Chapter 9: Substantive Procedures and the Financial Statement Audit

Initial Steps for Test of Details of Balances using a SAMPLE: *IS CONFIRMATION ONE OF THE AUDIT PROCEDURES: Inquiry, Inspect, Observe, Reperform* Reconcile this and find where Confirmation is originally mentioned Selection Method (select the sample: random # generator systematic) *Sampling Method (nonstatistical or statistical?)* Sampling Frame (the population from which sample will be selected)

1) Determine which account and assertion is being evaluated. What is audit objective? 2) Decide what audit procedure needs to be used to test the assertion. Could be: inspecting, confirmation, recalculation. Example: Existence of A/R, CONFIRM that debtor agrees to recorded amount. Valuation is different. Existence of Inventory, INSPECT physical inventory. Doesn't prove rights or other assertions, just EXISTENCE. Completeness of Accounts Payable, Sample company's vendor list regardless of amount. Concern with completeness is that some of the items that SHOULD have been recorded have been omitted. Send confirmation to each vendor. Examine cash disbursements (payment in subsequent year for A/P of prior year not shown as liability..) 3) Decide on the Sampling Method Non-statistical or statistical approach. If statistical, decide on method. 4) Decide on Sampling Frame and Sampling Unit: Sampling Frame is the physical population from which the sample is selected. Sampling Unit: Must be appropriate for sampling frame. IE, If selecting A/R balances of individual customers, customer Account Balance the sampling unit. The sampling frame is the A/R subidiary ledger. 5) Determine the method to SELECT the SAMPLE - Utilize identifying numbers produced by a random number generator -Systematic sampling with a random start. Systematic can also use multiple random starts or random skip interval. -Haphazard sampling. Block Sampling: sample of continguous items (all invoices #100 to #200) but not random enough to be representative of population. Selection method has to match sampling method and sampling frame. 6) Determine sample size needed. Based on judgment when nonstatistical sampling method used. For statistical approach, calculate it based on method used. 7) Select the sample, perform the test, identify discrepancies. 8) Evaluate Sample Results.

Audit Procedure for Security Count

1) Obtain list of the locations of all securities and type, volume of securities at each location. 2) Perform security count -- document company name, cert #, # of shares. face value, interest rate, due date, issue date 3) Authenticity Test -- examine signatures of trustee, registrar, transfer agent, corporate officers. 4) Compare results of security count with description of investments in the accounting records.

Substantive Procedures on Accounts and Disclosures Flow Diagram *PQ #56 on Correct Order of Tests Dual Purpose Test of Details of Balances Substantive Analytical Procedures *

1)Dual purpose tests 2)Tests of details of balances 3)Substantive Analytical Procedures | | Evaluate results and document | | Consider other information | | Form tentative conclusions on fairness of financial statements

Inventory: Analytical Procedures

1. Compare gross profit ratios in current and prior year. 2. Compare inventory turnover in current and prior year. 3. Compare inventory and cost of sales in current year with current-year budget and prior year actual. 4. Compare standard and unit costs of major items of inventory in current and prior years.

Procedures to Test Borrowings, Repayments, and Accrued Interest

1. Examine all transactions in the account for the year 2. Trace the proceeds from any borrowings to the cash receipts records, deposit slips, and bank statements. 3. Audit payments by examining canceled checks and canceled notes. (interest, principle payments) 4. Trace the authorization of all significant borrowings and any repayments not made in accordance with the terms of the debt instrument to minutes of meetings of the BOD.

Examples of Audit Steps for Long-Term Debt

1. Existence Confirm balance due to creditor 2. Obligation Confirm obligation with creditor 3. Completeness Send confirmation to all financial institutions with which business was transacted during the period 4. Valuation Recalculate the computation of debt premium and discount 5. Presentation Recalculate current portion of long-term debt, this portion shows up as Short Term Debt.

Procedures for Bank Reconciliation Company Records match Bank Records?

