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Lesson#21
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SUBSTANTIVE PROCEDURES
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SUBSTANTIVE PROCEDURES
Auditing
Auditor’s Opinion
(depends upon)
Reasonable Assurance
(depends upon)
Sufficient Appropriate Audit evidence
(depends upon)
Audit procedures
» Test of Control
» 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.
page
79
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)
page
80
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
(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;
page
81
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.
(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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