Prepared by: Angela Davis CA, CFE, MSc Booth University College Copyright John Wiley & Sons Canada, Ltd.

SUBSTANTIVE TESTING AND BALANCE SHEET ACCOUNTS Explain the relationship between the overall risk assessment for a significant account and the extent and timing of substantive procedures Design and understand how to execute substantive procedures to address audit risk related to cash Design and understand how to execute substantive procedures to address audit risk related to trade receivables Design and understand how to execute substantive procedures to address audit risk related to inventory Design and understand how to execute substantive procedures to address audit risk related to property, plant, and equipment Design and understand how to execute substantive procedures to address audit risk related to payables Understand how substantive testing is used for other balance sheet accounts Understand how to assess the results of substantive procedures to determine whether additional substantive tests are necessary Copyright John Wiley & Sons Canada, Ltd.

Risk and substantive procedures Extent of substantive procedures Determined by risk assessment Trivial or immaterial accounts are either ignored or subjected to analytical procedures only Audit risk model used to make a risk assessment on each significant account or disclosure High IR, CR: do not rely on and test controls, use significant amount of substantive testing to reduce DR to acceptable level Low IR, CR: testing controls shows them to be effective, limited substantive testing required Copyright John Wiley & Sons Canada, Ltd.

Risk and substantive procedures cont’d 2. Timing of substantive procedures Also determined by risk assessment Lower DR, more work done at year-end Audit firm must also consider availability of resources to conduct procedures around year-end Use techniques to influence schedule: Review events prior to year-end, e.g. acquisitions Review activity in period to date, e.g. review interim ageing of trade receivables then update at year-end Perform general audit procedures prior to year-end, e.g. read board minutes Review provisions prior to year-end, e.g. understand estimation processes used by management Leverage off internal audit (CAS 610) Copyright John Wiley & Sons Canada, Ltd.

Risk and substantive procedures cont’d Figure 10.2 Copyright John Wiley & Sons Canada, Ltd.

Risk and substantive procedures cont’d 3. Other matters to consider in designing substantive procedures Ensure procedures respond to specific risk faced by client from both IR and CR factors Different clients may have same overall level of risk but risk caused by different factors – procedures would be also different Take credit for work already done – early work in audit to assess risk also provides evidence Set appropriate testing thresholds – what does auditor consider important for this audit? Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Cash Most important assertions: existence, completeness, classification Existence Usually addressed by bank confirmation (CAS 505) Completeness Test bank reconciliation and cut-off of cash transactions Verify reconciling items to next period bank statement Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Cash cont’d Classification Important because of special disclosure requirements Rights and obligations assertion also significant where clients may pledge assets Pledging restricts client’s rights over cash Valuation and allocation usually only an issue when client has significant foreign currency bank accounts Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Cash cont’d Table 10.1 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Cash cont’d Processes impacting on the audit of cash Auditor assesses evidence obtained from interim testing on significant transactions, control testing When CR low, unlikely to do additional testing on cash receipts and payments, focus on balance If CR not low, substantive tests of receipts and payments may be required Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Cash cont’d Table 10.2 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Cash cont’d Table 10.2 (continued)

Substantive testing – Cash cont’d Testing cash account balances always done at some level, additional procedures required as risk assessment increases Tests include bank confirmations, bank reconciliation re-performance, analytical procedures etc Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Cash cont’d Table 10.3 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Trade Receivables Most important assertions: existence, valuation & allocation Existence Usually addressed by confirmation (CAS 505) Positive confirmation: auditor requests reply in all circumstances Negative confirmation: auditor requests reply only if debtor disagrees with balance shown Confirmations do not provide assurance about valuation because they do not address recoverability Examine receipts of cash by client after year end to assess valuation at balance date Copyright John Wiley & Sons Canada, Ltd.