1. Foot bank reconciliation with any supporting details. 2. Confirm balance per bank directly 3. Cutoff Bank Statement (1st 10 days after fiscal year end). 4. Trace the balance per bank to the year end bank statement and beginning balance of cut off bank statement. 5. Trace balance per books to cash book. 6. Trace dates and amounts of deposits in transit to the cutoff bank statement. 7. Paper checks. a) Trace to outstanding check list b) Compare signature with list of authorized sigs c) review Payees, look for checks payable to cash d) compare with cash book as to date, number, payee and amount 8. Paper Checks dated after audit date but within cutoff bank statement period, examine first bank endorsement to see that it does not precede audit date. 9. For checks outstanding on check list that did not clear with cutoff bank statement, investigate if any outstanding for a long time. 10. Account for all check numbers issued during the month as having cleared with the yeard end bank statement or as being outstanding.

Audit Procedures for Accounts Receivable - Auditing in Action

1. Total A/R listing and agree with general ledger 2. Testing aging of A/R (sort A/R by age of receivable - aging categories ) 3. Confirm Customer account balances on test basis 4. Alternative Procedures like examine invoice, shipping docs, remittance advice) on customer balances selected for confirmation but for which there was no reply received. 5. Test Adequacy of the Allowance for Doubtful Accounts by: a. Review of credit files and talk to credit mgr about collectibility b Review subsequent collection of account balances c. Comparison with the prior year of percentage of A/R in each of the aging categories

Management Assertions, Audit Objective, Evidence

An integrated audit investigates the fairness of management's assertions that are communicated through the financial statements. Mgmt shows a Line Item: transactions occurred, A/L really exist. Based on GAAP, correct, proper valuation, correct period, proper recording of allocations to more than one acctg period. Disclosures meet requirements of applicable professional standards. The substantive procedures of the financial statement audit specifically and directly investigae whether these messages communicated by management are valid. Auditor determines which accounts are significant Then determines relevant management assertions Decides what audit steps are necessary to collect sufficient evidence that is appropriate and thus both relevant and reliable about whether management's assertions are valid. *Audit objectives refers to what must be accomplished during the audit of a particular account or transaction cycle for the auditor to be PERSUADED about management assertions. * ICFR audit focuses on PROCESSES. Financial Statement Audit: concerned with management assertions about the account balances and disclosures presented in the financial statements. Evidence: In the subtantive tests and procedures phase, auditor collects evidence about the ACCOUNT BALANCE amounts and the RELATED DISCLOSURES.

Materiality and Reasonable Assurance

Audit report for the FS audit states the auditor's opinion about whether the FS are free of material misstatements that can occur from ERROR or FRAUD. Reasonable assurance = high level of assurance, but not absolute assurance. Why only Reasonable Assurance? ICFR failures can cause a company's system to produce improper information. Employees or mgmt can commit fraud. And many audit judgments are based on samples. Opinion communicates that although there may be misstatements in the FS, the auditor has accumulated PERSUASIVE EVIDENCE supporting the conclusion that they are not of a nature or amount that is material.

Performing Substantive Tests and Procedures

Auditors perform Substantive Tests using: 1) Tests of Details of Balances 2) Substantive analytical procedures Test of Details of Balance can be done in the following ways: 1) Test entire population of transactions that make up Account Balance. Can do this when population is small enough. 2) SAMPLE: Select a SAMPLE. Test sample of transactions for the important management assertions. If finds misstatement in sample, ESTIMATES misstatement in the total population. Suggest adjusting entry. 3) STRATIFY: Stratify population into different groups and use difft procedures on difft categories. Examine 100% of transactions in one category and test sample of population is another segment. Stratify based on impt characteristic that may influence risk of misstatement or ease of applying audit approach. Ex. Dollar size or frequency of transactions. Do 100% on 1st and sample on 2nd.

