The form of testing the auditors carry out is
divided into compliance tests of the system of controls and substantive testing
of transactions and balances.
divided into compliance tests of the system of controls and substantive testing
of transactions and balances.
Compliance tests
Compliance tests are tests to obtain audit evidence
about the effective operation
about the effective operation
of the control environment, in particular the
operation of control procedures.
The auditor will review the answers from:
·
The
internal control evaluation questionnaires which will highlight any particular
areas of weakness;
The
internal control evaluation questionnaires which will highlight any particular
areas of weakness;
·
Previous
period’s audit files to identify any problem areas encountered in previous
years;
Previous
period’s audit files to identify any problem areas encountered in previous
years;
·
The
letter of weakness (see chapter 28) sent to management at the conclusion of the
previous period’s audit identifying any areas of weakness in the control
environment which management was being asked to address.
The
letter of weakness (see chapter 28) sent to management at the conclusion of the
previous period’s audit identifying any areas of weakness in the control
environment which management was being asked to address.
In areas where the system appears to be
particularly defective or weak then the auditor may need to abandon a
systems-based approach and apply more detailed substantive tests, these would
normally be applied more at the period end than at the interim audit.
particularly defective or weak then the auditor may need to abandon a
systems-based approach and apply more detailed substantive tests, these would
normally be applied more at the period end than at the interim audit.
Two points must be made about compliance testing:
·
It is
very important for the student to understand that it is the application of the
control procedure that is being tested, not the transactions. When designing
audit tests emphasis must be placed on designing tests which check the
operation of the control. The actual transaction is, to this extent, not
relevant as long as it is representative of the entire population being tested.
It is
very important for the student to understand that it is the application of the
control procedure that is being tested, not the transactions. When designing
audit tests emphasis must be placed on designing tests which check the
operation of the control. The actual transaction is, to this extent, not
relevant as long as it is representative of the entire population being tested.
·
If the
auditors discover that the control procedures were not functioning correctly in
a particular way then:
If the
auditors discover that the control procedures were not functioning correctly in
a particular way then:
·
They may
need to revise the system description and re-appraise its effectiveness;
They may
need to revise the system description and re-appraise its effectiveness;
·
They will
need to determine if the failure of compliance was an isolated or was
symptomatic of a larger failure;
They will
need to determine if the failure of compliance was an isolated or was
symptomatic of a larger failure;
·
It may be
that a larger sample needs to be taken.
It may be
that a larger sample needs to be taken.
As an example of a test of control procedures,
suppose that a system provided that all credit notes issued by the client had
to be approved by the sales manager and that a space was provided on each
credit note for his initials, the auditor would inspect a sample of the credit
notes to determine if all of them had been initialed. This is testing that the
control is operating – and the details of the credit note aren’t relevant to
the test being performed.
suppose that a system provided that all credit notes issued by the client had
to be approved by the sales manager and that a space was provided on each
credit note for his initials, the auditor would inspect a sample of the credit
notes to determine if all of them had been initialed. This is testing that the
control is operating – and the details of the credit note aren’t relevant to
the test being performed.
Substantive testing
Substantive procedures are detailed tests of
transactions and balances. They are designed to obtain audit evidence to detect
material misstatements in the financial statements and are required to be used
in balance sheet testing in particular.
transactions and balances. They are designed to obtain audit evidence to detect
material misstatements in the financial statements and are required to be used
in balance sheet testing in particular.
They are general of two types:
·
Analytical
procedures – see later in this chapter.
Analytical
procedures – see later in this chapter.
·
Other
substantive procedures, such as tests of details of transactions and balances,
reviews of minutes of directors’ meeting and enquiries.
Other
substantive procedures, such as tests of details of transactions and balances,
reviews of minutes of directors’ meeting and enquiries.
From this definition, you may deduce that all audit
work comes within the definition of substantive testing. However, the term
‘substantive testing’ is usually used to mean all tests other than tests of
controls. A substantive test is any test which seeks direct evidence of the
correct treatment of a transaction, a balance, an asset, a liability, or any
item in the books or the accounts.
work comes within the definition of substantive testing. However, the term
‘substantive testing’ is usually used to mean all tests other than tests of
controls. A substantive test is any test which seeks direct evidence of the
correct treatment of a transaction, a balance, an asset, a liability, or any
item in the books or the accounts.
