charteredaccountants.com.au/training Fundamentals of Auditing in 2007 ICAA Audit Training Series 2008 Module 3 ASA 330 – The Auditor’s Procedures in Response to Assessed Risks charteredaccountants.com.au Michael Cain, FCA Audit & Accounting Technical Director Nexia International – Australia and New Zealand

 ASA 330 – Key issues  Testing of controls  Substantive tests of transactions and balances Module 3 - Overview

ASA 330 deals with 4 key issues: 1. Overall responses to assessed risk 2. Audit procedures responsive to risks of material misstatement at the assertion level 3.Evaluating the sufficiency and appropriateness of audit evidence obtained 4.Documentation The auditor’s procedures in response to assessed risk

Relationship between evidence-gathering procedures  Auditor has to obtain sufficient appropriate evidence to support the audit opinion.  Tests of controls and substantive tests of transactions and balances are the main evidence-gathering audit procedures.  Auditor selects the most efficient and effective combination of audit procedures that allows them to achieve audit objective.  Assertions are used to help them in their risk assessment of material misstatement, and to direct their audit procedures in responding to these risks.

 Consider effects of risk on the financial report as a whole first  Choice of two approaches - see diagram pg 4 Substantive Combined (test of controls and substantive) 1. Audit procedures responsive to risks

 Design and perform further audit procedures whose nature, timing and extent are responsive to the assessed risks at the assertion level.  Choice of two approaches - see diagram pg 4  Consider inherent and control risk, as this will affect the procedures selected.  For example, if inherent risk is low for a particular account then analytical procedures may be considered sufficient. 2. Audit procedures responsive to risks

 When your assessment of risks of material misstatement at the assertion level includes an expectation that controls are operating effectively, you perform tests of controls to obtain evidence that this was the case.  Where it is not possible to reduce the risks of material misstatement to an acceptably low level only via substantive procedures, tests of control should be performed. 2. Audit procedures responsive to risks

 When you obtain audit evidence about the effectiveness of controls during an interim period, you should determine what additional evidence should be obtained for the remaining period.  Irrespective of the assessed risk of material misstatement, you should design and perform substantive procedures for each material class of transactions, account balance and disclosure. 2. Audit procedures responsive to risks

 Conclude whether sufficient appropriate audit evidence has been obtained to reduce to an acceptably low level the risk of material misstatement in the financial report. 3.Evaluating audit evidence

3. Sufficiency and appropriateness  Dependent on the level of control risk the tests must support.  The lower the planned assessed level of control risk, the greater the amount of testing that is required.  Auditor should also consider:  Type and source of evidence  Timeliness  Interrelationship of evidence.

 Document the overall responses to address the assessed risks, the further audit procedures, the link of those procedures with the assessed risks at the assertion level, and the results of audit procedures. 4.Documentation

Testing of Controls

Tests of controls  When control risk is assessed at less than high, it is necessary to gather evidence that controls are working. This evidence is gathered via a test of controls.  If control risk is assessed at high, the auditor will not undertake test of controls.  Auditor selects most efficient and effective combination of tests of controls, and substantive tests of transactions and balances.

Assessing control risk  To assess control risk as high, auditor must expect that substantive procedures alone will provide sufficient appropriate evidence.  Areas where substantive procedures alone may not provide sufficient appropriate evidence include routine recording of significant classes of transactions, such as revenue or purchases. These areas are often highly automated with little or no manual intervention.

Planning the scope of tests of controls  Nature: if controls exist that the auditor expects to rely upon, undertake tests of these controls, otherwise undertake substantive testing.  Timing: to aid ability to meet deadlines and scheduling of staff, tests of controls sometimes scheduled before year-end. Testing then extended (rolled forward) until year-end.  Extent: the more the auditor relies on controls, the greater the extent of tests of controls. For tests of controls related to documents, extent determined by reference to sampling theory. Controls related to accounting routines (e.g. bank reconciliations) usually tested by re-performing a small number.

Existence, effectiveness and continuity of controls  For internal controls to provide audit evidence about risk of material misstatements at the assertion level, the auditor must collect audit evidence about the existence, effectiveness and continuity of controls.  Evidence of existence of controls is usually gained when auditor is assessing control risk.  Tests of controls are aimed at establishing their effectiveness and continuity.