FASB 850

Below is an overview of FASB Accounting Standards Codification Topic 850, Related Party Disclosures, as well as a list of FASB Accounting Standards Updates (ASUs) and proposed ASUs related to this Topic. Overview ASC 850-10 notes the following: The Related Party Disclosures Topic provides disclosure requirements for related party transactions and certain common control relationships. Accounting and reporting issues concerning certain related party transactions and relationships are addressed in other Topics. Information about transactions with related parties is useful in comparing an entity's results of operations and financial position with those of prior periods and with those of other entities. It helps users of financial statements to detect and explain possible differences. Examples of related party transactions include those between: A parent entity and its subsidiaries Subsidiaries of a common parent An entity and trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of the entity's management An entity and its principal owners, management, or members of their immediate families Affiliates. Transactions between related parties commonly occur in the normal course of business. Examples of common transactions with related parties are: Sales, purchases, and transfers of real and personal property Services received or furnished, such as accounting, management, engineering, and legal services Use of property and equipment by lease or otherwise Borrowings, lendings, and guarantees Maintenance of compensating bank balances for the benefit of a related party Intra-entity billings based on allocations of common costs Filings of consolidated tax returns. Transactions between related parties are considered to be related party transactions even though they may not be given accounting recognition. For example, an entity may receive services from a related party without charge and not record receipt of the services. While not providing accounting or measurement guidance for such transactions, this Topic requires their disclosure nonetheless. An arm's length transaction is a negotiation between two parties where the parties are not related. Related party transactions are conducted with other parties with which an entity has a close association. The disclosure of related party information is considered useful to the readers of a company's financial statements, particularly in regard to the examination of changes in the financial results and financial position over time, and in comparison to the same information for other businesses. Examples of related parties are: Affiliates Other subsidiaries under common control Owners of the business, its managers, and their families The parent entity Trusts for the benefit of employees There are many types of transactions that can be conducted between related parties, such as sales, asset transfers, leases, lending arrangements, guarantees, allocations of common costs, and the filing of consolidated tax returns.

Investments, Emphasis on Marketable Securities

Businesses of all sizes can use investments to manage ENTITY RISK. Audits require more time and effort now that so many sophisticated instruments. Companies invest in instruments to: - invest temporarily available cash -Hedge the risk of changes in: interest rates, cost of raw materials and energy, FX rates CONFIRM: EXISTENCE & RIGHTS by physical inspection of documents. Confirmation with Custodian of investment documents. Easy to validate. Other Assertions require more substantive testing (valuation, p&d). Examples of Audit Steps for Investment Securities 1. Existence: Examine securities maintained in a safe deposit box. Confirm securities held by outside custodian. 2. Rights: Examine securities to determine if they are registered in the client's name with no indication of pledging. 3. Completeness: Analytical procedures -- Match dividend and interest income with related investments. 4. Valuation: Review method of valuation for compliance with GAAP and test computation by reference to brokers advice, market quotations, or audited financial statements of investees. 5. Presentation: Review classification of investments as long or short term and confirm management intention in a representation letter.

Quantitative Evaluation of Fishcrackers' Inn Outcome.

CFO decides only to adjust for Know Misstatement, $300. Account Balance Rev = COPY AND PASTE IN EXCEL STUFF AND DRAW DIAGRAM on p 443

Which of the following accounts represents the Greatest Inherent Risk?

Cash, Marketable Securities, Accounts Receivable, Sales. Answer: Accounts Receivable In a financial audit, inherent risk is most likely to occur when transactions are complex, or in situations that require a high degree of judgment in regards to financial estimates. So many because of estimates of Uncollectables? Someplace in book it said Cash had a lot of Inherent Risk.

Audit of Long-Term Debt

Composed of both routine and nonroutine transactions. Borrowing Long-Term Debt is nonroutine. Extra scrutiny. Review debt contract and terms. Trace Funds rec'd to Cash Account. GAAP. Routine Transactions for LTD consist of periodic accruals and payments of interest and repayment of principle. Auditor examines whether cash is disbursed consistent with contract terms, interest expense agrees to a calculated amount, and amount of debt principle is reduced as expected. Presentation and Disclosure is an important Assertion for LTD. STD vs LTD. Violation of debt covenants.

Auditing Current Payables

Current Payables Management Assertion that is very important: Completeness Primary audit risk is that they may be omitted or understated. Test: 1) Search for Unrecorded Liabilities - review of cash disbursements made in the accounting period subsequent to the balance sheet date. Review cash disbursement after FYE and determine whether they are expenses of the period being audited or expenses of the period when the cash was disbursed. For any cash disbursements that are expenses of the year under audit, auditor should be able to trace the payment to a corresponding account payable posted on the company's year end books. 2) Confirm with Accounts Payable with outside parties. Sample the list of vendors.

