What are substantive tests?

Session Overview Test 3 topics Tut letter 104: Substantive procedures: My approach to this session General principles, when it comes to substantive procedures Developing frameworks for answering substantive questions Look at some specifics See if we can apply the frameworks to answering questions 1 What are substantive tests? Substantive tests Performed in response to the level of Detection Risk Aimed at concluding on the Rand value of items Incorporates Substantive tests of detail Substantive analytical review procedures Tests of control Performed in response to the level of Control Risk Aimed at concluding on whether or not a control activity was operating effectively ( Yes / No answer) 2 The basic principles The financial statement assertions Overstatement vs. Understatement tests The nature of audit evidence Designing Substantive procedures 3 1

The financial statement assertions These are critical!!!! They are what can go wrong in the AFS (what can cause misstatement) We set out to prove whether they have gone wrong or not They therefore become the basis for all substantive procedures all substantive procedures set out to gather sufficient, acceptable evidence to prove that these assertions are true (have not gone wrong!) 4 The financial statement assertions We saw them in session 1 In ISA 315 para A111 (flag!) 3 categories Transactions & events Year end balances Presentation & disclosure Need to recognise that every account balance contains / records transactions and / or events 5 Transaction & event assertions Completeness Occurrence Accuracy Classification Cut-off Nothing left out everything that should have been recorded, was recorded Everything that was recorded should have been recorded (because it happened & it pertains to the business) Everything that was recorded, was recorded at the correct amount Everything that was recorded, was recorded in the right place / account balance Stuff from this year was recorded this year and stuff from next year was not recorded in this year. 6 2

Completeness Existence Valuation Rights & Obligations Year end assertions Nothing left out assets & liabilities that should have been recorded, have been recorded Assets & Liabilities that were recorded should have been recorded they are not fictitious Assets & liabilities are recorded at their correct carrying value what they are worth / their fair value Legal entitlement assets belong to the client and liabilities are going to be settled by the client 7 Occurrence Presentation & disclosure assertions Completeness Accuracy Classification There is nothing in the AFS that shouldn t be there Nothing has been left out of the AFS Everything in the AFS is in at the correct amounts Amounts in the AFS are appropriately disclosed (IFRS / GAAP / Co s Act) 8 Over vs. Understatement Existence / occurrence ensure that the client is not recording things that they should not be (if wrong, they result in overstatement) Completeness ensures that the client is not leaving anything out (if wrong, it results in under-statement) Identifying the direction of the misstatement becomes critical when designing procedures to try and pick up the misstatement Over-statement must select from what has been recorded to be able to see if it does in fact belong in the records. (Existence / occurrence tests) Under-statement must select from outside the records (initiating event / what should have been recorded) to see if it was actually recorded. (Completeness tests) 9 3

Audit evidence (ISA 500) Need sufficient, acceptable evidence Forms of evidence: General sources of evidence Internal External / Auditor obtained General types of evidence Documentary Visual Oral The strongest external and documentary The weakest internal and oral 10 Procedures to obtain evidence (para A14) Inspection Of things (documents / assets ) Observation Of procedures / activities External Confirmation Written responses from external parties Re-calculation Checking mathematical accuracy Re-performance Re-doing what the client has done to see if it was done correctly Analytical procedures Analysis of plausible relationships (refer ISA 520) Inquiry Of people Often re-directs us (need to prove what was said to us) 11 Overview of subst. audit procedures Nature of the test What procedure are we going to do? Timing of the test When are we going to do it? Extent of the test How much of it are we going to do? Influenced by degree of control reliance and degree of risk of material misstatement 12 4

Designing procedures - Nature How are we going to get the evidence? Action.. / Verb Inspect / inquire / observe /etc What are we going to do / look at? What documents are we going to inspect / who are we going to inquire of, etc Why are we going to do it? What are wanting to get / prove from the procedure? 13 The use of Substantive CAATs The assertions don t change The required conclusions don t change All we are doing is using a computer assisted technique to help us get the evidence? Precede your normal manual procedure with: using the CAAT, Common uses Casting & recalculating Selection of items to test Review of database for unusual items Analytical review procedures 14 Timing interim Usually associated with a tight deadline Transaction based (never year end procedures) Tests of control Substantive tests of transactions Tests of detail and / or Analytical review procedures Will always be a remaining portion of the transactions to be tested later (usually after year end ) 15 5

Timing early verification Always associated with a tight deadline Applies to year end balances only Always only substantive tests Will always be roll forward procedures required Conclusion at verification date Plus / minus transactions during the period between early verification date and year end date Equals conclusion at year end 16 Timing at year end Certain account balances / assertions can only be proved at year end Inventory! Existence Completeness Valuation aspects Establishing cut-off document numbers 17 Timing after year end Balance of procedures Remaining tests of control Remaining substantive tests Finalisation procedures Subsequent events Going concern Management representation Error evaluation Audit opinion 18 6

Extent of procedures Influencing factors Dependence on tests of control? If able to place reliance on controls, less substantive evidence required Risk assessment? The higher the risk, the more substantive evidence required Degree of reliance on other evidence (analytical review procedures? / reliance on other parties?) If relying on other evidence, can reduce the extent of normal substantive evidence required 19 Designing procedures to audit specific Account Balances Is it a balance sheet or income statement account? What are the key transactions being posted into that account during the year? Create the framework around the assertions 20 Specific Examples Refer mind-maps for approach to learning the framework Property, plant & Equipment Accounts Receivable Accounts Payable Inventory Goodwill 21 7

