CHAPTER 10: SUBSTANTIVE TESTS AND DOCUMENTATION

Evidence, Procedures, Substantive tests, Working Papers

AUDIT EVIDENCE
Audit Risk Attributes of Audit Evidence

Audit Risk
The possibility that the auditors may

unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated
This is the risk that the auditors will issue an

unqualified opinion on financial statements that contain a material departure from GAAP.
Auditors must obtain sufficient appropriate audit

evidence to reduce audit risk to a low level in every audit.

Audit Risk
Audit Risk = = Risk of Material Misstatement Inherent Risk * Risk That the Auditors Fail to Detect Misstatement Control Risk Detection Risk

Inherent Risk--Risk of a material misstatement occurring in an

assertion assuming no related internal controls.

Control Risk--Risk that a material misstatement in an assertion will

not be prevented or detected on a timely basis by the companys internal control.

Detection Risk--Risk that the auditors procedures will lead them to

conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

Audit Risk

Audit Evidence Concept

PSA 500 Evidence (Redrafted), par. 6 Audit

The auditor shall design and perform audit procedures that are appropriate in the circumstances for the purpose of obtaining sufficient appropriate audit evidence.

What Constitutes the Evidence

Accounting records Corroborating Information Entitys accounting records alone cannot be considered sufficient evidence to support an opinion on the financial statements. When auditing financial statements, the auditor should go beyond the accounting records. Auditor should obtain other corroborative information to support his opinion.

Attributes of Audit Evidence

Reasonable assurance is attained when the auditor has obtained sufficient appropriate evidence to reduce audit risk to an acceptable level. Audit evidence is typically obtained by performing risk assessment procedures, tests of control and substantive test.

Audit Risk Model

Set Desired Level of Audit Risk
Assess the Level of Inherent Risk Assess the Level of Control Risk Determine the Acceptable Level of Detection Risk Design the Substantive Test

3rd Standard of Fieldwork

Sufficient competent evidential

matter Competence stems from nature of evidence Sufficiency stems from extent of testing

The Third Field Work Standard

Third standard of field work:

The auditor must obtain sufficient appropriate

audit evidence by performing audit procedures to perform a reasonable basis for an opinion regarding the financial statements under audit
Sufficient audit evidence
The quantity of audit evidence that must be

obtained

Evaluation of Sufficiency
Factors to be considered: The competence of evidence The materiality of the item being examined The risk involved in a particular account Experience gained during previous audits

Appropriateness of Audit Evidence

To be appropriate audit evidence must be:

Relevant Reliable

Appropriateness of Audit Evidence

Principles: Audit evidence is ordinarily more

reliable when it is:

Obtained from knowledgeable independent

sources outside the company rather than dependent sources Generated internally through a system of effective controls rather than ineffective controls. Obtained directly by the auditor rather than indirectly or by inference Documentary in form rather than oral Provided by original documents rather than copies

Reliability of Certain Types of Audit Evidence

RELIABILITY High TYPE Physical Documentary External External/Internal Internal EXAMPLE Inventory Observation Cutoff Bank Statement Purchase Invoice Sales Invoice

Low

Client Representations Management Representation Letter

Cost Benefit Consideration

As a guiding rule, there should be a

rational relationship between the cost of obtaining evidence and the usefulness of the evidence obtained. The auditor uses his professional judgment in determining the appropriate type of evidence that should be obtained.

Cost / Benefit of Evidence

Expensive Tests Physical examination Confirmation Inexpensive tests Observation Inquiry Reperformance

Evaluation of Audit Evidence

The auditor ordinarily obtains more assurance

from consistent audit evidence obtained from different sources or of different nature than from items of audit evidence considered individually. In addition, obtaining audit evidence from different sources or of a different nature may indicate that an individual item of audit evidence is not reliable.

Overall Types of Audit Procedures

Risk assessment procedures

To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement

Further Audit Procedures

Tests of controls When appropriate, to test the operating effectiveness of controls in preventing material misstatements Substantive procedures To detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

AUDIT PROCEDURES
Analytical Procedures Enquiry/Confirmation Inquiry Observation RecalcUlation/Reperformance

Relationship Among Assertions, Objectives and Procedures

Financial Statements Assertions

-Are representations made by the management explicit or otherwise embodied in the financial statement components

Assertions used by the auditor fall into the following categories:

a. Assertions about classes of

transactions and events for the period under audit: b. Assertions about account balances at the period end: c. Assertions about presentation and disclosure:

Relationship Among Assertions, Objectives and Procedures

Objectives
Identify the standards for good evidence,

the methods for obtaining and presenting the audit evidence.

