AUDITING: A RISK

ANALYSIS APPROACH
5th edition

Larry F. Konrath

Electronic Presentation
by Harold
O. Wilson
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CHAPTER 13

SUBSTATIVE AUDIT
TESTING:

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KEY CONCEPTS OVERVIEW
■ Investing (dangers of asset
overstatements)
■ Borrowing (dangers of debt
understatements)
■ Stockholders’ equity transactions
■ Audit risk analysis
■ Communications

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 LEARNING
OBJECTIVES
■ Identify audit objectives related to financing
and investing cycle.
■ Develop audit programs and procedures for
related party dealings, subsequent events.
■ Modify audit programs in light of “warning
signs,” analytical procedures, etc.
■ Complete audit field work (Representation
Letter, Reportable Conditions, Management
Letter, draft of audit report).
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FINANCING & INVESTING
CYCLE Concerns
■ Nature of the Financing Cycle
■ Internal Controls
■ Examining & confirming securities,
agreements, minutes, accruals
■ Audit Judgment: analytical procedures,
related-party dealings, subsequent events,
disclosures
■ Management Discretion and Intention
■ Full disclosure
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FINANCIAL INSTRUMENTS:
Using Capital (Lending)
■ Commercial Bonds
■ Marketable equity securities
(corporate stocks)
■ Treasury bills
■ Real estate

Related receivables, revenues,

and accounting for losses and gains!
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FINANCIAL INSTRUMENTS:
Raising Capital (Borrowing)

■ Bonds
■ CapitalLeases
■ Deferred Taxes

Related expenses (e.g., interest,

commissions, fees, taxes)
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STOCKHOLDERS’ EQUITY
TRANSACTIONS

■ Stock issues
■ Stock retirements
■ Dividends
■ Retained Earnings
■ Treasury stock
■ Stock options

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 FAQ?

What basic audit procedures add

creditability to assertions about
investments, debts, and equity?
Analyses of material accounts end with a
schedule of components. Accruals, gains
& losses should be calculated or verified.
Verify the material changes, and selected
FYE components (substantive testing).
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INVESTING TRANSACTIONS
■ Audit risk relates to existence, ownership,
completeness of securities.
■ Securities may be collateral for loans
(disclosure required).
And, how are securities
II
classified?

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Valuations of Securities
■ GAAP requires classifications:
– Trading Securities.
– Available-for-Sale Securities.
– Held-to-Maturity Securities.
■ “Intent,” [Motive!] and ability, and
“paper” gains & losses must be
scrutinized under current GAAP as
part of the audit.
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INTERNAL CONTROLS:
SECURITIES
■ Custody (internal vs. external).
■ Dual authority required.
■ Detailed records and periodic physical
counts and/or confirmations.
■ Acquisitions & dispositions approved by
appropriate committee(s)/Board.
■ Incomes monitored, verified.

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 FAQ?
Investments must be properly
accounted for under GAAP; what
criteria supports presenting
securities under current assets?
BOTH marketability and management
intent! Valuation principles, pledging,
and losses/gains must follow GAAP!

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SUMMARIZED AUDIT
PROGRAM: Investments
■ Confirm transactions/balances with *
trustee or transfer agent.
■ Inspect securities held by client, noting *
changes in serial numbers from prior year(s).
■ Verify cutoff procedures, consistency *
with recorded details.
■ Verify incomes earned, accrued.
■ Trace information through records
(documents through General Ledger) *
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SUMMARIZED AUDIT
PROGRAM: Investments
■ Verify losses/gains (both realized &
unrealized & disclosure of same.
■ Compare records with records of all
related parties & affiliates’ records,
to verify form vs. substance issues.
■ Scrutinize authorizations and prove
mathematics for changes, fair
values; compare data to trends, etc.
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Clues from cases…are there…
■ Inordinate third-party dealings, pressures?
■ Unusual sales of receivables?
■ “Gloomy” industry trends (e.g., layoffs)?
■ “Gloomy” trends in client’s customers?
■ High-tech with low assets?
■ Cycles of mergers, seasons, finances?
■ High fixed costs and low adaptability?
■ Unique industries, unique scenarios?

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BORROWING
TRANSACTIONS Concerns
■ Are all long-term debts included?
■ Should leases be capitalized?
■ Do “timing differences” create taxes
due or deferred?
■ Are net present values being reported?
■ Any possibility of lease or troubled
debt defaults or restructurings?
■ Data for disclosures, footnotes adequate?

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INTERNAL CONTROLS:
DEBT & EQUITY
■ Extensive documentation
exists, e.g., Board
approvals, minutes.
■ Unissued certificates controlled; all
certificates pre-numbered..
■ Detailed compared to physical items.
■ Extensive filing requirements [SEC].

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 INTERNAL CONTROLS:
ISSUANCE of DEBT
■ Reviews for compliance with covenants.
■ Dual authority required.
■ Detailed records, confirmation.
■ Interest payments, accruals monitored.
■ Premiums/discounts recorded.

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SUMMARIZED AUDIT
PROGRAM: Long-Term Debt

■ Confirm transactions/balances with *

creditors/bondholders, “lessors.”.
■ Examine agreements/indentures, note *
covenants, compliance, pledges, etc.
■ Verify cutoff procedures, consistency *
with recorded/”unissued” details.
■ Verify expenses incurred, accrued. *
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INTERNAL CONTROLS:
EQUITY ISSUES
■ Issuance/retirement/treasury shares
& dividends approved by Board
and/or appropriate committee(s).
■ Reviews for compliance:
– with shareholder covenants.
– with laws.
■ Detailed records, as with Transfer
Agents, confirmed, reconciled.