Quantitative Evaluation of Sample Results

Draw in p 441 Exhibit

Transaction Cycles and Account Balances

Effective way to organize audit work. *Transaction Cycles* can be defined differently for different business models and industries, but generally most businesses have a cycle dealing with: 1) Sales or sources of revenue and cash receipts 2) Purchases or acquisitions and cash disbursements 3) Human Resources 4) Production or Inventory, which, when necessary includes cost accounting 5) Financing related activities such as investment, debt, and equity transactions. Transaction cycles can guide organization of audit. But, Various accounts that are IMPORTANT or MATERIAL to the financial statements also impact the EMPHASIS of audit activities. *PQ 57 Which of following is not a transaction cycle Cash Receipts Inventory Cash disbursements Answer: All are transaction cycles*

Sampling Error

Errors in audit tests and proceduress are either 1) Non-Sampling or 2) Sampling Errors. 1)Non-Sampling Error = Human Error. To prevent, Quality Control Procedures including supervision and Review. 2) Sampling Error: Occurs when selected sample does NOT represent the population. 1) incorrect acceptance ** impacts audit effectiveness 2) incorrect rejection - efficiency problem To detect: use Analytical Procedures Impact of Sampling Error on Audit Decision Auditor Concludes Fairly Stated, Account Balance is Materially Misstated: Incorrect Audit Decision Incorrect Acceptance (no "tip off", no further investigating, remains undetected) Effectiveness Problem Auditor Concludes Materially Misstated, Account Balance is Fairly Stated Incorrect Audit Decision Incorrect Rejection (investigage further, will find actually is fairly stated) Efficiency Problem

Important Considerations in a Financial Statement Audit

Estimates (Collectibility of receivables, useful lives, salvage values) Must understand mgmt's methods for making estimates, evaluate reasonableness of resulting estimates. Fair Values Measurements Illegal Acts (MM from illegal acts, just like MM from error or fraud). Illegal Acts with Direct Impact on Financial Statements. Ex Violation of tax laws or financial reporting regulations. Related Party Transactions: disclosure required, must be "arms length". If Material related party transactions, it increases auditor's risk concerns regarding proper presentation and disclosure. *Define ARMS LENGTH* Going Concern: evaluate if there is substantial doubt about entity's ability to continue as a going concern for a year following the date of its financial statements.

Appendix A: Testing IT Application Controls and Computer Assisted Software

General IT Controls (ITGC) deals with IT environment and IT policies. Application controls deals with controls built into specific applications or processes. Test of Automated Controls 1) Test Data Approach Prepare sample data and then process it in application. Sample is specifically designed for the test. Auditor knows expected result. Access authorization, Field Limit Checks (upper bounds), Range Check, Validity Check (field type), Completeness Check (all fields populated that should be). Run to Run Control: Check that data are not dropped or added from one computer to the next. Error Handling Procedures 2) Parallel Simulation Reprocess previously processed data using a program that accomplished same step as client's original program. Compare results to original output to see if correct results. Can be performed using CAATs (computer assisted audit SW). 3) Integrated Test Facility (ITF) Part of the client's system (testing integrated into client system) and tests the functioning of applications on at Real-Time Basis as they are processing data. - Dummy files exist alongside Real Files. - Test transaction input and process concurrently with real transactions. - Results post to Dummy Files and are compared to Expected Results. Key Benefit: Processed Test data as part of REGULAR OPERATION. Files must be controlled so don't corrupt real files. Audit Software Related Expert Systems can assist auditor in audit planning, analyzing materiality, performing risk analysis. Benford's Law: Example of specialized task is programmed analysis for fraud detection using Benford's Law. This law states that individual digits in a group of random digits will occur with predictable frequency. Software that applies Benford's law analyzes numeric data and identifies patterns of numbers that occur with a frequency inconsistent with Benford's Law. The outcome gives auditor info regarding transactions that need further investigation.

Use of Analytical Procedures in Substantive Testing

If an analytical procedure is used as the principal substantive test of a significant financial statement assertion, the auditor documents: a. The expectation, when it is not easily determined from the documentation of the work performed, and how the expectation was developed. b. Results from comparing expected amounts to the amounts recorded in the company's books, or calculations based on those expected amounts c. If significant unexpected differences are found, any other auditing procedures performed and the results of the additional procedures.