Audit Procedure
are acts or methods used to gather the

validity of the assertions.

Using Assertion to Determine the Audit Procedure to be performed

The auditor should: should use assertions for classes of transactions, account balances and presentation and disclosures in sufficient detail to form a basis for the assessment of risks of material statement identify first their audit objectives or goals for each financial statement assertions; and then identify the audit procedures to fulfill that objective

Example of assertion and audit objectives

Table 1. Audit objectives for debtors and related transaction classes Assertion category Transaction class audit objectives Existence or occurrence Account balance audit objectives

Recorded sales transactions Debtors represent amounts represent goods shipped during owed by customers at the the period. Recorded cash balance sheet date. receipts transactions represent cash received during the period.

Completeness

All sales and cash receipts Debtors include all claims transactions that occurred during on customers at the the period have been recorded. balance sheet date.

Nature, Timing and Extent of Procedures

Timing Refers to when audit procedures are performed or the period or date to which the audit evidence applies Extent Includes the quantity of a specific audit procedure to be performed Effect of E-commerce Audit evidence is increasingly in electronic form. Auditors must evaluate how electronic information affects their ability to gather evidence. Auditors use computers to read and examine evidence.

Audit Procedures for Obtaining Audit Evidence

Audit Procedure According to Purpose a. Obtain an understanding of the entity and its environment, including its internal control, to assess the risks of material misstatement at the financial statement and relevant assertion levels ( risk assessment procedures); b. When necessary, or when the auditor has determined to do so, test the operating effectiveness of controls in preventing or detecting material misstatements at the relevant assertion level (tests of controls) c. Detect material misstatements at the relevant assertion level ( substantive procedures).

Audit Procedure According to Nature

Inspection of Records or Documents
Inspection involves examining records or

documents, whether internal or external, in paper form, electronic form, or other media, or physically examining an asset.

Types of Documents
Internal Documents
Prepared and used within client company.
Does not go outside the client.

External Documents
Document has been in hands of an outside

party to the transaction. More reliable than internal documents.

Inspection of Tangible Assets

Inspection of tangible assets consists of

physical examination of the assets. Inspection of tangible assets may provide appropriate audit evidence with respect to their existence, but not necessarily about the entity's rights and obligations or the valuation of the assets. Different from examining documentation is that the asset has inherent value.

 Direction of the Test

is important in establishing the

assertion being tested by a certain procedure.

VOUCHING TRACING

-Examination of documents that support a recorded transaction or amount. -The direction of testing must be from the recorded item to the supporting document. -Tests existence or occurrence Recorded Item to Supporting Document

-The primary test for unrecorded items and therefore tests the completeness assertion. -The direction of testing must be from the supporting document to the recorded item. Supporting Document to Recorded Item

Observation
Observation consists of looking at a process or

procedure being performed by others. Auditor witnesses the physical activities of the client. Differs from physical examination because physical examination counts assets, while observation focuses on client activities. Useful in obtaining evidence that controls which leave no documentary evidence of application or existence are in operation.

Inquiry
Inquiry consists of seeking

information from knowledgeable persons in financial or nonfinancial roles within the company or outside the company. Auditor obtains information from the client in response to questions.

Recalculation
Recalculation consists of

checking the mathematical accuracy of documents or records.

Reperformance
Reperformance is the auditor's

independent execution of procedures or controls that were originally performed as part of the entity's internal control, either manually or through the use of Computer Assisted Audit Technique

Analytical Procedures
Analytical procedures consist of evaluations of

financial information made by a study of plausible relationships among both financial and nonfinancial data. Auditors study relationships among data. Unusual fluctuations occur when significant difference are not expected but do exist or when significant differences are expected but do not exist. Required during the planning stage.

Confirmation
a specific type of inquiry, is the

process of obtaining a representation of information or of an existing condition directly from a third party.

