LECTURE 5 Assertions and Tests of Detail University of New South Wales School of Accounting Auditing and Assurance Services 2010 LECTURE 5 Assertions and Tests of Detail

The Audit Process An Audit consists of 3 basic steps: Planning Assessment of business risk Assessment of the internal control environment Evidence Gathering and Evaluation Tests of controls Substantive tests Formation of the Audit Opinion

This Lecture This lecture begins a three lecture series on the evidence gathering and evaluation phase. We will cover: Audit assertions and Tests of detail.

Audit Assertions The information in an account or disclosure may contain many types of errors. For example: Items being omitted, Non existent items being included, Items being entered into the wrong account, Items being recorded at the wrong amount. How can an auditor be sure that every possibility has been dealt with?

Audit Assertions Audit assertions are properties of: an account balance, a set of transactions, a disclosure in the financial statements, that must be true, for the account balance, transaction or disclosure to be correctly stated.

Audit Assertions For financial information (as per ASA 315.A111): About classes of transactions and events: Occurrence – Transactions and events that have been recorded have occurred and pertain to the entity. Completeness – All transactions and events that should have been recorded have been recorded. Accuracy – Amounts and other data relating to recorded transaction and events have been recorded appropriately. Cutoff – Transactions and events have been recorded in the correct accounting period. Classification – Transactions and events have been recorded in the proper accounts.

Audit Assertions (Cont’d) About account balances at the period end: Existence – Assets, liabilities and equity interests exist. Rights and Obligations – The entity holds or controls the rights to assets, and liabilities are the obligations of the entity. Completeness - All assets, liabilities and equity interests that should have been recorded have been recorded. Valuation and Allocation – Assets, liabilities and equity interests are included in the financial report at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.

Audit Assertions (Cont’d) About presentation and disclosure: Occurrence and Rights and Obligations - Disclosed events, transactions and other matters have occurred and pertain to the entity. Completeness - All disclosures that should have been included in the financial report have been included. Classification and Understandability - Financial information is appropriately presented and described and disclosures are clearly expressed. Accuracy and Valuation – Financial and other information is disclosed fairly and at appropriate amounts.

Assertions Example - Inventory XYZ’s financial statements contain a figure of $1,000,000 for inventory This consists of 1,000 computers at $1,000 each. First the 1,000 computers must exist. If there are fewer than 1,000 computers the inventory figure will be overstated. This is the assertion of EXISTENCE.

Assertions Example – Inventory (cont) Second, all the computers must be included. If some are omitted from the accounts, the inventory will be understated. This is the assertion of COMPLETENESS Third, the computers must be worth $1,000. If the values of the individual computers are wrong, the inventory will be overstated or understated. This is the assertion of VALUATION AND ALLOCATION

Assertions Example – Inventory (cont) Finally, XYZ must own the computers. The warehouse might contain computers that do not belong to XYZ. For example, computers that have been sold to customers but have not been delivered yet. These must not be included in the inventory figure. This is the assertion of RIGHTS & OBLIGATIONS

Assertions Example – Sales ABC’s financial statements contain a figure of $10,000,000 for sales This consists of 100,000 transactions with an average amount of $100. First, all the transactions must have actually happened, i.e. they are real sales to real customers. This is the assertion of OCCURRENCE

Assertions Example – Sales (cont) Second, all sales that actually happened must be included in the accounts. This is the assertion of COMPLETENESS Third, the sales transactions must be included in the accounts at the amounts that the customer actually paid. This is the assertion of ACCURACY

Assertions Example – Sales (cont) Fourth, sales must only be included if they occurred during the financial year. This is the assertion of CUT-OFF Finally, only sales transactions should be included in the sales account. Other types of transactions, such as asset disposals, should be excluded. This is the assertion of Classification

Assertions Example - Notes FGH reports subsequent events in Note 20 of its financial statements. First, all the events must be real events and must have resulted in actual economic impacts on FGH This is the assertion of OCCURRENCE AND RIGHTS AND OBLIGATIONS

Assertions Example – Notes (cont) Second, all the subsequent events that actually occurred, must be included in the notes This is the assertion of COMPLETENESS Third, the individual event disclosures must be written in a clear and obvious way, so as not to confuse users. This is the assertion of Classification and Understandability

Assertions Example – Notes (cont) Finally, all the figures in the subsequent event disclosures must be correct. This is the assertion of ACCURACY AND VALUATION

Assertions Relative Importance It should be noted – not all assertions may pose the same risk. The auditor needs to identify the key risk, and the assertion most at risk. Testing will be concentrated on these assertions. However, all assertions must be tested to some degree.