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SUMMARIZED AUDIT
PROGRAM: Capital Stock

■ Confirm transactions/balances with *

owners and/or transfer agents.
■ Analyze & verify all changes in all
stock accounts (e.g., dividends,
splits, options, treasury shares). *
■ Verify cutoff procedures, consistency *
with recorded/”unissued” details.

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SUMMARIZED AUDIT
PROGRAM: Capital Stock

■ Verify dividend approvals, payments.

*
■ Investigate any property dividends.
■ Review minutes & applications of *
GAAP, and math for above dealings. *
■ Verify EPS propriety, math, disclosure.
*

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 FAQ?
After all assets and liabilities & other
stockholders’ equity accounts are
audited, what is done to verify Retained
Earnings, per se, since it is intangible?
R.E., is a “plug;” however, the
“known” debits & credits should
include net income and dividends!
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Clues from cases…
■ Abnormal ratios & trends?
■ Complications with taxes, IRS?
■ Unusual accounting/GAAP applications?
■ International competition, complications?
■ Inordinate contingencies, lawsuits?
■ Unusual inventory changes, problems?
■ Unusual changes in personnel (actual,
pending)?
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RISK ANALYSIS SOURCES
Although evidence and clues emerge as the
audit progresses, sources of inputs for
audit attention are ever-present, such as…
■ Management inquiry
■ Auditor’s current and prior workpapers
■ Permanent files
■ Predecessor audit correspondence, contact
■ Analytical procedures
■ Industry guides/GAAP

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AUDIT RISK ANALYSIS:
Related Party Transactions
■ Form vs. substance
■ Conflicts of interests; Refunding of loans
■ Excessively risky investments
■ Complex practices, policies, structures
(e.g., transfers of problem loans)
■ Inadequate loss reserves
■ Unusual, excessive dealings with affiliates,
especially near FYE
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AUDIT RISK ANALYSIS:
Potential debt defaults
■ Meeting agreements, requirements
■ Potential restructurings
■ Ability to continue as a going concern
■ Derivatives, per se (undue speculation)
■ Disposals of segments (GAAP)

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SUMMARIZED AUDIT
PROGRAM: Valuations
■ Investments: Examine brokers’ advices;
compare to current market quotations.
■ Long-Term Debt: Confirmations provide
valuations; calculate premium/discounts.
■ Capital Stock: Verify to Board minutes,
issuance documents, etc.
■ Verify consistency of all with GAAP
and disclosure guidelines.
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AUDIT PROGRAM: Analytical
Procedures include ...
• Compare current transactions with
prior year incomes, expenses.
•Compare percentages for balances,
incomes, ROI, etc., to trends.
•Compare prior disclosures &
footnotes with current plans.
•Scan for clues to misstatements,
“aggregate” materiality, etc.
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AUDIT RISK ANALYSIS:
Subsequent Events
■ Type I: Events that provide additional
evidence with respect to conditions that
existed at FYE, and affect estimates
inherent in financial statements.
[AJEs likely!]
■ Type II: Events that provide evidence with
respect to conditions that did not exist at
FYE, but arose after FYE.
[Footnotes likely!]
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AUDIT RISK ANALYSIS:
Subsequent Events’ Clues
■ Interim financial statements
■ Substantial contingent liabilities, contracts
■ Changes in capital stock, LTD
■ Earlier estimates, tentative data
■ Unusual AJEs booked
■ Minutes of executive committees
■ Representation Letters
■ Communication with legal counsel

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“CLOSING”
CONSIDERATIONS
■ Cash Flow analysis, etc.
■ Workpaper review (complete, indexed &
“tied in,” no “pending” matters or open
items, etc.)
■ All exceptions cleared!
■ Auditor/Client conference (discussion of
adjustments, draft of Audit
Report/opinion, and draft of
Management Letter contents)
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CLIENTS NOR AUDITORS
LIKE SURPRISES!

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“CLOSING”
CONSIDERATIONS
■ Audit Committee communications:
– GAAS, auditor responsibility
– Nature of an audit
– Accounting policies, adjustments
– Managements’ responsibilities
– Compromises, difficulties encountered

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“CLOSING”
CONSIDERATIONS
■ Client Representation Letter (if refused, it
becomes a scope limitation):
– Confirms oral and written understandings
– Some assurance of auditor-client cooperation
– Psychological pressure on client

NO RELIEF OF AUDITOR RESPONSIBILITY!

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COMMUNICATIONS:
Representation Letter Contents
■ Financial Statements & management
beliefs, assurances
■ Completeness of information, availability
■ Accounting principles (recognition,
measurements, disclosures)
■ Internal controls
■ Subsequent events
■ Cooperation!

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COMMUNICATIONS:
Reportable Conditions Letter
■ Material internal control concerns of the
auditor
■ Addressed to the Audit Committee (copy to
each member, separately mailed) with
restricted distribution indication
■ Discussion of objectives of audits
■ Defines and lists“Reportable
conditions”
■ Some auditor protection!

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COMMUNICATIONS:
Management Letters
Management Letter comments to improve
controls and/or surveillance.
Reportable conditions include weaknesses
AND potential for improper activities and
for fraud.

Complex transactions challenge auditors

and management--
as both are under pressure!
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COMPUTER USES &
STATISTICAL SAMPLING
In general, investments, debts & equity
changes are not “statistically sampled,”
per se, although such techniques are
applied on large audits.
Transactions are usually in “large blocks”
with extensive documentation.
Don’t forget professional skepticism!
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Critical Key Terms
■ Accounting ■ Professional
symmetry skepticism
■ Representation ■ Irregularities
Letter ■ Debt agreements
■ Management Letter ■ Form vs. Substance
■ Materiality ■ Loan defaults
thresholds ■ Reportable
■ Collateral conditions
■ Derivatives ■ Subsequent events

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End of Chapter 13

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