE OF SUBSTANTIVE TESTING VARIES FROM ACCOUNT TO ACCOUNT AND CONSISTS OF ONE OR A COMBINATION OF TECHNIQUES, INCLUDING: 1. Key items testing 2. Representative testing 3. Other test of transactions/underlying data 4. Analytical procedures The appropriate mix of substantive procedures depends on: - The nature of the account balance - The risk assessment for the specific account and the client overall

Timing of Substantive procedures • • •

•

Influenced by level of control risk Typically at or near year-end, exceptions include: Accounts that accumulate transactions that mostly remain in year-end balance • E.g. additions to fixed asset register Control testing confirms a strong control system

Roll Forward Procedures •

Roll-forward procedures are defined as procedures that are performed during the period between an interim date and year-end (the roll-forward period) to provide sufficient and appropriate audit evidence to base conclusions upon as at year-end when substantive procedures are performed at an interim date. The procedures are used to update the auditor’s findings from the time of the interim date to the year-end.

•

Whether roll-forward procedures are appropriate depends on the auditor’s risk assessment. For example, when the entity’s control environment has been assessed as effective, controls have been tested, and no significant changes in the control environment and controls have occurred, limited roll-forward procedures such as analytical procedures or limited testing of intervening transactions may be all that is necessary.

Substantive Audit Procedures Test of detail • • •

Substantive tests other than analytical procedures Designed to verify a balance or transaction with supporting documentation Often referred to as either vouching or tracing • Vouching: taking a balance or transaction from the underlying accounting records and verifying it by agreeing the details to supporting evidence outside of the accounting records of the company Thus, the direction of testing is from the journals or ledgers back to the source documents. Vouching provides evidence that items included in the accounting journals or ledgers have occurred (Existence and occurrence assertions, valuation and allocation and accuracy) • Vouching does not provide evidence about completeness - because the auditor is testing information already recorded in the accounting records, and as such, will not normally uncover evidence about transactions and balances that are not in the accounting records. •

-

Tracing: tracking a source document to the accounting records Tracing refers to first selecting an accounting transaction (a source document) and then following it into the journal or ledger. The direction of testing in this case is from the source documents to the journals or ledgers and tests whether transactions that occurred are recorded (completeness) in the accounting records. Other assertions: accuracy and cut-off.

Audit Sampling: the application of procedures to less than 100% of items within a population o Auditors only select transactions, balances or disclosures more likely of material error. They do not test each on every transaction, balances or disclosures.

The three main types of tests of details that are also techniques applied when deciding how much of a balance to test include Key Item Testing – Identify key items in a balance – Usually select largest transactions within a balance to obtain ‘coverage’ of the total – The more persuasive other evidence available, the less coverage key items have to address Key item testing is done by using either a statistical basis or professional judgement to identify and test key items in a balance. The auditor focuses on selecting the largest transactions within a balance to obtain ‘coverage’ over the total. If the auditor tests the largest items in the balance, the auditor is able to reach a conclusion about the entire balance.

Representative Sampling – If further testing required after selecting key items – Select items that are representative of population – Sampling strategy depends on auditor’s expectations of error and overall audit objective (ie testing primarily for over or understatement of balance Representative sampling aims to take a representative sample from the population (perhaps after key items have been separately tested) for testing. Every item in the population has an equal chance of selection for the sample. Audit risk tables are used to determine the size of the representative sample based on the auditor’s expectation of error (which should be low for this type of sampling) and the risk of material misstatement (which should also be low). This technique is generally used when the primary focus is on overstatement, because items already in the client’s accounts are sampled.

Other Tests In addition to substantive procedures related to key items and representative sampling, and auditor will often perform other tests of transactions or underlying data. Such examples are: – – – – –

Tests of client prepared schedules Tests performed at interim date with roll-forward procedures Tests of underlying data to be used as part of analytical procedures Tests of income statement accounts for account classification Tests of individual transactions by vouching (agreeing) to supporting documents

Analytical Procedures AP is the evaluation of financial information through analysis of plausible relationships among both financial and non-financial data. - Analytical procedures also encompass such investigation as is necessary of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount. Analytical procedures may be used for • Primary (persuasive) tests of a balance • Corroborative tests in combination with other procedures • To provide at least some minimal level of support for the conclusion •

Analytical procedures can be the most effective test of a balance, or at least reduce extent of other substantive tests (ASA 520; ISA 520) • Planning the audit approach will enable the auditor to consider what analytical procedures are available and the extent to which Analytical procedures can reduce or eliminate other substantive procedures.

