Module 19. Audit Process: Substantive Testing - Pt 1

Question 1

Substantive Testing

Answer 1

Substantive testing involves performing audit procedures that are designed to detect material misstatements at the assertion level.
Substantive testing must be performed on every statutory audit.
It is predominantly performed on the year-end financial statements and underlying records. Mainly performed post year-end when the year-end figures have been produced by the client.

Question 2

Production of financial statements

Answer 2

Stage 1 - Source evidence/Documentation
Stage 2 - Sub-ledgers/supporting schedules
Stage 3 - Trial balance (TB)/Nominal ledger (NL)
Stage 4 - Financial Statements

Question 3

Examples of Source Evidence

Answer 3

1. Sales and purchase invoices
2. Goods despatch notes (‘GDN’) and Goods received notes (‘GRN’)
3. Bank statements
4. Calculations (of depreciation, accruals or prepayments)
5. Board minutes
6. Fixed assets and Stock

Question 4

When writing a test what elements should be included?

Answer 4

1. Verb - A testing technique. For example, recalculate, inspect or enquire
2. Population - What population of the sample is being selected from. For example, a sample of debtors over 90 days old. No need to state the sample size
3. Source Evidence - What evidence you want the sample to be agreed to. For example, agree outstanding debtors to post year-end cash receipts recorded in the bank statements.
4. Activity - What is actually being looked for? For example, agree additions to invoices to confirm the invoice is made out to the client, descriptions match, the date of acquisition matches the fixed asset register.

Question 5

What are the two approaches that can determine whether a test provides evidence over either completeness or existence/occurrence?

Answer 5

1. The missing method

2. Directional testing method

Question 6

The missing method

Answer 6

The first step is to determine what is missing and the impact it would have on the financial statements.
If the financial statement is too small (understated) the assertion being tested would be completeness.
If the financial statement is too large (overstated) the assertion being tested would be existence/occurrence.

Question 7

Directional testing method

Answer 7

Completeness or existence/occurrence procedures are sometimes known as directional tests. If we can correctly identify the direction of our testing then we can confirm which assertion is being tested.
If the starting point is source evidence and is being agreed to the ledger then this is a test of COMPLETENESS.
If the starting point is the ledger and is being agreed to the source evidence then this is a test of EXISTENCE/OCCURRENCE.

Question 8

What is the exception to the directional testing rule?

Answer 8

When there are decreasing items (e.g. Credit notes, a sales credit note would decrease trade debtors and sales figures and a supplier credit note would decrease trade payables and expenses.
In the case of a decreasing item, you must reverse the rule.

Question 9

What are GRNs and GNDs and how can they be used in substantive testing?

Answer 9

GRNs and GNDs are produced to record the movement of stock items to and from the client.

GRNs are raised to indicate that goods have been received and that a purchase has been made or to indicate that goods have been returned from a customer and a sale has been cancelled.

GDNs are raised to indicate that goods have been dispatched and therefore the sale has been made or to indicate that goods are being returned to a supplier and a purchase is to be cancelled.

The use of these documents provides further assurance that movement of goods has taken place and are seen as more reliable than checking purchase/sales invoice.

Question 10

Name the two key substantive procedures performed on all bank accounts

Answer 10

1. Testing the bank reconciliation for the account

2. Testing the bank confirmation letter for the account

Question 11

What audit tests should be completed with the year-end bank reconciliation?

Answer 11

1. Agree the bank balance per the reconciliation to the bank statements and bank letter
2. Agree the nominal ledger balance per the reconciliation to the nominal ledger
3. Cast the reconciliation
4. Obtain supporting evidence for a sample of the reconciling items on the bank reconciliation

Question 12

Bank confirmation letter

Answer 12

A bank confirmation letter is a third-party confirmation used alongside the bank reconciliation testing. The testing involves the auditor obtaining a letter directly from the client’s bank confirming the value of all the bank accounts, overdrafts and loans held.

Question 13

What steps should the auditor take in regards to the bank confirmation letter?

Answer 13

1. Bank letter should be obtained from each of the banks with which the client holds accounts
2. The client will have to give the bank permission to provide this information to the auditor
3. The auditor need only provide details of one bank account, asking the bank to provide details of all accounts in the client’s name

Question 14

What other common procedures for cash and bank exist?

Answer 14

1. Physical verification of material cash balances counted by the auditor at the balance sheet date. For existence and accuracy, valuation and allocation assertion.