Audit Evidence and Tests To test individual accounts/disclosures we do substantive tests. Tests of detail Substantive analytical procedures A substantive test involves comparison between: Information recorded inside the accounting system, External evidence.

Audit Evidence The auditor shall design and perform audit procedures that are appropriate in the circumstances for the purpose of obtaining sufficient appropriate audit evidence. (ASA 500, p.5). Sufficient = function of quantity Appropriate = function of quality

Sources of Evidence ASA 500 A14 – A25 lists the main sources of audit evidence. These are: Inspection (records or tangible assets), Observation External Confirmation Re-calculation Re-performance, Analytical procedures, Enquiry

Tests of Detail The most basic type of audit test is the test of detail. Tests of detail involve: Selecting a sample of items. Testing the items in the sample. Noting the errors. Based on these errors making an estimate of the overall error in the account.

Tests of Detail Inventory Using the XYZ inventory example Inventory is a balance sheet account so we need to test: existence, completeness, valuation and allocation and rights and obligations Inventory is recorded in the inventory sub-ledger.

Tests of Detail - Inventory Existence and completeness can be tested by conducting a physical stocktake. Existence – Take a sample of inventory items from the inventory sub-ledger and compare the quantities (recorded in the sub-ledger), to those from the physical stocktake Completeness – Take a sample of inventory items from the warehouse, count them and compare the count to the quantities recorded in the inventory sub-ledger.

Tests of Detail - Inventory To test valuation and allocation Take a sample of inventory items from the inventory sub-ledger and compare the recorded cost to: The last sales price of the item, The advertised price of the item. Take a sample of inventory items from the inventory sub-ledger and physically examine the items, to see if they are damaged or obsolete.

Tests of Detail - Inventory To test rights and obligations Take a sample of inventory items and examine the purchase documents, eg invoice, for those items, to check that they are not being sold on consignment. Take a sample of sales invoices and find the matching dispatch dockets. If these cannot be found then check that the sold items are not included in the inventory sub-ledger.

Tests of Detail - Sales Using the ABC sales example Sales is an income statement account so we need to test: Occurrence, completeness, Accuracy Classification Cut-off Sales are recorded in the sales journal.

Test of Detail - Sales To test occurrence To test completeness Take a sample of sales transactions from the sales journal and check that, for every transaction, there is a sales invoice and goods dispatch note To test completeness Take a sample of sales invoices and check that, for every invoice, there is a transaction in the sales journal.

Test of Details - Sales To test accuracy To test classification Take a sample of sales transactions, from the sales journal and, for each transaction, compare the amount recorded in the journal to the total amount on the sales invoice. To test classification Take a sample of sales transactions, from the sales journal and examine the sales invoice to check that it is an actual sale and not some other type of transaction, such as an asset disposal.

Test of Details - Sales To test cut-off we need to know which date the transaction occurred on for revenue recognition purposes. Determine the revenue recognition rule of the business, and therefore the relevant document (such as a sales invoice or delivery docket) that dates the transaction. Take sample of sales transactions, from the sales journal, both during the current period and the next period, and compare the date in the journal to the date on the relevant document (such as a sales invoice or dispatch docket).

Tests of Detail - Notes Using the FGH subsequent events note disclosure example. The subsequent event note is a disclosure, so we need to test: Occurrence and rights and obligations, Completeness, Classification and understandability, Accuracy and valuation. Subsequent events can be audited directly from the draft financial statements.

Tests of Detail - Notes To test occurrence and rights and obligations Take a sample of subsequent event disclosures from the draft financial report, and compare these to the minutes of the board of directors, to see that all disclosures are real and pertain to the company. To test completeness Take a sample of items, from the minutes of the board of directors, and check that each relevant item has a disclosure in the subsequent events note, in the draft financial statements, to see that all relevant material items are included in the note.

Tests of Detail - Notes To test classification and understandability Take a sample of subsequent event disclosures, from the draft financial statements and read them to ensure that they are clear and unambiguous. To test accuracy and valuation Take a sample of subsequent event disclosures, from the draft financial statements, and compare the figures to those in the minutes of the board of directors, to see that the figures are correct. Note, due to the small number of disclosures, the sample will include all items (a 100% sample), for all assertions.

Audit Sampling Tests of detail are based on testing samples; usually random samples. The larger the sample, the more likely the test is to find an error Larger samples are more costly to test. In many cases, individual errors are not material. Statistics and judgment are used to extrapolate to errors in the population (account balance). If this is inconclusive, the sample size may be increased.

Substantive Tests Examples Which substantive tests would you perform to test the following assertions Account Assertion Cash Existence A/C Receivable Valuation and Allocation Interest Expense Occurrence Wages Expense Cut-Off