Types of Analytical procedures There are a number of techniques that can be used to perform analytical procedures as a substantive test. The main objective is to select the most appropriate technique to provide the necessary level of assurance and precision. • • • • • •

Absolute data comparisons (prior year, budgets etc) Ratio analysis (activity, liquidity, profitability, leverage) Trend analysis (over several accounting periods) Common-size financial reports Break-even analysis Pattern analysis and regression (most sophisticated)

TESTING THE RELIABILITY OF ANALYTICAL PROCEDURES: • Biggest Risk: when performing analytical procedures is that the results will lead the auditor to accept an account as not misstated when it is materially misstated • Key way to minimize: to evaluate the relevance of the information used in analytical procedures and to ensure the auditor is satisfied that the financial and non-financial data they use in the analytical procedures is reliable •

•

•

Consider relevance of analytical procedures, they are less useful when: – When client’s operations are diverse – If industry data is unreliable or not comparable to client – When severe inflation – When client’s budget process not well-controlled Consider reliability of data – E.g. test reliability of ageing of debtors reports – Do control tests suggest data is reliable? – Consider controls over non-financial data (e.g. tones) The auditor need to be satisfied that the financial and non-financial information that they used for the analytical procedure is reliable especially when an analytical procedure is a persuasive substantive procedure

•

Using analytical procedure as an overall financial report analysis – It is not necessary to test underlying data because and overall financial report analysis is performed to increase the understanding of the client business.

Summary: The Auditor tests the reliability of the underlying data when the analytical procedure is to provide persuasive assurance; they use judgement to determine the need for, and extent of, tests of underlying data when the analytical procedure provides corroborative assurance; and they do not need to test underlying data when the analytical procedure provides minimal assurance.

Summary of Analytical Procedures 1. 2. 3. 4. 5. 6. 7. 8.

Identify computation, comparison, to be made or investigated Assess reliability of any data to be used Estimate probable balance in the account or outcome of computation Perform computations using internal or external data Compare estimated amount with calculation, assess if any difference is significant Determine appropriate procedures for investigating reasons for the difference Perform procedures Draw conclusions

Performing Substantive Testing using Computers Computer assisted audit techniques (CAATs) assist auditors with their testing in complex tasks. There are two main categories. 1. Software used to interrogate and examine client files (software can be special programs or spreadsheets) – Re-adding, performing logic tests, select key items, representative samples – Handle large volumes of data, be more comprehensive 2. Software that individual firms use to plan, perform and evaluate audit procedures, regardless of whether client automated or not - CAATs are more useful when client controls are stronger

Levels of Evidence Different levels of evidence are obtained while performing substantive procedures

PERSUASIVE EVIDENCE -

Analytical procedures can be the primary test of balance if they provide persuasive evidence When the provides a reasonable estimate of balance, it enables auditor to conclude whether or not the account balance is free from material errors The effect of classifying an analytical review procedure as persuasive meant that no further substantive procedures are required even in moderate situations Before an auditor concludes the analytical procedure is persuasive careful consideration must be given to the quality of evidence

Table 9.2 provides examples of analytical procedures that provide persuasive evidence

CORROBORATIVE Evidence gathered to confirm amounts recorded in clients’ records -

An analytical procedure provides corroborative if it Confirms audit findings from other procedures Supports management representations or otherwise decreases the level of audit scepticism  Eg: year to year comparisons by product line of stock levels and other key relationships such as turnover, gross margin, labour and overheads  Doesn’t provide sufficient evidence by themselves to allow auditors to conclude that the account is free from material misstatement. A corroborative analytical procedure includes the comparison of account balances to expected development and documented early in the audit. o These comparisons generally provide corroborative evidence about an account balance and enables the auditor to limit the extent of other procedures in the area  Eg: Administration expenses fall within a reasonable range of the expected balance a comparison of the actual amount would lead to corroborative evidence of the balance Unexpected result/fluctuations would require auditor to expand other substantive audit procedures to provide explanation of result to conclude that the balance is free from material misstatement.  Example: They may review a listing of accounts comprising of administration expenses for individual account balances and investigate those with significant or unexpected fluctuations Table 9.3 provides examples of analytical procedures that provide corroborative evidence  

-

-

-

Minimal –

Analytical procedure that does not provide persuasive or corroborative evidence contributes to minimal support for the conclusion The auditor has to evaluate both the extent of their analytical procedure and the quality of evidence they expect to obtain. – E.g. simple comparison with previous year to help identify problems, not to reduce other testing – If they do not supplement that comparison with any other analytical procedures, they obtain only minimal support for the conclusion Usefulness of procedure to generate more persuasive evidence depends on circumstances such as complexity of client and extent of fluctuations in particular account balance – Table 9.4 provides examples of analytical procedures that provide minimal evidence

–

–

General -

Analytical procedures might provide persuasive evidence in one circumstance but not in another

-

An auditor may need to expand the analytical review by segmenting the client’s portfolio and apply the relevant financial ratios to the various segment’s – if that is not feasible, they may find it necessary to perform a test of details of investment income

Evaluating, Documenting Results of Substantive Analytical Procedures The understanding of client’s business and industries alerts the auditor when planning the audit to likely fluctuations in the financial data. -

Fluctuations are caused by trends seasonal patterns, dependent relationships, business decisions taken and externals decisions that can impact the business Example: Union representing the workforce negotiates a 3% pay rise over two years – Analytical procedures performed on wages need to increase to confirm the pay rise Significant change from one year to another does not necessarily mean that the auditor can assume that the bank balance is reasonable – need to investigate the extent of the change in the balance

Evaluating errors identified in Testing -

During execution of substantive procedures auditor may identify misstatements or errors

-

when errors are identified Auditors need to reconsider the evaluation of effectiveness of controls and overall risk assessment (made in the planning stage) to determine if additional procedures are needed The impact of the misstatement also has to be determined Two types of misstatement Errors Judgement misstatement Including fraud Arise due to the...