CHAPTER 12

AUDIT PROCEDURES IN RESPONSE TO

ASSESSED RISKS: SUBSTANTIVE TESTS
Learning Check
12-1. The three steps involved in assessing the risk of material misstatement are:
1. Evaluate the type of potential misstatement(s) that may occur, such as evaluating
whether a risk is a financial statement level risk or an assertion level risk.
2. Evaluate the magnitude of the potential misstatement(s). For example, the auditor is
attempting to determine if the magnitude could of misstatement could aggregate to a
material amount.
3. Evaluate the likelihood of potential misstatement(s). This is a matter of determining
whether the probability of misstatement is very probable or the probability of
misstatement is remote.
12-2. If there is a significant risk of material misstatement due to financial statement level risks
the auditor will increase the level of substantive testing for many assertions. For
example, if management communicates the message that it is critical that the company
meet its financial targets, the auditor might increase the level of substantive testing for
revenue recognition, the completeness and classification of expenditures, as well as for
many accounting estimates in the financial statements. If the risk of material
misstatement is limited to one assertion, such a poor controls over the collection of
receivables, the auditor will increase the level of substantive testing specifically related to
the valuation and allocation assertion for receivables.
12-3. Following are examples of risks of material misstatement that might be found while
performing various risk assessment procedures.
Risk Assessment Procedure
a. Understanding the entity and its
environment
b. Performing analytical procedures

Risk of Material Misstatement

a. A companys most significant product is at
a mature stage and sales are beginning to
decline. This may affect the net realizable
value of inventory.
b. A company may report flat sales,
increasing levels of inventory, and
increasing gross profit margins. This may
indicate a problem with the existence and
occurrence of inventory.

c. Understanding the risk of fraud

d. Understanding inherent risks

e. Understanding the entitys system

of internal control

12.4.

c. A company may be very close to not

meeting its debt covenants. This might
increase the risk that company might
engage in fraudulent financial reporting to
report that it in fact met debt covenants.
d. The calculations associated with the
valuation of a large retail inventory using
the retail method represents a significant
inherent risk that is focused on the
valuation assertion for inventory.
e. A owner-managed company might allow
the bookkeeper to write and sign check
with little supervision or review by the
owner. This would increase the risk for
the existence and occurrence assertion for
expenditures.

The following bullets summarize each preliminary audit strategy, the appropriate level of
planned detection risk, the planned audit procedures that provide significant assurance,
and whether a higher or a lower level of assurance is needed from substantive tests.
A Primarily Substantive Approach requires a low planned level of detection risk for
tests of details, audit assurance is needed primarily from tests of details of transaction
or tests of details of balances, and the level of assurance needed from substantive tests
is high.
A Lower Assessed Level of Control Risk Approach usually results in a high planned
level of tests of details risk due to the fact that significant assurance is obtained from
tests of controls. As a result, the level of assurance that is needed from substantive
tests is low.
Emphasis on Inherent Risk and Analytical Procedures represents an audit strategy
associated with assertions where inherent risk is assessed below the maximum and the
planned tests of details risk is moderate or high. Evidence is needed from risk
assessment procedures to support an inherent risk assessment below the maximum
and substantive tests are performed using analytical procedures. The planned level of
assurance from substantive test of details is often moderate, as the auditor obtains
assurance from analytical procedures and the auditors knowledge of the business and
industry.

12-5. A revised or final acceptable level of detection risk is determined for each assertion after
(1) assessing inherent risk, (2) performing analytical procedures in audit planning, (3)
assessing the risk of fraud for an assertion, and (4) making a final assessment of control
risk for relevant controls. A risk matrix or the audit risk model can be used to solve for
the revised acceptable level of detection risk associated with analytical procedures and
tests of details based on the actual assessed levels of inherent and control risk and the
auditor's specification of audit risk.

12-6. The following table compares and contrasts tests of controls and substantive tests.
Tests of Controls
Tests of the control environment
Tests of the clients risk assessment system
Tests of the information and communication
system
Tests of control activities
Tests of the monitoring system
Tests of antifraud programs and controls

a.

Types

b.

Purpose

c.

Nature of test
measurement
Applicable audit
procedures

d.

Determine effectiveness of design and operation

of internal controls
Frequency of deviations from designed controls
Inquiring, observing, inspecting, reperforming,
and computer assisted audit techniques.

e.

Timing

Primarily interim work1

f.
g.

Audit risk component

Primary fieldwork
standard
Required by GAAS

Control Risk
Second.

h.