Information & its Source

Information Assets Cash in bank (example) Accounts receivable Notes receivable Owned inventory out on consignment Inventory held in public warehouses Cash surrender value of life insurance co. Source Bank Customer Maker Consignee Warehouse Insurance

Liabilities Accounts payable Notes payable Advances from customers Mortgages payable Bonds payable Owners Equity Shares outstanding
Other Information Insurance coverage Contingent liabilities

Creditor Lender Customer Mortgagor Bondholder

Registrar and transfer agent

Insurance co. Bank, lender, and clients legal counsel

External Confirmation
External Confirmation is the process of obtaining and evaluating audit evidence through a representation of information or an existing condition directly from a third party in response to a request for information about a particular item affecting assertions in the financial statements.

Two Kinds of Confirmation

Positive Negative

Positive Confirmations
- asks for response even if balance is correct. - request asks the respondent to reply to the auditor in all cases either by indicating the respondent's agreement with the given information - or by asking the respondent to fill in information - ordinarily expected to provide reliable audit evidence however there is a risk may reply to the request without verifying the information - may result to lower response rates

Negative Confirmations
asks for a response only if balance is

incorrect. uncertainty associated with no response. respondents reply only in the event of disagreement with the information provided in the request ordinarily provides less reliable audit evidence

Management Request Not to Confirm Information The auditor should consider whether there are valid grounds for such request: and obtain audit evidence to support the validity of management requests

Auditors Decision on the Managements Request not to seek External Confirmations

The auditor Accepts the Request

the auditor should - Apply alternative audit procedures to obtain sufficient appropriate audit evidence

The auditor does not accept

-There is a limitation of scope - The auditor should consider the possible effect on the auditors report.

Auditor Control
The auditor should maintain control:
on the process of selecting people to

whom request will be sent preparation and sending information requests responses to those requests

SUBSTANTIVE TESTING
Analytical Procedures, Test of Details

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Performing Substantive Tests

Set desired level of Audit Risk Assess Inherent Risk Assess Control Risk Determine Acceptable Level of Detection Risk

Audit Planning

Internal Control Consideration

Performing Substantive Test

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Audit Risk Model

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Audit Risk = Inherent Risk x Control Risk x Detection Risk AR DR = IR x CR

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Audit Risk Model

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Audit Risk = Inherent Risk x Control Risk x Detection Risk

Audit Risk - risk that auditor expresses an inappropriate audit opinion when the financial statements are materially misstated

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Audit Risk Model

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Audit Risk = Inherent Risk x Control Risk x Detection Risk

Risk of Material Misstatements Risk of material misstatement is a risk that financial statements might be misstated and this risk can further be divided into two components: Inherent Risk x Control Risk
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Audit Risk Model

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Audit Risk = Inherent Risk x Control Risk x Detection Risk

Inherent Risk - errors (or misstatements or deviations) will occur before internal controls CLIENT-CONTROLLED/INDEPENDENT

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Audit Risk Model

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Audit Risk = Inherent Risk x Control Risk x Detection Risk

Control Risk (CR) -risk that client's internal control system will fail to prevent/ detect/correct error CLIENT-CONTROLLED/INDEPENDENT

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Audit Risk Model

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Audit Risk = Inherent Risk x Control Risk x Detection Risk

Detection risk -auditors procedures will not be able to detect material misstatements in the financial statements AUDITOR-CONTROLLED/DEPENDENT

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Audit Risk Model

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Audit Risk = Inherent Risk x Control Risk x Detection Risk

SET
Audit Planning

Assessed Audit Planning

PreAssessment

Audit Planning
Final-Assessment
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SOLVE!
Substantive Testing

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Internal Control Tests

Chapter LOFTS URBN 10 Which Company will require more effort? Audit Risk Model Company A Company B

High IR and CR
Risk of Material Misstatements

Low IR and CR
Risk of Material Misstatements
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More Audit Effort Low Detection Risk

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Less Audit Effort High Detection Risk

Relationships
AR DR = IR x CR

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Detection Risk is INVERSELY related to:

1. Risk of Material Misstatements - Inherent Risk - Control Risk 3. Substantive Procedures

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Recap: Audit Procedures

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Mnemonic
Analytical Procedure Enquiry/Confirmation Inspection Observation RecalcUlation/Reperformance
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Procedures as to Type and Nature

