Much of what most people think of as auditing, the testing of account bal- ances, occurs in Phase IV. As illustrated in Exhibit 5.11, the information gath- ered in Phases II and III influences the nature, extent, and timing of substantive procedures to be performed. The auditor plans substantive proce- dures of account balances (substantive analytical procedures and tests of details) based on the potential for material misstatement, including the effec- tiveness of internal controls. As described in theAuditing in Practicefeature,
“Dual-Purpose Tests,” some audit efficiencies can result if the auditor per- forms substantive procedures at the same time as performing tests of controls.
Performing Substantive Procedures
The auditor performs substantive procedures for the relevant assertions of each significant account and disclosure, regardless of the assessed level of con- trol risk. These procedures can include both substantive analytical procedures and tests of details of account balances. Substantive analytical procedures are optional, whereas tests of details would be necessary for significant accounts and disclosures. As indicated in the Auditing in Practice feature, “Not Per- forming Sufficient Appropriate Substantive Audit Procedures Leads To Low Audit Quality,”a failure to perform sufficient substantive procedures is con- sidered an audit deficiency, indicative of a low quality audit.
In determining appropriate substantive procedures, the auditor considers (a) the source of potential misstatement and (b) the extent and type of potential
A U D I T I N G I N P R A C T I C E
Dual-Purpose Tests
In some situations, the auditor might perform a substantive procedure concurrently with a test of a control, if both are relevant to that assertion; this is called adual-purpose test. In those situations, the auditor should design the dual-purpose test to achieve the objectives of both the test of the control
and the substantive procedure. Also, when perform- ing a dual-purpose test, the auditor should evaluate the results of the test in forming conclusions about both the assertion and the effectiveness of the control being tested. Dual purpose testing is an efficient way to perform an audit.
LO11 Identify audit activities in Phase IV of the audit opinion formulation process.
misstatement. This process can be illustrated by looking at the typical entries into accounts receivable, including the related allowance account, as follows:
Accounts Receivable
Previous Balance Cash Receipts Revenue (sales) Write-Offs
Adjustments Adjustments
Allowance for Uncollectible Accounts
Write-Offs Previous Balance
Current Provision
Note that multiple processes affect the account balances. Some of the pro- cesses contain subjectivity and are considered high risk—for example, deter- mining how much of a receivable balance will ultimately be uncollectible.
The following processes affect the accounts receivable balance:
● Revenue—The processing of normal transactions is usually computerized with consistent controls built into the process. However, because of recur- ring evidence that companies who want to boost reported sales and/or earnings often do so by overriding controls related to the recording of revenue, the SEC has designated revenue recognition as high risk, requir- ing the auditor to do some direct tests of account balances, including receivables. These problematic overrides often occur in the nature of special contracts or unusual shipments near the end of the year.
● Cash Receipts—The processing of cash receipts is usually automated with implementation of consistent controls. If an organization has good segregation of duties, the likelihood of misstatement is relatively small.
A U D I T I N G I N P R A C T I C E
Not Performing Sufficient Appropriate Substantive Audit Procedures Leads To Low Audit Quality
The PCAOB performs periodic inspections of audit firms that conduct audits of public companies. Follow- ing are excerpts from various firms’inspection reports indicating that sufficient appropriate substantive audit procedures had not been performed. A quality audit requires that such procedures be performed.
“The Firm failed to perform sufficient substan- tive procedures to test a number of significant accounts, including revenue, accounts receiv- able, inventory, and certain accruals…”
“The Firm failed to review contracts or perform other substantive procedures, beyond inquiry of management, to test the completeness of deferred sales and the completeness and accuracy of adjustments to revenue for promo- tional and rebate allowances.”
“The Firm failed to sufficiently test the val- uation of accounts receivable and net revenue.”
“The Firm failed to perform sufficient pro- cedures to test the issuer’s evaluation of possible other-than-temporary impairment (‘OTTI’) of its securities. Specifically, the Firm failed to test whether the issuer had subjected to an evalua- tion of OTTI all securities that should have been subjected to such an evaluation and failed to test the assumptions and calculations used in this evaluation.”