Results of Substantive Tests and Procedures: Evaluating Results Testing 100% of Population

If examining 100% of population, evaluating results is straightforward. If discrepancies found: 1) identify and discuss with management. 2) May want to correct, even if not material. 3) if discrepancy causes FS to be MM, auditor discusses Adjusting Entry. Client is responsible for final decision on actually recording the adjusting entry. Auditor needs evidence client has made corrections of MM in order to issue unqualified opinions. 4) IF MM is found, must question assessment of fraud risk and audit conclusions about the effectiveness if ICFR. ICFR did not detect or prevent the MM. May revisit ICFR opinion. 5) Must consider all FS that are affected by a MS. Not material in Income Statement, could be material in BS.

Auditing Accounts Receivable

Important Management Assertions: EXISTENCE RIGHTS VALUATION Examples of Audit Steps for A/R: 1. Existence Confirmation of account balance with Customer 2. Rights: Inquiry and review of BOD minutes and loan agreements evidence of pledging. A/R could be factored (sell receivable or use as collateral for loan) 3. Completeness: Analytical procedures. Compare units shipped per sales records to Units Shipped per Shipping Records. 4. Valuation: Older balances at greater risk of being uncollectible. Inquiry of credit manager and review of aged A/R Trial balance and credit files. 5. *Presentation: Inquiry and review of BOD minutes for evidence of related party transactions -- is this factoring*?

Cut Off Issues and Substantive Procedures at Interim Dates (Another Impt Consideration in a financial statement audit)

Interim Work = when auditor conducts procedures to obtain substantive audit evidence prior to the end of the fiscal year. Efficient for auditor because it spreads work throughout the year. Auditor then "updates" information to verify that earlier audit informatioin done at interim date is still appropriate. Cutoff => Auditor tests whether client has effective cutoff of its financial records at the end of its fiscal year. - Good cutoff is integral to auditor's conclusions about management's assertions: 1) EXISTENCE or OCCURRENCE 2) COMPLETENESS If transaction recorded in wrong acctg period due to poor cutoff, both assertions will be improper. Transaction occurs in year 1 but is recorded in year 2, financial info in year 1 is INCOMPLETE. Financial info in Year 2 is misstated because it includes information that did not OCCUR in that year. Effective cutoff requires mgmt to plan its acctg procedures to determine the period in which transactions occur and post them correctly. Need control over transactions, cash, other liquid assets at year end, and control over receipt and shipment of inventory shortly before and after year end. Must be able to capture and record data that are received in the subsequent fiscal year but apply to activities of the year being audited. Inspect invoices after FYE to see if they are EXPENSES of the prior year or current year. p 454 Invoices for activities of the prior year can be properly posted as EXPENSES and PAYABLES for the year being audited. From: Accounting Coach End of Period Cutoff At the end of every accounting period (year, quarter, month, 5-week period, etc.) it is important that the accounts payable processing be up-to-date. If it is not up-to-date, the income statement for the accounting period will likely be omitting some expenses and the balance sheet at the end of the accounting period will be omitting some liabilities. During the first few days after an accounting period ends, it is important for the accounts payable staff to closely examine the incoming vendor invoices. *For example, a $900 repair bill received on January 6 may be a December repair expense and a liability as of December 31.*Another vendor invoice received on January 6 may not have been an obligation as of December 31 and is actually a January expense. Auditor checks company's cutoff procedures and checks transactions that occurred and were posted shortly before and after fiscal year end.