Aspects of internal control

Assertions and testing control activities  For the first two elements of IC (control environment and entity’s risk assessment process), controls relate less directly to specific financial report assertions.  For the remaining three elements of IC (information system, control activities and monitoring of controls), controls are built around major flows of transactions and events and related accounts (e.g. sales, receivables and cash receipts).  For these elements it is possible to link many controls to assertions about classes of transactions and events and related account balances (e.g. occurrence — controls which help ensure that transactions and events that have been recorded, have occurred and pertain to the entity).

Let’s look at the sales cycle What are the key functions??

Revenues, receivables and receipts (sales cycle)  Sales cycle involves all those transactions and events that are initiated when an entity makes a sale. It is commonly characterised by a high volume of routine transactions.  Audit problems commonly related to clerical processing rather than complex accounting problems.

Key functions in typical sales cycle  Order entry and order approval by credit department  Shipping  Invoicing  General ledger entry  Accounts receivable  Mail opening  Cashier functions

Sales cycle: routine and non-routine transactions Routine transactions:  Credit sales to customers, cash collections from customers (flowcharts), usually strong control system, auditor considers (and usually undertakes) tests of controls. Non-routine transactions:  Adjustments to sales, and provisions for doubtful debts. Less well controlled. Where material, auditor undertakes substantive testing.

Control objectives for sales system  Controls are in place to ensure that:  Occurrence — all sales recorded are bona fide transactions for merchandise actually shipped to customers  Completeness — all sales shipped are invoiced and recorded in accounting records  Accuracy — invoices have been recorded correctly as to amount and summarised correctly  Cutoff — invoices have been recorded in correct period  Classification — sales classified in accordance with written policies.

Example of linking objectives to control policies and tests of controls for sales Special control objectives Common control policies and procedures Tests of controls  Occurrence — All sales recorded are bona fide transactions for merchandise actually shipped to customers.  Policy of authorisation of credit and terms  Evidence of quantities shipped reconciled to quantities invoiced  Select sample of sales transactions from sales journal (daily activity report), check for authorisation and trace to shipping document file  Inspect reconciliation of shipments to invoices

Discussion problem

Expenditures, payables and disbursements  Expenditure cycle: all transactions and events initiated when an entity acquires assets or services used for cash or credit.  Auditors (and many entities) often separate this cycle into a number of sub- cycles, which reflect various types of services and assets that can be acquired, including:  Payroll  Property, plant and equipment  Inventory  Income taxes  Selling and administrative expenses  Miscellaneous expenses paid from petty cash.

Control objectives in a cash disbursements system  Controls are in place to ensure:  Occurrence — recorded cash disbursements are for goods or services authorised and received  Completeness — all cash disbursements are recorded  Accuracy — cash disbursements are recorded correctly as to amount  Cutoff — cash disbursements recorded in correct period  Classification — cash disbursements are recorded correctly as to account.

Example of linking control objectives, controls and test of controls: purchases: cash disbursements Special control objectives Common control policies and procedures Tests of controls  Occurrence — Recorded cash disbursement s are for goods or services authorised and received.  Cheques printed or prepared only when receipt of goods or services and approval are documented (e.g. supporting documents compared, recomputed and voucher approved)  Cheques signed only after viewing supporting documentation and prior approval  Supporting documentation cancelled and reference to cheque number  Select a sample of cash disbursement transactions from cash payments journal and inspect supporting documentation for indication of checking, review and approval  Observe and inquire about cheque preparation and signing and protection of unissued cheques  For the sample of cash disbursement transactions inspect supporting documents for cancellation, cheque number and endorsement

Key functions within the inventory sub-cycle  Purchasing  Receiving  Accounts payable  Cash disbursements function

Control objectives for purchases of inventory  Controls are in place to ensure:  Occurrence — all recorded purchases are bona fide transactions in that they relate to goods or services authorized or received  Completeness — all purchases for the period of inventory received are recorded  Accuracy — purchases of goods or services for inventory are recorded correctly as to amount and summarised correctly  Cutoff — purchase invoices have been recorded in correct period  Classification — purchase are classified in accordance with classification policies.

