VERIFICATION APPROACH OF AUDIT

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Fundamentals of Auditing ACC 311

Lesson 32

VERIFICATION APPROACH OF AUDIT

We are now moving on to deal with the substantive testing, or verification aspect of the audit. In the past

lectures we have been learning the early steps in the time structure of an audit:

Accepting the appointment

Planning, recording, controlling the audit

Evaluation internal controls

Testing the controls

By this stage, the auditor will have made a decision on the general approach to be taken to the audit work. If

the controls systems are effective and operating as laid down, the amount of verification work will be reduced.

If the controls are weak or are not operating effectively, a high level of verification work will be performed. It

is this verification work that we are dealing with in this and the next few lectures.

To verify means to establish the truth of something. This audit work involves the audit in gathering evidence

this will lead to a conclusion as to whether classes of transactions, balances and disclosures reflected in the

client's financial statements are properly stated (true and fair).

We have already discussed in detail the general audit verification principles; here we will have a brief over view

of those.

Audit Verification Techniques:

As we have already discussed in the previous lectures that at the verification stage of the audit, the auditor is

typically presented with a set of draft financial statements prepared by the client. The role of the auditor is to

generate evidence to allow a conclusion to be reached as to whether the information contained in

these financial statements, and the way the information is presented and disclosed, give a true and

fair view.

We already know that audit evidences are generated by the auditor performing audit tests. Here, in verification

work, the auditor will use substantive testing procedures, designed to give evidence relating to the figures in

the financial statements, rather than control test, dealing with the systems that produced those figures.

However, the testing procedures available to the auditor here are the same as those we saw earlier. As a

reminder, audit-testing procedures available to the auditor are:

1. Inspection

This covers the physical review or examination of records, documents and tangible assets. An example in

substantive testing is examining purchase invoices to ensure that they have been properly recorded and

analyzed in the financial statements.

2. Observation

This procedure is mainly applicable to tests of control, but may also be used in substantive testing, such as the

auditor observing the client's inventory count to gain evidence that the inventory figure in the financial

statements had been arrived at accurately.

3. Enquiry

Seeking relevant information from knowledgeable persons inside or outside the enterprise.

An example in substantive testing is asking management for an explanation as to why a receivable has, or has

not, been treated as bad.

4. Computation

Checking the arithmetical accuracy of records or performing independent calculations, for example computing

or re-computing the depreciation expense for the year.

5. Analytical procedures

You should note that these procedures are mainly used in substantive testing rather than as a test of controls.

They may help the auditor to understand relationships between figures in the financial statements. This is

sometimes referred to as the business approach to auditing.

Choice of Verification Techniques

There are no specific rules that exist as to the type(s) of techniques that the auditor should use in a given set of

circumstances.

This is principally a matter of audit judgment and the nature of the audit objective(s). The auditor has to look

at each individual item in its own right, identify the audit objective(s) for that particular item and then decide

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Fundamentals of Auditing ACC 311

the most reliable audit evidence available. The circumstances and evidence available will affect the type of

technique(s) he uses.

Audit Objectives and Financial Statement Assertions

As just stated the type(s) of technique(s) used depend on the audit objectives that the auditor is seeking to

achieve.

The general objective to be achieved by audit verification work is to establish whether the financial statements

present a true and fair view.

We can identify a number of more detailed objectives which underlie this overall objective. These more

detailed objectives allow the auditor to design a series of substantive test on each audit area (inventory,

receivables, etc) which will build up the overall bank of evidence necessary to support the overall audit

opinion.

In carrying out substantive audit tests (verification work) the auditor will be looking for evidence on different

assertions at the financial statements level.

Assertions in obtaining Audit Evidence:

(a) Assertions about classes of transactions and events for the period under audit;

(i)

Occurrence transactions and events that have been recorded have occurred and pertain to

the entity;

(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.

(b) Assertions about account balances at the period end.

(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.

(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.

This concept takes the view that draft accounts presented by the client to the auditor are making a number of

promises, or assertions. The role of substantive testing is to verify these assertions.

The assertions made by the financial statements and the related objectives of the substantive testing objectives

set out above can be shown as follows:

ASSERTION

TESTING OBJECTIVE

Assets shown include all rights under the

Completeness

control of the enterprise

Transactions arising during the period are

Occurrence

reflected in the period's financial statements

The amounts at which assets and liabilities

Valuation

are stated is correct

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Fundamentals of Auditing ACC 311

Assets and liabilities included on the balance Existence

sheet actually exist

Assets and liabilities are shown in the

Presentation and

financial statements such that the user would disclosure

have a clear understanding of the client's

financial situation

Review of Financial Statements

Content of Financial Statements

It is important that you are clear as to exactly what the financial statements consist of under modern

accounting practice.

They comprise the following:

a) The primary statements

Balance sheet

ii) Income statement

iii) Statement of changes in equity

iv) Cash flow statement

v) The notes to the accounts

b) The directors' report

c) The auditor's report.

The main principles underlying the preparation and presentation of company financial statements are now set

out by the International Accounting Standards Board's document Framework for the Preparation and Presentation of

Financial Statements.

The major points from this document are summarized below:

The elements of Financial Statements

The starting point here is definitions of assets and liabilities. The other elements are then defined in terms of

these.

Assets are rights or other access to future economic benefits controlled by an entity as a result of past

transactions or events.

Liabilities are obligations of an entity to transfer economic benefits as a result of past transactions or

events.

Owners' equity is arrived at by deducting liabilities from assets (capital = assets - liabilities).

Gains and losses are determined in terms of increases and decreases in owners' equity.

Recognition in financial statements

Recognition essentially means the recording process. The principles here address such questions as when is it

acceptable to recognize (record) an asset or liability and when should assets and liabilities be de-recognized (no

longer recorded in financial statements). The main points to note are:

Assets and liabilities should be recognized when there is evidence of their existence and they can be

reliably measured.

They should be derecognized when the right (assets) or obligations (liabilities) no longer exist.

The Timing of Audit Procedures:

Whereas tests of control can be (and usually are) performed by the auditor before the client's year end - at the

so called interim audit stage - Substantive Audit Procedures and verification work will be performed

primarily at or very soon after the client's year end, as these procedures normally rely on the availability of

draft financial statements.

Verification of the individual assets and liabilities by the auditor extends into the post balance sheet period (i.e.

the period between the year end date and the date of approval of the financial statements). The auditors will

use this to their advantage when seeking to verify amounts stated for contingent liabilities, and for post

balance sheet events (These are explained in a later chapter).

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.

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Fundamentals of Auditing ACC 311

Nature of Substantive Procedures

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)

Timing of Substantive Procedures

Year end substantive procedures are always more reliable

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 (Provision

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.

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.

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