Final required Substantive Audit Procedure

Is for Auditor to reconcile the company's General Ledger to the Financial Statements. Then Wrap Up phase of audit Issuance of Report

Known misstatements, Likely Misstatements, Tolerable Misstatement

Known Misstatements are discrepancies found during testing. Easily correctable by posting adjusting entries. Likely misstatement: When examining sample if misstatements found -- what other misstatements likely exist? What misstatements likely exist in the rest of the accont that were not identified because they were not included in the sample? Does an Additional entry need to be made to have Reasonable Assurance the FS on the whole are not misstated? *True Account Balance* Auditor estimates the true account balance based on results of sample. Since based on sample, true account balance won't be exact estimate. Tolerable misstatement: During planning, auditor sets $ dollar amount that is a materiality threshold for each account balance. After client makes any adjusting journal entries for Known Misstatements, auditor evaluates whether remaining Likely Misstatements > Tolerable Misstatement. Auditor Evaluates whether Estimate of True Book Value and any Cushioning due to sampling falls within the range of the Recorded Book Value +/- Tolerable Misstatement. Cushion = A calculated Precision Interval, Confidence Bound or allowance for Sampling Risk. If Est True Value +/ Cushion Is within range of Book Value +/- Tolerable Misstatement Then Book value may not have to be adjusted. See Practice Questions + Error Rate in Sample = $ Known or Understatement/Total $ in Sample Total Population * Error Rate = $ Likely Misstatement Amount of Under/Over in Total Population. Estimated True Balance is Book Value +/- Likely Misstatement In book example. Client makes adjusting entry for the Known Misstatement Only. Since Book Value Adjusted for the Known Mistatement +/- Tolerable Misstatemet

Client Acceptance and Planning Activities - Review

Learns client's business activities Important transactions and controls Management assertions impt to various financial statement accounts Risks that might cause those management assertions to be incorrect. Auditor considers impt accounts and the client processes from transaction initiation through financial statement reporting.

Appendix B: Statistical Techniqus and Test of Details of Balances

Major advantage of statistical techniques is that it limits the sample size to the SMALLEST appropriate size. Does not limit risk of anything or relate sample size to audit risk. Repeats steps for a Test of Details of Balances using a Sample - Determine account and assertion - Determine procedure to test assertion - Determine sampling method (statistical or non statistical) if statistical decide on approach Classical Variable Sampling or Monetary Unit Sampling - Determine Method of Sample Selection. If statistical sampling is used, method must produce random sample. - Determine Sample Size - Select sample, test, identify discrepancies - Evaluate sample results Lower risk of incorrect acceptance means larger sample size. Has to be perfect to test more on larger sample size. Confidence level is the arithmetic complement of risk. If risk is 5%, Confidence is 95%. Risk of Incorrect Acceptance is risk. 2 statistical approaches most common for Test of Details of Balances Classical Variable Sampling Monetary Unit Sampling (dollar sampling) Classical Variable -Can be applied to audit procedures testing for -Overstatements and Understatements -Appropriate only when MANY misstatements in recorded book values. MUS: -easier and generally requires smaller sample. -Addresses question of whether an account balance is misstated no more than a specified dollar amount. - Sampling unit is a single dollar. - Method of Selection causes Larger itms in the account to have a greater probability of being included in the sample. - Automatically stratifies the population. Makes it easier to use than classical. - MUS is effective when test is for OVERSTATEMENT and is especially appropriate when Small number of overstatements of large dollar amounts. - Not appropriate for UNDERSTATEMENTS. - MUS most appropriate when zero or few misstatements are expected in sample. Sampling With or Without Replacement With Replacement, after an item is selected, it is put back and can be selected again. An item of audit evidence that has already been used adds no new info. Auditor uses Sampling Without Replacement. This means that a smaller can be selected.

Examples of Audit Steps for Accounts Payable

Make sure nothing omitted or understated -- Completeness most Important 1. Existence Compare recorded A/P with vendor invoice and accompanying evidence of receipt of good or service. 2. Obligation Same as for existence 3. Completeness Send positive confirmation requests to vendors with whom client has significant purchase transactions. Examine material invoices for the period after the Balance Sheet Date up to the date the auditor finishes work at the client location. Determine whether the item has been properly included as an expense and liability, or properly excluded. 4. Valuation Not applicable 5. *Presentation Inquiry and review of minutes of BOD for indication of related party transactions*

Auditing Cash

Management Assertions important to cash are existence, rights, cut off, and disclosure. Does not require estimation, valuation (unless diff currency, fx). Most important: Cash Exists and is Owned by entity in period reported. Confirmation with banks is impt procedure. Bank statements. Examples of Audit Steps 1. *Existence*: Confirmation bank balances and reconciliation to book balance. 2. *Rights* Inquiry and review of board of director minutes and loan documents for evidence of pledging 3. Completeness: Confirmation to all banks re: accounts closed or open 4. Valuation: Not applicable unless FX 5. *Presentation* *ASK*: Inquiry and review of BOD minutes for evidence of compensating balances and escrow deposits

