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Fundamentals of Auditing

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Fundamentals of Auditing ­ACC 311
VU
Lesson 21
SUBSTANTIVE PROCEDURES
Auditing
Auditor's Opinion (depends upon)
Reasonable Assurance (depends upon)
Sufficient Appropriate Audit evidence
(depends upon)
Audit procedures
Č
Test of Control
Č
Substantive Procedures
 Test of details
 Analytical procedures
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.
2. Implementation ­ that the internal controls have been put into operation.
3. Operating effectiveness ­ that the systems of internal control were operating effectively at
relevant times during the period.
How to perform test of control
 Testing the Design:
­  Proper design of internal control is tested through ICQs and ICEC.
 Testing the Implementation:
­  Implementation of internal control is tested through walk through test with a little sample
size.
 Testing the Operating effectiveness:
­  Here the test is performed through a compliance test based on a judgmental sample.
Substantive Procedures
Substantive procedures are performed in order to detect material misstatements at the assertion level (like;
occurrence, completeness, accuracy, valuation, existence, rights and control), 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.
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Fundamentals of Auditing ­ACC 311
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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.
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.
Types of Substantive Procedures
 Test of details
­  Land
Registry
­  Debtors
Circular
­  Building rent
Deed/Agreement
Analytical procedures
­  Payroll
Turnover ratio
Comparing with previous
month's salary
­
Production Cost
Comparing with the number of
units produced
Comparing with the previous month's
cost of production
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.
 Analytical procedures are applied on large volume of transactions, which are predictable over time.
(cost of goods sold, payroll, sale)
In designing substantive analytical procedures, the auditor considers such matters as the following:
 The suitability of using analytical procedures given the assertions.
If controls, over sales order processing, are weak; the auditor may place more reliance on tests of details
rather than substantive analytical procedures for assertions related to debtors.
When auditing the collectibility of accounts receivable, the auditor may apply substantive analytical
procedures to an aging of customers' accounts in addition to tests of details on subsequent cash receipts.
 The reliability of the data;
In determining whether data is reliable for purposes of designing substantive analytical procedures, the
auditor considers the following:
o Information is ordinarily more reliable when it is obtained from independent sources outside the
entity
o Comparability of the information available
o Nature and relevance of the information available (whether budgets have been established as
results to be expected rather than as goals to be achieved.
o Controls over the preparation of the information (controls over the preparation, review and
maintenance of budgets)
 Whether the expectation is sufficiently precise to identify a material misstatement at the desired level of
assurance.
For this the auditor considers the following facts:
i. The accuracy with which the expected results of substantive analytical procedures can be
predicted (comparison of GP ratio should be consistent rather than the ratio of discretionary
expenses like entertainment)
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Fundamentals of Auditing ­ACC 311
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ii. The degree to which information can be disaggregated (effective analysis will be of a component
not of the entity as a whole)
iii. The availability of the information, both financial and non financial (budgets are financial,
whereas units of production are non financial)
 The amount of any difference in recorded amounts from expected values that is acceptable.
Depends upon the:
i.
materiality
ii.
Possibility of misstatement in the specific account balance, class of transactions, or disclosure
Timing of Substantive Procedures
YEAR END SUBSTANTIVE PROCEDURES ARE ALWAYS MORE RELIABLE
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. (Like payroll disbursement)
 The availability of information at a later date that is necessary for the auditor's procedures (prov for
doubtful debts can be investigated interim but debtor and inventory can be verified at the year end).
 The objective of the substantive procedure.
 The assessed risk of material misstatement (prefer always at year end).
 The nature of the class of transactions or account balance and related assertions (like frequency of
occurrence of the transactions e.g. salaries are paid monthly whereas bonuses are paid annually).
 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 (staffing problem that cannot make the
auditor able to extend till the year end)
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.
Assertions in obtaining Audit Evidence
Assertions about classes of transactions and events for the period under audit;
(a)
i.
Occurrence ­ transactions and events that have been recorded have occurred and pertain
to the entity;
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Fundamentals of Auditing ­ACC 311
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ii.
Completeness ­ all transactions and events that should have been recorded have been
recorded;
iii.
Accuracy ­ amounts and other data relating to recorded transactions and events have been
recorded appropriately.
iv.
Cutoff ­ transactions and events have been recorded in the proper period.
v.
Classification ­ transactions and events have been recorded in the proper accounts.
Assertions about account balances at the period end.
(b)
i.