Example of linking control objectives, controls and test of controls: purchases Special control objectives Common controls Tests of controls  Occurrence — All recorded purchases are bona fide transactions in that they relate to goods or services authorised or received.  Approval of purchase order  Goods received are counted, inspected and compared to purchase order before acceptance  Comparison of purchase order, receiving report and supplier’s invoice and recomputation of supplier’s invoice before recording liability  Examine evidence of approved purchase and service orders  Select a sample of order entries in purchases journal, trace back to vouchers and inspect supporting documentation including receiving report, ensuring agreement of details and indication of approval From Table 9.6 (pp. 422–3)

Payroll  The payroll function is usually audited in either of two ways (or best combination):  Focusing on analytical procedures (disaggregated and strong relationships in this area, e.g. comparing fortnightly payrolls)  Tests of transactions over the payroll area with the key control being appropriate segregation of duties in the hiring function, approval of time worked, payroll preparation and payroll distribution.

Payroll (cont.)  If tests of controls are necessary, the following audit procedures may be undertaken:  Authorisation by supervisors of time worked  Check signed time cards/sheets  Check use of approved pay rates (personnel department)  Check for reasonableness, compared with awards.

Substantive tests of transactions and balances

Relationship between tests of controls and substantive tests of transactions  Most controls are built around transaction flows.  Tests of controls: transactions selected to test whether related controls are working. Does not directly measure monetary error in accounting records.  Substantive test of transactions: transactions selected to determine whether monetary errors have occurred.

Dual purpose tests  These are tests of transactions that address both control and substantive matters simultaneously.  Very common in practice since both tests of controls and substantive tests of transactions commonly involve inspection of documents.  It is efficient to perform tests of control and substantive tests on transactions selected simultaneously, e.g. select document and check evidence of authorisation (test of control) and recompute amount (substantive test of transaction).

Relationship between substantive tests of transactions and balances  Objective of substantive tests is to reduce detection risk to an acceptable level.  Substantive tests of transactions focus on the individual transactions that make up the balance.  Substantive tests of balances substantiate the ending balance of an account (which is comprised of multiple transactions).

Distinguishing between substantive tests of transactions and substantive tests of balances >The $5000 balance for Able could be verified by confirming this balance with customer (substantive test of balances) or verifying to supporting documentation the three transactions comprising this balance (substantive tests of transactions).

Financial report assertions and substantive audit procedures  The auditor develops specific audit procedures to evaluate and address the risk of material misstatement for both classes of transactions and events, and account balances.  The risk associated with each assertion is assessed, and substantive audit procedures are directed at specific assertions based on this assessment.

Assertions about transactions and events  Occurrence: in testing whether transactions that generated financial report accounts actually occurred.  Completeness: the auditor identifies evidence indicating items that should be included in the class of transactions and investigates whether they are, in fact, included.  Accuracy: relates to determining the appropriate recording of the dollar value and other information of transactions.

Assertions about transactions and events  Cutoff: involves checking that transactions are recorded in the correct period.  Classification: in designing substantive tests for the assertion of classification, the auditor considers the appropriate classification of the item in the financial report.

Assertions about account balances  Existence: the auditor selects from items contained in the accounting records and obtains evidence that supports them.  Rights and obligations: the auditor must ascertain that the assets are owned/controlled by the client and that the liabilities are those of the client.

Assertions about account balances  Completeness: the auditor identifies evidence indicating items that should be included in the account balance and investigates whether they are in fact included.  Valuation and allocation: the auditor considers the appropriateness of the basis of valuation of the asset or liability and the basis of any allocation of this valuation across accounting periods.

Existence/occurrence and completeness assertions Note that the direction of testing determines whether existence/occurrence or completeness assertion is tested.

Cash, cash receipts and cash payments: assertions of interest CashCash receipts/payments  Existence;  Completeness; and possibly  Valuation and allocation (if foreign currency balances).  Occurrence  Completeness; and possibly  Accuracy (if foreign currency transactions). These are primarily: — since these are areas where misstatements are most likely to occur.

Approach in auditing cash balances  Determined by assessing level of control risk in bank and cash handling procedures.  Much of this information will come from evaluations and tests of controls in the sales and cash receipts system, and the purchases and cash payments system.

Assertions, objectives and procedures for cash receipts and payments (cont.)

Assertions, objectives and procedures for cash Table 10.1 (cont.)

Cash: key procedures  These are:  Obtaining confirmation of bank balances from client’s bankers  Testing of client’s bank reconciliation.