Fraud

Misappropriation of Asset (theft) Fraudulent Financial Reporting

Owners Equity

Nonroutine: Issue new stock Purchased Treasury stock Handled like nonroutine debt transactions

Analytical Procedures, Fluctuation Analysis

Quality Control Procedures help detect Human Errors. Analytical Procedures can help auditors detect mistakes resulting from Sampling Errors. If auditor made incorrect acceptance due to fact that sample did not represent population, mistake could be caught when auditor performs Analytical Procedures like *Fluctuation Analyses* = compare at prior year to current year. Exhibit Current Common Prior Common $ Change, and % Change *PQ#60 Compare prior year to current year is an example of substantive analytical procedure and fluctuation analysis *

Audit Documentation

Reviewer or inspector of audit documents must be able to identify what: auditor has done, evidence used by auditor, source of evidence, audit conclusions and that sufficient evidence was obtained to support conclusions. (AS 3) Standards don't specify how should be organized but auditors use Working Trial Balance, Lead Schedules and Detailed Work Papers.

Materiality and Reasonable Assurance: Impacts of Sampling

Sampling is also used for TEST OF DETAILS OF BALANCES as well as ICFR. Test of Details of Balances = examining transactions to determine whether underlying evidence corresponds with the amounts or other info that is in company records and reported in its FS. Use Audit Procedures: Inspection, External Confirmation, and Reperformance. The Existence of Correspondence supports Management Assertions. Sampling based on assumption that auditor can examine less than 100% of population and come to conclusion about population from which sample was drawn. Auditor must consider possible sources of error when using sampling.

Audit Risk Model for Account Balance

Start with one from C8 AR = RMM x DR AR = (IRxCR) x DR AR = Audit Risk = Risk of issuing a clean audit opinion when it is not justified. Here, possiblity of concluding Account Balance is Fair when is is not. RMM = Risk of Material Misstatement is likelihood that a material misstatement occurs in an Account Balance. Likelihood of MM in Account Balance is a function of: 1) Inherent Risk = riskiness of account,higher IR. like valuing obsolete inventory) 2) Control Risk = the risk that a material misstatement will go undetected by the Client. ICFR not sufficient to either prevent or detect a misstatement Detection Risk DR is risk that: 1) Account Balance is materially misstated 2) Controls do not prevent or detect misstatement and 3) Auditor's procedures miss the problem. Tools that auditor uses to detect misstatements are Test of Details of Balances and Analytical Procedures. When Analytical Procedures are included, Audit Risk Model is stated as: AR = RMM x DR *AR = (IR x CR) x (TD x AP) * Components of Audit Risk for Account Balance IR = Inherent Risk (nature of account or transactions) CR = Control Risk (client's controls do not prevent or detect) TD is the Detection Risk of Tests of Details of Balances (Auditor does not discover misstatement through Test of Details) AP = Detection Risk of Analytical Procedures. (auditor performs Analytical Procedures and still misses problem) *This equation describes the risk that an auditor will conclude an account balance is properly stated when it is not.* In audit risk model, the sampling error is expressed as TD, the detection risk of Test of Details of Balances. TD is the risk that when the auditor is using samples for Tests of Details of Balances, he or she incorrectly accepts an account balance as fair when it is materially misstated because the sample used does not represent the population from which it was selected. Sampling risks always exist whether or not statistical techniques are used. Statistical techniques simply permit the risk of sampling error to be measured. *PQ#63 Sampling Risk is a function of the audit, regardless whether statistical methods are used or not. Whether sample is based statistics or not. (not a f(statistical procedures) and not a f(statistical method chosen))

Benefit of using Statistical Approach to sampling

Statistical sampling permits the auditor to quantify sampling risk.