Question 15

What is the fixed asset register (FAR)?

Answer 15

The fixed asset register contains all the details of fixed assets held by a company. All purchases, disposals, revaluations and depreciation will be recorded here.
If an asset is sold or scrapped it should be removed from the FAR. The FAR should be regularly reconciled to the nominal ledger.

Question 16

What are the three key substantive procedures performed on trade debtors?

Answer 16

1. Performing a debtors circularisation
2. Performing subsequent cash testing
3. Testing the allowance for doubtful debts

Question 17

Explain debtors circularisation method?

Answer 17

Involves writing to a sample of customers to request that they provide confirmation of the balance that they owe at the year-end. Confirmation will either be positive or negative (not both)
Positive confirmation - a request for debtors to reply to confim the balance
Negative confirmation - only reply if they disagree with balance owed.

Question 18

Which type of confirmation in debtor circularisation provides lower assurance?

Answer 18

Negative, as the lack of reply may indicate other circumstances rather than actually agreeing with the balance. The debtor could forget to respond.

Question 19

Explain process for debtors circularisation

Answer 19

1. The auditor will prepare the circularisation, including debtors year end balance
2. The client will create confirmation on their own headed paper (as client has relationship with customer)
3. Auditor emails the confirmation and requests the debtor to confirm directly to the auditor.
4. Any non-responses should be followed up with a second email

Debtor circularisation primarily covers the existence, classification and rights and obligations assertions for the trade debt balance.

Question 20

Explain subsequent cash testing

Answer 20

Involves selecting a sample of trade debtors and checking for related cash receipts in the clients post year-end bank statements.
Agreeing year-end debtors to cash received after year-end date provides assurance over existence, rights and obligations and accuracy, valuation and allocation.

Question 21

What are the two main areas to auditing stock

Answer 21

Auditing the quantity of stock

Auditing the value of the stock

Question 22

What are the three key substantive procedures performed on stock.

Answer 22

1. Following up tests performed at the stock count (Testing quantity)
2. Cut-off testing (Testing quantity)
3. Cost vs NRV testing (Testing value)

Question 23

Explain the stock count procedure

Answer 23

The auditor will attend stock count and re-perform test counts from floor-to-sheet and sheet-to-floor. As part of the year-end the auditor may follow up on these test counts. These tests can gain assurance over the completeness and existence of the year-end stock balance.

Question 24

Explain cut-off testing

Answer 24

The auditor will select a sample of GRNs and GDNs close to the year end. The auditor will then check that each transaction has been accounted for in the correct period.

Sale and cost of sales transactions, stock, trade debtors and trade creditors are all affected by cut-off testing.

Cut-off testing meets the cut off assertion in the statement of profit and loss
And completeness and existence assertions for balance sheet items.

Question 25

What are the two components tested by the auditor with regards to Cost vs NRV testing?

Answer 25

1. Agree that the cost of stock is accurately recorded through agreement to purchase invoices
2. Review NRV and compare to cost

Question 26

Under what circumstances would NRV be lower than the cost of a particular stock item.

Answer 26

1. Reduction in sales volume, requiring stock prices to be reduced in order to sell items.
2. Stock becoming obsolete
3. Damaged stock requiring a write down.

Question 27

Why are trade creditors a significant risk for the auditor ?

Answer 27

Company may understate its liabilities.

A key risk over trade creditors is the completeness assertion.

Question 28

What are the three substantive procedures performed on trade creditors?

Answer 28

1. Perform creditors circularisations
2. Supplier statement reconciliations
3. Search for unrecorded liabilities.

Question 29

Explain creditor circularisations

Answer 29

It is possible to circularise creditors in the same manner as debtors. However it is often time consuming and may not be necessary if suppliers issue frequent supplier statements.
If performed it provides assurance over completeness, existence, accuracy, valuation and allocation, classification and rights and obligations.

Question 30

Explain supplier statement reconciliations

Answer 30

If supplier statements are available the auditors should select a sample of these and review the supplier statement reconciliations performed by the client between the statement and creditors ledger.
This provides evidence over completeness, existence, classification, accuracy, valuation and allocation and rights and obligations of the liability.

Question 31

Explain the testing for unrecorded liabilities

Answer 31

1. Selecting a sample of post year-end cash payments from the post year-end bank statements and checking that a trade creditor existed at the year-end
2. Selecting a sample of invoices received or processed after the year-end and check if they relate to goods or services received pre-year end and that creditor existed at the year-end.