Analytical review is also seen as a separate type
of test.
of test.
Some examples:
·
Of a
transaction – the sale of a piece of plant will require the auditor to examine
the copy invoice, the authorization, the entry in the plant register and other
books, the accounting treatment and some evidence that the price obtained was
reasonable.
Of a
transaction – the sale of a piece of plant will require the auditor to examine
the copy invoice, the authorization, the entry in the plant register and other
books, the accounting treatment and some evidence that the price obtained was
reasonable.
·
Of a balance
– direct confirmation of the balance in a deposit account obtained from the
bank.
Of a balance
– direct confirmation of the balance in a deposit account obtained from the
bank.
·
Analytical
review – evidence of the correctness of cut-off by examining the gross profit
ratio.
Analytical
review – evidence of the correctness of cut-off by examining the gross profit
ratio.
·
Completeness
of information – obtaining confirmation from a client legal adviser that all
potential payments from current litigation had been considered.
Completeness
of information – obtaining confirmation from a client legal adviser that all
potential payments from current litigation had been considered.
·
Accuracy
of information – obtaining from each director a confirmation that an accurate
statement of remuneration and expenses had been obtained.
Accuracy
of information – obtaining from each director a confirmation that an accurate
statement of remuneration and expenses had been obtained.
·
Validity
of information – validity means based on evidence that can be supported. For
example, a provision for future warranty claims may be extremely difficult to
estimate in precise monetary terms. If such a provision is made in the
financial statements, the auditor would need to apply substantive tests to
determine its validity, i.e. that it was supported by adequate evidence.
Validity
of information – validity means based on evidence that can be supported. For
example, a provision for future warranty claims may be extremely difficult to
estimate in precise monetary terms. If such a provision is made in the
financial statements, the auditor would need to apply substantive tests to
determine its validity, i.e. that it was supported by adequate evidence.
IAS 500 ‘audit evidence’ states:
When
substantive procedures alone do not provide sufficient appropriate audit
evidence the auditor is required to perform tests of controls to obtain audit
evidence about their operating effectiveness….
substantive procedures alone do not provide sufficient appropriate audit
evidence the auditor is required to perform tests of controls to obtain audit
evidence about their operating effectiveness….
…..substantive
procedures for material classes of transactions, account balances and
disclosures are always required to obtain sufficient appropriate audit
evidence.
procedures for material classes of transactions, account balances and
disclosures are always required to obtain sufficient appropriate audit
evidence.
Auditors must therefore use both these types of
tests in order to provide the evidence they need.
tests in order to provide the evidence they need.
The tests set out below comprise a mixture of
compliance and substantive approaches as it is really not necessary when
designing audit tests to decide which tests falls into which category.
compliance and substantive approaches as it is really not necessary when
designing audit tests to decide which tests falls into which category.
Remember though that the amount of testing carried
out and the emphasis of the tests is very much geared to the assessment of
audit risk (see chapter 10). If audit risk is considered to be high sample will
be larger and the audit will focus on testing a larger number of transactions
and balances than if the risk assessment is low and the audit approach can be
one based on the successful operation of the company’s internal control
procedures.
out and the emphasis of the tests is very much geared to the assessment of
audit risk (see chapter 10). If audit risk is considered to be high sample will
be larger and the audit will focus on testing a larger number of transactions
and balances than if the risk assessment is low and the audit approach can be
one based on the successful operation of the company’s internal control
procedures.
Audit tests comprise a combination of:
·
Inspecting
for evidence that a control has been operated;
Inspecting
for evidence that a control has been operated;
·
Re-performing
the accounting procedures on a sample of transactions, in either direction, to
demonstrate that they have been carried out correctly;
Re-performing
the accounting procedures on a sample of transactions, in either direction, to
demonstrate that they have been carried out correctly;
·
Carrying
out substantive tests on balances and reconciliations including obtaining
independent evidence and analytical review procedures.
Carrying
out substantive tests on balances and reconciliations including obtaining
independent evidence and analytical review procedures.