Sales, cash receipts and accounts receivable > Assertions of interest — as these are areas in which misstatements are most likely to occur Sales/cash receiptsAccounts receivable  Occurrence  Accuracy  Existence  Valuation and allocation

Accounts receivable: key audit procedures  Confirmation  Subsequent receipts review  Cutoff  Analytical procedures  Tests of sales transactions  Review of aged trial balance

Assertions, objectives and procedures for sales

Assertions, objectives and procedures for accounts receivable

Accounts receivable confirmation and other procedures  Auditor may obtain confirmation from debtors using:  Positive form — once debtor has been selected, auditor must obtain evidence and asks client to respond, whether or not they agree with information as to amount owed in request. There will be follow-up procedures such as second request, checking invoices to shipping documents to prove sale for any non-response.  Negative form — requests client to respond when they disagree with amount shown.  Auditor should also consider other procedures such as examining evidence of subsequent cash receipts, and examining sales and shipping documents.

Confirmation procedure versus subsequent cash receipts testing Subsequent cash receipts testing is commonly viewed as a superior form of evidence compared with confirmation procedures because it achieves both key assertions. ConfirmationSubsequent cash receipts testing  Existence YES  Valuation and allocation NO  Existence YES  Valuation and allocation YES Confirmation still requires further tests of likelihood of payment (doubtful debts provision), which is part of valuation and allocation.

Purchases and inventory  Inventory consists of goods to be sold or used in the production of saleable goods.  Major transactions involving inventory: increase to inventory when goods purchased and decrease to inventory when goods sold.  Inventory is generally considered high risk because it:  Is significant to determination of income  Involves a high volume of activity  Involves accounting complexities  Is susceptible to manipulation.

Inventory: assertions of interest Two key assertions of inventory are generally:  Existence  Valuation and allocation.

Inventory: key procedures  Observation of physical inventories  Analytical procedures  Cutoff  Tests of pricing and summarisation

Assertions, objectives and procedures for purchases

Assertions, objectives and procedures for inventory

Inventory: observation of physical inventory — stocktake  Where inventory is considered material, auditor should attend a physical inventory count (stocktake), unless impractical.  When attending stocktake, auditor uses a combination of observation, inquiry and making test counts.  If inventory is outside auditor’s area of expertise, he/she should consider utilising services of expert.

Inventory: tests of pricing and summarisation of count procedures  The auditor uses a combination of vouching, tracing and recomputation evidence-gathering procedures. In performing these procedures the auditor’s main concerns are:  Identifying obsolete, excess and slow-moving items  That inventory is counted correctly and that the results of inventory count are updated correctly  That prices for goods are applied appropriately  That inventory is appropriately valued at the lower of the cost and net realisable value

Accounts payable and payments  A primary assertion of concern is completeness, as the most likely form of misstatement is understatement.  Confirmation is a common audit procedure that addresses this assertion.  A search for unrecorded liabilities and analytical procedures performed on related expense account balances are also common procedures for completeness.

Assertions, objectives and procedures for purchases

Table 10.4 (cont.)

Assertions, objectives and procedures for accounts payable

Discussion problem

Non-current assets  The balances of non-current asset accounts are usually affected by a few relatively large transactions each year.  For this reason, it is usually efficient for auditors to verify account balances by performing tests on individual transactions.

Property, plant and equipment  Assertions of interest are generally:  Existence  Rights and obligations  Valuation and allocation.

Property, plant and equipment: key procedures  Substantiating additions and identifying retirements  Considering any revaluations  Analytically testing and recomputing related expense accounts such as depreciation

Assertions, objectives and procedures for property, plant and equipment

Discussion problem

Investments and intangible assets  Assertions generally of interest are:  Rights and obligations  Existence  Valuation and allocation.

Assertions, objectives and procedures for investments

Intangibles — use of experts  Assertions in relation to existence, valuation and allocation for intangible assets are particularly subjective given the nature of intangible assets.  Auditor may consider the use of experts where issues are outside of auditor’s own expertise.

Investments and intangibles: key procedures  Physical examination  Confirmation  Inspection of legal documents  Recomputation, vouching, tracing  Specialised valuation procedures

Non-current liabilities and owners’ equity: key procedures  Key assertion:  Completeness  Key procedures:  Confirmation  Reading minutes of meetings  Examination of contracts and agreements  Inspection of share registers.

Assertions, objectives and procedures: non-current liabilities

Relationship between evidence-gathering procedures  Auditor has to obtain sufficient appropriate evidence to support the audit opinion.  Tests of controls and substantive tests of transactions and balances are the main evidence-gathering audit procedures.  Auditor selects the most efficient and effective combination of audit procedures that allows them to achieve audit objective.  Assertions are used to help them in their risk assessment of material misstatement, and to direct their audit procedures in responding to these risks.

Conclusion and questions