Procedure Analytical Procedure
Enquiry

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TOC ST

RAP

Confirmation
Inspection Observation RecalcUlation Reperformance
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Types of Test According to Cost

Cheapest to Most Expensive
Analytical Procedures Risk Assessment Procedures Test of Controls Test of Details of Transactions Test of Details of Balances
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Types of Test
Test TOC TODT AP TODB Name

(Further Audit Procedures)

Relation to Risk Model Control Risk X X X X Detection Risk

Tests of Controls Test of Details of Transactions Analytical Procedures Tests of Details of Balances
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Substantive Tests VS Test of Controls

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Tests of Controls
Reliance of Clients Internal Control Purpose: Reduce Substantiate Work Low Control Risk Test of Control are audit procedures used to test the operating effectiveness of control policies and procedures in support of a reduced assessed control risk.
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Substantive Test
Purpose To substantiate account balances To detect material misstatements that have passed through the accounting/internal control system filter.
Substantive tests are audit procedures designed to test for errors or irregularities directly affecting the Monetary correctness of financial statement assertions.
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TOC vs ST
Test of Controls

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Completeness of Payables

Substantive Tests

Inspect a sample of supplier statement reconciliations for evidence that they have been reviewed by an appropriate level of management.

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Inspect the cash book payments in the past year for any significant payments to suppliers to ensure the year end liability is accurately recorded.

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Procedures to Reduce Risk

Control Risk Procedures to gain an understanding of internal control Tests of controls

URBN Detection RiskLOFTS Substantive tests of transactions Analytical procedures Tests of details of balances

TAKE NOTE:
Stronger controls will allow the auditor to assess control risk below the maximum. The more evidence an auditor collects from the Substantive Tests, the lower the detection risk. Detection risk must be lower when control risk is higher. (Inverse Relationship)
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URBN LOFTS Audit Assurance at Different Levels of Internal Control Effectiveness

AUDIT ASSURANCE

Acceptable assurance

C3 C2 C1 Audit assurance from substantive tests

Audit assurance from control risk assessment and tests of control

No assurance

A C B INTERNAL CONTROL EFFECTIVENESS Weak control Strong control

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Test of Controls vs. Substantive Tests URBN LOFTS

HIGH
LOW

DETECTION RISK

LOW

CONTROL RISK HIGH Basic Understanding of Internal Control

Why is there a GAP here?

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TAKE NOTE!

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The Auditor will Always DO SUBSTANTIVE TESTING regardless of the assessed level of Control Risk. THERE IS NO PURE CONTROL BASED APPROACH.
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Audit Approach

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Two kinds of Approach 1. Combined Approach 2. Substantive Approach

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Audit Approach
Source of Audit Assurance Combined Internal Approach/Re Controls and liance Substantive Test Substantive Substantive Approach/No Test only Reliance Approach Control Risk
Less than Maximum

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Detection Risk
Increase

At Maximum

Decrease

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Chapter LOFTS URBN 10 Relationship between Test of Controls, Detection Risk and Substantive Procedures
Approach Result of Test of Controls Internal Control is Reliable Final Assessment of Control Risk Decrease Assessed Level of Detection Risk Increase Substantiv e Test Less Extensive More Extensive

Combined Approach

Substantive Internal Approach Control is Not Reliable

Increase

Decrease

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Types of Substantive Tests

1. Substantive Analytical Procedures 2. Test of Details of Classes of: Transactions Account Balances Disclosures

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Substantive Analytical Procedures

TAKE NOTE
Required for Planning and Overall review Not Required for Substantive Testing
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Substantive Analytical Procedures

Evaluation of Financial Information Identify/Study Plausible Relationships Uses Financial & Non-Financial Data

Expect

How much to accept?