Existence ­ assets, liabilities, and equity interests exist;
ii.
Rights and obligations ­ the entity holds or controls the rights to assets, and liabilities are
the obligations of the entity;
iii.
Completeness ­ all assets, liabilities and equity interests that should have been recorded
have been recorded;
iv.
Valuation and allocation ­ assets, liabilities, and equity interests are included in the financial
statements at appropriate amounts and any resulting valuation or allocation adjustments
are appropriately recorded.
(c)
Assertions about presentation and disclosure:
i.
Occurrence and rights and obligations ­ disclosed events, transactions and other matters
have occurred and pertain to the entity;
ii.
Completeness ­ all disclosures that should have been included in the financial statements
have been included;
iii.
Classification and understandability ­ financial information is appropriately presented and
described, and disclosures are clearly expressed;
iv.
Accuracy and valuation ­ financial and other information are disclosed fairly and at
appropriate amounts.
Audit Procedures for obtaining Audit Evidence
The auditor uses one or more types of audit procedures described below:
(i)  Inspection of Records or Documents
It consists of examining records or documents whether internal or external, in paper form, electronic form,
or other media. Inspection provides evidence of varying degrees of reliability depending on their nature and
source and in the case of internal records, on effectiveness of controls over their production.
(ii)  Inspection of Tangible Assets
It consists of physical examination of the assets. It may provide reliable audit evidence of their existence
cannot necessarily about other assertions.
(iii) Inquiry
It means seeking information of knowledgeable persons throughout the entity or outside the entity. Those
may be formal written or informal oral. It provides an auditor with new information or corroborative
evidences. It may also bring to high information different from the one possessed by the auditor. Certain
oral inquiries might be got confirmed through written representations.
(iv) Confirmations
It is a specific type of inquiry. It is the process of obtaining a representation of information or an existing
condition directly from a third party. Confirmations are sought from debtors, creditors, bankers, legal
advisors etc.
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Table of Contents:
  1. AN INTRODUCTION
  2. AUDITORSí REPORT
  3. Advantages and Disadvantages of Auditing
  4. OBJECTIVE AND GENERAL PRINCIPLES GOVERNING AN AUDIT OF FINANCIAL STATEMENTS
  5. What is Reasonable Assurance
  6. LEGAL CONSIDERATION REGARDING AUDITING
  7. Appointment, Duties, Rights and Liabilities of Auditor
  8. LIABILITIES OF AN AUDITOR
  9. BOOKS OF ACCOUNT & FINANCIAL STATEMENTS
  10. Contents of Balance Sheet
  11. ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
  12. Business Operations
  13. Risk Assessment Procedures & Sources of Information
  14. Measurement and Review of the Entityís Financial Performance
  15. Definition & Components of Internal Control
  16. Auditing ASSIGNMENT
  17. Benefits of Internal Control to the entity
  18. Flow Charts and Internal Control Questionnaires
  19. Construction of an ICQ
  20. Audit evidence through Audit Procedures
  21. SUBSTANTIVE PROCEDURES
  22. Concept of Audit Evidence
  23. SUFFICIENT APPROPRIATE AUDIT EVIDENCE AND TESTING THE SALES SYSTEM
  24. Control Procedures over Sales and Debtors
  25. Control Procedures over Purchases and Payables
  26. TESTING THE PURCHASES SYSTEM
  27. TESTING THE PAYROLL SYSTEM
  28. TESTING THE CASH SYSTEM
  29. Controls over Banking of Receipts
  30. Control Procedures over Inventory
  31. TESTING THE NON-CURRENT ASSETS
  32. VERIFICATION APPROACH OF AUDIT
  33. VERIFICATION OF ASSETS
  34. LETTER OF REPRESENTATION VERIFICATION OF LIABILITIES
  35. VERIFICATION OF EQUITY
  36. VERIFICATION OF BANK BALANCES
  37. VERIFICATION OF STOCK-IN-TRADE AND STORE & SPARES
  38. AUDIT SAMPLING
  39. STATISTICAL SAMPLING
  40. CONSIDERING THE WORK OF INTERNAL AUDITING
  41. AUDIT PLANNING
  42. PLANNING AN AUDIT OF FINANCIAL STATEMENTS
  43. Audits of Small Entities
  44. AUDITORíS REPORT ON A COMPLETE SET OF GENERAL PURPOSE FINANCIALSTATEMENTS
  45. MODIFIED AUDITORíS REPORT