Other specific ISA s There are open book opportunities for these... Enquiry of legal advisors (ISA501) Use of external confirmations (ISA505) Audit of opening balances (ISA510) Analytical procedures (ISA520) Audit of accounting estimates (ISA540) Auditing related parties (ISA550) Management representations (ISA580) Use of other parties Component auditors groups (ISA600) Internal audit (ISA610) Auditor s experts (ISA620) 22 ISA501 litigation & claims Completeness (para 9) Inquiry of management Review minutes of meetings Examine legal expense accounts Consider all info re the business (para A18) If considered risky, need to communicate with legal council (para 10) Letter prepared by management, sent by auditors Usually a list of identified claims, with managements opinion, that we get them to confirm With a request for additional info if list is incomplete / inaccurate Often linked to the accounting considerations regarding provisions for legal claims (IAS37)? 23 ISA510 Opening balances If audited by another auditor ISA600! (A4 & A5) If not, (A6 & A7) some evidence can be obtained through current transactions (e.g. receipts from debtors prove that they existed at the beginning) Inventory? Current count and roll-back? Confirmation (loans, investments, leases, etc.) Consider appropriateness of accounting policies 24 8

ISA540 Accounting estimates (valuation) Revised statement combining the old ISA 540 and ISA 545 Detailed statement worth spending time going through Audit procedures Para 12 & 13 plus the detailed explanatory para s (A13 to A28) - good flags! Has management applied the applicable IFRS framework? Are the methods used appropriate and consistent with the PY? Review subsequent events for evidence confirming the estimate Test management process to make the estimate Method of measurement used Consider assumptions used Test operating effectiveness of any controls over the estimate Develop independent estimate / range Consider use of an auditor s expert (ISA620) 25 ISA 550 Related parties Definition para 10 Procedures to identify related parties Para s 12 to 17 Procedures to respond to identified related party transactions Para s 21 to 24 Significant detail in explanatory para s No need to summarise these flag and highlight / underline 26 Reliance on other parties ISA 600 Group audits Component auditor performing work on components to be incorporated into group statements OR Involving other auditors in the audit of AFS that are not group statements (para 2) ISA 610 Internal audit Assessing the reliability of the function and evaluating their work ISA 620 Auditor s Expert Engaged by the auditor to provide evidence Refer mind map summaries of ISA s (note the info you need is all in the ISAs flag & highlight in the ISA to make it easier to access) 27 9

Auditing derivative financial instruments Chapter 17 in Dynamic auditing Need to understand these things from an accounting point of view Definitions? Types? Accounting treatment? 28 Auditing derivative financial instruments Refer to IAPS 1012 Auditing derivative financial instruments Key financial risks para 21 Inherent risks para 27 Control activities para 39 to 48 Tests of control para 64 & 65 Substantive procedures (by assertion & detailed!) para 77 to 89 Start with this and consider the degree to which you may need to supplement this reference material with additional learning from Ch 17 of Dynamic Auditing 29 Approaching the CTA Q s Let s review the required and discuss how you should be starting the Q s contained in the tut letter Note that there are additional questions from Applied Q s on Auditing that have also been set these should ideally also be attempted (even just as HLS and as revision before Test 3 ) 30 10

Review of assignment q s Q1, Pg 33 Audit procedures on creditors recon Audit procedures on long term loan Easy question? Creditors Don t forget the general procedures on a recon Deal with each recon item separately (how do you prove it is legitimate consider the assertions?) Long term loan Consider the year end assertions Consider the transaction assertions Q2 (Pg 39) very similar 31 Review of assignment q s Q3, Pg 47 Audit procedures on capitalised development costs Development of software NB to know IAS 40 in terms of what can be capitalised or not. Take each category separately Consider the assertions (Occ, Acc, Compl, Class, C/off) as a checklist Don t forget general procedures Classification will require a consideration of whether the requirements for capitalisation have been met or not 32 Review of assignment q s Q4, Pg 49 Audit procedures re investment in preference share Quite difficult need good knowledge of accounting for investments & Co s Act But still some easy marks General procedures Structure your answer i.t.o the assertions Consider each assertion separately and get the obvious points Accuracy Occurrence (authorisation) Classification (accounting treatment appropriate) 33 11

Review of assignment q s Q5, Pg 51 a) Provision for restoration of land (15 marks) Don t forget the general procedures Structure by assertion & consider each one separately (some easy marks there) Consider the procedures to be performed on the use of the environmental consultants ( management s experts )! Consider the appropriateness of the accounting treatment and the audit evidence required to support this? b) fair value of inventories (20 marks) Fair value = cost and NRV so separate those Cost split into local AND imported components NRV split into identification of items requiring adjustments AND determining what hey are worth Refer to ISA540 (estimates) i.t.o the procedures to perform on management s estimates? Refer to the info in the Q always (determine the procedure first and then relate it to the Q info ) 34 Review of assignment q s Q6, Pg 53 Ships! additional audit work a) on costs of the 5 th ship; any financial assets or liabilities related to it s purchase (9 marks) b) carrying value of the fleet (12 marks) Refer ISA 540 c) any other work relating to the ships (5 marks) Review info in questions carefully to pick up what has not yet been done d) any provision related to the lease of the 4 th ship (4 marks) Review info in question around provision for restoration prior to returning the ship to it s owners. 35 Review of assignment q s Q7, Pg 57 2009 Test 3 question a) Audit procedures for JE s (25 marks) For each JE, consider the assertions Be sure to identify the issues Use of other auditors? Related party transactions? Relevant accounting requirements (trademarks) to be met? b) Substantive procedures for warranty provision & leave provision (20 marks) Easy question Take each one independently Don t forget the general procedures Structure around the assertions ISA540? 36 12