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Compare Expectation to Reality

Investigate

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Chapter LOFTS URBN 10 Generalizations On Plausible Relationships

Plausible appearance of truth/persuasive

Relationships DIFFER in their Predictability.
Therefore, with regards to Predictability

Dynamic/Unstable < Stable Environment Balance Sheet < Income Statement Management Discretion < Other actions in entity
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Chapter LOFTS URBN 10 Types of Analytical Procedures

Direct Test - Test reasonableness of accrued commissions/expense by multiplying sales x rate Indirect test - Compute gross margin(provides evidence as to likelihood of errors in inventory and accounts receivable).
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Chapter LOFTS URBN 10 Types of Expectations

Trend analysis - analyze changes in accounts of a company over time Ratio analysis compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial data Liquidity (e.g., current ratio) Leverage (e.g., debt to equity) Profitability (e.g., gross profit percentage) Activity (e.g., inventory turnover)
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Chapter LOFTS URBN 10 Approaches to ratio analysis

Horizontal analysis Review ratios over time Cross sectional analysis Analyze ratios of similar firms at a point in time Vertical analysis Analyze relationships within a period Common size statements prepared Other methods Regression analysis, reasonableness test
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Test of Details
Two General Types of Test of Details 1. Substantive Tests of Transactions or Test of Details of Transactions 2. Tests of details of account balances and disclosures
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Test of Details
Test of Details of Transactions/ Substantive Tests of Transactions

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Tests of Details of Balances

Testing for monetary Testing for monetary misstatements to determine if misstatements to determine the following 9 balance-related if the following 6 transaction- Audit objectives have been met: related audit objectives Existence have been met: Completeness Existence Accuracy Completeness Classification Accuracy Cutoff Classification Detail tie-in Timing Realizable value Posting and Summarization Rights and obligations Presentation and disclosure
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Test of Details of Transactions

Substantive Test of Transactions test for errors or fraud in individual transactions. EX: An auditor may examine a large purchase of inventory by testing that the cost of the goods included on the invoice is properly recorded in the inventory and accounts payable accounts.
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Test of Details of Balances & Disclosures

focus on the items that are contained in the financial statement account balances and disclosures. Example: Balances The auditor may want to test accounts payable by examining a sample of individual invoices that make up the ending balance of accounts payable.
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Example: Disclosures
For example, the auditor might read a loan contract to ascertain the maturity schedule and debt covenants for the loan

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Test of Details of Balances

If the results of tests of controls, substantive tests of transactions, and analytical procedures are inconsistent with the predictions, tests of details of balances will need to be changed as the audit progresses.
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Take Note: Other Types Chapter LOFTS URBN 10 Test of Details of Accounting Estimates
involve obtaining evidence in support of the client's estimations process ensures that the estimation process is applied consistently from period to period.
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Dual Purpose Tests

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Audit procedures are classified as substantive tests or tests of controls. Reperformance of client procedures
Example: re-add client invoice TOC - was client verification procedure effective? STOT - was transaction accurate?
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Scope of Audit Procedures

One may change the scope of audit procedures by changing the (NTE, or re-ordered as NET): Nature (type and form) Timing (when performed) Extent (quantity of evidence obtained)
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Timing of Substantive Test

YEAR END SUBSTANTIVE PROCEDURES ARE ALWAYS MORE RELIABLE.

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Timing of Tests

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1. Test of Controls (TOC) and Test of Details of Transactions (TODT) performed simultaneously 2. When used as direct evidence, Analytical Procedures (AP) follows TODT and TOC. 3. Most TODB are performed last, and are performed after year-end. 4. Where controls are good, it is also possible to perform some TODB at an interim date.
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Consideration:
Early Substantive Tests

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Early Substantive Testing is applicable when the auditor has assessed low control risk for that period. The auditor may sometimes consider applying tests of controls while extending his substantive procedures. In situations of actual or expected fraud, auditor may prefer applying substantive procedures at period end. There should be an ALLOWANCE for SIGNIFICANT CHANGES.
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Consideration:
Early Substantive Tests

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Perform substantive procedures or combined approach to cover the remaining period FACTORS to consider The control environment and other relevant controls The availability of information Objective of the substantive procedure. The assessed risk of material misstatement The nature of the class of transactions The ability of the auditor
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Interim Testing: Roll Forward Procedures

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Auditor should determine what additional evidence concerning the operation of the controls for the remaining period is necessary
Accounts Receivable, Nov. 30 Add: December Sales Less: December Collections Accounts Receivables, Dec 31 xx xx (xx) xx

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Factors to Consider in Updating Interim Tests Evidences to Year End

Specific control tested prior to the as-of date Sufficiency of the evidence of effectiveness The length of the remaining period Significant Changes in Internal Control