Debtor’s confirmation

Substantive testing – Receivables cont’d Valuation & Allocation Use subsequent receipts test Analytical procedures based on ageing Classification assertion can also be important because of disclosures, such as related parties and financial instruments Rights & obligations can also be important because of restrictions on trade terms Completeness can be addressed through cut-off testing Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Receivables cont’d Table 10.4 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Receivables cont’d Processes impacting on trade receivables Most important transactions impacting the balance of receivable are sales, sales returns and allowances, cash receipts Usually, auditor relies on control testing of these transactions to confirm low CR If CR not low, substantive tests required for the transactions Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Receivables cont’d Table 10.5 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Receivables cont’d Table 10.5 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Receivables cont’d Table 10.5 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Receivables cont’d Table 10.5 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Receivables cont’d Table 10.6 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Receivables cont’d Table 10.6 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory Most important assertions: existence, valuation & allocation Existence Usually addressed by testing client’s annual or cyclical inventory count (CAS 501) Auditor tests client’s verification of physical inventory with records, and auditor must sight inventory If controls not strong or if physically difficult to count inventory often the inventory count is performed annually Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Valuation & allocation Important inventory recorded at the appropriate carrying value Viewing inventory at the inventory count allows auditor to assess slow-moving, damaged, obsolete, impaired, excess inventory which should be written down Typical techniques: Vouching to invoices to verify initial cost Vouching to sales details to verify cost of sales Test provision for impairment calculations Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Completeness not usually a major issue, but risk of understatement can be issue where goods sold on consignment Rights & obligations also relevant for some clients due to consignment sales, complex purchasing contracts Classification usually addressed by testing inventory listing, allowing verification of disclosures Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.7 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Processes impacting inventory Purchasing, cash payments, and inventory records Usually, auditor relies on control testing of these transactions to confirm low CR If CR not low, substantive tests required for the transactions Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.8 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.8 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.8 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.8 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.8 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.9 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.9 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Inventory cont’d Table 10.9 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – PPE Most important assertions: existence, valuation & allocation Existence Verify items recorded in client’s fixed asset register Physically sight assets listed in first audit and periodically for subsequent audits Focus on additions and disposals in later years Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – PPE cont’d Valuation & allocation Evidence about condition gathered when sighting physical assets Consider appropriate cost, carrying value or fair value (IAS 16), and asset impairment Change in client operations could impact fair values Vouch initial cost to invoices, contracts Vouch disposals to sales contracts, receipts Test depreciation through reasonableness testing of depreciation charge compared to cost base and useful life of the asset Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – PPE cont’d Completeness not usually major issue Rights and obligations – tested during initial audit then test periodically depending on type of assets in the register Tests include verifying Registered titles, registration papers, invoices Lease agreements Classification - generally addressed by testing fixed asset register Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – PPE cont’d Table 10.10 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – PPE cont’d Processes impacting PPE Cash receipts, cash payments, purchasing Substantive testing when CR high Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – PPE cont’d Table 10.11 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – PPE cont’d Table 10.11 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – PPE cont’d Table 10.12 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing - Payables Most important assertions are completeness and valuation & allocation Major risk is understatement Use subsequent payments testing Vouch payments after balance date to invoices to verify invoices dated prior to year-end are included in payables Cut-off testing Select sample of purchases either side of year-end and verify that each included or excluded from payables based on invoice date Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Payables cont’d Existence and rights & obligations not usually important because they relate more to risk of overstatement Classification important if there are related party transactions, lease commitments or other forms of finance included in the payables balance Accruals are treated in same way as payables, search for unrecorded amounts through subsequent payments testing Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Payables cont’d Table 10.13 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Payables cont’d Table 10.14 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Payables cont’d Table 10.14 (continued) Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Payables cont’d Table 10.15 Copyright John Wiley & Sons Canada, Ltd.

Substantive testing – Other Most other accounts are typically audited substantively because they do not rely on high volume processes and specific application controls Auditor’s objective is to identify and quantify any errors Understand why error occurred Assess need for additional testing Make final estimate of misstatement, assess materiality Copyright John Wiley & Sons Canada, Ltd.

Copyright John Wiley & Sons Canada, Ltd.