Substantive Tests
Initial procedures
Analytical procedures
Tests of details of transactions
Tests of details of balances
Tests of details of accounting
estimates
Substantive tests required by GAAS
Tests of details of disclosures
Determine fairness of significant
financial statement assertions.
Monetary errors in transactions and
balances.
Same as tests of controls, plus
analytical procedures, counting,
confirming, tracing, and vouching.
At balance sheet date or one or two
months prior to year-end.2
Detection Risk
Third

When audit risk cannot be reduced to a

Yes
sufficiently low level by substantive tests alone.
Concurrent tests of controls are performed in audit planning with procedures to obtain an understanding of the system
of internal control. Additional tests of controls are performed during interim fieldwork.
2
Tests of details of transactions may also be performed with test of controls as dual-purpose tests during fieldwork.

12-7. a.

b.

The purpose of substantive tests is to provide evidence about the fairness of each
significant financial statement assertion, or conversely, to reveal monetary errors
or misstatements in the recording or reporting of transactions and balances.
As detection risk increases substantive tests should be more effective and auditors
should seek more reliable evidence related to the assertion.

12-8. There are several types of initial procedures that are performed before proceeding to
other substantive tests. First, it is important for the auditor to have an understanding of
the economic substance of the transactions that are subject to audit. Second, it is
important to trace beginning balances in the general ledger to the audited balances in the
prior years financial statements.
Two initial procedures that require special consideration in a first time audit are (1)
determining the propriety of the account balances at the beginning of the period being
audited, and (2) ascertaining whether the accounting principles used in the preceding
period are the same as those used in the current period as a basis for determining the
consistency of application of principles. This is normally accomplished by reference to
the working papers of a predecessor auditor. In a continuing engagement this can be
accomplished by reference to the prior years working papers.
1
2

12-9. a.

b.

The primary advantage of analytical procedures is that they are very cost effective
and they are also reasonably effective at identifying accounts that may contain
unintentional misstatements. The primary disadvantage is that analytical
procedures are usually considered less effective than tests of details. They are
also less effective at identifying accounts that are intentionally misstated as the
balances have usually been misstated to appear reasonable.
The auditor should consider the following matters when designing substantive
analytical procedures:

The suitability of the substantive analytical procedure given the assertion.

The reliability of the data, whether internal or external, from which the
expectation of recorded amounts or ratios is developed.

Whether the expectation is sufficiently precise to identify a material

misstatement at the desired level of assurance.

The amount of any difference of recorded amounts from expected values

that is acceptable.
In some cases where substantive analytical procedures are effective, they may
also add to the efficiency of the audit. For example, for public utilities and cable
companies, relatively small amounts of revenue are billed to and collected from
many thousands of customers each month. Tests of details of these high-volume,
low-value revenue transactions would be very tedious and costly. On the other
hand, revenues in such cases can often be estimated with a fair degree of precision
using independent variables such as number of subscribers, billing rates for
various types of services, temperature data (for electric and gas utilities), and so
on. Alternatively, total sales commissions expense could normally be estimated
from total sales revenues rather than examining the details of entries to sales
commissions.

c.

In some cases the auditor can obtain good nonfinancial information about the
underlying drivers of revenues and expenses and use that information to estimate
revenues or expenses. The following table provides several examples.
Account
Hotel room revenue
Tuition revenue
Wages expense
Gasoline expense
Commission Expense

Analytical Procedure
Number of rooms x Occupancy rate x Average
room rate.
Number of equivalent fulltime students x Tuition
rate for a fulltime student
Average number of employees per pay period x
Average pay per period x Number of pay
periods.
Number of miles driven Average miles per
gallon x Average per gallon cost.
Sales x Commission Rate

Income statement accounts may be tied directly to an underlying economic driver

(cost driver). Balance sheet accounts are subject to transactions that cause both
increases and decreases and may be less predictable. Hence, analytical
procedures may provide more assurance about the fair presentation of income
statement accounts.
12-10. a.

Tests of details of transactions primarily involve tracing and vouching to test for
understatements and overstatements, respectively. Other procedures may also be
used such as inquiring and reperforming calculations.

b.

Tests of details of transactions are typically more time consuming and thus more
costly to perform than analytical procedures, but less costly than tests of details of
balances. Their cost-efficiency is enhanced when performed concurrent with tests
of controls as dual-purpose tests.

c.

Tests of details may be applied directly to income statement accounts when

evidence obtained from tests of related balance sheet accounts does not reduce
detection risk to an acceptably low level. This may include situations in which:
Inherent risk is high, such as when (1) nonroutine transactions or (2)
managements judgments and estimates affect assertions.
Control risk is high either because (1) related internal controls for nonroutine
and routine transactions are ineffective, or (2) the auditor elects not to test the
internal controls.
Analytical procedures reveal unusual relationships and unexpected
fluctuations.
An account requires analysis because it (1) requires special disclosures in the
income statement, (2) contains information needed in preparing tax returns or
reports for regulatory agencies such as the SEC, or (3) has a general account
title that suggests the likelihood of misclassifications and errors.