Low Control Risk during Roll Forward Period Inquiry as a Roll Forward Procedure will SUFFICE.
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Excerpt: Audit program Test of Balances Inventory & Warehousing Cycle Scenario and Amounts are assumed.
Audit objective Inventory as recorded on tags exists Validity. [Purpose: to uncover the inclusion of nonexistent items in inventory.] Audit procedure (a) Select a random sample of tag numbers & identify the tag with that number attached to the actual inventory. (b) Observe whether movement of inventory takes place during the count. Inventory is valued (a) Trace unit costs in the correctly Valuation. inventory listing as at 31 Dec 2006 to standard costs or supplier invoices. (b) Perform a lower of cost & net realisable value test on inventory items.
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Comments (a) All inventory tag numbers should tally with the number written on the inventory. (b) No movement of inventory during the count. (a) No exceptions noted.

(b) Lower of cost & NRV test valuation of finished goods is correct.

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Excerpt: Audit program Analytical Procedures Chapter LOFTS URBN 10 Inventory & Warehousing Cycle Scenario and Amounts are assumed.
Audit procedure Compare unit costs of inventory with those of previous years. Compare total inventory value with that of previous years. Audit objectives Over/understatement of unit costs, which affect inventory & cost of goods sold. Misstatements in compilation, unit costs or extensions, which affect inventory & cost of goods sold. Comments Appendix A. Unit costs have remained reasonably consistent. Appendix B. Noted an increase in pencil inventories awaiting shipment which subsequently took place on 3.1.2007.

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Appendix A
Pens Unit cost 2006 2.50 2005 2.48 Variance 0.81%

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Pencils 2006 2005 2.45 2.43 Variance 0.82%

Appendix B
Pens Unit cost No. of units Inventory value Total inventory Pencils Pens Pencils Variance 2006 2.50 2.45 37,283.26 112,869.34 93,208.15 276,529.88 369,738.03 2005 2.48 2.43 35,704.73 95,590.58 88,547.74 232,285.10 320,832.84

48,905.19 15.24%

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FRAUD AND ERROR

FRAUD AND ERROR

ERROR
unintentional misstatement in financial statements, Misinterpretation of an accounting estimate Omission of amount

FRAUD
intentional misstatements resulting from:
1. Management Fraud 2. Employee Fraud

Two types of intentional misstatements 1. Management Fraud/Fraudulent Financial Reporting fraud involving one or more members of management or those charged with governance 2. Employee Fraud - fraud involving only employees of entity

Fraud, whether fraudulent financial reporting or misappropriation of assets, involves: Incentive or pressure to commit fraud Perceived opportunity to do so Rationalization of the act.

For example: (a) Incentive or pressure to commit fraudulent financial reporting may exist when management is under pressure, from sources outside or inside the entity, to achieve an expected earnings target or financial outcome.

(b) A perceived opportunity to commit fraud may exist when an individual believes internal control can be overridden. (c) Individuals may be able to rationalize committing a fraudulent act.

Primary RESPONSIBILITIES
Management /Governance prevention and detection of fraud Auditor
obtaining reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error.

INHERENT LIMITATIONS OF AUDIT

The risk of not detecting a material misstatement resulting from fraud is higher than the risk of not detecting one resulting from error.

The auditors ability to detect a fraud depends on factors such as:

1.skillfulness of the perpetrator 2.the frequency and extent of manipulation 3.the degree of collusion involved 4.the relative size of individual amounts manipulated, 5.the seniority of those individuals involved.

TAKE NOTE: The risk of the auditor not detecting a material misstatement resulting from management fraud is greater than for employee fraud.

PROFESSIONAL SKEPTICISM Attitude of questioning mind

This enables the auditor to identify/evaluate: (1) matters that increase the risk of material misstatement (2) circumstances that make the auditor suspect that financial statements are materially misstated (3) evidence obtained that brings into question the reliability of management representations.

Fraud risk factors

EFFECT

FRAUD RISK FACTORS events or conditions that indicate an: Incentive or pressure commit fraud Opportunity to commit fraud Attitudes/Rationalizations Uses professional judgment.

Inherent and Control Risk

TAKE NOTE: The size, complexity, and ownership characteristics of the entity have a significant influence on the consideration of relevant fraud risk factors.