Results of Substantive Tests and Procedures: Evaluating Results Sample the Population

Steps to Evaluate an Account Balance Based on Audit Test of a Sample 1. Determine the recorded amount of the sample 2. Using evidence collected from the sample, investigate misstatements 3. Using the sample as a basis, estimate the "true" account balance. (determine what recorded amount should be based on audit evidence) Linear proportion: Sample was 15% understated so account total will be 15% understated. Nonstatistical approadh, auditor makes a judgment about quality of estimate of population. Statistical sampling plan, auditor calculates a *precision interval* around the population estimate. 4. Set a Tolerable Misstatement Quantitative threshold of misstatements in the recorded account balance that can be estimated based on sample results without triggering need for an adjusting entry to account balance. 5. Evaluate whether the account balance is materially misstated and requires an adjustment. 6. Consider the impact of the audit findings on other accounts, fraud risk and ICFR.

Areas Addressed in a Financial Statement Audit Introduction

Substantive Audit procedures are targeted at selected financial statement accounts for important assertions. Assertions that are MOST important vary by account: 1) Assets: Existence, Right, Valuation 2) Liabilities: Completeness and Obligations From fraud perspective, greater risk that liabilities (rather than assets) will be intentionally omitted. 3) Income Statement Transactions: Occurrence and Completeness. 4) Relevant to All FS components: Proper and complete presentation and disclosure. Complex disclosures present higher presentation and disclosure risk.

Audit of Inventory

Substantive Procedures vary widely depending on nature of business -- retail (purchase than sell goods) versus manufacturing (raw materials, work in progress, finished goods), for example. In most cases, auditor must PHYSICALLY INSPECT inventory if it is material to FS. Evidence of EXISTENCE. Can help with VALUATION (damage, obsolescence). Examples of Audit Steps for Inventory 1. Existence: Observation of physical inventory counts and reconciliation of test counts with Perpetual Inventory records. 2. Rights Inquiry and review of BOD minutes and loan agreements for evidence of pledging 3. Completeness Test receiving cutoff procedures 4. Valuation *ASK*: Inspection of vendor invoices, payroll records, and overhead application work sheets. 5. Presentation: Comparison of disclosures in financial statements with reqs for GAAP.

Summary of Substantive Tests and Procedures

Substantive audit tests and procedures vary based on: 1) Account being Audited 2) The Relevant Management Assertion of the account 3) The resulting Audit Risk Most appropriate test is selected based on risks and Audit Objectives. Direct Examination of transactions and components of Account Balances + Analytical Procedures.

Revenue and Expenses

Tests of balances of Revenues and Expenses are often performed in combination with tests of controls and are called dual purpose tests. As transactions are selected and audited to test Operating Effectiveness of Controls, auditor also examines supporting documents and recorded transactions. Analytical Procedures often used as evidence for Income Statement Accounts.

Chapter presents overview of Substantive Tests and Procedures that are used by auditors during the financial statement audit of an integrated audit.

These are new -- these specifically target account balances and disclosures. Purpose of Substantive Tests and procedures - to obtain evidence on any misstatements in the various accounts and disclosures that would prevent the auditor from concluding that the financial statements are free of material misstatement.

Faulty Audit Conclusions Related to Sampling Risk

When auditor uses a sample from a population that makes up an account balance, the sample may not be representative of the rest of the population. Incorrect Rejection: Efficiency Problem Concluding that account balance was materially misstated when it is no. Incorrect Acceptance: Effectiveness Problem Concluding Account Balance is not materially misstated when it is.

Working Trial Balance, Lead Schedules, Detailed Work Papers

Working Trial Balance = fundamental starting place for the post-closing general ledger, providing both line item account titles and amounts Each line item on Trial Balance is supported by a lead schedule work paper. Lead schedule = term for the audit paper work that lists and specifies the components that make up the line item on the Working Trial Balance. Detailed Work Papers = support the information on the lead schedule, providing information about the audit tests performed on each component of the trial balance line item and results of tests Documentation in Electronic Form -Start at top with Working Trial Balance -Select Line Item on Working Trial Balance -Links to Lead Schedule providing details about the line item -Select item on Lead Schedule and follow link to Detailed Work Paper that provides details such as sampling plan, tests performed, results, conclusions, who performed and reviewed work.

Concept of Cushion around Estimate of "True" Account Balance *ASK*

p 444 ASK