CHAPTER 12 Audit Strategy in Response to Assessed Risks Fall 2007 u Designing Substantive Tests u Special Consideration in Designing Substantive Tests.
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CHAPTER 12 Audit Strategy in Response to Assessed Risks Fall 2007 u Designing Substantive Tests u Special Consideration in Designing Substantive Tests
Designing Substantive Tests In each audit, there are certain substantive procedures that must be performed: 1.Initial procedures 2.Analytical procedures 3.Tests of details of transactions 4.Tests of balances including estimates 5.Tests of disclosures
Initial Procedures Before doing any detailed testing: Economic substance of transactions Consistency of accounting principles applied “Tie out” beginning balances and detailed records How do we do each of these?
Recall the AR Model AR = IR x CR x AP x TD When do we focus on each category of substantive tests? –Analytical procedures –Tests of transactions –Tests of balances
Use: -Top-down:to identify areas of greater risk of misstatement and identify where need to do more tests of details -In testing phase: as a substantive test of a balance Fundamental Assumption: - Relationships are expected to persist in absence of information to the contrary Effectiveness and efficiency depends on: -Nature of the assertion -Plausibility and predictability of the relationship -Availability reliability of data used to develop expectation -Precision of the expectation Analytical Procedures
Analytical Procedures cont’d Examples: -Ratio analysis -Comparisons with prior year -Comparisons with industry data -Common sized analysis -Budget to actual -“Reasonableness tests” -Depreciation expense -Amounts based upon contractual obligations -Use of non-financial metrics: # subscribers, ticket sales, miles flown, etc.
Use: -Bottom up test of individual transactions and the related journal entries -Generally involve tracing and vouching -May involve a sample to reach conclusion about an account balance Fundamental Assumption: -If the transactions are appropriate, then the acct balance is too Examples -Vouch recorded sales & AR to source documents -Trace shipments to Sales journal -Examine certificates of title for PPE additions Tests of Details of Transactions
Tests of Details of Balances Use: -Bottom up test of individual account balances rather than individual debits and credits -Sampling can be used to draw a conclusion about the whole balance Fundamental Assumption: - Effectiveness depends upon the procedure performed & evidence obtained Examples not related to estimates -Obtain bank confirmation -Recalculate accrued interest expense -Count ending inventory
Tests Balances: Estimates What is an “accounting estimate”? -Amount uncertain, pending future events -Event already occurred, but can’t be easily determined Fundamental Assumption -Management responsible for making estimate -Auditor responsible for auditing it How to audit an estimate (SAS 57) -Consider relevant economic, industry & co factors -Understand how management develops estimate -Evaluate reasonableness of estimate -Review and test the process used by management -Develop an independent expectation of the estimate to corroborate the reasonableness of management's estimate. -Review subsequent events or transactions
Tests of Disclosures Think about the appropriate footnotes Read text for consistency with your understanding of the transactions and accounting policies Test any “numbers” Related party transactions Use disclosure checklist
Related Party Transactions Responsibilities Consider need for disclosure Understand business purpose Examine supporting documents Test for approval by BOD Consider need for coordination with audits of other party
More evidence is needed to achieve a low acceptable level of detection risk than a high detection risk. “Extent” is used in practice to mean the number of items or $ as a percentage of total to which a particular test or procedure is applied. This generally involves sampling. Extent of Substantive Tests