EX: Circumstances indicative of fraud

1. Discrepancies in the accounting records Unauthorized balances/transactions Last-minute significant adjustments 2. Conflicting or missing evidence, Missing documents. Likely altered documents 3. Unusual relationships between the auditor and management Denial of access to records Undue time pressures

Actions to be taken related to Fraud and Error: 1. Identify if there are circumstances that indicate a possible misstatement in the financial statements. 2. Determine whether statements are materially misstated.

3. If misstatements are identified, the auditor should consider whether such misstatement may be indicative of fraud. 4. In evaluating and disposing of misstatements, consider materiality.

5. The auditor should document: (1) Fraud risk factors identified as being present during the risk assessment process and during the performance of audit; (2) the auditors responses to the fraud risk factors.

COMMUNICATION
Matters to communicate: 1. Management competence and integrity. 2. Management Fraud 3. Material Misstatements from: Error Material weakness in internal control Future effect on Financial Statements

To WHOM to REPORT: To Management To Those Charged With Governance To Regulatory and Enforcement Authorities

Auditor Unable to Continue the Engagement (a)Determine the professional and legal responsibilities (b)Consider whether it is appropriate to withdraw from the engagement (c) If the auditor withdraws: Discuss with the appropriate level of management/governance the auditors withdrawal Determine whether there is a professional or legal requirement to report

AUDITING ACCOUNTING ESTIMATES

Accounting Estimates an approximation of the monetary amount in the absence of a precise means of measurement.

Example: Allowance for doubtful accounts Inventory obsolescence Warranty obligations Depreciation Impairment loss Fair value determination

Responsibility
Management making accounting estimates Auditor obtain sufficient appropriate evidence as to whether accounting estimate is properly accounted for and disclosed and accounting estimate is reasonable in the circumstances

Risk or material misstatement is greater when estimation of uncertainty is based on assumptions 1. accounting estimates relating to the outcome of litigation 2. fair value estimates of financial instruments that are not publicly traded

When assessing the risk of material misstatement relating to accounting estimates, the auditor should: 1. understand the degree of uncertainty involved the requirement of the standards 2. the procedures used by the client in making these estimates

When evaluating the reasonableness of accounting estimates, the auditor should : 1.obtain an understanding of the procedures and methods including the accounting 2.internal control system used by management in making accounting estimates

In evaluating estimates, the auditor may use these approaches: 1. Review and test the process used by management to develop the estimate 2. Making independent estimate 3. Reviewing subsequent events which confirm estimate made.

Case where only disclosure required by generally accepted accounting principle is necessary:
Some estimates, such as a potential loss from litigation, (because there are no relevant historical data or transaction in subsequent period).

AUDIT DOCUMENTATION
Audit Working Papers

Audit Documentation &Working Audit documentation Papers

the principal record of the basis for the auditors

conclusions principal support for the representations in the auditors report. includes records on the planning and performance of the work, the procedures performed, evidence obtained, and conclusions reached by the auditor. Documentation means the material (working papers) prepared by and for, or obtained and retained by the auditor in connection with the performance of the audit. Working papers may be in the form of data stored on paper, film, electronic media or other media. PSA 230

Working Papers
A direct aid in the planning, performance, and supervision of the audit; Record the audit evidence Assist in review of the audit work. Provide proof of the adequacy of the audit

Significant Matters
PSA 230 states: The auditor should record

in the working papers information on planning the audit, the nature, timing and extent of the audit procedures performed and the results thereof, and the conclusions drawn from the audit evidence obtained. The auditor must document significant findings or issues, actions taken to address them (including additional evidence obtained), and the basis for the conclusions reached.

Form and Content of the Working Papers

Audit documentation must contain sufficient

information to enable an experienced auditor, having no previous connection with the engagement Convey the auditors reasoning on all matters which require the exercise of judgment and the auditors conclusions. (Professional Judgment) Designed and organized to meet the circumstances and the auditors needs

The working papers should contain at a minimum:

information on planning the audit work;
the nature, timing, and content of the

audit procedures performed; the results of the audit procedures; and the conclusions drawn leading to an opinion.

