Overview of Substantive Procedures Flashcards
Substantive audit procedures
These are audit procedures that are directly related to the financial statement elements and disclosures. Recall that the word substantive is derived from substantiate, which means “to verify that substantive procedures are those audit procedures designed to verify the entity’s financial statement elements and disclosures” or, in other words, “to search for material misstatements if there are any.”
Tests of details
These are the relatively precise (but usually rather expensive, labor-intensive) procedures (that suggest whether the client’s recorded amounts are right or not).
The AICPA states that the effectiveness and efficiency of substantive analytical procedures depends on the following four factors or considerations:
1) Nature of the assertion
2) Plausibility and predictability of the relationship
3) Availability and reliability of data used
4) Precision of the expectation
Nature of the assertion
Substantive analytical procedures may be particularly effective in testing for omissions of transactions that would be hard to detect with procedures that focus on recorded amounts. In other words, the skillful use of analytical procedures may be more effective than tests of details in addressing the completeness assertion, since there may be no supporting documents to examine for transactions that were not recorded in the first place!
Plausibility and predictability of the relationship
Developing a meaningful expectation to compare to the client’s recorded balance is critical to the skillful use of analytical procedures, so the predictability of the relationship is very important.
Availability and reliability of data used
The reliability of the expectation increases when the data used is (1) obtained from independent outside sources; (2) when it is subject to audit testing (either currently or in the past); or (3) is developed under conditions of effective internal control.
Precision of the expectation
The likelihood of detecting a misstatement decreases as the level of aggregation of the data increases. (That is, procedures would be less effective for “high altitude” global comparisons than for more focused, specific comparisons. In other words, relationships of interest to the auditor might be obscured by the noise in the data at a high level of aggregation, whereas those relationships might be more identifiable at a lower level of aggregation. For example, the auditor could focus on sales by month broken down by product line instead of simply comparing current annual sales currently to the prior year.)
Liquidity ratio
also known as solvency ratios): Measures of an entity’s short-term ability to meet its obligations.
1) Working Capital = Current assets – Current liabilities. This is a definition, not a ratio.
2) Current ratio = Current assets/Current liabilities
3) Quick ratio (acid-test ratio) = (Cash + Marketable securities + A/R)/Current liabilities
4) Current cash to debt ratio = Net cash from operations/Average current liabilities
Activity ratios
(also known as turnover or efficiency ratios): Measures of an entity’s effectiveness putting its assets to use.
1) Asset turnover = Net sales/Average total assets
2) Receivable turnover = Net (credit) sales/Average trade receivable (net)
3) Number of days sales in receivables = 365 days/Receivable turnover
4) Inventory turnover = Cost of goods sold/Average inventory
5) Number of days sales in inventory = 365 days/Inventory turnover
Profitability ratios
Measures of an entity’s operating success (failure) for a period of time.
1) Profit margin on sales = Net income/Net sales
2) Gross profit percentage = (Sales – Cost of goods sold)/Sales
3) Rate of return on assets = Net income/Average total assets
4) Rate of return on common stockholders’ equity = (Net income – Dividends attributable to preferred stockholders)/Average common stockholders’ equity
5) Earnings per share = (Net income – Preferred dividends)/Average number of common shares outstanding
6) Price earnings ratio (P-E ratio) = Market price of stock/earnings per share
Coverage ratios
also known as leverage ratios): Measures of the entity’s ability to meet its obligations over time (i.e., measures of long-term risk to creditors and the extent to which the entity has borrowed up to its available capacity).
1) Debt to total assets ratio = Total liabilities/Total assets
2) Debt to equity ratio = Total liabilities/Total stockholders’ equity
3) Times interest earned = Income before interest expense and income taxes/Interest expense
4) Cash to debt coverage ratio = Net cash from operations/Average total liabilities
The element of the audit planning process most likely to be agreed upon with the client before implementation of the audit strategy is the determination of the
Timing of inventory ovservation procedures to be performed
Which of the following factors would most likely influence an auditor’s determination of the auditability of an entity’s financial statements?
The adequacy of the accounting records
At the conclusion of an audit, an auditor is reviewing the evidence gathered in support of the financial statements. With regard to the valuation of inventory, the auditor concludes that the evidence obtained is not sufficient to support management’s representations. Which of the following actions is the auditor most likely to take?
Obtain additional evidence regarding the valuation of inventory
Which of the following is an analytical procedures
Comparing current year balances to prior year balances