“In this audit, the Firm failed to perform sufficient procedures to evaluate the reason- ableness of a significant assumption manage- ment used to calculate the gain on the sale of a business.”
The Audit Opinion Formulation Process 183
● Current Provision for Uncollectible Accounts—Most companies rely heavily on previous experience in making these estimates. Recent SEC cases indicate that the allowance is often subject to misstatements based on (a) inaccurate or nonrelevant data fed into the model and (b) motiva- tion of management to meet earnings goals and therefore allowing sub- jectivity and bias to enter into the estimate.
● Write-Offs—The determination of when to write off account balances is subjective.
● Adjustments—Adjustments, other than those noted above, should be rare. If there are significant adjustments, the auditor should test the pro- cess or the adjustments to determine the correct balance.
Similar analyses will be made for other related accounts and will incor- porate the following concepts:
● Assertions affected by highly subjective estimates usually require direct tests of the account balances.
● Nonstandard and large adjusting entries should be reviewed and tested using appropriate substantive procedures.
● The size of the account (materiality) influences, but does not totally dic- tate, the substantive procedures that should be performed.
● The extent and results of control testing performed by management, as well as the control testing performed by the auditor, will influence the substantive procedures of the account balance to be performed.
● The evidence the auditor has from risk assessment procedures and tests of controls influences the substantive procedures to be performed.
● The existence of other corroborating tests of the account balance, such as the knowledge gained from testing related accounts, affects substan- tive procedures to be performed.
The effects of some of these evidence factors on substantive procedures are summarized in Exhibit 5.12.
While performing substantive procedures, the auditor may identify mis- statements—both material and immaterial—in the financial statements. The auditor accumulates a list of any identified misstatements for consideration prior to determining the appropriate audit opinion to issue.
Example: Effect of Nature of Misstatements on Audit Procedures Ultimately, the auditor considers which account balances might be misstated and how they might be misstated. We demonstrate the audit process using the accounts receivable example. Assume the following scenario. Consistent with the relevant professional guidance, the auditor has assessed revenue to be high risk, even though management has concluded that internal controls over trans- actions processing are effective. A preliminary analytical review of the last quar- ter (conducted as part of the risk assessment procedures) led to the identification
E X H I B I T 5.12 Factors Affecting Substantive Procedures to be Performed
Factor If Auditor Assessment is:
Effect on Extent/Nature of Substantive Procedures
Subjectivity of accounting process High More / more rigorous
Materiality of account balance High More / more rigorous
Effectiveness of internal control as assessed by management and the auditor
Internal controls are effective Less / less rigorous
of a large number of sales with nonstandard contractual terms. After reading a sample of the sales contracts and testing controls, the auditor concludes that there is an unacceptable level of residual risk in the revenue account. The audi- tor identified a number of ways in which the account could be misstated. For example, sales might:
● Be recorded in the wrong period
● Contain unusual rights-of-return provisions that have not been accounted for correctly
● Contain terms that are more consistent with a consignment rather than a sale
● Be concentrated in a very few customers, many of whom are international customers and may have different credit risks than most other customers Given the identified risks, the auditor decides to expand substantive audit procedures of the recorded transactions that have unusual sales terms and focus on the existence and valuation assertions. The auditor has decided not to perform any substantive analytical procedures; the auditor will only perform substantive tests of details. In order to bring the residual risk to an acceptable level, the audi- tor gathers substantive evidence on the revenue (and receivables) associated with the unusual contracts and identifies sales that have these special terms. In testing receivables, the auditor decides to concentrate accounts receivable tests on a com- bination of large accounts, plus all of those that have unusual sales terms. Confir- mations will be sent to both of those groups, with follow-up where confirmations are not returned, or where the auditor might suspect the validity of the contract, the customer, or the possibility of“side agreements”affecting the contracts.