Document Retention (PSA 230)

The auditor should adopt appropriate procedures for maintaining the confidentiality and safe custody of the working papers and for retaining them for a period sufficient to meet the needs of the practice and in accordance with legal and professional requirements of record retention. When additions are made, the documentation added must indicate the date the information was added, by whom it was added, and the reason for adding it. Working papers are the property of the auditor.

Types of Working Files

Current

files

Current year working papers Index and cross-referencing

Permanent

files

Items of continuing audit interest

Examples
Permanent File Copies or excerpts of company documents Prior year analysis Internal control information Current File accounting-related information such as trial balances lead schedules analyses of transactions and balances recommended journal entries

The permanent file usually includes the following:

The current file work papers will usually contain

accounting-related information such as trial balances, lead schedules, analyses of transactions and balances and, if necessary, recommended journal entries to correct the accounts records. The largest portion of working papers includes the detailed schedules prepared by the client or the auditors in support of specific amounts on the financial statements.

Lead Schedules

Supports Trial Balance Each detailed account on the lead schedule is supported by audit work performed and the conclusions drawn.

The major types of supporting schedules

Account analysis List schedules Reconciliation of amounts Tests of reasonableness

Preparation of working papers

Requires structuring the information Working Paper Elements

1. Heading (clients name, period covered, a

description of contents of the work paper, the date of preparation, 2. Index code 3. Initials/Dates of the staff/reviewer 4. Tick Marks

Tick Marks and Indexing

Tick marks - the nature and extent of

procedures Indexing - cross referenced to aid in the organizing and filing.

APPLICATION
Knowledge becomes Wisdom when shared.

Tinkerbell Toys Co.

Tinkerbell Toys Co (Tinkerbell) is a manufacturer of childrens building block toys; they have been trading for over 35 years and they sell to a wide variety of customers including large and small toy retailers across the country. The companys year end is 31 May 2011.

Sales ordering and Invoicing

Each customer has a unique customer account number and this is used to enter sales orders when they are received in writing from customers. The orders are entered by an order clerk and the system automatically checks that the goods are available and that the order will not take the customer over their credit limit. For new customers, a sales manager completes a credit application; this is checked through a credit agency and a credit limit entered into the system by the credit controller. The company has a price list, which is updated twice a year. Larger customers are entitled to a discount; this is agreed by the sales director and set up within the customer master file.

Test of Control
Test of control The auditor should attempt to enter an order for a fictitious customer account number. The system should not accept this order Confirm discounts applied to invoices agree to the customer master file. Objective of test To ensure that orders are only accepted and processed for valid customers. To ensure that sales discounts are only provided to valid customers.

Substantive Procedure
Select a sample of sales invoices for larger customers and recalculate the discounts allowed to ensure that these are accurate. (Vouching - Existence) Select a sample of credit notes issued after the year end and follow through to sales invoice to ensure the returns were recorded in the proper period. (Tracing Completeness)

Tinkerbell Toys Co.

FRAUD
During the year a material fraud was uncovered. It involved cash/cheque receipts from customers being diverted into employees personal accounts. In order to cover up the fraud, receipts from subsequent unrelated customers would then be recorded against the earlier outstanding receivable balances and this cycle of fraud would continue.

The fraud occurred because two members of staff who were related colluded. One processed cash receipts and prepared the weekly bank reconciliation; the other employee recorded customer receipts in the sales ledger. An unrelated sales ledger clerk was supposed to send out monthly customer statements but this was not performed. The bank reconciliations each had a small unreconciled amount but no-one reviewed the reconciliations after they were prepared. The fraud was only uncovered when the two employees went on holiday.

Test of Control
Control Members of staff who are related should not be permitted to work in the same department whereby they can breach Segregation of duty controls. Bank reconciliations should be reviewed by a responsible official (different to the preparer of the reconciliation) on a regular basis. Any unreconciled amounts should be promptly investigated and resolved. Mitigate Risk This should reduce the risk of staff collusion and being able to commit a fraud without easily being discovered. A small unreconciled amount can actually represent two large balances which almost cancel each other out and hence could indicate significant problems with cash and bank. Where fraud arises it can often be quickly spotted by performing and reviewing a bank reconciliation.

Keep your eyes on the stars, and your feet on the ground. Thank You! God Bless us.
Falculan, Plata, Pumida, Mendoza