12-11. a.

Tests of details of balances focus on obtaining evidence directly about an account

balance (e.g., accounts receivable) rather than the individual debits and credits
comprising the balance. Testing the individual debits and credits is a test of
transactions.

b.

12-12. a.

Tests of details of balances often involve the use of external documentation and/or
the direct personal knowledge of the auditor. Therefore, they can be very
effective. They also tend to be the most costly to perform.
Tests of accounting estimates involve understanding the entitys process of
estimating future outcomes (e.g., the receivables that will not be collected in the
future or the costs of providing warranty coverage in the future) of past
transactions. This requires significant knowledge of the business, industry, and
economy.

b.

12-13. a.

When evaluating the reasonableness of an accounting estimate the auditor should

determine that
All accounting estimates that could be material to the financial statements
have been developed.
The accounting estimates are reasonable in the circumstances.
The accounting estimates are presented in conformity with applicable
accounting principles and are properly disclosed.
As detection risk for test of details decreases, the auditor should perform
substantive tests of balances closer to, or at, year-end.

b.

The decision whether to perform substantive tests prior to the balance sheet date
should be based on whether the auditor can:
Control the added audit risk that material misstatements existing in the
account at the balance sheet date will not be detected by the auditor. This risk
becomes greater as the time period remaining between the date of the interim
tests and the balance sheet date is lengthened.
Reduce the cost of substantive tests necessary at the balance sheet date to
meet planned audit objectives so that testing prior to the balance sheet date
will be cost effective.

c.

The potential added audit risk can be controlled if substantive tests for the
remaining period can provide a reasonable basis for extending the audit
conclusions from the tests performed at the interim date to the balance sheet date.
Conditions contributing to the control of this risk are:
The internal controls during the remaining period are effective.
There are no conditions or circumstances that might predispose management
to misstate the financial statements in the remaining period.
The year-end balances of the accounts examined at the interim date are
reasonably predictable as to amount, relative significance, and composition.
The client's accounting system will provide information concerning
significant unusual transactions and significant fluctuations that may occur in
the remaining period.

12-14. As a general rule, detection risk and the extent of substantive test are inversely related;
i.e., the lower the acceptable level of detection risk, the more extensive the substantive
tests should be. Note however, that the auditor has choices between substantive tests
involving analytical procedures and substantive tests involving tests of details.
12-15. Traditionally, account balance assertions focus on the balance sheet and transaction
assertions focus on the income statement and statement of cash flows. However, when
performing tests of account balance assertions the auditor often learns about the fair
presentation of transactions. For example, if the auditor learns that inventory is
overstated, it usually implies that cost of sales is understated. If accounts receivable is
overstated, sales might also be overstated.

12-16. a.

b.

12-17. a.

The auditor's objectives in auditing related party transactions are to obtain

evidential matter as to (1) the purpose, nature, and extent of these transactions and
(2) their effect on the financial statements.
Substantive tests that may be used in auditing related party transactions include
the following:
Obtain an understanding of the business purpose of the transaction.
Examine invoices, executed copies of agreements, contracts, and other
pertinent documents, such as receiving reports and shipping documents.
Determine whether the transaction has been approved by the board of
directors or other appropriate officials.
Test for reasonableness the compilation of amounts to be disclosed, or
considered for disclosure, in the financial statements.
Arrange for the audits of inter-company account balances to be performed as
of concurrent dates, even if the fiscal years differ, and for the examination of
specified, important, and representative related party transactions by the
auditors for each of the parties, with appropriate exchange of relevant
information.
Inspect or confirm, and obtain satisfaction concerning, the transferability and
value of collateral.
An audit program is a list of audit procedures to be performed.

b.

The general framework for developing an audit program must accomplish two
tasks.
1) It should describe the nature of procedures to be performed.
2) It should ensure that audit evidence is obtained for all financial statement
assertions (audit objectives).

c.

Audit programs should be sufficiently detailed to provide:

An outline of the work to be done.
A basis for coordinating, supervising, and controlling the audit.
A record of the work performed.
In addition to listing audit procedures, each audit program should have columns
for (1) cross-references to other working papers containing the evidence obtained
from each procedure (when applicable), (2) the initials of the auditor(s) who
performed each procedure, and (3) the date performance of the procedure was
completed.

12-18. a.

Six types of substantive audit procedures that are normally included in an audit
program are:
1) Initial procedures.
2) Substantive analytical procedures.
3) Tests of details of transactions.

4) Tests of details of balances.

5) Tests of detail of accounting estimates.
6) Tests of details of disclosures.
b.

Audit programs describe the nature of audit procedures to be performed. A well

designed audit program should include audit procedures to obtain sufficient,
competent evidence about each relevant financial statement assertion (or audit
objective).