Module 19. Audit Process: Substantive Testing - Pt 1 Flashcards
Substantive Testing
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.
Production of financial statements
Stage 1 - Source evidence/Documentation
Stage 2 - Sub-ledgers/supporting schedules
Stage 3 - Trial balance (TB)/Nominal ledger (NL)
Stage 4 - Financial Statements
Examples of Source Evidence
- Sales and purchase invoices
- Goods despatch notes (‘GDN’) and Goods received notes (‘GRN’)
- Bank statements
- Calculations (of depreciation, accruals or prepayments)
- Board minutes
- Fixed assets and Stock
When writing a test what elements should be included?
- Verb - A testing technique. For example, recalculate, inspect or enquire
- 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
- 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.
- 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.
What are the two approaches that can determine whether a test provides evidence over either completeness or existence/occurrence?
- The missing method
2. Directional testing method
The missing method
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.
Directional testing method
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.
What is the exception to the directional testing rule?
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.
What are GRNs and GNDs and how can they be used in substantive testing?
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.
Name the two key substantive procedures performed on all bank accounts
- Testing the bank reconciliation for the account
2. Testing the bank confirmation letter for the account
What audit tests should be completed with the year-end bank reconciliation?
- Agree the bank balance per the reconciliation to the bank statements and bank letter
- Agree the nominal ledger balance per the reconciliation to the nominal ledger
- Cast the reconciliation
- Obtain supporting evidence for a sample of the reconciling items on the bank reconciliation
Bank confirmation letter
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.
What steps should the auditor take in regards to the bank confirmation letter?
- Bank letter should be obtained from each of the banks with which the client holds accounts
- The client will have to give the bank permission to provide this information to the auditor
- The auditor need only provide details of one bank account, asking the bank to provide details of all accounts in the client’s name
What other common procedures for cash and bank exist?
- Physical verification of material cash balances counted by the auditor at the balance sheet date. For existence and accuracy, valuation and allocation assertion.
What is the fixed asset register (FAR)?
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.
What are the three key substantive procedures performed on trade debtors?
- Performing a debtors circularisation
- Performing subsequent cash testing
- Testing the allowance for doubtful debts
Explain debtors circularisation method?
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.
Which type of confirmation in debtor circularisation provides lower assurance?
Negative, as the lack of reply may indicate other circumstances rather than actually agreeing with the balance. The debtor could forget to respond.
Explain process for debtors circularisation
- The auditor will prepare the circularisation, including debtors year end balance
- The client will create confirmation on their own headed paper (as client has relationship with customer)
- Auditor emails the confirmation and requests the debtor to confirm directly to the auditor.
- 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.
Explain subsequent cash testing
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.
What are the two main areas to auditing stock
Auditing the quantity of stock
Auditing the value of the stock
What are the three key substantive procedures performed on stock.
- Following up tests performed at the stock count (Testing quantity)
- Cut-off testing (Testing quantity)
- Cost vs NRV testing (Testing value)
Explain the stock count procedure
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.
Explain cut-off testing
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.
What are the two components tested by the auditor with regards to Cost vs NRV testing?
- Agree that the cost of stock is accurately recorded through agreement to purchase invoices
- Review NRV and compare to cost
Under what circumstances would NRV be lower than the cost of a particular stock item.
- Reduction in sales volume, requiring stock prices to be reduced in order to sell items.
- Stock becoming obsolete
- Damaged stock requiring a write down.
Why are trade creditors a significant risk for the auditor ?
Company may understate its liabilities.
A key risk over trade creditors is the completeness assertion.
What are the three substantive procedures performed on trade creditors?
- Perform creditors circularisations
- Supplier statement reconciliations
- Search for unrecorded liabilities.
Explain creditor circularisations
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.
Explain supplier statement reconciliations
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.
Explain the testing for unrecorded liabilities
- 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
- 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.
