CANADIAN EDITION

AUDITING

A PRACTICAL APPROACH

Prepared by:
Angela Davis CA, CFE, MSc
Booth University College

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CHAPTER 11

SUBSTANTIVE TESTING AND INCOME

STATEMENT ACCOUNTS
LEARNING OBJECTIVES
1. Explain the relationship between the overall risk assessment
for a significant account and the extent and timing of
substantive procedures, and the differences between auditing
income statement and balance sheet accounts
2. Design and understand how to execute substantive
procedures to address audit risk related to revenue
3. Design and understand how to execute substantive
procedures to address audit risk related to cost of sales and
other significant expenses
4. Understand how to assess the results of the substantive
procedures to determine whether additional substantive tests
are necessary

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Risk and substantive

procedures
1. Differences between auditing income statement
and balance sheet accounts

Balance sheet accounts typically represent only

recent transactions, or one-off transactions
Income statement accounts reflect sum of entire
reporting period transactions
Difference in nature of account is reflected in
difference in testing

Typically use analytical procedures for income

statement accounts rather than confirmations etc

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Risk and substantive

procedures
2. Extent of substantive procedures

As discussed for balance sheet accounts, extent

of testing determined by risk assessment for
each significant account or disclosure

High IR, CR: do not rely on and test controls, use

significant amount of substantive testing to reduce DR
Low IR, CR: testing controls shows them to be
effective, limited substantive testing required

3. Timing of substantive procedures

Dependent on risk assessment, can perform some

types of work prior to year-end, leverage off internal
audit etc
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Substantive testing Revenue

Sales is usually very significant account

Pressure to achieve sales targets creates risk of
overstatement
High overall inherent risk, e.g. manipulation, fraud

Also significant because:

Material size
High volume of transactions

Auditors usually either use only substantive

testing techniques, or use controls testing
supplemented with high-level analytical
procedures
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Substantive testing
Revenue contd
Most important assertions: occurrence, accuracy,
cut-off
Occurrence
Test recorded sales are bona fide and have occurred

Accuracy
Sales are recorded at correct amount, not overstated

Cut-off
Risk that sales occur after year-end are recorded
early

Completeness is not usually significant, except if

pressure to increase next years sales
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Substantive testing
Revenue contd
Service revenue requires testing projects
delivered to customers, or in progress
Interest, dividend revenue recalculate, check
bank statements
Other items not usually material

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Substantive testing
Revenue contd

Table 11.2

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Substantive testing
Revenue contd
Processes impacting sales revenue
Sales and sales returns and allowances
Consider evidence from interim testing, control
testing phase
If substantive testing required, use detailed
testing such as vouching, tracing of documents,
recalculating pricing and discounts, testing
postings etc

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Substantive testing
Revenue contd
Table 11.3

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Substantive testing
Revenue contd
Table 11.3 (continued)

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Substantive testing
Revenue contd
Table 11.3
(continued)

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Substantive
testing
Revenue
contd
Table 11.4

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Substantive testing Cost

of sales and expenses
Cost of sales and expenses are significant
accounts in income statement
Major risk relates to understatement
Key assertions are accuracy, completeness and
cut-off
Accuracy
Verify by vouching recorded amounts to
documents or underlying account, e.g.
Depreciation tested as part of verifying PPE balance
Bad debts part of verifying receivables balance
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Substantive testing Cost

of sales, expenses contd
Accuracy contd
Cost of sales is verified to:
Opening inventory balance (last year closing balance)
Purchases and payables
Closing inventory balance part of inventory valuation

Purchases typically subjected to additional

testing through controls testing, and if necessary,
vouching to supplier documentation
Sophisticated analytical procedures can be used,
based on clients production processes

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Substantive testing Cost

of sales, expenses contd
Completeness and cut-off
Assertions combined auditor to verify that client
has not understated expenses and cost of sales
by deferring recording expenses to next period
Examine invoices around year-end to verify dates

Classification can be important for special

disclosure requirements
E.g. interest expense, depreciation

Occurrence not typically significant

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Substantive testing Cost

of sales, expenses contd
Table 11.5

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Substantive testing Cost

of sales, expenses contd
Processes impacting on costs and expenses
Substantive testing of purchases and payroll
usually undertaken only if controls not effective,
or if more efficient to test substantively

Testing of balances some procedures ordinarily

always performed, others if risk assessment
warrants

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Substantive testing Cost

of sales, expenses contd

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Substantive testing Cost

of sales, expenses contd
Table 11.7

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Substantive testing Cost

of sales, expenses contd
Table 11.7 (continued)

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Substantive testing Cost

of sales, expenses contd
Payroll generally one of the more significant
expenses
Auditor usually test the controls over the payroll
cycle and then performs substantive analytical
procedures
If payroll outsourced auditor still responsible for
auditing payroll related balances
Many payroll services will issue an audit report
on their operations which the clients auditors can
then rely on
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Substantive testing Cost

of sales, expenses contd
Table 11.6

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Substantive
testing
Cost of
sales,
expenses
contd
Table 11.8

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Assessing results of
substantive procedures
Other costs or expenses that could be significant
include:

Administration costs
Selling expenses
Audit fees
Advertising and marketing costs
Impairment charges

Nature of tests similar to purchases and payroll

Use risk assessment based on knowledge of
client and professional judgement to determine
timing and extent of testing
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Assessing results, contd

Auditors objective is to determine if there are
misstatements within the account balance and to
quantify the amount of any misstatement
If error identified:

Understand why it occurred

Consider increase to sample size
Consider additional testing
Continue testing until error can be accurately
quantified or balance fully tested to ensure no
error remains
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Copyright
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